House of Lords - European Union - Thirty-Third Report

Select Committee on European Union Thirty-Third Report

Revision of the EU's Emissions Trading System

CHAPTER 1: Introduction

1. Last year, the Fourth Report[1] of the United Nations Intergovernmental Panel on Climate Change[2] warned that "eleven of the last twelve years (1995-2006) rank among the twelve warmest years in the instrumental record of global surface temperature (since 1850)". The report concluded that most of the observed increase is "very likely to result from" an increase in greenhouse gas concentrations caused by human activities.[3] In the previous year (2006), the Stern Review of the Economics of Climate Change described climate change as "a serious and urgent issue" that could be viewed as "the greatest example of market failure" that has ever been seen[4].

2. Europe has warmed even more than the global average.[5] The cornerstone of the European Union's strategy for tackling climate change is its Emissions Trading Scheme (ETS). Introduced in 2005, the ETS is the first international trading system for carbon dioxide emissions in the world. Over 10,000 installations in the energy and industrial sectors currently participate in the EU ETS, which is now in its second phase (2008-2012). They are collectively responsible for close to half of the EU's carbon dioxide emissions and 40 per cent of its greenhouse gas emissions.[6]

3. In January 2008, the European Commission published its proposals for the third phase (2013-2020) of the EU ETS, in the form of a series of revisions to the current scheme.[7] Our inquiry sought to examine these proposed changes, and their implications for climate change policy at national, EU and international levels. The inquiry was motivated by the recognition that both the European Union and the UK Government have placed the EU ETS at the centre of their climate change policy: the scheme's effectiveness will therefore have far-reaching implications for both the EU and the wider international community's efforts to tackle global warming.

4. Our report begins with a brief explanation of the basic economic principles underpinning the ETS, an outline of the international and EU-level developments that preceded the Commission's legislative proposal, and a summary of the proposal itself. We then examine the key provisions of the proposal in detail in Chapters 2-8, presenting our witnesses' views and our own conclusions and recommendations. We conclude in Chapter 9 by identifying what we regard as the key conditions for a successful EU ETS over the period 2013-2020 and beyond.

5. The inquiry that led to this report was carried out by EU Sub-Committee D, whose Members are listed in Appendix 1. We received written evidence and took oral evidence from a range of witnesses, who are listed in Appendix 2. We are grateful to them all for their contributions and would also like to thank our Specialist Adviser, Alyssa Gilbert (Consultant, Ecofys UK). We make this report to the House for debate.

How does emissions trading work?

6. Emissions trading schemes like the EU ETS are based on the insight—drawn from environmental economics—that markets left to their own devices can fail to provide the signals that would prompt individuals or organisations to factor the environmental costs of their actions into their behaviour. This can result in environmental degradation.Emissions trading schemes are designed to rectify this so-called "market failure" by creating a price signal that should raise the cost of pursuing activities that produce environmentally harmful emissions, and thereby promote changes in behaviour.

7. The EU ETS is a "cap and trade" scheme, meaning that regulatory authorities place a "cap" or ceiling on the overall level of emissions to be permitted, and then issue emissions allowances (permits) that add up to that cap. In the EU ETS, one allowance gives the holder the right to emit one tonne of carbon dioxide, or its equivalent in other greenhouse gases. These allowances are then traded among participants in the scheme, who must surrender allowances equivalent to their emissions to the regulatory authorities at the end of each year.

8. The regulatory authorities overseeing an emissions trading scheme may use one of a number of methods to allocate emissions allowances to participants in the scheme. Allowances can be allocated to participants for free on the basis of their historical emissions ("grandfathering"). Alternatively, allowances can be allocated to participants for free on the basis of their potential emissions if they use a particular technology ("benchmarking"). Lastly, the regulatory authorities may choose to auction allowances to participants in the scheme, allowing those who value the ability to emit the most to bid the highest price. The highest bidders will usually be those who find it particularly difficult or costly to reduce their emissions.

9. The cap on the overall quantity of allowances—reflecting the overall cap on emissions—is what creates scarcity in the market, and therefore makes allowances valuable. For participants, the incentive to reduce emissions lies in the prospect of making money from the sale of unused allowances, or the prospect of losing money by having to buy allowances to cover their emissions. Emissions trading schemes are supposed to deliver emissions reductions cost-effectively because they should prompt those that find it cheap to reduce their emissions to do so, either in order to avoid having to buy emissions allowances or in order to sell excess allowances already in their possession. Emission reduction efforts should therefore be concentrated where they are easiest and cheapest.

10. In time, however, even participants who find it relatively expensive to reduce their emissions in the short run may find it worth their while to invest in the development of new technologies that may allow them to cut their emissions in the future and thereby reduce their ongoing expenditure on emissions allowances. An emissions trading scheme with a clear and predictable future trajectory ought therefore to encourage innovation.

The International Context

11. The aim of the EU ETS is to help European Union Member States achieve their commitments to limit or reduce greenhouse gas emissions. These commitments stem from the adoption of the Kyoto Protocol (see Box 1)[8] under the United Nations Framework Convention on Climate Change (UNFCCC).[9] In signing up to the Protocol, the EU committed itself to reduce its greenhouse gas emissions by 8 per cent by 2012 compared to 1990.

BOX 1

The Kyoto Protocol

Recognising that industrialised countries are primarily responsible for the high levels of Greenhouse Gas (GHG) concentrations in the earth's atmosphere, the Kyoto Protocol set legally binding emission reduction targets for 37 industrialised countries (so-called "Annex I countries" under the UNFCCC) and the European Community.

Under Kyoto, industrialised countries agreed to reduce their collective GHG emissions by 5 per cent against 1990 levels over the five-year period 2008-2012. Individual emission reduction targets vary from country to country.

Each country's emissions allowance is expressed in the form of "Assigned Amount Units" (AAU). Should a country have AAUs to spare, these can be traded between countries through an emissions trading scheme.

Under the "Joint Implementation" (JI) scheme, countries may sponsor emissions reductions in other countries with reduction commitments under the Protocol. In so doing, they earn Emissions Reduction Units (ERU) that count as credits against their own targets.

Under the Clean Development Mechanism (CDM), emission reduction projects in developing countries can earn Certified Emissions Reduction (CER) credits, which can be sold and traded, and used by Annex I countries to help meet their emission reduction targets.

Land use, land use change and forestry activities such as reforestation can earn Removal Units (RMU) which can again be used as credits.

The UN maintains the International Transaction Log[10] (ITL) to verify that transactions are consistent with the rules of the Protocol.

12. The Kyoto Protocol was signed in 1997 and entered into force in February 2005 once it had been ratified by the required number of signatories. It has not been ratified by the United States, which accounts for almost 20 per cent of global man-made greenhouse gas emissions. Meanwhile other large emitters, such as India and China, were exempted from Kyoto's emission reduction targets due to their status as developing countries. As the Kyoto Protocol is due to expire at the end of 2012, international negotiations on a successor agreement are now underway, with the aim of reaching agreement on a new treaty in December 2009, at the UN Climate Change Conference in Copenhagen, Denmark.

The Evolution of the European Union's Emissions Trading System

13. The European Union's Emissions Trading System (EU ETS) was launched on 1 January 2005 and is based on a Directive adopted in 2003.[11] The first trading period (Phase 1), described by the Commission as a "learning by doing"[12] phase, ran for three years to the end of 2007. The second trading period (Phase 2) began on 1 January 2008 and runs for five years until the end of 2012, coinciding with the period in which the Kyoto Protocol applies (see Box 2). For the duration of Phase 2, national emissions in sectors covered by the ETS have been capped at an average of around 6.5 per cent below 2005 levels, in order to help ensure that the EU as a whole, and Member States individually, meet their Kyoto targets.

BOX 2

Main Features of the EU ETS 2005-12

Phase 1 (2005-7)—The "pilot phase"

The scheme applied to heavy industries such as electricity generation (but not nuclear and renewable energy); iron and steel; cement, glass and large-scale ceramics production; pulp and paper processing industries; and some other large combustion installations.
Each Member State was allowed to set its own national emissions limit to reflect its own commitments under the Kyoto Protocol.
At least 95 per cent of allowances were allocated free of charge. Member States could choose how to allocate these free allowances.
Member States presented "National Allocation Plans" (NAPs) to the Commission for adjudication, indicating the total quantity of allowances to be allocated, and the allocation methodology to be used.
Only carbon dioxide emissions were covered by the scheme.

Phase 2 (2008-12)

Building on Phase 1 experience and data, the Commission was able to promote tighter cap-setting through more rigorous oversight of the NAP process.
At least 90 per cent of allowances will be allocated free of charge.
More installations are being brought within the scope of the scheme.
Member States may extend the scope of the scheme to other greenhouse gases.
The aviation sector is to be brought within the scope of the scheme from 1 January 2012.

14. A number of lessons have been drawn from the first trading period of the EU ETS.[13] The scheme has put a price on carbon dioxide emissions in the sectors to which it applies, and created a market in emissions allowances, as it was intended to do. Trading volumes have risen steeply: over two billion EU allowances worth €37 billion were traded in 2007—a near six-fold increase compared to 2005.[14]

15. However, too many emission allowances were allocated to participants in some Member States and some sectors, with grave repercussions: when it emerged (from 2005 verified emissions data published in 2006) that allowances would not after all be scarce, the price of allowances plummeted. This in turn reduced participants' incentives to cut their emissions, by bringing down the price of acquiring additional allowances and reducing the profits to be made from selling unused allowances. The environmental benefits delivered by the scheme in Phase 1 are thus expected to be far more limited than had been hoped.

16. The Commission attributes the price crash observed in Phase 1 to Member States' freedom to set their own "overoptimistic"[15] national caps. This allowed Member States to limit the compliance costs faced by their industries by issuing a large number of emission allowances.

17. Three further problems were also observed in Phase 1. One was the phenomenon of windfall profits in some industries. This occurred when companies that had received emissions allowances free of charge from the authorities nevertheless put up the price of their products or services to reflect the market price of those allowances (the price for which they would be able to sell them on to other participants in the ETS), thus turning a profit.

18. The Commission also observed distortions of competition within and among participating sectors across the Member States, and attributes this to the different approaches taken in different countries to the allocation of allowances and the selection of installations for inclusion in the scheme. Meanwhile the approval of National Allocation Plans (NAPs) proved to be a "long lasting, cumbersome and complex process"[16] according to the Commission, creating considerable uncertainty.

19. In Phase 2 of the EU ETS, the Commission has attempted to rectify some of the problems encountered in Phase 1, for example by evaluating National Allocation Plans for the second trading period more stringently, and by introducing an aggregate emissions cap across the Member States. As Phase 2 of the EU ETS has only just begun, it is too early to tell whether these adjustments will be sufficient to ensure that the ETS delivers the desired environmental results by 2012.

Proposals for the Third Phase of the EU ETS

20. Although some of the lessons learned in Phase 1 of the ETS have already led to adjustments in Phase 2, a more significant overhaul of the scheme was proposed by the Commission in a draft Directive published in January 2008.[17] The proposed changes, which are the subject of this report, would apply from 2013, and create a third trading period lasting until 2020. The main elements of the Commission's proposal are summarised in Box 3 below, and explored in detail in the rest of our report.

21. The draft Directive revising the EU ETS is part of a package of energy and climate change measures designed to give effect to a commitment made by EU leaders at the March 2007 European Council to reduce the EU's greenhouse gas emissions by 20 per cent by 2020 compared to 1990 levels. EU leaders pledged to raise that target to 30 per cent if an international agreement on global emissions reductions meeting certain criteria can be reached.[18]

BOX 3

Proposed Revisions of the EU ETS

A single EU-wide cap on emissions, as opposed to national caps, would be set. The proposed cap would reduce greenhouse gas emissions in sectors covered by the ETS by 21% compared to 2005 levels. In Chapter 2, we consider some of the issues at stake, including whether the ETS sectors are making an appropriate contribution to the EU's overall emissions reduction target relative to non-ETS sectors, and whether an EU-wide cap is desirable.

A number of new industries—for example petrochemicals, ammonia, and aluminium—would be brought within the scope of the EU ETS from 2013. Emissions of some new gases, namely nitrous oxide and perfluorocarbons, would also become part of the scheme. In Chapter 3, we consider whether the sectors to be included and excluded from the ETS are appropriate, and at what stage and under what conditions additional sectors might be brought into the scheme.

Over the 2013-2020 period, a much larger proportion of emissions allowances would be auctioned, rather than allocated to participants free of charge. Harmonised, EU-wide rules for allocating free emissions allowances would be adopted. In Chapter 4, we consider what the best method for allocating allowances is, whether that may vary across sectors, what uses auction revenues should be put to, and whether this should be prescribed at EU level.

Sectors deemed at risk of "carbon leakage"—that is, the relocation of emissions-intensive activities to third countries, or the loss of market share in emissions-intensive industries to third countries—would receive special protection. In Chapter 5, we consider how sectors at risk of carbon leakage should be identified, what protective measures might be appropriate, and the timetable for such decisions.

It is proposed that the Commission guidelines for monitoring and reporting emissions be replaced by two Regulations, on monitoring and reporting and on verification and accreditation, in order to ensure consistency across the EU. In Chapter 6, we consider whether such harmonisation is necessary, and whether the compliance regime associated with the ETS is adequate.

From 2013, access to external credits (from emission reduction projects in third countries) to meet ETS obligations would be restricted substantially. Should a satisfactory international agreement replacing Kyoto be reached, this restriction would be loosened. In Chapter 7, we consider what proportion of emissions reductions should be taking place within EU borders rather than in third countries, and what type of qualitative restrictions on external credits would be appropriate.

It is proposed to extend the linking provisions of the ETS to include not only links with the emissions trading schemes of other industrialised countries that have ratified the Kyoto Protocol, but also links with any national or regional cap-and-trade system whose design features would not undermine the environmental integrity of the ETS. In Chapter 8, we consider whether such links would be feasible, and under what conditions they should take place.

22. The package includes proposals on greenhouse gas emission reductions in sectors not covered by the ETS[19], on carbon capture and storage (CCS)[20] and on renewable energy[21]. The aim of the latter proposal is to ensure that by 2020, 20 per cent of total EU energy consumption will come from renewable sources. We examine that target and its implications for the UK in our recent report, "The EU's Target for Renewable Energy: 20% by 2020"[22].

23. In order to achieve an overall reduction in EU greenhouse gas emissions of 20 per cent by 2020 compared to 1990 levels, the Commission has calculated that the EU ETS should contribute a 21 per cent reduction in emissions (compared to 2005 levels) in sectors within the scope of the ETS by 2020. This translates into a linear tightening of the overall "cap" on emissions of 1.74 per cent per year between 2013 and 2020. For sectors outside the scope of the EU ETS, emission reductions of around 10 per cent (again compared to 2005 levels) will be necessary.

24. The Commission's proposals for the third phase of the EU ETS are the subject of ongoing negotiations in Brussels among the European Union institutions. As the European Parliament and the Council of Ministers have equal responsibility for the legislation, negotiations have been taking place with the European Parliament on the basis of the amendments to the draft Directive adopted by its Environment Committee on 7 October 2008[23]. At the time of writing, it is expected that political agreement on the draft Directive will be sought in December 2008.

1 http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr_spm.pdf Back

2 The IPCC was established by the World Meteorological Organisation and the UN Environment Programme. Recognised as the definitive source of advice on climate change, it publishes regular scientific assessment on climate change. Back

3 Greenhouse gases, such as water vapour, carbon dioxide and methane, absorb thermal infrared radiation, and in doing so warm the Earth's atmosphere. They also radiate thermal infrared radiation, and consequently affect the Earth's surface temperature. Back

4 HM Treasury, 2006. Back

5 http://reports.eea.europa.eu/eea_report_2008_4/en/pp1-19_CC2008Executive_Summary.pdf Back

6 The importance of different greenhouse gases in contributing to the greenhouse effect is a function of their strength and their abundance. Methane for example, is a more powerful greenhouse gas than carbon dioxide, but it is present in smaller concentrations. Carbon dioxide (released through activities such as the combustion of fossil fuels and deforestation) is the most significant driver of man-made greenhouse gas emissions. Back

7 COM(2008) 16, 23.01.2008 Back

8 http://unfccc.int/resource/docs/convkp/kpeng.pdf Back

9 http://unfccc.int/resource/docs/convkp/conveng.pdf Back

10 http://unfccc.int/kyoto_protocol/registry_systems/itl/items/4065.php Back

11 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC (OJ L 275 pp 32-46, 25.10.2003) Back

12 European Commission, Memo/08/35, 28.01.2008 Back