Order Code RL34150
Climate Change: The EU Emissions Trading
Scheme (ETS) Gets Ready for Kyoto
August 27, 2007
Larry Parker
Specialist in Energy and Environmental Policy
Resources, Science, and Industry Division
Climate Change: The EU Emissions Trading Scheme
(ETS) Gets Ready for Kyoto
Summary
The European Union’s (EU) Emissions Trading Scheme (ETS) is a cornerstone
of the EU’s efforts to meet its obligation under the Kyoto Protocol. It covers more
than 11,500 energy intensive facilities across the 27 EU Member countries; covered
entities emit about 45% of the EU’s carbon dioxide emissions. A “Phase 1” trading
period began January 1, 2005. A second, Phase 2, trading period will begin in 2008,
covering the period of the Kyoto Protocol, with a third one planned for 2013.
Several positives resulting from the Phase 1 “learning by doing” exercise may
assist the ETS in making the Phase 2 process run more smoothly, including: (1)
greatly improving emissions data, (2) encouraging development of the Kyoto
Protocol’s project-based mechanisms — Clean Development Mechanism (CDM) and
Joint Implementation (JI), and (3) influencing corporate behavior to begin pricing in
the value of allowances in decision-making, particularly in the electric utility sector.
However, several issues that arose during the first phase remain contentious as
the ETS moves into Phase 2, including allocation schemes, shutdown credits and new
entrant reserves, and others. In addition, the expansion of the EU and the
implementation of the directives linking the ETS to the Kyoto Protocol project-based
mechanisms created new issues to which Phase 2 has had to respond.
The United States is not a party to Kyoto. However, almost three years of carbon
emissions trading has given the EU valuable experience as it prepares for Kyoto.
This experience, along with the process of developing Phase 2 NAPs, may provide
some insight into cap-and-trade design issues currently being debated in the U.S.
! The U.S. currently requires only electric utilities to monitor CO . The EU-
2
ETS experience suggests expanding similar requirements to all facilities
covered under a cap-and-trade scheme would be pivotal for developing
allocation systems, reduction targets, and enforcement provisions.
! In the U.S. debate on comprehensive versus sector-specific reduction
programs, the EU-ETS experience suggests that adding sectors to a trading
scheme once established may be a slow, contentious process.
! Like the EU-ETS, most U.S. industry groups either oppose auctions
outright or want them to be supplemental to a base free allocation. The
EU-ETS experience suggests Congress may want to consider specifying
any auction requirement if it wishes to incorporate market economics
more fully into compliance decisions.
! EU-ETS analysis suggests the most important variables in determining
Phase 1 allowance price changes were oil and natural gas price changes;
an apparent linkage that raises possible market manipulation issues,
particularly with the inclusion of financial instruments such as options and
futures contracts. Congress may ultimately be asked to consider whether
the Securities and Exchange Commission or the Commodities Futures
Trading Commission should have regulatory and oversight authority over
such instruments.
Contents
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
National Allocation Plans and the ETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Need for Further Emissions Reductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Need to Adjust ETS Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Issues Arising in NAPs for the ETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Supplementarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Auction Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
New Entrant Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Closure Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Allocation and Energy Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Harmonization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Summary and Considerations for U.S. Cap-and-Trade Proposals . . . . . . . . . . . . 23
Emission Inventories and Target Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Allocation Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Flexibility and Price Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
List of Figures
Figure 1. ECX CFI Futures Contracts: Price and Volume . . . . . . . . . . . . . . . . . . 7
Figure 2. Actual and Projected Emissions for EU-25 and EU-15 . . . . . . . . . . . . . 9
List of Tables
Table 1. ETS Annual Allocations for Phase 2: 2008-2012 . . . . . . . . . . . . . . . . . . 4
Table 2. JI/CDM Limits for Phase 2: 2008-2012 . . . . . . . . . . . . . . . . . . . . . . . . 11
Table 3. Value of Annual Allocation for New NGCC Powerplant . . . . . . . . . . 17
Climate Change: The EU Emissions Trading
Scheme (ETS) Gets Ready For Kyoto
Overview
Climate change is generally viewed as a global issue, but proposed responses
typically require action at the national level. With the 1997 Kyoto Protocol now in
force and setting emissions objectives for 2008-2012, countries that ratified the
protocol are developing appropriate implementation strategies to begin reducing their
emissions of greenhouse gases.1 In particular, the European Union (EU) has decided
to use an emissions trading scheme (called a “cap-and-trade” program), along with
other market-oriented mechanisms permitted under the Protocol, to help it achieve
compliance at least cost.2 The decision to use emission trading to implement the
Kyoto Protocol is at least partly based on the successful emissions trading program
used by the United States to implement its sulfur dioxide (acid rain) control program
contained in Title IV of the 1990 Clean Act Amendments.3
The EU’s Emissions Trading System (ETS) is a cornerstone of the EU’s efforts
to meet its obligation under the Kyoto Protocol. It covers more than 11,500 energy
intensive facilities across the 27 EU Member countries, including oil refineries,
powerplants over 20 megawatts (MW) in capacity, coke ovens, and iron and steel
plants, along with cement, glass, lime, brick, ceramics, and pulp and paper
installations. Covered entities emit about 45% of the EU’s carbon dioxide emissions.
The trading program covers neither CO emissions from the transportation sector,
2
which account for about 25% of the EU’s total greenhouse gas emissions, nor
emissions of non-CO greenhouse gases, which account for about 20% of the EU’s
2
total greenhouse gas emissions. A “Phase 1” trading period began January 1, 2005.4
1 Six gases are included under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide,
hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. The United States has not
ratified the Kyoto Protocol and, therefore, is not covered by its provisions. For more
information on the Kyoto Protocol, see CRS Report RL33826, Climate Change: The Kyoto
Protocol and International Actions, by Susan Fletcher and Larry Parker.
2 Norway, a non-EU country, also has instituted a CO trading system. Various other
2
countries and a state-sponsored regional initiative located in the northeastern United States
involving several states are developing mandatory cap-and-trade system programs, but are
not operating at the current time. For a review of these emerging programs, along with other
voluntary efforts, see International Energy Agency, Act Locally, Trade Globally (2005).
3 P.L. 101-549, Title IV (Nov. 15, 1990).
4 For further background on the ETS and its first year of operation, see CRS Report
RL33581, Climate Change: The European Union’s Emissions Trading System (EU-ETS),
(continued...)
CRS-2
A second, Phase 2, trading period is scheduled to begin in 2008, covering the period
of the Kyoto Protocol, with a third one planned for 2013.5
Under the Kyoto Protocol, the then-existing 15 nations of the EU agreed to
reduce their aggregate annual average emissions for 2008-2012 by 8% from 1990
levels under a collective arrangement called a “bubble.” By 2001, collective
greenhouse gas emissions in the EU were 2.3% below 1990 levels, mostly the result
of a structural shift from coal to natural gas in the United Kingdom and the
incorporation of East Germany into West Germany. Several countries, including
Ireland, Spain, and Portugal, experienced emissions growth of over 30% during this
period.6 In light of the Kyoto Protocol targets, the EU adopted a directive
establishing the EU-ETS that entered into force October 13, 2003.7 The importance
of emissions trading was elevated by the accession of 10 additional central and
eastern Europe countries to EU membership in May 2004. Collectively, these 10
countries’ greenhouse gas emissions dropped 22.6% from 1990-2001, with only
Slovenia’s emissions increasing during that time (10.4%). With the accession of
Bulgaria and Romania in January 2007, this expansion of the EU trading zone to 27
countries greatly increases the opportunities for cost-effective allowance trades.
The EC hopes that the Phase 1 “learning by doing” exercise has prepared the
community for the more difficult task of achieving the reduction requirements of the
Kyoto Protocol. Several positives have resulted from the Phase 1 learning by doing
exercise that will assist the ETS in making the Phase 2 process run smoothly. First,
Phase 1 established much of the critical infrastructure necessary for a functional
emission market, including emissions monitoring, registries, and inventories. Much
of the publicized difficulties the ETS experienced in the first phase can be traced to
inadequate emission data.8 Phase 1 has significantly improved those data in
preparation for Phase 2.
4 (...continued)
by Larry Parker.
5 More information, including relevant directives, on the EU-ETS is available on the
European Union’s website at [http://europa.eu.int/scadplus/leg/en/lvb/l28012.htm].
6 Pew Center on Global Climate Change, The European Union Emissions Trading Scheme
(EU-ETS): Insights and Opportunities (no date), available at [http://www.pewclimate.org/
docUploads/EU%2DETS%20White%20Paper%2Epdf].
7 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003
establishing a scheme for greenhouse gas emissions allowance trading within the
Community and amending Council Directive 96/61/EC.
8 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), pp. 69-70; and, International Emissions Trading Association, “IETA
Position Paper on EU ETS Marking Functioning,” (no date), p. 3.
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Second, the ETS has helped jump-start the project-based mechanisms — Clean
Development Mechanism (CDM) and Joint Implementation (JI) — created under the
Kyoto Protocol.9 As stated by Ellerman and Buchner:
The access to external credits provided by the Linking Directive has had an
invigorating effect on the CDM and more generally on CO reduction projects
2
in developing countries, especially in China and India, the two major countries
that will eventually have to become part of a global climate regime if there is to
be one.10
Third, according to the EC, a key result of Phase 1 has been its effect on
corporate behavior. An EC survey of stakeholders indicates that many participants
are pricing in the value of allowances in making decisions, particularly in the electric
utility sector where 70% stated they were pricing in the value of allowances into their
daily operations, and 87% into future marginal pricing decisions. All industries state
that it was a factor in long-term decision-making.11
However, several issues that arose during the first phase remain contentious as
the ETS moves into Phase 2, including allocation (including use of auctions and
reliance on model projections), shutdown credits and new entrant reserves, and
others. In addition, the expansion of the EU and the implementation of the linking
directives create new issues to which Phase 2 has had to respond. These new and
continuing challenges, and the ETS response to them are discussed below.
National Allocation Plans and the ETS
National Allocation Plans (NAPs) are central to the EU’s effort to achieve its
Kyoto obligations. Each Member of the EU must submit a NAP that lays out its
allocation scheme under the ETS, including individual allocations to each affected
unit. For the second trading period, these NAPs are assessed by the EC to determine
compliance with 12 criteria delineated in an annex to the emissions trading
directive.12 Criteria include requirements that the emissions caps and other measures
proposed by the Member State are sufficient to put it on the path toward its Kyoto
9 For more on the effect of the ETS on Kyoto mechanisms, see: A Denny Ellerman and
Barbara K. Buchner, “The European Union Emissions Trading Scheme: Origins,
Allocations, and Early Results,” 1 Environmental Economics and Policy 1 (Winter 2007),
p. 84; and, International Emissions Trading Association, “IETA Position Paper on EU ETS
Market Functioning,” (no date), p. 2. For more information on the Kyoto Protocol
mechanisms, see: CRS Report RL33826, Climate Change: The Kyoto Protocol and
International Actions, by Susan Fletcher and Larry Parker.
10 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 84.
11 European Commission, Directorate General for Environment, Review of EU Emissions
Trading Scheme: Survey Highlights, (November 2005), pp. 5-7.
12 Commission of the European Communities, Directive 2003/87/EC, available at
[http://ec.europa.eu/environment/climat/emissions_plans.htm].
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target, protections against discrimination between companies and sectors, delineation
of intended use of CDM and JI credits for compliance, along with provisions for new
entrants, clean technology, and early reduction credits. For the second trading period,
the NAP must guarantee Kyoto compliance.
NAPs for the second trading period were due June 30, 2006. One year later, the
EC has reviewed and approved (sometimes conditionally) 23 Member States’ NAPs.
As indicated by Table 1, the EC has reduced the proposed allocations of individual
Member States by an average of 9.5% to increase the probability that the EU will
achieve its target under the Kyoto Protocol. The need to reduce the requested
allocations reflects both the structure of the ETS and the lessons the EC learned
during the first phase.
Table 1. ETS Annual Allocations for Phase 2: 2008-2012
(for 23 Member States with approved NAPs)
2005
Proposed
EC Approved
Approved as
Member
Emissions
Kyoto Cap
Kyoto Cap
Percent of
State
(MMTCO E)
(MMTCO E)
(MMTCO E)
Proposed
2
2
2
Austria
33.4
32.8
30.7
93.6%
Belgium
55.4
63.3
58.5
92.4%
Czech Rep.
82.5
101.9
86.8
85.2%
Cyprus
5.1
7.12
5.48
77%
Estonia
12.62
24.38
12.72
52.2%
Finland
33.1
39.6
37.6
94.8%
France
131.3
132.8
132.8
100%
Germany
474
482
453.1
94%
Greece
71.3
75.5
69.1
91.5%
Hungary
26.0
30.7
26.9
87.6%
Ireland
22.4
22.6
22.3
98.6%
Italy
225.5
209
195.8
93.7%
Latvia
2.9
7.7
3.43
44.5%
Lithuania
6.6
16.6
8.8
53%
Luxembourg
2.6
3.95
2.5
63%
Malta
1.98
2.96
2.1
71%
Netherlands
80.35
90.4
85.8
94.9%
Poland
203.1
284.6
208.5
73.3%
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2005
Proposed
EC Approved
Approved as
Member
Emissions
Kyoto Cap
Kyoto Cap
Percent of
State
(MMTCO E)
(MMTCO E)
(MMTCO E)
Proposed
2
2
2
Slovakia
25.2
41.3
30.9
74.8%
Slovenia
8.7
8.3
8.3
100%
Spain
182.6
152.7
152.3
99.7%
Sweden
19.3
25.2
22.8
90.5%
UK
242.4
246.2
246.2
100%
Total
1947.86
2101.64
1903.43
90.5%
Source: European Commission, “Emissions Trading: Commission Adopts Decision on Cyprus’
National Allocation Plan for 2008-2012,” EC Press Release, July 18, 2007. Bulgaria, Denmark,
Portugal, and Romania do not have approved NAPs.
Need for Further Emissions Reductions
It is unclear to what degree the first phase of the ETS achieved real emissions
reductions. Emissions are dynamic over time; a product of a country’s population,
economic activity, and greenhouse gas intensity.13 To capture these dynamics, the
Member States of the EU develop emissions baselines from models that project
future trends in a country’s emissions based on these and other factors, such as
anticipated energy and greenhouse gas policies.14 During the first phase, the
emissions goal was to put the EU on the path to Kyoto compliance — not actually
comply with the Protocol (which isn’t necessary until the 2008-2012 time period).
Thus, countries developed “business as usual” baselines based on projected growth
in emissions. Such a projected baseline suffers from two sources of uncertainty: data
uncertainties, and forecasting uncertainties. With respect to data, Phase 1 suffered
from uncertainties with respect to data collection and coverage, in monitoring
methods for historic data, and data verification. With respect to projecting future
emissions, Phase 1 faced uncertainties with respect to economic or sector-based
growth rates. Fueled in many cases by over-optimistic economic growth
assumptions, these uncertainties increased the probability of inflated business as
usual baselines.15
13 For more information, see:CRS Report 33970, Greenhouse Gas Emission Drivers:
Population, Economic Development and Growth, and Energy Use, by John Blodgett and
Larry Parker.
14 On the role of modeling in the first phase, see: A Denny Ellerman and Barbara K.
Buchner, “The European Union Emissions Trading Scheme: Origins, Allocations, and Early
Results,” 1 Environmental Economics and Policy 1 (Winter 2007), pp. 72-73.
15 Regina Betz and Misato Sato, “Emissions Trading: Lessons Learnt from the 1st Phase of
the EU ETS and Prospects for the 2nd Phase,” 6 Climate Policy (2006), p. 354.
CRS-6
The combination of these factors and modest reduction requirements resulted
in the emissions allocations for the 2005-2007 trading period being higher than
actua1 2005 emissions.16 This result has raised questions about how much reductions
achieved during Phase 1 were real as opposed to being merely paper artifacts. On the
positive side, verified emissions in 2005 were 3.4% below the estimated 2005
baseline used during the allocation process. In addition, the allowance prices for 2005
stayed persistently high, suggesting some abatement was occurring and raising
questions of “windfall” profits. As stated by Ellerman and Buchner:
First, and most importantly, the persistently high price for EUAs [EU emissions
allowance] in a market characterized by sufficient liquidity and sophisticated
players must be considered as creating a presumption of abatement. It would be
startling if power companies did not incorporate EUA prices into dispatch
decisions that would have shifted generation to less emitting plants. There is
plenty of anecdotal evidence that this was the case, and the prominent charges
of windfall profits assume that the opportunity cost of freely allocated
allowances was being passed on (without noting the implications for abatement).
Similarly, it would be surprising if there were no changes in production
processes that could be made by the operators of industrial plants.17
However, EU emissions allowances (EUAs) during Phase 1 have not maintained
value. As indicated by Figure 1 below, Phase 1 EUAs are basically worthless with
six months left in 2007. This continuing decline in EUA prices at least partially
reflects the general non-transferability of Phase 1 EUAs to Phase 2. Only Poland and
France included limited banking in their Phase 1 NAPs. The EC further restricted
use of Phase 1 EUAs in Phase 2 with a ruling in November, 2006.18 As a result, any
excess Phase 1 EUAs will be essentially worthless at the end of 2007.19
16 For a further discussion, see: Climate Change: The European Union’s Emissions Trading
System (EU-ETS), CRS Report RL33581, by Larry Parker.
17 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 83.
18 European Commission, Communication from the Commission to the Council and to the
European Parliament on the assessment of national allocation plans for the allocation of
greenhouse gas emission allowances in the second period of the EU Emissions Trading
Scheme, COM(2006) 725 final, (November 29, 2006), p. 11.
19 For a further discussion, see: Joseph Kruger, Wallace E. Oates, and William A. Pizer,
“Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy, 1
Environmental Economics and Policy 1 (Winter 2007), p. 126; and, Frank J. Convery and
Luke Redmond, “Market and Price Development in the European Union Emissions Trading
Scheme, 1 Environmental Economics and Policy 1 (Winter 2007), pp. 96-7, 107.
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Figure 1. ECX CFI Futures Contracts: Price and Volume
12
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Total Volume
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2
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0
€0
2/6/2006 3/20/2006 5/3/2006 6/15/2006 7/27/2006
9/7/2006 10/19/2006 11/30/2006 15/01/2007 26/02/2007 10/04/2007 22/05/2007 03/07/2007 14/08/2007
CRS-8
The upside of Figure 1 and the non-transferability of Phase 1 EUAs is that
prices for Phase 2 EUAs have been firm. This firmness may reflect the ability of the
EC to certify Phase 2 NAPs using more verifiable baseline data than were available
for Phase 1.20 Scarcity is critical for the proper functioning of an allowance market.
A major reason the EC rejects ex post adjustments21 is fear that such adjustments
would have a disruptive effect on the marketplace.22 Phase 1 did not firmly establish
this foundation of markets23 — based on the Phase 2 EUA future’s market, further
market development appears to be occurring, although several challenges to that
development will be discussed later.
Need to Adjust ETS Allocations
While the environmental performance of Phase 1 may be disputed, the need for
additional reductions to achieve Kyoto is not. As indicated by the red arrow in
Figure 2, the EC projects that the EU-15 existing measures will halt the projected
increase in greenhouse gases; however, as indicated by the green line, they are
insufficient to reduce EU-15 emissions to their Kyoto requirements that begin in
2008. To achieve this target and the additional requirements of the new EU
countries, the EU envisions three sources: (1) further reductions by EU-15 countries
covered by the EU bubble (the blue arrow), (2) ensuring the new countries remain in
compliance with their Kyoto commitments (the purple arrow), and (3) the use of
Kyoto mechanisms (Joint Implementation (JI) and Clean Development Mechanism
(CDM) and carbon sinks (the green bar).24 By 2010, EU-25 emissions are projected
at 4.6% below Kyoto baseline levels assuming current policies. This reduction is
20 International Emissions Trading Association, “IETA Position Paper on EU ETS Market
Functioning,” (no date), p. 2.
21 Once the EC has approved a country’s NAP, including the total number of allowances and
the allocation to each covered entity, the allocations can not be re-visited. Attempts to
include provisions permitting such post-approval adjustments to a facility’s allocation have
been uniformly rejected by the EC.
22 European Commission, Communication from the Commission to the Council and to the
European Parliament on the assessment of national allocation plans for the allocation of
greenhouse gas emission allowances in the second period of the EU Emissions Trading
Scheme, COM(2006) 725 final, (November 29, 2006), p 8; and, A Denny Ellerman and
Barbara K. Buchner, “The European Union Emissions Trading Scheme: Origins,
Allocations, and Early Results,” 1 Environmental Economics and Policy 1 (Winter 2007),
p. 71.
23 On the mixed record of the EU-ETS and the need for allowance scarcity to a functioning
emissions market, see: Eric Haymann, EU Emission Trading: Allocation Battles
Intensifying, Deutsche Bank Research (March 6, 2007). For a generally positive view of
ETS market development, see: Frank J. Convery and Luke Redmond, “Market and Price
Development in the European Union Emissions Trading Scheme, 1 Environmental
Economics and Policy 1 (Winter 2007), pp. 97-106. For a more negative view, see: Karsten
Neuhoff, Federico Ferrario, Michael Grubb, Etienne Gabel, and Kim Keats, “Emissions
Projections 2008-2012 Versus NAPs II,” 6 Climate Policy 5 (2006), pp. 395-410.
24 For more information on the Kyoto Protocol mechanisms, see: CRS Report RL33826,
Climate Change: The Kyoto Protocol and International Actions, by Susan Fletcher and
Larry Parker.
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projected at 8.1% if additional measures are included, and increases to 10.8% with
the addition of JI, CDM, and carbon sink credits. Currently, two countries are
projected to meet their requirements without additional control measures: The United
Kingdom and Sweden.
Figure 2. Actual and Projected Emissions for EU-25 and EU-15
Source: European Commission, Progress Towards Achieving the Kyoto Objectives, (October 27,
2006), p. 4.
As indicated by Table 1 earlier, part of the EC response to the need for
additional measures to meet the Kyoto requirements has been to reduce Member
States’ proposed ETS allocations. In the case of new Members, these reductions
have been substantial in some cases. So far, only three countries — France,
Slovenia, and the United Kingdom — have had no reductions in their proposed ETS
allocations. Other responses include moving toward imposing mandatory CO2
emissions standards on light-duty vehicles.25
25 European Commission, Results of the review of the Community Strategy to reduce CO2
emissions from passenger cars and light-commercial vehicles, (Brussels, February 7, 2007).
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Issues Arising in NAPs for the ETS
Supplementarity
As noted early, for Phase 2, the EC has issued a linking directive permitting the
use of Kyoto mechanisms for compliance. Including the linking directive has had
beneficial effects on the development of JI and CDM markets. As noted earlier, a
major benefit of the development of the ETS has been its positive effect on the CDM
and more generally on CO reduction projects in the developing world.26
2
This emerging JI/CDM supply has the potential to largely fill the projected EU-
15 shortfall in meeting the Kyoto Protocol requirements.27 According to the World
Bank, the estimated aggregate shortfall (“distance to target”) for the EU-15 for Phase
2 ranges from 900-1,500 million metric tonnes of CO e (CO equivalent) with an
2
2
average estimate of 1,250 million — this represents a 8%-10% further reduction from
projected levels and is in line with the EU estimated shortfall discussed above.28 In
contrast, the World Bank cites estimates that 1,000-1,200 million metric tonnes of
CO e credits from CDM and JI projects are likely to be imported into the EU-ETS:
2
“Put in perspective, it means that installations, using credits from CDM and JI, could
be in a balanced position or a marginally short one. In the latter case, fuel switching
would help bridge the gap.”29
However, a potential barrier to this scenario is the “supplementarity”
requirements of the Kyoto Protocol which is embodied in criterion 12 of the EC NAP
approval process. Supplementarity requires that developed countries, such as most
EU countries, ensure that their use of JI/CDM credits is supplemental to their own
domestic control efforts. In defining supplementarity for Phase 2, the EC has used
10% of a country’s allowance allocation as a rule of thumb in approving NAPs —
with a greater limit possible based on a country’s domestic efforts to reduce
emissions. As indicated in Table 2, this process has resulted in some significant
reductions in some countries’ proposed limits (e.g., Ireland, Poland, Spain), but some
increase in others (e.g., Italy, Latvia, Lithuania). Although these reductions appear
substantial in individual cases, most analysts agree that they do not represent a major
barrier to the cost-effective use of JI/CDM. As stated by the World Bank:
26 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 84. Also, see: International Emissions Trading Association, “IETA
Position Paper on EU ETS Market Functioning,” (no date), p. 2.
27 The ten other Annex 1 EU countries (mostly Eastern European “economies in transition”)
are estimated by the World Bank to have an excess of Assigned Amount Units (AAUs) of
700-1,500 million metric tonnes of CO2e. The two other EU countries — Cyprus and Malta
— are non-Annex 1 countries.
28 The World Bank, State and Trends of the Carbon Market 2007, (Washington, D.C., May
2007) pp. 14-16, 39-40.
29 Ibid., p. 16.
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The Commission assessed NAPs for imports of carbon assets (including planned
and substantiated governmental purchases) ostensibly with a view to limit
imports to no more than 50% of the “expected distance to target” for each
Member State. According to the vast majority of analysts, this does not place
any practical constraints on the demand for CDM/JI from EU installations: The
market received the November 2006 EU decision to impose tighter caps with an
immediate increase in the price of EUA-II, while uncertainty at that time about
supplementarity caps immediately dampened prices for CERs [i.e., CDM credits]
(secondary CER market reacted more quickly than the more stable primary
market).30
Table 2. JI/CDM Limits for Phase 2: 2008-2012
(23 Member States with approved NAPs)
Proposed JI/CDM Limit
Approved JI/CDM Limit
Member State
(% of allocation)
(% of allocation)
Austria
20%
10%
Belgium
8%
8.4%
Czech Rep.
10%
10%
Cyprus
(not included)
10%
Estonia
0
0
Finland
12%
10%
France
10%
13.5%
Germany
12%
12%
Greece
9%
9%
Hungary
10%
10%
Ireland
50%
10%
Italy
25%
14.99%
Latvia
5%
10%
Lithuania
9%
20%
Luxembourg
10%
10%
Malta
(not included)
(to be determined)
Netherlands
12%
10%
Poland
25%
10%
Slovakia
7%
7%
30 Ibid., p. 16.
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Proposed JI/CDM Limit
Approved JI/CDM Limit
Member State
(% of allocation)
(% of allocation)
Slovenia
(not included)
15.76%
Spain
39%
20%
Sweden
20%
10%
United Kingdom
8%
8%
Source: Source: European Commission, “Emissions Trading: Commission Adopts Decision on
Cyprus’ National Allocation Plan for 2008-2012,” EC Press Release, July 18, 2007. Bulgaria,
Denmark, Portugal, and Romania do not have approved NAPs. Proposed JI/CDM Limits from
Cambridge University, Second Phase National Allocation Plans: A Comparative Analysis, at
http://www.econ.cam.ac.uk/research/tsec/euets/.
The advantage of EU access to the JI/CDM market is lower costs under current
market conditions. In 2006, guaranteed CDM and JI credits sold at a discount to
EUAs, a 10-30% discount that reflects risks involved in CDM/JI transactions. The
degree to which this discount continues depends to some degree on the efforts of
participating governments and the CDM and JI Executive Boards to streamline
procedures and regulations, firm up methodological assessments, and integrate the
different markets. The Chinese government has set a credit price floor of 8-9 euro
— price setting that reflects its dominant role in the CDM market.31 The ability of
CDM host countries to raise this floor to reflect more fully the 18-20 euro EUA price
depends on supply. In contrast to the World Bank, Point Carbon reports that its
survey of respondents claimed that CDM/JI supply will be insufficient to meet EU
demand. As a result, price will be set by the marginal cost of EU domestic emissions
reductions (which in turn sets the ceiling on EUA prices). The availability of JI/CDM
credits will reduce that marginal cost (reducing the price of EUAs), but the survey
suggests that JI/CDM prices are likely to rise.32 In contrast, if the JI/CDM
availability exceeds the need of the EU, the price would be set by the margin cost of
JI/CDM credit supply — a considerably lower price as reflected by the Chinese price
floor.
Some observers praise the broadening and increased flexibility that CDM and
JI represent in helping Annex 1 countries meet their Kyoto requirements. The World
Bank argues that the flexibility enshrined in the Kyoto flexibility mechanisms and
other market mechanisms (e.g., banking) is a superior “safety valve” for cost
concerns than a price cap as suggested in some U.S. legislation. As stated by the
World Bank:
Flexibility is key to ensuring that there is a built-in safety valve for compliance
without resort to market distortion through price caps.... It would be appropriate
to recall here that flexibility is not the goal of climate policy; rather it is a tool
31 In 2006, China supplied 70% of CDM credits. Point Carbon, Carbon 2007, (March 13,
2007), p. 18.
32 Ibid., p. 42.
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to help achieve the most stringent targets. In this regard, the use of flexibility
mechanisms in Phase II coupled with much stronger reductions in Phase III and
the unilateral European target announced for 2020 should be at stringent enough
levels that can help stimulate a low carbon clean investment future. Setting an
arbitrary price cap distorts the level of innovation required to meet the
compliance target and dilutes the ability to meet the environment target.[footnote
omitted] 33
In contrast, some environmental groups are concerned that widespread use of
CDM and JI will prevent the investment in domestic efforts that the Kyoto Protocol
envisioned and that will be necessary as emission caps become more stringent and
more countries participate.34 In addition to concerns about the volume of outside
credits that may be used in the ETS, there are issues over the quality of the credits,
particularly with respect to “additionality” — the requirement in the Kyoto Protocol
that project credits represent reductions that would not have occurred in the absence
of the CDM program. In expressing concern about CDM not being additional to
current policies, WWF-UK states: “It is important to remember that CDM projects
do not themselves reduce net global greenhouse gas emissions — they merely allow
the project investor to pollute more at home. Ensuring that projects are additional is
therefore crucial to maintaining the environmental integrity of the whole system as
a breach of this means that global emissions actually increase.”35 Such concerns may
prevent full exploitation of CDM opportunities for some time.
Auction Policy
In general, allowances have been allocated free to participating entities under
the ETS. During Phase 1, The EU-ETS Directive allowed countries to auction up to
5% of allowance allocations, rising to 10% under Phase 2.36 Under Phase 1, only
four of twenty-five countries used auctions at all, and only Denmark auctioned the
full 5%. The political difficulty in instituting significant auctioning into ETS
allowance allocations is the almost universal agreement by covered entities in favor
of free allocation of allowances and opposition to auctions.37 Free allocation of
allowances represents a one-time transfer of wealth to the entities receiving them
from the government issuing them.38 The resulting transfer of wealth has been
33 The World Bank, State and Trends of the Carbon Market 2007 (Washington, DC, May
2007), p. 39.
34 For example, see: World Wildlife Fund — UK, Emission Impossible: Access to JI/CDM
Credits in phase II of the EU Emissions Trading Scheme (June, 2007).
35 Ibid., p. 7.
36 For a further discussion of auctioning and the ETS, see: Cameron Hepburn, et. al.,
“Auctioning of EU ETS phase II allowances: how and why?” 6 Climate Policy (2006), pp.
137-160.
37 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 73.
38 Joseph Kruger, Wallace E. Oates, and William A. Pizer, “Decentralization in the EU
(continued...)
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described by several analysts as “windfall profits”.39 As summarized by Ellerman and
Buchner: “Allocation in the EU ETS provides one more example that,
notwithstanding the advice of economists, the free allocation of allowances is not to
be easily set aside.”40
Despite concerns about windfall profits and economic distortions resulting from
the free allocation of allowances, there will be little change in basic allocation
philosophy for Phase 2. No country has proposed auctioning the maximum
percentage of allowances allowed (10%). Most do not include auctions at all.41 The
unwillingness of governments to employ auctions as an allocating mechanism
revolve around equity considerations, including: (1) inability of some covered entities
to pass through cost because of regulation or exposure to international competition;
(2) potential drag on a sector’s economic performance from the up-front cost of
auctioned allowances; and, (3) the potential that government will not recycle
revenues to alleviate compliance costs, international competitiveness impacts, or
other equity concerns, resulting in the auction costs being the same as a tax.42
Against these concerns, economic analysis provides several arguments in favor
of auctions in general, and in the case of the EU ETS in particular. General
arguments in favor of auctions include:43
! Purest embodiment of the “polluter pays” principle;
! Reduces distributional distortions that free allocation (and
accompanying “windfall profits”) can create;
! Creates a “level playing field” for existing and new covered entities;
38 (...continued)
Emissions Trading Scheme and Lessons for Global Policy,” 1 Environmental Economics
and Policy 1 (Winter 2007), p. 114.
39 E.g., Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying,
(March 6, 2007) pp. 2-3; and, Regina Betz and Misato Sato, “Emissions Trading: Lessons
Learnt from the 1st Phase of the EU ETS and Prospects for the 2nd Phase”, 6 Climate Policy
(2006), p. 353.
40 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 85.
41 For a review of proposed NAP 2 auction proposals as of January 12, 2007, see: Karsten
Neuhoff, EU ETS Auction Workshop, (Cambridge, January 12th, 2007), p. 26.
42 Martina Priebe, Distributional Effect of Carbon-allowance Trading, (Cambridge, January
12, 2007). Also, see: Eurochambres, Review of the EU Emission Trading System (June,
2007), p. 5.
43 Michael Grubb, The Growing Role of Auctioning in the Economy? Or Allocation Theory
and the Practice in Europe: the Great Divide, (Paris, September 25, 2006), p 4.
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! Potential for reducing the impact of compliance on the economy as
a whole if auction revenues are used to reduce more distorting taxes
on investment (i.e., “double dividend”); and
! Can improve emission market liquidity and transparency.
In the case of the EU-ETS, the use of free allocations rather than auctions has
created some perverse incentives for covered entities and unnecessary complexity to
the ETS. As discussed later in more detail, providing allowances free to existing
entities can encourage the continued use of inefficient plant, and reduce the incentive
for investing in efficiency improvements. The degree to which this occurs depends
on the specific allocation approach taken. In contrast, an auction can help create a
price floor, particularly if coupled with a reserve price, that encourages development
of new technologies and efficiency improvements in existing plant.
A free allocation scheme generally has to make some provision for new entrants
in addition to allocating allowances to existing entities. It also raises issues with
respect to existing sources that later decide to shutdown. This added complexity to
the ETS is discussed next.
New Entrant Reserves
Unlike previous cap and trade programs, the Member States of the EU have
included provisions for the allocation of allowances to new entrants to the system.44
The reasoning behind this decision is based on equity: (1) it isn’t fair to allocate
allowances free to existing entities while requiring new entrants to purchase them,
and (2) the EU doesn’t want to put Member States at a disadvantage in competing
for new investments.45 These equity concerns trumped concerns about economic
efficiency.
As is the case for existing entities, the free allocation of allowances to new
entrants is a subsidy. For the ETS, the size and distribution of this subsidy is left to
the individual Member States. For Phase 1, the reserve varies widely from the
average of 3% of total allowances: Poland set aside only 0.4% of its allocation for
new entrants while Malta set aside 26%. For Phase 2, the spread continues with
Poland reserving 3.2% of its allowances for new entrant in contrast to 45% proposed
by Latvia.46
44 For example, the U.S. acid rain program provides no allocation of allowances to new
entrants; instead, an EPA sanctioned auction is held annually to ensure that allowances are
available to new entrants. New entrants can also obtain allowances from existing sources
willing to sell them, either directly, through the EPA auction, or via a broker.
45 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 75.
46 Karoline Rogge, Joachim Schleich, and Regina Betz, An Early Assessment of National
Allocation Plans for Phase 2 of EU Emission Trading, Fraunhofer Institute System and
Innovation Research (January 2006).
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The decision to employ a new entrant reserve adds complexity to Member
States’ allocation plans and influences the investment decisions of covered entities.
Rules have to be promulgated with respect to the reserve’s size, manner in which the
allowances will be dispensed, and how to proceed if the demand either exceeds the
supply, or vice versa. As indicated, countries have not harmonized new entrant
reserve rules with respect to size. Likewise, there is no standardization on dispensing
allowances and replenishing the reserve: first-come, first-serve with no replenishment
is one approach used, but a variety of procedures have been developed both to
dispense allowances and to replenish the reserve if supply is inadequate.47 Member
States also have different formulas for determining how many allowances a new
entrant should receive. Member States claim to use a form of “benchmarking” to
determine allowance allocations — an approach based on a standard of “best
practices” or “best technology” that is applied to the new entrant’s anticipated
production or capacity. However, the definitions and application of the benchmarks
used by the Member States are not uniform.
This diversity in approaches to addressing new entrants results in technology or
fuel-specific subsidies, which vary by country. Table 3 presents the results of a study
of the value of annual allocations for a natural gas combined-cycle power plant under
different countries’ Phase 2 new entrant allocation rules. Assuming an allowance
value of 10 euro, the plant’s allocation would vary between 0 in Sweden (no free
allocation) to 11 million euro annually in Germany.48 At the current Phase 2
allowance price of 20 euro, this annual subsidy is equivalent to the fixed annual costs
of the power plant.49 Subsidies of this magnitude are likely to affect investment
decisions. As noted by Schleich, Betz, and Rogge, these subsidies: “run counter to
the logic of emission trading systems, where market prices and flexibility are
supposed to guide investment decisions rather than subsidies for particular types of
installations.”50
47 For a summary of 18 proposed NAPs with respect to new entrant reserves, see ibid., pp.
46-47.
48 Markus Ahman and Kristina Holmgren, “New entrant allocation in the Nordic energy
sectors: incentives and options in the EU ETS,” 6 Climate Policy (2006), p. 430.
49 Ibid., p. 431. Estimated at 19.5 million euro (2003$).
50 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better Job
Second Time Around? Fraunhofer Institute System and Innovation Research (February,
2007), p. 23.
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Table 3. Value of Annual Allocation for New NGCC Powerplant
(millions of euro, allowance price of 10 euro)
Country
Value of Free Allocation
Finland
2.7
Germany
11.0
Latvia
8.3
Lithuania
10.0
Poland
10.3
Sweden
0.0
Source: Markus Ahman and Kristina Holmgren, “New entrant allocation in the Nordic energy sectors:
incentives and options in the EU ETS,” 6 Climate Policy (2006), p. 430.
Closure Policy
The reverse side of the new entrant allocation issue is the what to do with the
allocations to existing plants that shut down. Under U.S. cap and trade programs,
those allowances are retained by the company, based on the assumption that a new
power plant will be built to replace the closed one. For most countries in the ETS,
closure policy is directly linked to the new entrant reserve: allowances allocated to
existing sources that shut down are fed into the entrant reserve to be allocated to new
sources. Thus, free allowances to existing facilities are tied to continued operation
of that facility. One reason for this approach may be the multiple country aspect of
the ETS and the political fear that owners of facilities could shut down plants in one
country, keep the allowance allocation, and move to another Member State.51
Unfortunately, this closure policy encourages inefficient facilities to continue
operating to maintain the subsidy the free allowance allocation represents. As
examined by Ahman, et al.:
The withdrawal of allocation based on reduced economic activity or closure
makes the loss of the allocation into an additional opportunity cost affecting the
production decision. In considering the marginal cost of operation, the firm will
recognize that it receives the allocation if and only if it continues to operate.
Consequently, the firm will not maximize its profits only with respect to the cost
of production (including resource cost and the opportunity cost of allowances);
in addition, it will take into account the value of the allowances that it will lose
should it cease to produce output. Imposing a condition that the allocation
51 Ibid., p. 19.
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depends on continued operation of the installation transform the allocation into
a production subsidy. [footnote omitted] 52
One response to the perverse incentives of the closure rule has been pioneered
by Germany and adopted by a few countries. Under the “transfer rule,” owners of
existing facilities being shut down can transfer the allocation from that facility to a
new replacement facility.53 For Phase 1, seven countries — Germany, Greece,
Hungary, Luxembourg, the Netherlands, Poland, and the UK — included transfer
rules in their NAP. For Phase 2, Cyprus, Flanders (part of Belgium), and Malta have
joined in including such rules in their NAP.54
Benchmarking
A third aspect of free allocation is benchmarking. As noted earlier, for new
entrants benchmarking involves allocating allowances based on a standard of “best
practices” or “best technology” that is applied to the new entrant’s anticipated
production or capacity. Environmental and other groups have advocated the
expansion of benchmarking to allocations for existing facilities in addition to new
entrants. However, benchmarking is very difficult given the diversity of processes
involved and subject to manipulation in favor of one technology or fuel-source over
another. For example, The Netherlands made a serous attempt to use benchmarks in
its allocation scheme, but abandoned the effort after 125 benchmarks were
developed.55
Benchmarks can also be used to encourage investment in one fuel-source over
another. This issue has arisen in the case of Germany’s proposed Phase 2 NAP. As
part of Germany’s overall energy policy, the NAP provides for the “fuel-neutral”
allocation of allowances to new powerplants based on benchmarks reflecting current
best practice for each fuel. For a coal-fired facility, the benchmark is 750 grams
CO /Kwh reflecting a conversion efficiency of 45%. For natural gas-fired facility, the
2
benchmark is 365 grams CO /Kwh, reflecting a conversion efficiency of 55%. These
2
are benchmarks that current technology can achieve without the addition of any
carbon capture and sequestration technology or purchase of offsets from other
sources. In addition, the government proposed to provide new entrants with a
guaranteed allocation of allowances based on actual emissions for 10 years after a 4
year allocation based on an 85% capacity factor. As a result, the NAP would provide
almost no incentive to utilities to reduce CO emissions by fuel shifting, and to
2
52 Markus Ahman, Dallas Burtraw, Joseph Kruger, Lars Zetterberg, “A Ten-Year Rule to
guide the allocation of EU emission allowances,” 35 Energy Policy (2007), p. 1721.
53 For a further discussion of the German NAP II, see Christoph Kuhleis, The German NAP
II (London, September 13, 2006).
54 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February,
2007), p. 19.
55 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 77.
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essentially encourage the use of lignite — Germany’s most abundant and least
expensive fossil fuel.56 This policy reflects concerns about Germany becoming too
dependent on imported Russian natural gas whose price tracks oil.57 Indeed,
economic analysis suggests that the price of an EUA would have to reach 45 euro
before lower-carbon emitting natural gas-fired facilities become more economic than
coal.58 As summarized by German utility RWE’s chief financial officer:
The name of our oil is lignite. We want to develop this energy source using new
technology and based on environmentally friendly processes. However,
governments will have to create the right political framework for this to occur.59
In reviewing the German proposed NAP, the EC disapproved the guarantee of
allowances to new entrants that extended beyond the Kyoto compliance period
(2008-2012), but approved the fuel-specific allocation formulas.60
Allocation and Energy Policy
As suggested above, the conflict between national energy policies and the free
workings of a carbon market are reflected in most countries’ allocation schemes. The
combination of free allocations to existing facilities and new entrants, along with
closure and benchmarking policies, allow countries to maintain substantial control
over energy policy and related economic investment regardless of the price signals
the carbon market might send if the market economics of carbon emission reductions
were the sole determinant of future investments. This control has been used to
preserve existing investment and jobs, encourage exploitation of domestic resources
(e.g., coal, lignite) and lower energy prices. Economists argue that such a strategy
56 Klaus Traube, Germany’s NAP — Perspectives of Concerned Actors, (Salzburg,
September 30, 2004), p. 5. As noted by the EC: this approach”encourages investment in new
power plants but not automatically in low CO2 emitting ones.” European Commission,
Questions and Answers on Emissions Trading and National Allocation Plants for 2008 to
2012 (Brussels, November 29, 2006) p. 4.
57 Reported by Vera Eckert, “Germany’s Coal Power Plans Threaten EU Climate Goal,”
Reuter News Service, (May 15, 2007).
58 Analysis by Booz Allen as reported by Vera Eckert, “Germany’s Coal Power Plans
Threaten EU Climate Goal,” Reuter News Service, (May 15, 2007).
59 Statement of Klaus Sturany, “RWE Slams German NAP Decision,” Carbon Finance,
(March 16, 2007), p. 1.
60 European Commission, On the assessment of National Allocation Plans for the allocation
of greenhouse gas emission allowances in the second period of the EU Emission Trading
Scheme accompanying Commission Decision of 29 November 2006 on the National
Allocation Plans of Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta,
Slovakia, Sweden and the United Kingdom in accordance with Directive 2003/87/EC.
(Brussels, November 29, 2006).
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is based on an economic misconception about how prices are set,61 and is inherently
contradictory. As stated by Deutsche Bank Research:
The political objective frequently expressed in both the EU and Germany of
achieving lower energy prices at the same time as implementing climate
protection measures should be rejected. The objectives of climate protection and
lower energy prices (for fossil fuels) are contradictory. Higher energy prices are
desirable from an ecological point of view. Although more competition in the
electricity and gas sectors could — ceteris paribus — lead to a reduction in
prices, this will probably be more than outweighed in the medium term by rising
commodity prices and higher fiscal burdens. In this respect, more honesty is
needed from all parties.62
The EC has put some limitations on country’s efforts to influence investment,
including disallowing any ex post adjustments and allowance guarantees. As noted
above, the EC explicitly disallows any provision of a country’s NAP that guarantees
allowances to covered entities beyond the phase for which the allowances are
allocated. The EC argues that allocation guarantees give such installations an unfair
advantage over other installations that do not get such guarantees.63
Proponents of allocation guarantees argue it is difficult to plan new investment
based on five-year allowance allocations.64 Yet, it is precisely the long term effects
of new investments and the potential that they will lock-in high carbon emitting
technologies that worry some, including the EC and member governments. As stated
in the Stern Review:
The next 10 to 20 years will be a period of transition, from a world where
carbon-pricing schemes are in their infancy, to one where carbon pricing is
universal and is automatically factored into decision making. In this transitional
period, while the credibility of policy is still being established and the
international framework is taking shape, it is critical that governments consider
how to avoid the risks of locking into a high-carbon infrastructure, including
61 As stated by Cameron Hepburn, et al., in the context of auctions: “One of the widest
economic misconceptions about auctioning is that it would simply add costs which would
be passed through to ‘downstream’ companies and consumers. [footnoted example omitted].
Yet, if firms maximize profits, then even with free allocation they pass on the opportunity
costs of allowances to downstream prices. Changing from free allocation to auctioning will
have little impact on product prices. [further explanatory footnote omitted] However,
because auctioning raises revenue that may be reallocated, it has, prima facie, the potential
to correct distributional impacts.” Cameron Hepburn, et al., “Auctioning of EU ETS phase
II allowances: how and why?” 6 Climate Policy (2006), p. 140.
62 Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying (March
6, 2007) p. 8.
63 European Commission, Questions and Answers on Emissions Trading and National
Allocation Plans for 2008 to 2012 (Brussels, November 29, 2006), pp. 3-4.
64 For example, see: “RWE slams German NAP decision,” Reported in Carbon Finance
(March 16, 2007).
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considering whether any additional measures may be justified to reduce the
risks.65
Avoiding locking-in high carbon energy technology by encouraging deployment
of advanced low carbon energy technology under the ETS would involve two
elements: (1) reducing behavioral distortion resulting from the current free allocation
system, and (2) energy pricing that reflects carbon costs. As indicated by the previous
discussions, the NAP 2 submitted to and approved by the EC generally have not
reduced the distortions from the free allowance system. The primary means of
reducing such distortions would be to increase the use of auctions and/or by more
extensive use of benchmarking based on capacity alone (not differentiated by fuel
source). As indicated above, no country has submitted a NAP that requires the full
10% auctioning allowed by the EC for Phase 2, although the number of countries
auctioning at least some percentage of their allocations has grown from 4 in Phase
1 to 9 in Phase 2. In addition, the EC allows countries to institute or expand auctions
at any time without its pre-approval. Uniform benchmarks are also rare with only
four countries intending to use them to any significant degree.66
With respect to a price signal for energy development, the Phase 1 experience
was instructive with respect to the value of accurate emissions inventories and
registries, but not in terms of developing a price floor that would stimulate
development of new technology. One mechanism to develop such a floor, banking,
was not used extensively during Phase 1; indeed, as noted earlier, the lack of Phase
1 to Phase 2 banking contributed to the collapse in Phase 1 prices in 2007. It is likely
to be far more important in Phase 2.
In the context of the ETS, options to provide a price floor beyond banking
include expanding use of auctions (including incorporating a reserve price into
auctions), financial instruments (such as options and futures contracts), and
expansion of industries covered by the ETS. The EC is moving very slowly with
respect to auctions, despite support for them by environmental groups and
economists. Financial instruments are being made available to entities by the major
65 Nicholas Stern, The Economics of Climate Change: The Stern Review (Cambridge, 2006),
p. xix. As stated by the EC with respect to fossil fuel power plants: “The expectations of
higher costs associated with CCS-equipped power plants after 2020 give rise to a tangible
risk. This is the risk of a “non-CCS technology lock-in” as the result of ill-considered
investment decisions with respect to the coal-fired capacity due for replacement in the
coming 10-15 years. It is imperative to avoid a situation where much of the new build
before 2020 is undertaken in a way that would either preclude or insufficiently guarantee
the addition of CCS components on a sufficiently wide scale after 2020.” European
Commission, Sustainable power generation from fossil fuels: aiming for near-zero
emissions from coal after 2020 (Brussels, January 10, 2007), p. 7.
66 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February,
2007), p. 17.
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emission exchange, although not extensively used as of yet.67 It is the third option,
expanding coverage that the EU has stated as an important goal for Phase 3.68
With respect to longer-term planning and investment, the EC apparently agrees
that a five-year allowance allocation may be too short and believes that in order to
provide greater predictability for long-term investment decisions, a longer allocation
period should be considered for Phase 3.69
Expansion
Despite the EC interest in expanding the ETS, its coverage in terms of industries
included for Phase 2 is essentially the same as for Phase 1. The potential exception
is for aviation. In December, 2006, the EC proposed bringing greenhouse gas
emissions from civil aviation into the ETS in two phases.70 In 2011, the proposal
would cover flights within the EU; in 2012, the coverage would expand to include
all flights to and from EU airports. EU and foreign airplane operators would be
included. This proposal is subject to approval by the European Parliament and The
Council of the European Union.
In discussing future climate change activities, the EC has identified two other
areas for possible inclusion under the ETS: (1) methane emissions from gas engines,
and from coal, oil and gas production; and (2) nitrous oxide emissions from large
combustion facilities.71 However, their incorporation into the ETS will not occur
before 2013 at the earliest.
Harmonization
The improved emissions inventories resulting from Phase 1 have allowed the
EC to harmonize the types of installations covered by the ETS across the various
Member States.72 In addition, as noted above, the EC has impose a uniform rule on
the Member States preventing the use of ex-post adjustments. However, the above
discussion also suggests that the ETS enters Phase 2 having made little advancement
67 For example, see: European Climate Exchange, The Carbon Market: How to Trade ECX
Emissions Contracts (July 2007).
68 European Commission, Limiting Global Change to 2 degrees Celsius: The Way Ahead for
2020 and Beyond, (Brussels, January 10, 2007), pp. 6-7.
69 Ibid., p. 6.
70 European Commission, Proposal for a Directive of the European Parliament and of the
Council amending Directive 2003/87/EC so as to include aviation activities in the scheme
for greenhouse gas emission allowance trading within the Community, (Brussels, December
12, 2006).
71 European Commission, Limiting Global Change to 2 Degrees Celsius: The Way Ahead
for 2020 and Beyond (Brussels, January 10, 2007), p. 7.
72 Ibid., p. 23.
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in harmonizing individual countries’ allocations schemes.73 As with Phase 1,
countries will continue to differ widely on the use of auctions; design and use of
benchmarks; design, size, and allocation for new entrant reserves; and rules for
closure during Phase 2.
The expansion of the EU to 27 Member States and the EC’s desire to enlarge
the ETS promise to test the willingness of the EC, Member governments, industry,
and environmental groups to harmonize and improve the efficiency of allocation
rules. Currently, there is no consensus on the specifics of any harmonized rules. The
EC has stated that one of its goals is by 2020 to “harmonise allocation processes
across Member States to achieve undistorted competition across Europe, including
through a wider use of auctioning.”74 Experience with Phase 1 and Phase 2 NAPs
suggests this may be a slow process.
Summary and Considerations for U.S. Cap-and-
Trade Proposals
The United States is not a party to the Kyoto Protocol and no legislative
proposal before the Congress would impose as stringent an emission reduction
regime on the United States as Kyoto would have. However, through almost three
years of carbon emissions trading the EU has gained valuable experience as it
prepares for Kyoto. This experience, along with the process of developing Phase 2
NAPs, may provide some insight into current cap-and-trade design issues in the U.S.
Emission Inventories and Target Setting
The ETS experience with market trading and target setting confirms once again
the central importance of a credible emissions inventory to a functioning cap-and-
trade program.75 The lack of credible EU-wide data on emissions is a direct cause of
the ETS Phase 1 allowance market collapse in 2006. As noted above, combined with
the use of projections to set targets, the poor data in some countries draw into
question the environmental benefits of Phase 1. Arguably, the most important result
of Phase 1 was the development of a credible inventory on which to base future
targets and NAPs.
In the United States, section 821 of the 1990 Clean Air Act Amendments
requires electric generating facilities affected by the acid rain provisions of Title IV
73 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February
2007), p. 23.
74 European Commission, Limiting Global Change to 2 degrees Celsius: The way ahead for
2020 and beyond, (Brussels, January 10, 2007), p. 6.
75 As stated by CRS in 1992: “For an economic incentive system to be effective, several
preconditions are necessary. Perhaps the most important is data about the emissions being
controlled. Such data are important to levy any tax, allocate any permits, and enforce any
limit.” CRS Issue Brief IB92125, Global Climate: Proposed Economic Mechanisms for
Reducing CO , by Larry Parker (archived November 16, 1994), p. 9.
2
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to monitor carbon dioxide in accordance with EPA regulations.76 This provision was
enacted for the stated purpose of establishing a national carbon dioxide monitoring
system.77 As promulgated by EPA, regulations permit owners and operators of
affected facilities to monitor their carbon dioxide emissions through either
continuous emission monitoring (CEM) or fuel analysis.78 The CEM regulations for
carbon dioxide are similar to those for the acid rain program’s sulfur dioxide CEM
regulations. Those choosing fuel analysis must calculate mass emissions on a daily,
quarterly, and annual basis, based on amounts and types of fuel used. As suggested
by the EU-ETS experience, expanding equivalent data requirements to all facilities
covered under a cap-and-trade program would be the foundation for developing the
allocation systems, reduction targets, and enforcement provisions.
Coverage
Despite economic analysis to the contrary, the EU decided to restrict ETS
coverage to six sectors that represent about 45% of the EU’s CO emissions.79 This
2
restriction was estimated to raise the cost of complying with Kyoto from 6 billion
euro annually to 6.9 billion euro (1999 euro) compared with a comprehensive trading
program. A variety of practical, political, and scientific reasons were given by the
EC for the decision.80
The experience of the ETS up to now suggests that adding new sectors to an
existing trading program is a difficult process. As noted above, a stated goal of the
EC is to expand the coverage of the ETS. However, the experience of Phase 1 did
not result in the addition of any new sectors going into Phase 2. The only possibility
of expanded coverage during Phase 2 is the proposed addition of aviation.
U.S. cap-and-trade proposals generally fall into one of two categories.81 Most
bills are more comprehensive than the ETS, covering 80% to 100% of the country’s
greenhouse gas emissions. At a minimum, they include the electric utility,
transportation, and industrial sectors; disagreement among the bills center on the
agricultural sector and smaller commercial and residential sources. In some cases
discretion is provided EPA to exempt sources if serious data, economic, or other
considerations dictate such a resolution.
76 Section 821, 1990 Clean Air Act Amendments (P.L. 101-549, 42 USC 7651k).
77 S.Rept. 101-952.
78 See 40 CFR 75.13, along with appendix G (for CEMs specifications) and appendix F (for
fuel analysis specifications.
79 For more background, see CRS Report RL33581, Climate Change: The European Union’s
Emissions Trading System (EU-ETS), by Larry Parker.
80 Ibid., p 3.
81 For an overview of cap-and-trade proposals, see: CRS Report RL33846, Greenhouse Gas
Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry Parker and Brent D.
Yacobucci. For an overview of multi-pollutant control bills, see: CRS Report RL34018, Air
Quality: Multi-pollutant Legislation in the 110th Congress, by Larry Parker and John E.
Blodgett.
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A second category of bills focuses on the electric utility industry, representing
about 33% of U.S. greenhouse gases and therefore less comprehensive than the ETS.
Sometimes including additional controls on non-greenhouse gas pollutants, these
bills focus on the sources with the most experience with emission trading and the
best emissions data. Other sources could be added as circumstances dictate.
As noted, the EU’s experience with the ETS suggests that adding sectors to an
emission trading scheme can be a slow and contentious process. If one believes that
the electric utility sector is a cost-effective place to start addressing greenhouse gas
emissions and that there is sufficient time to do the necessary groundwork to
eventually add other sectors, then a phased-in approach may be reasonable. If one
believes that the economy as a whole needs to begin adjusting to a carbon-
constrained environment to meet long term goals, then a more comprehensive
approach may be justified. The ETS experience suggests the process doesn’t
necessarily get any easier if you wait.
Allocation Schemes
Setting up a tradeable allowance system is a lot like setting up a new currency.82
Allocating allowances is essentially allocating money with the marketplace
determining the exchange rate. As noted above, analysis of the free allocation scheme
used in the ETS has resulted in “windfall profits” being received by allowance
recipients. As stated quite forcefully by Deutsche Bank Research:
The most striking market outcome of emissions trading to date has been the
power industry’s windfall profits, which have sparked controversy. We are all
familiar with the background: emissions allowances were handed out free of
charge to those plant operators participating in the emissions trading scheme.
Nevertheless, in particular the producers of electricity succeeded in marking up
the market price of electricity to include the opportunity-cost value of the
allowances. This is correct from an accounting point of view, since the
allowances do have a value and could otherwise be sold. Moreover, emissions
trading cannot work without price signals.83
The free allocation of allowances in the ETS incorporates two other mechanisms
that create perverse incentives and significant distortions in the emissions markets:
new entrant reserves and closure policy. Combined with an uncoordinated and spotty
benchmarking approach for both new and existing sources, the result is a greenhouse
gas reduction scheme that is influenced more by national policy than by the emissions
marketplace.
The most discussed alternative allocation scheme in the ETS is the expanded
use of auctions: this approach could simplify allocation and permit market forces to
influence compliance strategies more fully. Most countries did not employ auctions
82 Unlike a carbon tax which uses the existing currency system to control emissions — be
it euro or dollars.
83 Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying (March
6, 2007), p. 2.
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at all during Phase 1 and auctions continue to be limited going into Phase 2. No
country has combined an auction with a reserve price to encourage development of
new technology. The EC has limited the amount of auctioned allowances to 10% in
Phase 2: a limit no country has chosen to meet. Efforts to expand auctions have met
opposition from industry groups, but support from environmental groups and
economists.
Currently, all U.S. cap-and-trade bills introduced have some provisions for
auctions, although the amount involved is sometimes left to EPA discretion. Two
bills, S. 317 and S. 1766, specify a schedule for the increased use of auctions with S.
317 allocating 100% of allowances by auction in 2036 and S. 1766 allocating 66%
by 2043. Funds would be used for a variety of purposes, including programs to
encourage new technologies. None of the bills include a reserve price on the auctions
to create a price floor for new technology.
Like the situation in the ETS, most U.S. industry groups either oppose auctions
outright or want them to be supplemental to a base free allocation. Given the
experience with the ETS where the EC and individual governments have been
unwilling or unable to move away from free allocation, the Congress may ultimately
be asked to consider specifying any auction requirement if it wishes to incorporate
market economics more fully into compliance decisions.
Flexibility and Price Volatility
Despite EU rhetoric during the Kyoto Protocol negotiations, it is moving into
Phase 2 without a significant restriction on the use of CDM and JI credits. This
embracing of project credits will significantly increase the flexibility facilities have
in meeting their reduction targets. In addition, Phase 2 will include the use of
banking to increase flexibility across time. Each of these market mechanisms is
projected to reduce both the EU’s Kyoto compliance costs and allowance price
volatility. As a further defense against price volatility, the European emission
exchanges are creating financial instruments, such as futures contracts and options,
to permit entities to hedge against price changes.
Unfortunately, Phase 1 experience with the ETS does not provide much useful
information on the value of market mechanisms or financial instruments in reducing
costs or price volatility. The combination of poor emissions inventories, non-use of
project credits, and time-limited allowances with effectively no banking resulted in
extreme price volatility in Spring 2006, and virtually worthless allowances by mid-
2007. The real test for the mechanisms employed by the ETS to create a stable
allowance market will be Phase 2, beginning in January 2008.
Like the ETS, U.S. cap-and-trade proposals would employ a combination of
devices to create a stable allowance market and encourage flexible, cost-effective
compliance strategies by participating entities. All include banking. All include use
of offsets, although some would place substantial restrictions on their use. One bill,
S. 1766, incorporates a “safety valve” that would effectively place a ceiling on
allowance prices.
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No current proposal has specific provisions with respect to financial instruments
or who would regulate such a market or its participants. This may be a problem,
based on experience with the ETS. Analysis of ETS allowance prices during Phase
1 suggests the most important variables in determining allowance price changes were
oil and natural gas price changes.84 This apparent linkage between allowance price
changes and price changes in two commodities markets raises the possibility of
market manipulation, particularly with the inclusion of financial instruments such as
options and futures contracts. Congress may ultimately be asked to consider whether
the Securities and Exchange Commission or the Commodities Futures Trading
Commission should have regulatory and oversight authority over such instruments.
84 Maria Mansanet-Bataller, Angel Pardo, and Enric Valor, “CO Prices, Energy and
2
Weather,” 28 The Energy Journal 3 (2007), pp. 73-92.