Bumpy Road to EU ETS Reform (Watch this! #3)

See Watch This! #3, October 2012

The European Union is considered a leader in the international negotiations on climate change. Its main instrument to cut greenhouse gases (GHGs) from industrial emitters is the European Emissions Trading Scheme (EU ETS). However, the effectiveness of the EU ETS has been increasingly questioned because of a massive over-supply of emission permits. Still, it remains a crucial model for the development of other carbon markets globally and influences the way policies are constructed to tackle climate change.

A quick look at history

The EU ETS began in 2005 with a two year pilot period. In tune with the first commitment period of the Kyoto protocol, the second phase lasted from 2008 to 2012. Starting January 2013 the ETS will enter a phase 3 which will continue up to 2020. With around 11 000 power stations and industrial plants in 30 countries (27 EU member states, Lichtenstein, Norway and Iceland), the ETS is currently the largest emissions trading market. Yet the ETS faces many challenges, worsened by economic recession still looming over Europe.

The role of emission permits (allowances)

The market functions on the ‘cap and trade’ principle. A ‘cap’ (limit) is set on the total amount of certain GHGs emitted by industrial installations in the system. Companies receive emission permits, or allowances, to cover emissions produced within this cap. They then have the option to either lower their emissions by investing in green technologies or continue to pollute and buy allowances from other companies with extra allowances. The progressive declining cap, or limit available, is meant to ensure the scarcity of allowances and, consequently, the overall reduction of GHGs. The problem is that projected emissions never accounted for a drop in industrial production due to the economic crisis. This means the loose cap was insufficient for pressuring industry to reduce emissions. Furthermore, allowances from the first and second phase (2005 up to 2012) were mainly handed out for free to industrial polluters. This resulted in significant windfall profits for the power sector, which was generously over-allocated such permits. In phase 3, there is full auctioning of permits for the power sector, wherein dangerous loopholes exist. For example, the Commission allows up to 70% of free allocation until 2019 for power generators in 10 member states to help modernise their energy sectors.

Watch the over-supply!

Since 2009, there has been a gradual build-up of permit oversupply currently estimated at about 2 billion tonnes of CO2. The main reason for this glut is that the amount of allowances and use of international credits available for compliance was higher than verified emissions in 2009, 2010 and 2011. Because there is oversupply and low demand, carbon prices continue to tumble to record lows which in turn threatens the very core of EU climate policy and questions the ETS as a viable policy mechanism. EU decision makers are now trying to come up with a roadmap for reforming the ETS. Issues at stake are: tackling the market’s oversupply of allowances and proposed structural measures to trigger a stable carbon market, as well as, creating conditions for a transition to a low carbon economy and investment in clean technologies.

Bumpy road to reform

A European Commission proposal to delay the auctioning of a part of allowances in 2013 is expected for November 2012. This so called ‘set-aside’ is aimed at increasing scarcity and the subsequent rise in carbon prices. However, this plan has met fierce opposition from Poland, currently in a bid to convince other states to oppose such measures. Poland’s economy is heavily reliant on coal and, together with other East European states, has a big surplus in unused allowances they wish to use.

A temporary set-aside of allowances, or a permanent cut, would increase the price of carbon and ensure the market is on its way to meeting the climate targets set under Kyoto Protocol. But countries like Poland are determined to oppose anything that would increase the price of carbon arguing that the European Commission is unlawfully regulating a free market.

This is just one of the many challenges the carbon market is facing. In its bid to restrict companies from using environmentally and socially problematic offsets for compliance in the ETS, the EU has already implemented restrictions on international credits from certain types of projects (like the ban on HFC and NO2 projects). Yet, given the serious problems with current practices to test additionality of CDM projects, a large percentage of carbon offsets from CDM projects are likely to be non-additional anyway, thus adding to global emissions. As well, carbon credits from registered coal power projects will also add millions of non-additional carbon credits to the already over-supplied market. To this end, the European Commission has announced that offset credits from Joint Implementation (JI) projects in countries that do not sign on to a second Kyoto commitment period will be banned from trading in the EU ETS. The pressure is on and future quality restrictions are imminent!

While it is true that the EU has successfully imposed industry wide regulations to reduce GHGs, the road ahead is more than bumpy. Ahead of the UNFCCC in Doha, the EU carbon market faces record low prices that stand no chance in incentivising a low carbon economy. Yet, member states remain with divergent views on tackling the problems. Addressing systemic problems of the ETS market design and allocation, while further restricting the use of international credits for stronger domestic action, should be paramount in reforming the carbon market. Ultimately, any carbon market reform only makes sense with ambitious binding climate targets.