Since 2005, some 10,000 large industrial plants in the EU have been required to buy and sell permits to release carbon dioxide into the atmosphere. A so-called 'emissions trading scheme' enables companies that exceed individual CO2 emissions targets to buy allowances from 'greener' ones to help reach the EU's targets under the Kyoto Protocol. However, pollution credits were grossly overallocated by several countries during the initial implementation phase, forcing down carbon prices and undermining the scheme's credibility, which has prompted the EU to consider toughening up the system.

Overview

To minimise the economic costs of its commitments to combat climate change under the Kyoto Protocol, EU countries have agreed to set up an internal market enabling companies to trade carbon dioxide pollution permits. 

Under the EU Emissions Trading Scheme (EU ETS), some 10,000 energy-intensive plants across the EU are able to buy and sell permits to emit carbon dioxide, representing around 40% of the EU's total CO2 emissions. Industries covered by the scheme include: power generation, iron & steel, glass, cement, pottery and bricks.

An emission cap is defined, for each individual plant, via a National Allocation Plan (NAP) submitted by member states and approved by the Commission. Companies that exceed their quotas are allowed to buy unused credits from those that are better at cutting their emissions.

Originally, a fine of €40 per excess tonne of CO2 emitted was imposed on plants exceeding their individual target, which rose to €100 in 2008. For comparison, carbon prices fluctuated between €8-30 a tonne in 2005-06 (one tonne = one allowance). By offering a much cheaper alternative to fines, the Commission hopes that the EU ETS will stimulate innovation and create incentives for companies to reduce their carbon emissions.

Issues

Under the current scheme, EU states benefit from a number of exemptions:

  • Whole sectors are at the moment not covered, including transport and buildings, which represent the largest share of CO2 emissions after the power-generation and energy-intensive industries,;
  • Member states can apply to opt out individual plants from the system, and;
  • in cases of "force majeure", such as exceptionally low winter temperatures, additional emissions allowances can be issued by national authorities.

Link with Kyoto Protocol's 'flexible mechanisms'

One key aspect is the possibility to link the EU ETS with the Kyoto Protocol's Joint Implementation (JI) and Clean Development Mechanism (CDM). These 'flexible mechanisms' allow member states to meet part of their target by financing emission reduction projects in countries outside the EU.

The aim is to offer EU countries cheaper emission cuts than at home, while fostering technology transfers to developing countries (via the CDM) and other industrialised nations (via the JI), which have signed up to the Kyoto Protocol.

Over-allocation

Official EU data published in May 2006 showed that a group of countries, including large polluters such as Germany, were left with 44.1 million tonnes of extra CO2 allowances for the year 2005. Among the EU's major polluters, only the UK had emitted more than its quota, forcing it to buy over 30 million tonnes of extra allowances on the EU carbon market. 

The supply surplus sent carbon prices crashing, calling into question the credibility of the EU scheme (EurActiv 16/05/06). In an bid to avoid a repeat of this situation during the second trading period, which began in mid-2008, the Commission announced in October 2007 a 10% reduction in the emissions that member states are allowed to emit (to a total of 2.08 billion tonnes for the period), forcing some countries to slash their suggested targets by as much as 50%.

EU-ETS review

According to a November 2006 report by the Commission, the ETS has proven successful so far, with the latest official data showing that the 15 EU members which originally signed up to Kyoto had achieved a 2% CO2 cut in 2005 compared to 1990 levels. Furthermore, projections imply that, based on existing policies alone, this figure should rise to 7.4% by 2012 – just short of the Kyoto target. 

However, in March 2007, EU leaders agreed that, by 2020, they would cut overall greenhouse gas emissions by 20% compared to 1990 levels. The Commission says this will require a "much steeper reduction path" for industrial emissions, which is the aim of its ETS reform proposal for the post-2012 period, presented on 23 January 2008. 

The revision of the EU ETS was negotiated by the Union's heads of state and government in Brussels on 11 December 2008, and the European Parliament approved the new regime at first reading on 17 December. The main elements of the new system, which will enter into force in 2013 and run until 2020, are the following:

  • Capping total EU industrial emissions at 21% below 2005 levels by 2020: i.e. a maximum of 1720 million allowances, with total emission allowances cut by 1.74% annually as of 2013. The EU-wide target replaces the current 27 national targets. 
  • Enlarging the scope  of the scheme to new sectors, such as the petrochemical, ammonia and aluminium sectors, to two new gases (nitrous oxide and perfluorocarbons), and to aviation as of 2012, so that around 50% of all EU emissions would be covered. Road transport and shipping remain excluded, although the latter is likely to be included at a later stage. Agriculture and forestry were also left out, due to difficulties related to measuring emissions from those sectors accurately.
  • Sectors not covered by the ETS, such as transport, buildings, agriculture and waste, are to achieve an average GHG reduction of 10% by 2020. To achieve this, the Commission has set national targets according to countries' GDP. Richer countries are asked to make bigger cuts – up to 20% in the case of Denmark, Ireland and Luxembourg – while poorer states (notably Portugal, as well as all countries that joined the EU after 2004 except Cyprus) will be entitled to increase their emissions in these sectors – by up to 19 and 20% respectively for Romania and Bulgaria – in order to take into account their high expectations for GDP growth.
  • Smaller installations  that emit under 25,000 tonnes of CO2 per year will be allowed to opt out from the ETS, provided that alternative reduction measures are put in place. 
  • Industrial GHGs prevented from entering the atmosphere through the use of so-called carbon capture and storage (CCS) technology are to be credited as 'not emitted' under the EU Emissions Trading Scheme (EurActiv 16/11/07). Up to 300 million allowances will be made available from the new entrants' reserves until the end of 2015 to subsidise the construction of 12 carbon capture and storage (CCS) demonstration plants and support projects on innovative renewable energy technologies (EurActiv 12/12/08).
  • Auctioning: The Commission's proposal foresaw a huge increase in auctioning as early as 2013. While today, 90% of pollution allowances are handed out to industrial installations for free, the text states that "around 60% of the total number of allowances will be auctioned in 2013". It adds that "full auctioning should be the rule from 2013 onwards for the power sector". This is expected to lead to a 10-15% rise in electricity prices. In other sectors, free allocation will gradually be completely phased-out on an annual basis between 2013 and 2020. The original proposal foresaw a complete phase-out between 2013 and 2020, but the compromise text states that the level of auctioning will reach 70% in 2020, with a view to 100% auctioning in 2027. Nevertheless, certain energy-intensive sectors could continue to get all their allowances for free in the long term if the Commission determines that they are "at significant risk of carbon leakage," i.e. relocation to third countries with less stringent climate protection laws. The sectors to be affected by this measure will be determined by the end of 2009.
  • EU solidarity fund:  Under the compromise, 10% of emission quotas delivered under the EU's emissions trading scheme for carbon dioxide (EU ETS) are to be reserved for a "solidarity fund" designed to help poorer countries from Central and Eastern Europe in their transition to cleaner energy production. An additional 2% are to be redistributed among those nine countries, with the bulk going to Romania (29%), Poland (27%) and Bulgaria (15%). EU states also agreed to "use at least half" of revenues generated from the auctioning of allowances in the EU emissions trading system to invest in low-carbon technologies.

  • distribution method for free allowances will be developed by the end of 2010 by expert panels within the Commission (through the so-called 'comitology procedure'). The rules will be determined by benchmarks based on the most efficient techniques and processes. The benchmarks will be calculated for products rather than for inputs in each sector, to achieve the maximum energy savings in each production process. The text states that the Commission will consult relevant stakeholders in defining the criteria, but the default position will be the average performance of the top 10% most-efficient EU installations in any given sector between 2007 and 2008. 

  • Competitiveness: The directive stresses that the risk of "carbon leakage" – and subsequently, the need for compensatory measures for European companies – is dependent on whether or not an international agreement subjecting all countries to similar climate change mitigation measures is reached. It therefore delays any decision on eventual compensation measures until mid-2010, when the Commission will have to present a review of the situation. If no global pact is reached by then, some sort of "carbon equalisation system" will be introduced – whether in the form of additional free allocations or through the inclusion of carbon-heavy imports from third countries in the ETS. 
  • Flexibility and third countries: Assuming a global climate change deal is reached, member states will continue to be entitled to meet part of their target by financing emission reduction projects in countries outside the EU (through the CDM and JIs). In the absence of a global climate change deal, the compromise allows a top-up to the Commission's proposal to limit the use of such credits to 3% of member states' total emissions in 2005, provided that the additional quantity does not exceed 50% of EU-wide reductions between 2008 and 2020. Assuming an international agreement is reached, member states could gain access to additional credits and be allowed to use additional types of project credits and mechanisms created under the agreement. However, only credits from projects in third-countries that ratify the new international agreement will be eligible.

Positions

Business circles have focused their criticism on the EU "going it alone" on climate change and imposing costly unilateral measures  which do not apply to the EU's major competitors. They expressed their disappointment that the ETS review fails to name sectors that could benefit from free allowances or set up measures, such as free allocation, aimed at protecting European companies from competition from third countries with less demanding climate legislation.

"This neither ensures predictability nor certainty for business," lamented Folker Franz, senior advisor on industrial affairs and the environment for the European employers organisation BusinessEurope

They also expressed concern that trade-restrictive action on imports was still under consideration by the EU, as this could provoke retaliatory measures. "If you impose import measures on others, the others might do the same," said Franz. As an alternative, he said the EU should continue to promote the clean development mechanism. A key fear is that such projects could be discontinued if no global climate deal is reached. Most environmental NGOs disapprove the use of CDM/JIs, saying they undermine the EU's pledge to cut emissions at home.

Commission President José Manuel Barroso justified the absence of a list of sectors that could receive compensation for EU climate measures, saying: "At this stage, we cannot draft a precise list of industries that will really be affected by the carbon leakage phenomenon […] So what we have done now is establish the criteria to determine, at a later stage, precisely which sectors are affected." 

He nevertheless insisted that the EU would take action if it proves necessary to maintain the competitiveness of European businesses: "We all know that there are sectors where the cost of cutting emissions could have a real impact on their competitiveness against companies in countries which do nothing. There is no point in Europe being tough if it just means production shifting to countries allowing a free-for-all on emissions. An international agreement is the best way to tackle this - but […] if our expectations about an international agreement are not met, we will look at other options such as requiring importers to obtain allowances alongside European competitors, as long as such a system is compatible with WTO requirements." 

Energy Commissioner Andris Piebalgs added: "We are doing everything to avoid the need for such legislation. But, if common sense does not prevail […] then in 2011, we will assess the situation and determine whether energy-intensive industries in the EU will be compensated for the lack of climate measures in other countries." 

Trade Unions within the EU  are upset that the Commission is delaying such measures and believe that a border adjustment mechanism is essential. ETUC General Secretary John Monks stressed: "There is a way of keeping employment and the planet from being the losers: a compensation mechanism such as a carbon tax on imports, which would equalise carbon costs for all companies, whether they are based in Europe or outside its borders. Under such a system, a considerable effort could be demanded of European industry while keeping heavy industry and jobs in Europe." He added: "The Commission's postponement of that decision is a mistake, since it has acknowledged the dangers of relocation and 'carbon leakage'." 

Environmental associations strongly criticised the fact that the plans for the new scheme are solely based on a 20% reduction target, rather than on a 30% goal. "The European Union should be planning for the success, not failure, of international negotiations to cut climate pollution. The 20% target is not even in line with the latest Bali agreement - that developed countries should cut emissions by 25-40% by 2020," complained the WWF. "Overall, it is a very small effort to cope with a threat that might lead to Arctic melting and displacement of millions of people in developing countries because of increased floods," said Dr Stephan Singer, head of the European Climate and Energy Unit at WWF

Nevertheless, green groups did welcome the planned increase in auctioning, saying it would help put an end to windfall profits made by businesses, who received allowances for free and then were able to sell on their extra credits. 

Timeline

  • 2005-2007: First trading period (and first round of NAPs). 
  • Dec. 2006: Commission adopts legislative proposal to include aviation into the EU's emissions trading scheme (see LinksDossier Aviation and Emissions Trading).
  • 2008-2012: Second trading period (coincides with period under which Kyoto commitments are to be achieved), with an EU-wide CO2 cap set at 2.08 billion tonnes.
  • 23 Jan. 2008: Commission unveiled EU-ETS legislative proposal for post 2013 period of trading as part of a larger package on renewable energies and climate change.
  • 3 April 2008: Data on industrial CO2 emissions in 2007 published, indicating a slight increase (EurActiv 03/04/08).
  • 7 Oct. 2008: Parliament'd environment committee voted on the EU ETS proposal (EurActiv 08/10/08).
  • 17 Dec. 2008: Parliament approved, by overwhelming majority, the revised EU ETS for the third trading period 2013-2020 as part of the EU's climate and energy package (EurActiv  18/12/08).
  • 31 Dec. 2009: Deadline for the publication of the Commission's list of sectors deemed to be exposed to a significant risk to carbon leakage.
  • By 30 June 2010: Commission will publish the absolute Community-wide quantity of allowances for 2013.
  • By Dec. 2010: Commission will publish an estimated amount of allowances to be auctioned.
  • 2013: Revised scheme due to enter into force.