The European Union Emission Trading Scheme - Coursework Example

ANALYSIS OF THE EUROPEAN UNION EMISSION TRADING SCHEME In the year 2005, over 28 member s of the European Union merged together with the aim of addressing the greenhouse gas emissions as a way of combating climate change as outlined in the EU climate policy. The merging resulted to the formation of the European Union Emissions Trading Scheme (C2es.org, 2014). Initially proposed in 2001 the Emissions Trading System of the EU (EU ETS) was officially established and launched in 2005 as the first cap-&-trade system for the emissions of carbon dioxide in the world with reference to the Kyoto Protocol (Change, 2014). Even though the EU ETS derived its inspiration from the Kyoto protocol, it was ratified before the Kyoto protocol and thus became lawfully requisite in the global and the EU law and would have become operational without even the Kyoto Protocol being implemented in 2005, February (Ellerman and Joskow, 2008). Phases or Trading Periods Phases I Being the first global emission trading scheme of it is kind, the EU ETS has experienced significant changes some of which are threatening the achievement of its goals while others are lessons for follow-up phases. Moreover, this phase constitutes a “test” period in which the member countries and companies were allowed to examine and understand the goals of the charter before implementing the scheme (Joskow and Ellermann, 2008, p. 7). Further, the phase was meant to build up infrastructure that would provide familiarity to the scheme to facilitate the use of a cap-&-trade system to limit European greenhouse gas emissions, in addition to, providing a framework for the subsequent trading period, 2008-2012, which was considered analogous to the commitment of the first period of the Kyoto Protocol as opposed to realizing significant reductions of CO2 emissions in the three years (Joskow and Ellermann, 2008, p. 11). In terms of allowance prices during this phase, the prices increased to a maximum in the year 2006, April to about €30per tonne of CO2 gas. However, in the last week of 2006, April the allowance prices dropped significantly by about 54% from €30 to about €13. Further, deficiency in terms of scarcity under the 1st phase of the scheme continued through the year 2006 leading to a trading price of €1.2 per tonne in 2007, March before declining further to €0.10 per tonne in 2007, Sep. The reasons for the decrease were due to the trade participants being cognizant that collective emissions were below the figure of the allowances/limitations that were issued and thus, the price drop undermined the incentive to prolong emission reductions (Hoffmann, and Trautmann, 2008). Phase II The second phase materialized in 2008, January after a couple of amendments were made to the legislation of the EU ETS by the Emissions Trading Directive (ETD) because of the significant design challenges witnessed in the first phase that warranted some amendments. The challenges included deficiency of precise data in advance of the course, allowances to emitters were over-allocated, concerns about the program volatility were raised and the generation of windfall profits by electric power generators (Ellerman and Joskow, 2008, p. 7). Moreover, the carbon prices within this period increased to about €20 per tonne of CO2 in the 1st half of 2008 before rising further to €22 per tonne of CO2 in the 2nd half of 2008 & €13 per tonne of CO2 in the 1st half of 2009. Phase III The commitment of the EU was to achieve a 20% greenhouse emission reduction by 2020 from the levels in of the 1990. This phase is currently ongoing after kicking off in 2013, January and is expected to run through to the year 2020. The EU commission has projected some changes to this phase so that by the year 2020 the emissions will have reduced by 20%. Thus, to ensure that the phase does not encounter challenges as its predecessors, a number of changes were proposed. For instance, the auction levels got an increase whereby over 50% of allowances were auctioned in 2013 compared with a 3% auction of the phase II. In addition, a proposal was made, which allowed any sector preferring to move its production out of Europe due to escalating costs to cause carbon-leakage to receive 100% of their benchmarked share for free. The proposal also envisaged 80% award to sectors that are not likely to cause a leakage but which can have a decline of about 30% by 2020. Further, whilst keeping the Kyoto dream alive, Phase III posted changes to regulate access to project credits by subjecting all access to certain confines to guarantee more emission within the EU to allow further extension of benefits to the least developed countries. Criticism of the EU ETS At inception, the EU ETS was considered to be an effective initiative, which had overwhelming public support because it was considered as an alternative way of achieving the Kyoto Protocol goals (Ellerman and Joskow, 2008, p. 24). However, it was not long after 2005, January that the policy became the subject of high public criticism because of mainly two focal issues that included over-location and windfall profits. Over-location refers to an emissions limit that was not sufficiently prohibitive, or at least not demanding enough. Conversely, windfall refers to high electricity costs and subsequent higher corporate profits that resurfaced from the free allocation of allowances (Ellerman and Joskow, 2008, p. 11). Further, they argue that the windfall profits appraisal is aggravated largely by the concern about the effects of elevated electricity prices. They go on saying further that electricity prices would have been much cheaper if the passage of the market value of generously billed allowances was not passed. Equally, "the over-location critics assert that the cap was too negligent and implied that it should have been tighter signifying a higher carbon prices and consequently higher power prices” (Ellerman and Joskow, 2008, p. 24). Moreover, the critics argue that the intensive wholesale prices during the 1st half of the trial period that were inappropriately incorporated in the market value of freely billed allowances as a replacement of the zero cost value caused higher indiscriminate power prices and considerably higher profits for some generators (Ellerman and Joskow, 2008, p. 25). Therefore, the proposed remedy is for the government to sell the allowances in public lieu of allocating them freely. Economic Impacts of the EU ETS The contemplation and implementation of the EU emission trading scheme was facilitated by three significant theories. According to Fiona Smith, the union had not accepted the emission trading scheme earlier but with immense influence from these theories, which later formed a basement framework for decision making leading to the formation of the EU ETS, the union was convinced and it changed its stand allowing the creation of the EU ETS. These theories included the Neo-Functionalism theory, the Inter-governmentalism theory and the Constructivism theory (Smith, 2010). Despite having a common goal of developing the scheme, the theories held varied views on the implementation of a market-based scheme. Cost-Effectiveness Theory The theoretical roots of the cost effectiveness theory emanates from the production theory of the firm and thus, from an economic perspective, the theory emphasizes that economic evaluations ought taking into consideration all benefits and costs, which are associated with any intervention regardless of who gains or bears the costs from such an intervention (Boyle et al., 1983). Moreover, from a societal perspective the cost effectiveness theory allows for the possibility of taking into consideration allocative efficiency issues i.e. is there explicit recognition that companies who are the beneficiaries in this case are gaining at the expense of society/losers on whom their activities impact directly or indirectly. However, given that government interventions through such activities as taxes influence the operations of companies in any given open economy, thus, the impact of taxes on EU ETS cannot be exception as illustrated in below figures: Figure 1. Illustration of a carbon tax-left & a permit allowance-right (Fabian, 2011). The above figure 1 demonstrates a reduction amount of carbon that can be anticipated with the introduction of taxes based on the assumption; all abatement measures up to tax costs on CO2 can be realised. Conversely, a representation showing the resulting CO2 prices in case of permits resulting from the introduction of a cap-& trade system although with total emissions limited is also represented. It is imperative noting that, the above incentive based instruments of the EU ETS are preferred to the non-incentive based. Moreover, they help achieve a lower overall cost with the same reduction of carbon targets when compared to instruments of regulation. Therefore both price & quantity based instruments with no uncertainty can be said to be equally efficient even though the costs of marginal abatement and carbon abatement benefits are unknown in the future. Ultimately, MAC curves can thus help quantify uncertainties associated with abatement costs through sensitivity analysis. The figure 2 below illustrates the marginal cost-benefit analysis of the EU ETS. From the graph it is evident that as the marginal benefits increase the marginal reductions costs keeping on reducing. This true from an economic perspective that as the marginal reduction costs keeps on reducing in the future i.e. the costs incurred further in the future probably carry less weight compared to those incurred today. Figure 2. Illustration the marginal cost-benefit analysis of the EU ETS (Sam, 2014) With the commencement of the EU’s operation in 2005, many companies were drawn into a dilemma. It was uncertain whether the EU ETS would be able to initiate technological innovations successfully in order to achieve the Kyoto Protocol goals (Hoffmann and Trautmann, 2008, p. 2). They further argue that, the incentive-based approach proposing conformity to environmental policy had a higher probability of inducing cost-effective innovations and diffusions than command and control approaches (Hoffmann and Trautmann, 2008, p. 2). Further, uncertainties ensuing from execution of the EU ETS were essential determinants for companies’ technological response by outlining whether proactive or reactive strategic resolutions were necessary. According to Hoffman and Trautmann (2008), the companies’ response to the EU ETS’ implementation, had three significant effects, which are evident and need to be addressed. The first effect is direct costs, which resulted from the need for corporates to purchase carbon allowances. Such costs for covering direct carbon discharge continue to influence investment decisions and technology preference. According to a study by Price Water Coopers (PWC), almost every company by now replicates the allowance costs in both their everyday operations and evaluation of upcoming investment choices (Schultz & Williamson, 2005). Second is the indirect costs on tactical decisions, which are incurred when the directly affected company transfers its direct carbon costs into its merchandise prices. Such impact reflects the indirect emissions that a company generates when the demand for its CO2 products moves further up the value chain. The third impact is the uncertainty surrounding the implementation of the EU ETS on a companies’ strategic decisions (Aldy and Stavins, 2012). While noting that most allowances were freely given for installation, from an economic perspective, the value of these allowances should be factored in cost calculations using the opportunity cost principle as reflected by the in-depth empirical analysis. Direct costs impact The objective of the EU ETS was to introduce low-carbon technologies through emission price allowances by requiring companies to make compensation for their direct or indirect carbon emissions to the environment (Hoffmann and Trautmann, 2008, p. 2). The best term to define the allowance purchase is direct costs. According to Hoffmann, the price for allowances ranged between €8 in 2005, January to about €30 on 2005, June and thereafter stabilized at €20 in the subsequent months during the year. Thus, to keep up with deviations in the cost of carbon allowance companies had to make several forecasts in response to the cost of their carbon emission. For instance, an analysis by the International Energy Agency indicated “power plant operations would switch from coal to gas at an allowance of €20/tonne of carbon emitted” (Barten, 2005). Further, to cement this finding, Vattenfall’s study also maintained that investments in carbon capture and storage with regard to power generation and power consuming industries, companies require allowance prices beyond €20 per tonne of CO2 to make this technology practical (Barten, 2005). Impact by Indirect costs The second impact is indirect costs resulting from increased input factors as the suppliers transfer their costs from the direct emissions. For instance, in power generation sectors the emissions of direct costs may be replicated as an opportunity cost in electricity price rates resulting to the ETS effecting indirect costs levies on power intense industries such as the steel, the pulp/paper, or the cement industry (Hoffmann and Trautmann, 2008, p. 5). This was witnessed in European Energy Exchange (EEX) between 2004 and 2005 when the costs of power increased from “€27.35 per MWh in 2004, June to €/29.74MWh in 2004, December and €46.67 per MWh 2005, June (Hoffmann and Trautmann, 2008, p. 6). However, this escalation of costs is not entirely as a result of the introduction of EU ETS but because of factors such as oil and gas price changes. Therefore, such costs increase influence the strategic decisions of power intensive companies called impact from indirect cost in which power costs collectively accounts for about 40% industrial production costs (Anger, 2008). Uncertainty effects Finally, the third EU ETS impact is uncertainty resulting from limited predictability and planning dependability that the trading system creates on investment decisions (Hoffmann and Trautmann, 2008). They go further to argue that, this narrow predictability results from both prices vagueness in the market for emission allowances and from systemic uncertainties. In addition, an analysis of the EU ETS by the Pew Center wraps by saying that the main inherent uncertainties “include not only the expectations of prospect targets and prices but also the promptness of all parties to trade, associations with other trading programs, the availability, and use of project-based allowances among other factors” (Barten, 2005). Thus, such uncertainties may be partly replicated on the companies’ future allocations and eventually in the carbon allowance prices. Conclusion Therefore, it is evident that from that even although the EU ETS scheme has not been able to fully achieve its intended goals, it has to some extent managed to promote and encourage companies to realize the need for including environmental greening strategies in their strategic plans even though the negotiations for a global consensus have progressively proved futile. That notwithstanding, the ambition of the EU has been to link up its emission trading scheme with other trading mergers in order to build a global carbon market. However, it is evident that such endeavours by the EU are not likely to materialize due to constant, unwavering willingness of external partners. Ultimately, the EU’s Emission Trading Scheme has achieved a lot of in-line with Kyoto protocol to keep Europe green. Bibliography Aldy, J. and Stavins, R., 2012. The promise and problems of pricing carbon: theory and experience. The Journal of Environment and Development. Anger, N., 2008. Emissions trading beyond Europe: Linking schemes in a post-Kyoto world. Energy Economics, 30(4), pp.2028--2049. Barten, H., 2005. International Energy Agency. Boyle, M.H., Torrance, G.W., Sinclair, J.C., and Horwood, S.P., 1983. Economic evaluation of neonatal intensive care of very low birth-weight infants. New England Journal of Medicine, 308, 1330-7. C2es.org, 2014. The European Union Emissions Trading Scheme (EU-ETS): Insights and Opportunities | Center for Climate and Energy Solutions. [Online] Available at: http://www.c2es.org/publications/european-union-emissions-trading-scheme-eu-ets-insights-and-opportunities [Accessed 25 Oct. 2014]. Change, U. (2014). Kyoto Protocol. [Online] Unfccc.int. Available at: http://unfccc.int/kyoto_protocol/items/2830.php [Accessed 27 Oct. 2014]. Ellerman, A. D., and Joskow, P. L. (2008). The European Unions emissions trading system in perspective. Arlington, VA: Pew Center on Global Climate Change. European Union Emissions Trading System (EU ETS) Phase IIIHow to comply with the EU ETS, including the Small Emitter and Hospital Opt-Out Scheme. (2013). 1st ed. [ebook] Rotherham: Environment Agency. Available at: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/296962/LIT_7590_44cc82.pdf [Accessed 4 Nov. 2014]. Fabian, K., 2011. Marginal abatement cost curves for policy making – expert-based vs. model-derived curves. London, 14 Upper Woburn Place: University College London. Hoffmann, V. and Trautmann, T., 2008. Three types of impact from the European emission trading scheme: direct cost, indirect cost and uncertainty. Springer. Huijgen, W. and Comans, R., 2005. Carbon dioxide sequestration by mineral carbonation. Literature Review Update 2003-2004. [Online] Inis.iaea.org. Available at: https://inis.iaea.org/search/search.aspx?orig_q=RN:37083921 [Accessed 26 Oct. 2014]. Sam, B., 2014. The EU ETS: The Price Ain’t Right. Available at: http://www.bard.edu/cep/blog/?p=5863 [Accessed 17 Nov. 2014]. Schultz, K., & Williamson, P., 2005. Gaining Competitive Advantage in a Carbon-constrained World: Strategies for European Business. European Management Journal, 23(4), 383-391. Smith, F. (2010). The Emissions Trading Scheme: EU Leadership, Problems and Decision-Making. E-International Relations. Retrieved 4 November 2014, from http://www.e-ir.info/2010/12/09/the-emissions-trading-scheme-eu-leadership-problems-and-decision-making/ [Accessed 4 Nov. 2014]. Read More