21 Aug 2018, 16:05

Understanding the European Union’s Emissions Trading System

Germany's increasing CO2 emissions from coal-fired power plants are partially due to the historically low prices for emissions allowances in the EU's Emissions Trading System (EU ETS). One of the world's biggest carbon markets has for years struggled with structural deficiencies, including an oversupply of permits. Against this backdrop, the German government, many other EU member states, and the European Commission have successfully pushed for a reform of the tool that they hope will make greenhouse gas emissions more costly. This factsheet explains the ETS's purpose, its initial struggles, and the reforms made to the system.

What it does

With the EU ETS, the European Union aims to create a market mechanism that determines a price for CO2 emissions and creates incentives to reduce emissions in the most cost-effective manner. Under the system, companies have to hold allowances corresponding to their CO2 emissions, making power production from burning coal and other fossil fuels more expensive and clean power sources more attractive. At the same time, firms are incentivized to become more energy efficient because they can then sell their emissions permits on the secondary 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. Extra-EU flights are not included in the system’s scope; only those between and within countries in the EU and European Economic Area must comply with the programme. 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 objective 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. Between 2021 and 2030, the linear reduction factor is to be raised, with the cap to be reduced by 2.2 percent per year. These reduction factors were set to align with the EU targets of cutting all greenhouse gas emissions by 20 per cent by 2020 and by at least 40 percent by 2030 compared to 1990 levels.

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 pollution can be emitted each year, and companies need to hold European Emission Allowance (EUA) 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 2017. Companies have an incentive to reduce emissions by investing in energy efficiency because they can then 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. This is to create a mechanism to cut emissions in the most cost-effective way. However, during the program’s operation between the years 2021-2030, no international offsets are currently envisaged.

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 amounts, so the price for first-period allowances fell to zero in 2007.

With the ETS now in its third phase (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 deemed as exposed to “carbon leakage” also receive an extra amount of free allowances.

During the programme’s latest reform, a reduction in the number of permits distributed for free was agreed upon. As part of this reform, in the programme’s fourth phase (2021-2030), the number of economic sectors deemed to be at risk of carbon leakage, and thus entitled to free emissions allowances, is to be cut. Furthermore, free allocation to all other economic sectors, save district heating, is to stop altogether by 2030. However, the latest reform envisages a “free allocation buffer” initially reserved for auctioning to be made available if the initial free allocation is fully absorbed.

As a consequence of the generous distribution of free emissions allowances, 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. However, since the latest reforms for the programme’s fourth phase were agreed upon, permit prices have risen. The clearing price at the auction of 23 February 2018 stood at 9.68 euros; in August 2018, trading prices for EUAs rose to 18.50 euros per tonne.

What other changes have been made?

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.

However, the scheme’s many challenges led several EU member states to push for a reform of the ETS, and the EU took some preliminary steps to doing so. 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.

In 2015, a decision to create a market stability reserve (MSR) was adopted. The MSR is due to start operation in January 2019. 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. If the total number of allowances in circulation surpasses 833 million, allowances will be added to the reserve and reinjected if the number of pollution permits falls below 400 million. Initially intended to be returned to the system in 2019-20, the 900 million back-loaded permits are to be added directly into the reserve.

The MSR will also allow member states to close down fossil fuel power stations without the adverse effect of freeing up large amounts of CO2 allowances that could, in turn, be used by other emitters. To prevent this so-called “water bed effect”, as of 2023, the MSR will allow for both the automatic deletion of surplus allowances and member states’ active removal of emission permits.

The problems plaguing the ETS since its entry into force in 2005 have led a number of countries to take unilateral steps. The UK introduced a price floor for carbon; Denmark, Sweden, Finland, France, Ireland, and 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 domestic CO2 emissions.

 

 

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