The International Network
for Sustainable Energy

Updated: 03.07.2008

Functioning of the Emission Trading Scheme (ETS)

How the Emission Trading Scheme Works ?

The aim of the 2003 and 2004 Directives are to reduce greenhouse gas emissions in a cost-efficient way, with introduction of greenhouse gas emission ceilings and trading.
All greenhouse gas emitters in EU that are covered by the emissions cap and trading directive must have enough greenhouse gas "allowances", to be allowed to emit their greenhouse gases. The EU countries' governments will allocate greenhouse gas allowances to companies in their respective countries. These allowances can be traded between companies if they choose to do so. Each year, companies must submit a number of allowances that corresponds to their actual emissions. If they do not have enough allowances, they will have to pay a fine. The holding and tracking of allowances will be done through an electronic register. The sectors to be covered are energy, iron, cement, glass, ceramics, pulp, paper, and board. Only larger installations are covered, e.g. combustion
The first phase of the scheme, between 2005 and the end of 2007, before the Kyoto Protocol's commitment period. In this phase, the Commission believes that the Community would greatly benefit from experience of greenhouse gas emissions trading, so that it is prepared for the international emissions trading under the Kyoto Protocol that will begin in 2008. During 2005-2007 it is proposed that allowances should be allocated to participating installations free of charge and that there is a lower common level of penalty for non-compliance of 40 EUR/tons of CO2. From 2008, the countries can agree to auction 5% of the allowances while the remaining 95% should be given for free. The penalty for non-compliance will increase to 100 EUR/ton of CO2. Also from 2008, the exchange of allowances between installations in two different Member States will give rise to the adjustment - through the national registries - by a corresponding number of tons of the total quantity of emissions allowed for each Member State following the burden-sharing agreed with the ratification of the Kyoto Protocol.

EU-ETS: Limits of the System

The EU Emission Trading Scheme is regarded as one of the cornerstones of the EU climate policy.The first period of the EU-ETS (2005-2007) has shown a number of weaknesses in the system which clearly show the needs for better frameworks for the EU-ETS as part EU climate policies. The scheme will continue with the second period 2008-2012 with almost the same framework as in the first period.

Some of the main problems of the first period of the EU-ETS were:

- Large variations in prices of allowances, reducing the incentives for long-term investments to reduce emissions.
- Much too low prices in the last part of the period, as a result of too high allocations.
- Unjustified windfall profits for companies with large CO2 emissions that receive free allowances and that can increase their product prices with the quota prices. These windfall profits were enjoyed by many power companies in the beginning of the period (2005), when quota prices were high.
- Reduced incentives to continue with reductions when allowances are sufficient and prices are low. This is because a number of previous policies are abandoned for the companies included in the EU-ETS, such as CO2-taxes.
- The uncertainty regarding future systems have given uncertainty for actors if they should aim at low or high emissions.
- Strong support for new emitters with free allocations of allowances for new entrants, e.g. with new coal-fired power plants.

In the coming period, 2008-2012, some of the above-mentioned problems will continue, therefore the EU-ETS will only have a smaller effect for reduction of the greenhouse gas emissions in the EU. The emission allowances proposed by the EU Commission for 2008-2012 for the EU-27 are as large as 98% of the emissions in 2005. The EU-ETS will therefore only target a small fraction of the reduction potentials in the sectors covered by the system. The effect will be even more reduced because of the possibilities for the companies to buy CDM (Clean Development Mechanism) and JI (joint Implementation) quotas instead of reducing emissions inside the EU.

INFORSE-Europe Proposals to Improve the EU-ETS

To improve the EU-ETS and achieve larger greenhouse gas reductions, INFORSE-Europe proposes the following changes:
- Stop free allocations of allowances to companies: all allowances are sold by the EU countries either via auctions or at fixed prices.
- The EU-ETS must not be the only way to regulate the almost 50% of EU CO2 emissions that the system covers. It must be supplemented with other measures that are not as prone to market failures as the EU-ETS is. Such measures include phase out of coal use with national energy planning and policies, national measures such as mandatory energy efficiency and emission reduction plans for companies, more efficient implementation of the EU directives for combined heat and power, for Integrated Pollution Prevention and Control (IPPC), and for Large Combustion Plants.
- A part of the income from sale of allowances must be returned to the companies that are emitters or that are large users of e.g. electricity for support for investments in energy efficiency and for transition to renewable energy. This could include low-interest loans, and for long-term investment also subsidies.
- Each allocation period should not be extended beyond two years, to avoid that reductions are postponed until the end of a longer period.
- Emission limits should be met with reductions inside the EU, including that JI and CDM quotas can no longer be used by companies as an alternative to reduce emissions.
- That future emission reduction schemes for aviation and navigation must not be merged with the EU-ETS for land-based emissions.

Follow also the development at Climate Action Network's site at www.climnet.org/EUenergy/NAPs.htm.

and the Commission's site http://ec.europa.eu/environment/climat/emission.htm

Legislation

Agreement to Include Airline Emissions into the EU-ETS

On June 26, 2008, a compromise agreement has been reached between the European Parliament and the European Council on airline emissions. This agreement plans to include aviation in the EU-ETS in 2012. Emissions from plane will be reduced by 3% in 2012 (compared to the 2004-2006 level) and by 5% in 2013. According to the compromise, 85% of the emission certificates will be allocated for free whereas the 15% remaining will be auctioned. This agreement should be still formally endorsed by the Council and by the European Parliament during the next plenary meeting (9th July 2008).

Directive amendent of the 2003 Directive (2003/87/EC) to improve and extend the greenhouse gas emission allowance trading system (COM(2008)16final).

On 23 January 2008, the Commission published a proposal for a Directive to amend the 2003 Directive on the Emission Trading Scheme. The draft directive proposes the following modifications:
- The total amount of allowances circulating in 2012 will be then cut by 1,74% annually.
- Extending the scope of the ETS: new sector and gases will be covered like petrochemicals, ammonia, aluminum and N2O. Shipping could be including at a later stage after impact assessments. However, installations emitting less than 10,000 tonnes of CO2 per year will not be included in the scheme.
- National Action Plans will be replaced by a common auctioning system and common allocation for free. Full auctioning will be the rule from 2013 for power sector and carbon capture and storage and from 2020 for other sectors. However, energy-intensive industries exposed to carbon leakage could receive up to 100% of allowances free of charge.
- A regulation will be adopted to improve performance of the monitoring and reporting system.
- CDM will only be accepted if they come from third countries having ratified the Kyoto Agreement.
The Directive would enter into force in 2013. The Council and the Parliament haven’t adopted it yet (July 2008).

Read the draft Directive on the EU Law website.

Link Directive: Directive 2004/101

September 13, 2004: The Directive was formally approved by the EU countries.
Since the countries have agreed to the compromise with the Parliament the proposal is approved without a second reading.

April 20, 2004, the EU Parliament agreed to a compromise to the so-called ‘Link Directive’ (COM2003/0403) regulating the industry's purchase of Kyoto Protocol emission quotas. The compromise is between the Parliament and the council of environmental ministers of the EU countries. Unfortunately, the Parliament agreed to unlimited use of the Kyoto quotas; however, they agreed to some qualitative limitations, in particular:

NGOs have been criticizing the Parliament's compromise, and are urging the countries to agree to a strict and harmonized cap on the use of Kyoto project emission quotas in the EU's internal emissions trading system.

July 2003 the Commission proposed a directive for linkage of the EU greenhouse gas emission allowance trading (see below) and the Kyoto Protocol's CDM and Joint Implementation mechanisms. It was first be discussed by the EU environmental ministers at the end of December 2003.

Read also Climate Action Networks overview at www.climnet.org/EUenergy/Linking.htm

World Wildlife Fund Proposals Regarding the Link Directive

Just after the emissions trading directive was agreed in July 2003, the EU Commission proposed a new directive linking the EU emissions trading scheme with Joint Implementation and the Clean Development Mechanism (CDM) of the Kyoto Protocol (the "link-directive").

It is a general fear that loopholes such as cheap emission allowances of doubtful origin easily could undermine the effectiveness of the emissions-trading system (the hot air problem), if they are allowed to enter the system via the "link" directive or otherwise.

The World Wildlife Fund has released the following proposals for strengthening of the proposal that are also important in the ongoing national implementation of the emissions ns trading directive:

• The establishment of the targets for the sectors involved must ensure that all participants will be required to make significant additional reductions in their emissions and do not reward business-as usual activities. Similarly targets must be compatible with each Member State's obligations under the Kyoto Protocol and the need for far deeper long-term cuts in emissions. In this context the system must be constructed in a way that encourages countries to move ahead and set stronger targets, with incentives for such initiatives included.
• Grand fathering (giving for free) is not an acceptable method for allocating allowances to firms. Instead there should be a system that rewards early action, discourages delay in response and reflects the polluter pays principle, for example, on the basis of sectoral benchmarking or auctioning. (and the opportunity to auction 5% of emission s allowances must be used)
• National compliance with rigorous and harmonized monitoring, reporting and verification standards must be satisfied before companies in a given Member State may participate.
• Other gases should be included in the scheme, once their monitoring and reporting can be demonstrated to meet the same standards as for CO2 from the combustion of fossil fuels.
• Project-based greenhouse gas emission reduction credits, if included at all, should be restricted to those generated by investment in new and additional renewable energy development and demand-side energy efficiency projects. They should also be required to meet the same monitoring, measurement and reporting standards as the CO2 generated by participating firms. Credits from carbon sequestration, nuclear energy and large hydro must be specifically excluded.
• There must be a specific exclusion of hot air from EU accession and other Central and Eastern European countries entering the scheme. Firms in non-EU countries wishing to participate in EU emission trading should only be allowed to do so once their governments have ratified the Kyoto treaty and formally agreed to be bound by the rules - both explicit and implicit - governing the EU emission trading scheme. Of particular importance are the setting of targets, allocation of allowances in a way that does not constitute an unfair subsidy and harmonized monitoring reporting and compliance rules.
• There must be stronger guarantees of transparency and public access to information - on transactions, monitoring and verification reports and registries - to maintain the credibility of the system and foster public confidence in a complex and as yet untried policy instrument.
• The emissions trading system must be developed as part of a coherent package of policies and measures that generate ambitious emission reductions across all sectors of the EU (and national) economy. While the emissions trading Directive will go some way to achieving this for energy-intensive industries and power sector utilities, comparable targets need to be set and instruments developed for non-energy-intensive manufacturing, small and medium-sized enterprises and the transport, domestic, government, service and agricultural sectors.
• Any revenue generated from the application of sanctions for non-compliance should be invested in obtaining further emissions reductions."

Directive 2003/87 on an EU Emissions Trading Scheme

The Directive entered into force on October 23, 2003.

The emissions trading directive was discussed in the EU Parliament in June-July 2003. A consensus was reached between the Parliament and the council of environmental ministers.

On December 10, 2002 the EU environment minister made a political agreement on the proposal, agreeing the above-mentioned maximal 10% of allowances to be sold from 2008, while the rest are given for free. They also agreed the above-mentioned penalty-levels for non-compliance. The ministers will now continue discussion to reach a more detailed common position. Then they will negotiate the proposal with the EU Parliament.

On October 10, 2002 the EU Parliament supported the proposal on some conditions including that:
-credits from JI and CDM cannot be included before 2008 and must not include credits from sinks or nuclear energy projects.
-15% of the credits should be sold, 85% given for free (this was later reduced, see below).

The Directive was proposed by the EU Commission in October 2001.

Read more about the Directive (COM/2001/581) at: http://www.europa.eu.int/comm/environment/climat/emission.htm at http://www.climnet.org/EUenergy/ET.html.

Early Experience

One of the countries that have a "cap and trade" system for CO2 emissions already is Denmark. Here is the experience of the first two years that the system has worked so far, even with a low penalty of 5 EUR/ ton of CO2, starting in 2001. The first two year the system worked in the way that polluters kept below their total cap and traded rather than paying penalties. The system applies for large power plants only, and the results from the first years did not keep into 2003, when a tighter cap was applied, combined with high power prices in the Nordic electricity market due to low hydro-power production. This resulted in huge emissions, about 5 mill tons above the he cap of 19 mill. ton of CO2, i.e. 25% above the ceiling. The government bended the law to avoid using the penalty energy efficiency and renewable energy. The positions of several Danish environmental NGOs are that the the penalty should be increased to reduce the CO2-generating electricity export substantially. This point will probably be fulfilled if emission credits are traded at 10 EUR/ton of CO2 or higher, but with prices of 5 EUR/ton, it was better for the Danish power companies to sell coal-based power to the Nordic Power Pool and pay the fines.

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