Emissions Trading:- 

a new dawn?

 
The EU emissions trading scheme: an overview

Part I: Background and concepts  

The EU emissions trading scheme became live in January 2005, swiftly followed by the ratification of the Kyoto Protocol in February 2005. Now four months into the scheme, the price of carbon has rocketed, reaching €17/tCO₂e in April, up from €8 in early January. In preparation for the publication of our emissions trading report, due out at the end of May, this article explains the background to, and concepts of, the EU emissions trading scheme. Part two, in next month’s Mzine, will focus on the operation and impact of the scheme. Figures are taken from the draft report, The EU emissions trading scheme: a practical guide[1], to be published by the Energy Publishing Network in the next month.  

The EU emissions trading scheme (EU ETS) has been designed to assist EU countries in meeting their emissions targets under the Kyoto Protocol in an economic and efficient manner. Under the Kyoto Protocol agreed in 1997 the EU15, together with other industrialised countries, including eight of the EU’s 2004 accession states, agreed targets to limit emissions during the 2008-2012 Kyoto compliance period relative to 1990 base year levels. Although the overall Kyoto targets were designed to reduce emissions from industrialised countries to 5.2% below 1990 levels, the EU as a block agreed to an 8% reduction. This was then re-distributed between the EU15 countries in the 1998 EU Burden-sharing Agreement, allocating greater cuts to states deemed more able to meet them due to the extent of industrial development or opportunities for low-cost abatement, such as Germany and the UK , and smaller cuts or even increases to states with less developed economies, such as Portugal and Ireland .  

The eight Eastern European states that joined the EU in 2004 all have a 92% of base year target, apart from Poland , which has 94%. Malta and Cyprus were not set targets under the Kyoto Protocol.  

Actual progress towards meeting Kyoto targets has been very mixed across the EU. The eight Eastern European states apart from Slovenia are all below Kyoto targets due the contraction of their energy-intensive industry following the collapse of the Soviet Block after 1990. In the EU15 the picture is more mixed, UK , Germany , Sweden and France all ahead of target in 2002 based on a linear progression between 1990 and 2010. However, the other 11 states, and the EU15 as whole, are behind target, Spain and Portugal by more than 20%. 

The EU ETS is intended to help make up the ground between current progress and the Kyoto commitment period. The ETS is a cap and trade trading system. The idea is to set a limit on the total permitted emissions from included installations. Emissions allowances (referred to as EU allowances or EUAs) each equivalent to 1tCO₂e are issued by national authorities to 12,000 installations covered by the scheme. After the end of the year each site operator has to submit to the authorities EUAs equivalent to their calculated CO₂ in that year – failure to hand in sufficient EUAs is punishable by a heavy fine, initially of €40/tCO₂e, rising to €100/tCO₂e in 2008-2012, and an obligation to make up the EUA shortfall later. With a cap set on total CO₂ emissions from the included sectors, a market for EUAs has developed, with companies trading in order to cover their expected emissions or benefit from the value of emissions reductions, either through improved efficiency or reduced activity.  

That’s the theory at least. A key issue in making the market work has been the national allocation plans (Naps). Each EU state has produced a Nap setting out their total allocation of emissions to the included sectors for the first period of the scheme, 2005-2007, and the allocation to each included installation. However, as there are no legal Kyoto targets for this period, countries have had considerable discretion to set their total emissions allocations. Most, but not all appear to have set targets assuming a non-linear progress towards Kyoto . In other words, most of the emissions reductions are to be made up in the second period, 2008-2012. Others, however, have set targets to meet Kyoto or even go beyond it. A key example is the UK , which is already on target to meet its Kyoto cut of 12.5%, due not so much to intelligent green policies, as the skewed electricity market of the 1990s, which encouraged the dash-to-gas replacing large volumes of coal-fired generation with gas-fired combined cycle turbine power stations. The UK draft Nap, published in early 2004, aimed to set a tone for the other countries to follow with stringent cuts to meet the Government’s target of a 20% CO₂ reduction by 2010. The UK Nap proposed allocating 736 mt of EUAs over the first period of the scheme. Unfortunately, reassessments of the business as usual forecasts during 2004 suggested that the UK would produce significantly more CO₂ than had been expected at the time of drafting the Nap. The UK ’s plea to the European Commission to let them change the total allocation to 756 mt fell on deaf ears, and despite mutterings about the European Court of Justice, the UK has now accepted the lower figure.  

From January 2005 it has been illegal for an installation which is included in the scheme (this includes installations involved in energy production from combustion, oil refineries and coke oven, and the industrial production of iron and steel, cement, lime, glass, ceramics, and paper, above a certain size) to operate without a permit to emit carbon dioxide from the relevant national authorities. On the basis of these permits, and the Naps, issuing of EUAs to each installation was due to begin early this year, although in many states this has been delayed somewhat. Having received their EUAs, companies then face many decisions, depending on needs and allocations. Companies that are short of EUAs, relative to their expected CO₂ emissions over the three years, may need to purchase EUAs, reduce production, or seek alternative means of reducing emissions, such as investment in cleaner technology or improved efficiency. Alternatively, those that expect to have a surplus of EUAs, have benefited from the free allocation of a now valuable commodity. They may choose either to keep the EUAs and increase production, possibly gaining ground against carbon-constrained competitors, or to trade EUAs on the market. Others such as financial institutions, environmental pressure groups, or even individuals, may enter the market to buy EUAs, either as a trading opportunity, or to reduce the total number of EUAs in circulation – a climate-concerned individual could buy EUAs and not use them, in effect reducing the quantity of CO₂ that can be emitted by the included installations over the years of the scheme. Emissions trading will potentially offer parties a whole new range of opportunities and risks, covering liability, accounting, monitoring emissions, trading and other areas. The impact of the scheme is certainly wide-ranging and is already impacting a various different markets even in its infancy.  

As the scheme has gone live, the trading market has also become more active, with trade volumes in the first quarter of 2005 much higher than total volumes in 2004. The price of carbon has also risen, from around €7/tCO₂e in January 2005 to above €17/tCO₂e in April. Trading systems are being developed, with exchanges such as NordPool, EEX, APX and the IPE all providing trading points to the market. At the beginning of May 2005 emissions trading seems to be on the cusp of great developments, with markets emerging, the cost of carbon higher than some had expected, and most systems apparently working. However, many questions remain about the medium-term development of emissions markets and the wider impact of emissions trading. These issues will be addressed in part two of this article in June’s Mzine.