The EU Emissions Trading Scheme

The EU ETS is an instrument launched in 2005 in an effort to help EU Member States achieve compliance with their commitments under the Kyoto Protocol at lower costs. The basic idea of emissions trading is to limit the amount of emissions by creating rights to emissions and to make these rights (allowances) tradable. The scarcity of emissions allowances gives them a market value. Those emitters whose CO2 abatement costs are lower than the allowance price will reduce their emissions. They can also sell excess emission rights to other more prolific emitters.

Whilst the European Commission has succeeded in making the EU ETS the largest ‘cap and trade’ programme in the world – 817 m. of CO2 equivalent worth €14.6 bn were traded over these two years - it has so far failed to put the appropriate incentives in place to support lower carbon and clean technology investments. Serious design faults, many of them predicted by the European Wind Energy Association, NGO’s and renowned economists, have impaired investment in clean energy sources.

The EU ETS design discourages clean technology investment

The experience of the first period of the EU ETS (2005-2007) shows that the scheme offers little investment incentives to replace intensive emitting power generation with cleaner sources, such as wind power. This is mainly due to a combination of adverse incentives associated with the EU ETS design, such as the strong role of government and business interests in the allocation process, counter-productive allocation methods which generate distortions of competition along with windfall profits for conventional power generators.

Under the current ETS system, where a significant degree of freedom over the elaboration of the National Allocation Plans (NAPs) is retained by Member States, the price of carbon price is more a result of national pressures and negotiated compromises rather than the real cost of reducing CO2. The price of carbon risks being too low and instable because the amount of available carbon allowances depends directly on government’s decisions concerning allocation, and these in turn hinge upon emission projections, national interests and business efforts to increase the number of allowances. As experienced during the phase I of the ET ETS, in the presence of price uncertainty, the risk of low CO2 prices leads to a delay in investment decisions and hampers clean technology investments.

Furthermore, the system of free carbon allowances, whereby fossil-fuel producers are allocated valuable licenses at no cost, along with the power sector who are able to pass the marginal costs of free allowances onto electricity prices, creates high profits for conventional power generators. This system reduces renewables and wind power competitiveness compared with fossil fuel power generation. Finally, free allocation serves to penalize “early action” because firms that have taken prompt measures to reduce emissions get fewer allowances allocated in the future.

More harmonisation, auctioning and inclusion of new gases and sectors

In EWEA’s view, the success of the EU emissions trading scheme as a climate policy instrument hinges on a more credible, transparent and distortion-free market design. The environmental effectiveness should be reinforced by encouraging the development of clear, stable, and consistent incentives for timely investment in low-carbon, clean energy sources. This implies greater harmonisation on emission reduction targets, allocation methods and rules, rules for new entrants and closures, definition of sectors covered by the system and monitoring, reporting and verification requirements.

EWEA contends that country targets should be agreed upon at the community level, and calls for the replacement of free allocation of CO2 allowances by an auction-based system of allowances.

EWEA also contends that despite the advantages of a full auctioning system, the EU Emissions Trading Scheme must be seen as only one amongst multiple instruments that must be implemented towards the mitigation of climate change. In EWEA’s view, the system in itself cannot ever fully reflect the external costs associated with the pollution and emissions of conventional power sources.

Furthermore, a narrow focus on emission and electricity prices teaches us little about the positive economic, environmental and social impacts of other environmental measures. Renewables in general and wind energy specifically bring great benefits to society beyond CO2 reduction, such as security of supply, employment, technological development, social cohesion and exports. These benefits are today widely recognised yet cannot be fully guaranteed by the EU ETS system.

EWEA is also in favour of extending the EU ETS into other sectors. The ETS directive should cover a wider range of economic sectors - such as aviation, maritime and road transport, chemical and petrochemical production and the aluminum industry - as well as other greenhouse gases – for example N2O from the production of ammonia and CH4 from coal mines.

EWEA also calls for EU-wide quantitative and qualitative limits to the use of CDM and JI credits. On the quantitative side, and in consideration of the EU target of 20% reduction of greenhouse gas emissions by 2020, EWEA considers that CER’s and ERU’s from project activities should not exceed the 6% of the total quantity of allowances allocated by Member States (as foreseen in the initial proposal of the European Commission²). On the qualititative side, EWEA highlights the need to ensure that the EU’s use of Kyoto mechanisms is supplementary to its domestic efforts in reaching its environment targets, and that the allowance of CDM and JI credits to EU companies is strictly limited to high quality projects.

²European Commission, EC (2003). Proposal for a Directive of the European Parliament and of the Concil amending the Directive establishing a scheme for greenhouse gas emission allowance trading within the Community, in respect of the Kyoto Protocol's project mechanisms. COM(2003) 403 final.