Emission Trading Schemes - Essay Example

Emission Trading Schemes The European Union Emissions Trading System (EU-ETS) is a landmark environmental policy, representing the world's first large-scale greenhouse gas (GHG) trading program, covering around 12,000 installations in 25 countries and 6 major industrial sectors. The scheme commenced on 1 January 2005. The first phase runs from 2005-2007 and the second phase will run from 2008-2012 to coincide with the first Kyoto Commitment Period. The scheme will work on a "Cap and Trade" basis. EU Member State governments are required to set an emission cap for all installations covered by the Scheme. [1]. Emissions' trading has emerged over the last two decades as the preferred environmental policy tool. The key advantage of emissions trading is that firms can flexibly choose to meet their targets, rather than use predetermined technologies or standards - i.e., command-and-control policies. Emissions sources with low-cost reduction opportunities can over comply and sell their additional allowances to sources where reductions would be more difficult and costly. This leads to the lowest overall cost, or most economically efficient solution. Emissions' trading is particularly relevant to climate change mitigation as carbon dioxide (CO2) and other green-house gases (GHGs) have the same effect wherever they are emitted and compliance costs differ dramatically across sources. Hence there is considerable scope for trading, and opportunity for considerable gains from these trades. Experience in the United States and other countries have shown that well-designed emissions trading programs can reduce environmental policy costs by as much as 50%. [1]. The origins of the EU-ETS date back to 1992 when 180 countries signed the United Nations Framework Convention on Climate Change (UNFCCC). Following negotiations under this agreement, the Kyoto Protocol was signed in 1997, committing the industrialized nations to an averaged 5.2% reduction from 1990 levels by the first commitment period in 2008-2012. The EU-ETS officially began on January 1, 2005 and consists of a "warm-up" phase from 2005-2007 and then successive 5-year periods, with the second phase from 2008-2012 set to coincide with the Kyoto compliance period. Six key industrial sectors are covered, notably electricity and heat production plants greater than 20MW capacity. Other included sectors (with specific facility size thresholds) are oil refineries, coke ovens, metal ore and steel installations, cement kilns, glass manufacturing, ceramics manufacturing, and paper, pulp and board mills. These sectors are likely to account for around 12,000 installations (depending on the final details of the specification process), and represent close to half of the total CO2 emissions from the EU-25 countries. Participating companies are allocated allowances, each allowance representing a ton of the relevant emission, in this case carbon dioxide equivalent. Emissions' trading allows companies to emit in excess of their allocation of allowances by purchasing allowances from the market. Similarly, a company that emits less than its allocation of allowances can sell its surplus allowances. [1]. Monitoring and reporting of an installation's emissions are carried out based on binding EU-wide guidelines mainly through fuel purchases and use of emissions factors, although continuous monitoring and third party verification are allowed. All self-reported emissions must be verified by an independent third party (similar to an auditor reviewing a firm's financial accounts). [2].Methodologies are under development to allow inclusion of additional sources, greenhouse gases and emissions factors. Hefty fines exists for non-compliance (40 Euro/TCO2 from 2005-2007, then 100Euro/TCO2 from 2008 onwards), levels that are considerably higher than most predictions of allowance prices. [3]. Even though the EU ETS will ultimately be judged on the basis of its effectiveness as a tool to reduce GHG emissions, the underlying rationale for choosing emissions trading was based on economic considerations. One of the principal challenges therefore has been getting the balance between supply and demand 'rights'. Recent developments suggest that the first period may have failed in this respect. This should not come as a surprise though, as i.e. allocation methodology and cap level has been determined somewhat arbitrarily, notably as result of allocations being based on emissions forecasts, which in many cases have turned out to be wrong. [3]. On the other hand, the EU ETS has been adopted in a very short period of time - reflecting the strong political will in the EU to meet its obligations under the Kyoto Protocol - but implementation is far from complete. In many respects, the EU ETS is still a construction site, with many critical elements of the infrastructure still under creation. A lack of infrastructure inhibits trading and efficient price-setting. Beyond that, another important factor for the initial results of the EU ETS has been the increased spread between coal and gas prices, which has pushed up EU allowance prices. In the short term, fuel switching - from coal to gas - is the principal way to reduce CO2 emissions. However, the coal/gas spread increase has compelled power plants to burn more coal, which in return has made CO2 prices climb. In addition to shortcomings due to the lack of infrastructure, this has generally meant that it was mainly the power sector, which has been short due to allocation and the coal/gas spread that has engaged in the trading market. The industrial sector - generally long - has been less engaged. [2]. Uncertainty has prevailed because of doubts on the further development of the Kyoto Protocol project mechanisms, the timing of the International Transaction Log, international developments with effects on oil and gas markets, the relative illiquidity and the perceived high level of market power concentration in the EU ETS market but also the possibility of a prolonged legal battle on the UK claim for an addition of 20 MtCO2 to its NAP, the effects of future entry in the EU and the ETS of Bulgaria and Romania. The dramatic price collapse in late April has reflected this uncertainty. [4]. Now that the first round of allocation is almost completed, a number of concerns have been identified. An important concern is that of environmental targets, because most member states have allowed emissions from the covered sectors to rise in the period 2005-07, despite the fact that many must reduce their emissions to achieve their Kyoto Protocol targets. Other concerns relate to the high degree of decentralization - a deliberate member state choice - with a considerable amount of member state discretion in the allocation process (i.e. NAP-related issues), which has been a deliberate policy choice by the EU. [4]. Inflated baselines were a striking feature of the first round of allocation plans, resulting in substantial over-allocation for industries in some countries (LETS Update 2006: 6-7). Generally, governments engaged in close dialogue with the industry prior to the allocation, and the national governments could do little else but give in to pressures from their own industry. While the considerable discretion of member states when undertaking allocation has helped to accommodate national differences, at the same time it has submitted member states to considerable pressure from industry not to provide less allowances than other governments. [4]. Each member state has developed rules for allocation to new entrants and these rules vary considerably between member states. A new natural gas CHP plant would in Germany receive allowances corresponding to 130% of its expected emissions. The corresponding figures are 120% for Finland, 90% for Denmark and 60% for Sweden. Since the differences in allocation are associated with large values, current allocation rules have an impact on investment decisions, and can significantly distort competition if they remain unchanged. [3]. Experience with the first round of allocation in the ETS has shown the limits of using "grand-fathering" as an allocation methodology. In addition to the complexities related to new entrant allocation as well as closure rules, they have raised distributional issues and miss to provide adequate investment incentives. In addition, the high degree of discretion for member states has increased complexity, administrative burdens and transaction costs while leading to distortions to competition in the internal market. Industry has put pressure on governments not to hand out fewer allowances than other governments. [3]. Benchmarks have been used by some member states in their phase I NAPs. Some (e.g. Germany, Denmark and Finland) have utilized benchmarks for allocation to new entrants, and others (e.g. Sweden, Netherlands, Italy) for installations in general and/or fixed energy efficiency rates for energy production installations. While such approaches are covered by the EU ETS Directive, the problem is that the metrics differ between member states. For instance, some member states base allocation on installed capacity and projected utilization rates, some on projected output and others on best-available technology. Hence, better coordination across member states to work towards EU-wide benchmarks could be an important first step towards progress on benchmarking. EU-wide benchmarks instead of national ones are necessary to avoid fragmentation in the EU internal market. [5]. The potential economic impact of the ETS can either stem from the need to cover process emissions, i.e. emissions in excess of those covered by 'free allocation' or the fact that it covers combustion emissions, which - regardless the allocation method - leads to power price increases. The actual impact on each sector or installation then depends on: i) a sector's ability to pass through costs in different product markets and ii) the structure of national or regional power markets. Several studies (e.g. IEA, 2005a; Demailly & Quirion, 2005; Carbon Trust, 2004; Quirion, 2003) tend to confirm that the EU ETS could lead to market share losses and, as a result, to carbon leakage, especially if the indirect effects owing to the inclusion of carbon in the power price are realized. Potential losses in market share, however, depend on the extent to which EU producers can pass on the extra cost to consumers and suppliers. A second element is how quickly non-EU producers can increase their production in the short-term. Therefore it is most likely that negative effects on competitiveness do not fully come into play in the immediate short-term. [5]. Both the European Commission and the Council of the EU have expressed their interests in analyzing whether air transport emissions could be included into the EU ETS. The last six months the discussions have focused on design elements of how aviation can be included in the system. These elements include coverage of non-CO2 effects of aviation such as condensation trails, geographical coverage, trading entities, allocation responsibility, allocation methodology and interaction with the Kyoto protocol. [6]. From a pure economic point of view, putting transport under the same cap would minimize the society costs of meeting a given climate target, given dynamic effects not considered. Since the transport sector is important as an emission source the introduction of this sector in the EU ETS is attractive. But given the growth rate and the willingness to pay, we would expect a dramatic increase in the demand for allowances from transport under the same cap as the current trading industry. This would increase the price of allowances and probably that of electricity, and increase the risk for relocation of EU industries to outside the EU. [6]. In conclusion, we can formulate three possible options for an emerging global carbon market: 1) Linking of national or regional schemes: principal challenges are complexity, allocation and dealing with winners and losers; 2) Bottom-up carbon market based on market participants searching for arbitrage possibilities enabled by the existence of project-based credits in all emission trading schemes. Environmental outcome is uncertain as dynamics is fuelled by economic concerns primarily; speed is also uncertain. 3) Sector-wide international trading schemes would provide clearer market signals but pose many institutional, notably governance issues, notably monitoring and enforcement at the global level. [7]. In the long-term, a critical element for meeting the climate change challenge will be the development and diffusion of new breakthrough technologies. Ultimately, any climate strategy will have to be measured against its capacity to foster first the development and then investment in new low-carbon technologies. EU governments indeed struggle in combining an 'affordable price' to reduce competitiveness effects with 'appropriate investment signals'. This struggle increases political pressure on governments, which in return reduces the credibility of the long-term price signal. Emissions trading schemes (e.g. EU ETS) - as well as taxes - therefore are more of a short-term tool that provides incentives to increase energy efficiency by incremental improvements rather than the development of breakthrough technologies. [7]. Works Cited 1. hman, M. and A.Holmgren (2006), Harmonising Allocation to New Entrants in the Nordic Energy Sectors, report for the Nordic Council of Ministers, Temanord 2006:515. 2. Bode, S. (2003), Implications of linking national emissions trading schemes prior to the start of the first commitment period of the Kyoto Protocol, HWWA Discussion Paper No. 214, Hamburg Institute of International Economics. 3. Carbon Trust (2004), The European Emissions Trading Scheme: Implications for Industrial Competitiveness, the Carbon Trust, UK, June. 4. CE (2006), "Feasibility on including the transport sector into the EU ETS", Paper presented at the seminar at Swedish Environmental Protection Agency, 9 March. 5. European Commission (2005a), Further guidance on allocation plans for the 2008-12 trading period of the EU Emissions trading scheme, COM (2005) 703final, 22.12.2005. 6. European Commission (2005b), Reducing the climate change impact of aviation, European Commission Communication, COM (2005) 459final, 27.9.05. 7. LETS Update (2006), Decision Makers Summary. LETS/LIFE Emissions Trading Scheme, report produced for the LETS Update Partners, AEA Technology Environment and Ecofys, UK. Read More