THE EUROPEAN UNION EMISSIONS TRADING SCHEME (EU ETS)

By Mobolaji Obisakin

The European Union has been a major player in the climate change regime, although the region does not have the highest emitter of GHGs at this present moment, they lead in the percentage reduction commitments agreed to. The EU ETS is one of the major systems which the region is to use to meet their targets. The scheme is based on Directive 2003/87/EC which was entered into force in October, 2003, but the system did not start operation until January, 2005.[1] The EU has a commitment to reduce GHGs emissions by 8 per cent using 1990 levels by the end of the Kyoto commitment period (2008- 2012).

 Although the first phase of the trading system as been concluded and the second phase is presently in session, it can be said that the operations during the first phase and the achievements of the phase can not be the criteria to base other phases due to the allowances given in the first phase to test run. To do this, we have to understand the way the EU ETS works and the how it links to the mechanisms provided by the Kyoto Protocol.

Overview of the EU ETS.

The European Union Greenhouse Gas Emissions Trading System (EU ETS), in January 2005, commenced operation as the largest multi-sector Greenhouse Gas Emissions Trading System. The scheme is based on Directive 2003/87/EC. The aim of the EU ETS is to help EU member states achieve their targets from the KP (Kyoto Protocol). It enables cheaper compliance with existing targets. Allowing the companies that are participating in this scheme to buy and sell emissions allowances means that the targets can be achieved at the least cost.[2] The EU member states are responsible for developing a National Allocation Plan (NAP). This plan specifies how many emissions allowances (EUAs) the member states intend to use and how they intend to allocate those allowances; each NAP must adhere to agreed criteria and be formally approved by the EC.[3]

The EU ETS is a scheme established through binding legislation which was proposed and assented by the EC and the European parliament respectively. It is based on the following principles:

• It is a cap and trade system.
• Participation is mandatory for businesses in the sectors concerned.
• It contains a strong compliance framework.
• The market is linked to emissions reductions opportunities of the regions by accepting credits from the Kyoto protocol mechanisms.[4]

The EU ETS covers Co2 emissions from large industrial installations in some energy intensive sectors such as refining, coke ovens, cement, pulp, paper, glass, steel and metal, and power generation.[5] In the NAP (National Allocation Plan), the EU member states had the right to set the rules on what plan of action to take, the states each decide which sectors of the economy would be included or excluded in the emissions trading. Also in term of the specific plans, the states only need to adhere to EC criteria, the specific rules and regulations are decided on by the state. This position has been subjected to debates by experts in the field and some have called for the harmonizing of all NAPs for a more effective EU ETS.

The EU ETS Framework.

The EU ETS was established by the EU as one of the major ways to meet its targets by 2012. The first phase of the scheme which is called by many as the test run stage started in 2005 to 2007. In this phase, carbon was traded with EUAs (European Union emission Allowance), and most of the mistakes were observed in order to perfect the system for the second phase which coincided with the start of the Kyoto Protocol regime. The EU ETS was linked to the flexible mechanisms provided by the Kyoto Protocol through Directive 2004/101/EC, which is known as the linking directive. This linking directive allows the EU ETS to enjoy the flexibility mechanisms and trade with their credits and the EUAs .

The EU ETS uses a cap and trade system, this is where each EU member state allocates some EU allowances to each installation in line with their national reduction targets and once the year ends, the installations must hold sufficient allowances to cover their actual emissions. These allowances can be traded by each member state through their registries[6]. This system is beneficial to installations that would find it hard to reduce their emissions and stay within their allotted allowances. One provision that was negotiated into the EU ETS was the “opt out” provision; this was applied in the situations when a firm was seen to be undertaking equivalent efforts to reduce Co2 emissions (undertaking targets in preceding schemes like the UK ETS). This provision was however limited to the first phase of the EU ETS.

Trading under the EU ETS.

Under the EU ETS, trading started in 2005 with the EUAs as credits. The EU ETS developed contracts for the sale and purchase of a commodity at an agreed price but with a delivery and payment happening at a later date[7]. One of the reasons for this is that the EUAs are bankable (at least from the start of the second phase). The EU ETS covers over 12,000 installations in the 27       EU countries, two countries entered the scheme in time to participate in the second phase (Bulgaria and Romania).

The first phase of the EU ETS popularly known to some as the “test run” stage commenced in 2005. In this stage, all allowances were given free of charge to the installations which participated in the scheme. The emission of Co2 was the only GHGs covered by the first phase, the sectors included were responsible for over 46 per cent of the EU’s Co2 emissions and 38 per cent of GHG worldwide, while in the second phase nitrous oxide has been added. It is important to note that although the EU ETS started earlier than the Kyoto Protocol, the linking directive as made it possible for the EU to recognise the allowances gained from the flexible mechanisms provided by the Kyoto Protocol. This linking to other trading schemes would be done by bi-lateral agreements to promote liquidity and encourage the rise of trade between schemes.

Allocation, Monitoring and compliance

When the scheme commenced its first phase in 2005, the EC approved 21 NAPs, which have now risen to 27. As mentioned above, the allocation of allowances during the first phase was free of charge to the tune of 95 per cent , while the remaining 5 percent was  either auctioned off to the highest bidder or given free of charge depending on the state. This allocation was slightly different in the second phase, the amount given free of charge was reduced to 90 per cent and the remaining 10 per cent to be auctioned or given out free.

One of the problems encountered in the allocation process was the situation where “grandfathering” was suggested instead of using auctions to give out allowances. This situation is not seen by all as a problem, there are views that this system will help the investments of these companies. But at the same time this would be an unfair advantage to other companies who have to buy allowances to meet their emissions. It is important to note that the over allocation of the emissions credits would hinder the real aim of the scheme for there would be little emissions control as seen in the first phase of the scheme.

It can be said that the success of the EU ETS has a lot to do with the allocation of allowances that are to be traded, so it is important that the transactions are monitored and reported. This is done through binding EU guidelines which consist of fuel purchases and the use of emissions factors, although continuous monitoring and third party verifications are allowed.[8]

To ensure compliance, the installations have to return a number of allowances equivalent to their verified Co2 emissions after every year. Theses allowances will be cancelled and then used the next year, the installations with left over allowances can sell them or save them for later use. It is when the installations do not return enough allowances to meet their emissions that they are penalised[9]. The fines to be paid are 40 euro/ TCO2 for the first phase and 100 euro/ TCO2 from 2008 onwards. These fines once paid do not mean the defaulters would not make up the emissions in the next year, so defaulters would pay the fines and still make up the missed emissions reduction. In the first phase, additional allowances could be given with the approval of the EC for installations experiencing unusually high emissions due to “acts of God”. But this does not apply to later phases.

Impact and Issues of the first Phase

With the end of second phase of the EU ETS drawing closer, the impact of the scheme in helping the EU reach its target comes into sharp focus. The fact that it did not succeed in reducing emissions in the first phase is a source of worry, with respect to the possibility of not meeting the 8 per cent targets by 2012. One of the issues was that of over-allocation of allowances, which brought about a zero price for Co2 in the first stage. But it can be said that in the second phase there would be no prohibition of banks, which will in turn affect the price of Co2.

One issue plaguing the scheme now is the complaints made by Eastern European countries that the targets given to them under the second phase are to low and will affect their economies and competition. This issue as been taken to court by these aggrieved parties- which could derail or draw back the scheme from attaining its overall goals by 2012.

The major impact of the EU ETS on the EU companies participating the scheme it is that the recognition of the CDM (Clean Development Mechanism) and JI (Joint Implementation) credits increase the range of options available for limiting their emissions, improving the flow of liquidity of the market and can potentially reduce the compliance cost through the reduction of allowance fees. Also the strong demand for emissions credits has led to major EU financial institutions providing finance for emissions reduction projects. It can therefore be said that the impact of the EU ETS although laudable, still as a lot of issues to sort out.

Bringing it home

It is seen from the above analysis, that the EU ETS is the largest functioning regional emissions trading scheme which has made the EU a force to be reckoned with in the issues of climate change. This position they claim to have solidified by being the region with the largest reduction targets (8 per cent by 2012). This position is a grand one considering the highest emitters of Co2 are not in the region. But the actual means of doing these great expectations are the main cause of concern.

The EU ETS, being the major source of the region’s target of meeting these great expectations can be said to be a step in the right direction and with the linking directive, the allowances needed can be obtained through a cheaper means using the CDM and the JI. It must be said at this point that the phase 1 of this scheme was not altogether a success, but that could be excused as a learning stage in which there was an over allocation of allowances and the desired effect of the regime was not achieved (that is if the desired effect was to not have a zero price on Co2). The second phase though bringing cheaper alternatives to acquire allowances, also brings up the issue of the value of the different credits acquired from the KP to the EUAs from the EU regime.

This article agrees with the view of some experts to the fact that although the EU ETS would help the region reduce GHGs emissions to a considerable level; at this point reaching their KP targets is not feasible. This is due to the fact that the ETS has not been completely ironed out to work effectively- which as to be done for the results of the regime to be optimized. That been said, the EU as made a good step as a front runner in the climate change regime and also in looking beyond 2012. The trading scheme is already looking towards the third phase of its operations after hopefully reaching their targets while the international community is not having as much success in finding a successor to the KP with the Copenhagen Accord still hanging in the balance.

NUTSHELL

According to Bolaji, to have an understanding of the EU ETS, one must necessarily examine its framework and more importantly, how it is implemented. She has taken a critical look at the first phase of the regime and how the regime can be improved from that phase- moving forward. Bolaji’s analysis concludes that the EU has had mixed success so far in its solitary attempts at compliance with the Kyoto Protocol’s binding emissions-reduction targets. There are still some challenges in the implementation of the regime, but if these are corrected, the EU would have a good chance of meeting its targets. To view Bolaji's professional profile and for more information on this article, please click here..-->