Trials and tribulations
July 04th 2007

The trials and tribulations of the EU ETS. Sanjeev Kumar, ETS Coordinator,WWF European Policy Officer explains how the European Union emissions trading scheme has performed so far

The EU ETS was hastily put together and launched in 2005 to send a clear signal to the international community that the EU took climate change. To other industrialised nations it signified the EU’s commitment to meeting its Kyoto Protocol targets. To developing economies it confirmed that the EU was serious about its historic responsibility for greenhouse gas emissions and would take the first steps in reducing its emissions. EU ETS has rapidly become the largest carbon market with over 320 million permits traded worth in the region of € 6.5 billon in 2005. It has even sparked a number of discussions in other developed economies about the establishing similar schemes. Unfortunately, structural problems have largely hampered substantial delivery of emission reductions as well as a fully operational and robust market. There is room for improvement. The question is where leaders have the boldness to make the necessary improvements.

CAPs, NAPs and mad dogs….….

In any cap and trade scheme the level of the cap is one of the most important determinants of price.By virtue of its design, EU ETS has 27 different caps which are set by Member States. These caps, which are called National Allocation Plans (NAPs), determine the number of permits (EU Allowances referred to as EUAs) that installations covered buy EU ETS receive. The political nature of this arrangement had had dramatic ramifications for the first phase of the EU ETS and will continue to do so unless addressed quickly.

EU ETS also allows linking to the Kyoto credits from the Clean Development Mechanism (CDM) and Joint Implementation (JI).These mechanisms support low cost abatement in non-Annex 1 Kyoto countries.The number of Kyoto credits entering the EU ETS is limited and determined on a national basis through a calculation that the Commission does when agreeing a NAP with a Member State. External credits increase the size of the CAP, reduce scarcity in the market and therefore deflate prices. Access to credits is one of the biggest challenges that the EU ETS will face in Phase 2 and beyond.

Interestingly, access to external credits is not a feature of some of the newly designed schemes principally those at US regional level. In these cases the thinking is that abatement funds should be reinvested in the economy.

A great leap into the dark… Phase 1 2005-2007

The first phase literally had its ups and downs. EU ETS went live on 1 January 2005 with permits initially trading at 5? but this rose sharply by mid 2005 to just under 30?. This was because of perceptions of a scarce supply of permits in the market. However, the design problems became apparent after the release of the Community Independent Transaction Log (CITL) data. CITL lists all installations covered, the number of permits they were allocated and importantly their emissions in the preceding year.This showed that NAPs had woefully over allocated permits to installations creating a substantial glut in the overall number of permits in the market.

Following conventional economic theory, this over supply lead to a dramatic collapse in price.This was, to an extent, understandable as there was a lack of sufficiently robust data on which companies could make accurate assessments of their baseline emission profiles. This was amplified by cautiousness on the part of Member States when setting their NAPs. In total a recipe for disaster. To its credit, the Commission did use the caveat that the first phase was a “trial”to facilitate practical experience of emissions trading. It might be able to hide behind this excuse for the second phase (2008 – 2012) but not by the third phase (2012…). Importantly, the Commission announced a review of the EU ETS that focuses on reforming the structure of the scheme in areas such as adding new sectors, allocation methodology (how permits are distributed to the participants), harmonised cap setting procedures,consistent monitoring, reporting and verification procedures and issues relating to linking with other sectors.

Once more into the breech… The second phase (2008-2012)

2008-2012 coincides with the Kyoto trading period. Climate Action Network (CAN) has assessed the allocation of permits from the agreed NAPs agreed for phase 2. In comparison to the Phase 1 NAPs there appears to be reduction in the number of permits of about 6 to 7%. Therefore, there is likely to be some scarcity in the market. At present, the Phase 2 forward market has been trading between 14? to 23? (29 May 2007) per permit.However, it is too early to say whether there will be sufficient scarcity and robustness in the market to signal abatement. However the following factors will be significant:

Total allocation – As mentioned the NAPs for phase 2 indicate that there is likely to be a reduction of 6 to 7% of permits compared to the 2005 verified emission levels.Whether this is enough to generate a robust price has yet to be seen and will not be until the results of the first year are published in the CITL.

External credits – Although limits were placed on access to external credits it has yet to be seen where these limits will be respected. As indicated earlier, unlimited access to credits will destroy the CAP and carbon price. One advantage is that the EUA will effectively set the price for credits.

Economic growth – NAPs factor in a level of projected economic growth. So if the level of economic growth is lower than the forecast level accounted for in a NAP, it is likely to push the EUA price downwards.

International economic conditions – EUA prices are linked to a series of factors such as internal gas prices (gas price increases push up the EUA price), weather which would also combine with gas price increases to amplify increases in EUA prices although it is difficult to accurately predict these events.

Legal challenges to NAPs – At the time of writing, Poland,The Czech Republic and Slovakia have taken the Commission to court over their NAP. It is unwise to speculate on the ramifications of this decision though it is fair to recognise that if there is a case proven in favour of the Member States there are likely to be further cases as Member States that had significant revisions to their original submissions also push for a revision of the Commission’s decision. Whether the EU ETS will be able to survive is another question altogether.

Banking – Permits can be banked from the second phase into the third phase. This allows companies that do not want to sell their permits to hold on to them in order to achieve a desired price when the time is right. By holding on to permits this maintains and perhaps creates a degree of scarcity of stability at least.However, the decision to bank will depend largely on the direction of the post 2012 international negotiations.

The carrot……

There is much said about the post 2012 framework and the uncertainty that it poses for investments, prices and overall carbon reductions.EU ETS will have a role to play in this world for a variety of reasons.Firstly, there is no “sunset clause” in the directive. This means that unless there is further legislation removing it, EU ETS has no legal end date. Coupled with this is the visionary Spring Council conclusions agreed by the heads of Member States in March 2007. Heads of states committed the EU to a total greenhouse gas emission reduction of 20% by 2020 and a total 30% by 2020 if another countries accepts realistic emission reduction targets. The contribution that EU ETS will make to this target is being negotiated at present but it is clear that EU ETS will have a role.

Another important ingredient in the mix is the interest in cap and trade schemes in other countries. Norway recently joined the EU ETS and discussions are nearing completion with other neighbours in Europe. Importantly, the US is witnessing the birth of has 2 regional schemes, whilst there are rumblings in New Zealand.This is supported by proactive moves by the EU to actively engage other potential schemes to facilitate their potential to link with EU ETS.

Furthermore, Member States are lining up to add new sectors into the scheme such as aviation, which is currently going through the legislative process,shipping and a host of other unlikely candidates such as surface transport and domestic offsets.

So,although it has had a brief live EU ETS has certainly been eventful. The review process that was launched towards the end of 2006 is likely to make some improvements to its design and operation as a functioning and robust market. Whether significant carbon reductions are delivered however remains to be seen.