02 Oct 2014 | Kerstine Appunn

Understanding the European Union’s Emissions Trading System

Germany’s increasing CO2 emissions from coal-fired power plants are partially blamed on the low prices for emission allowances in the EU’s Emissions Trading System (EU ETS). The biggest carbon market in the world is faced with an oversupply of permits. The German government, and many EU member states and the European Commission are therefore pushing for a reform of the tool that will make greenhouse gas emissions more costly. This factsheet explains what the EU wants to achieve with the ETS, what went wrong and what is being done to fix it.

What it does

With the EU ETS, the European Union wanted to create a market mechanism that determines a price for CO2 emissions and creates incentives to reduce emissions in the most effective way. Companies would have to pay for CO2 emissions, making power production from burning coal or other fuels more expensive and clean power sources more attractive. At the same time, firms would get an incentive to improve energy efficiency because they could sell their rights to emit CO2 on the market.

The EU Emissions Trading System (EU ETS) sets an overall limit on all CO2 emissions from power stations, energy-intensive industries (e.g. oil refineries, steelworks, and producers of iron, aluminium, cement, paper, and glass) and civil aviation. The system includes more than 11,000 power plants and factories in the 28 EU member states plus Iceland, Liechtenstein and Norway, and covers around 45 per cent of the EU’s greenhouse gas emissions. The target of the EU ETS is to reduce greenhouse gas emissions from power stations and other energy intensive industries (such as the production of iron, aluminium, cement, glass, cardboard, acids, etc.) by 1.74 per cent every year starting in 2013, and to achieve an overall reduction in these sectors of 21 per cent by 2020, compared to 2005 levels. These objectives were set with the EU targets of cutting all greenhouse gas emissions by 20 per cent in 2020 compared to 1990 in mind.

How it is supposed to work

The EU ETS follows a “cap-and-trade” approach: the EU sets a cap on how much greenhouse gas can be emitted each year, and companies need an emission allowance for every tonne of CO2 they emit within one calendar year. They receive or buy these permits – and they can trade them. Companies face a fine if they emit more CO2 than they have covered by emission allowances. The fine is 100 euros per excess tonne – for context: the world’s largest chemical company, BASF, produced 23 million tonnes of CO2 equivalents in 2013. Companies have an incentive to reduce emissions by investing in energy efficiency because then they can sell excess allowances. Instead of EU ETS allowances, companies can buy credits from emission-saving projects under the Kyoto Protocol’s Clean Development Mechanism (CDM) in developing countries. The idea was to create a mechanism to cut emissions in the most effective way.

Does it work?

The EU ETS has existed since 2005. In the first two trading periods (2005-2007 and 2008-2012) the majority of allowances were given out for free and in generous numbers, so the price for first-period allowances fell to zero in 2007. Now, in the third period (2013-2020) 40 per cent of allowances are being auctioned and power generators have to buy all of their allowances (with exceptions in some member states like Poland, Bulgaria, Hungary, Lithuania, etc.). Still, free allocation prevails in the manufacturing industry (80 per cent) and the aviation sector (85 per cent), and sectors seen exposed to “carbon leakage also receive an extra amount of free allowances.

As a consequence, prices for permits were never as high as envisaged. The surplus of permits grew even greater after the 2008 economic crisis caused emissions to fall faster than anticipated (production in the steel industry alone declined by 28 per cent between 2008 and 2009). Critics also said that companies’ frequent use of cheap CDM credits pushed the carbon price down.

While the system has had some effect – it does after all put a cap on carbon emissions – the EU ETS has not produced the anticipated result of making electricity generation from fossil sources like coal more expensive compared to energy from clean power sources such as renewables. In fact, low prices have contributed to a revival of lignite as a cheap and competitive power source. Scientists at the German Institute for Economic Research (Deutsches Institut für Wirtschaftsforschung, DIW) have calculated that only a price of more than 40 euros per emitted tonne of CO2 could affect the price of power from coal in a way that would make other energy sources more competitive. But CO2 allowances were as cheap as 2.81 euros in early 2014 and the average price is around 5 euros.

Can it be fixed?

Purists among economists consider an effective emissions trading scheme like the EU ETS the panacea to cut greenhouse gas emissions – in all sectors, across all countries and without the need of national legislation and subsidies for renewables.

Many member states are now pushing for a reform of the defunct system and the EU has taken some preliminary steps. In a first attempt to reduce the surplus of around 2 billion allowances (July 2014) the EU temporarily removed 900 million permits from auction in 2014-2016 – this instrument is called backloading. The EU intends to return these allowances in 2019-20.

The Commission suggested the implementation of a market stability reserve (MSR) as of 2020. This instrument should allow authorities to increase or decrease the number of CO2-permits in the market, following clear rules, in order to regulate the price.

Member state governments will debate the idea again in autumn 2014. Germany has called for the MSR to come into force in 2017 and has suggested transferring the backloaded allowances directly into the reserve. Critics have pointed out that this instrument would have only limited effects because it reacts to sudden events with a two-year time lag, and that even with the MSR the number of total allowances will probably not be reduced quickly enough to reduce the current surplus.

Such doubts have led a number of countries to take individual steps. The UK introduced a price floor for carbon; Denmark, Sweden, Finland, France, Ireland, the Netherlands have introduced a carbon tax. In Germany, the environmental lobby is also putting pressure on the government to rely less on the ETS and to step up efforts to reduce CO2.

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