by Joe Kruger and Billy Pizer
November 28, 2005

(This commentary is a revised version of Europe Goes to Market: Opportunities and Challenges with a Trail Blazing Trading System, a Weathervane Commentary originally published October 15, 2004.)

The European Union Emissions Trading Scheme (EU ETS), an ambitious effort to curb carbon dioxide (CO2) emissions, began operation on January 1, 2005. As the first year of the EU ETS comes to an end, there has been good progress in setting up many of the institutions associated with the first significant carbon market. For example, several trading exchanges have been established, and a variety of private brokers, traders, verifiers, and others are providing the services needed for an effective market. By all accounts, many European companies affected by the program have begun to factor the price of carbon in their decision making processes. Governments have finished the first round of allowance allocations, and officials have begun to operate registries and implement monitoring, reporting, and verification provisions.

However, some features of the program remain controversial. The most contentious issue in the design of the EU ETS has been how to initially distribute the emissions allowances. At play is the creation and transfer of wealth in the form of a tradable property right to emit carbon dioxide (CO2). These permits already have an annual value of approximately €38 billion. Moreover, the way in which the emissions allowances initially are distributed provides incentives that affect economic behavior, which has important consequences for the costs of reaching emissions targets and for perceived fairness and stability of the trading program.

The EU rules specify that in the first period (2005–2007), only a small percentage of allowances may be auctioned and at least 95 percent of allowances should be allocated for free. In the second period (2008–2012), the amount to be given away has to be at least 90 percent. In addition, general criteria by which the EU Member States must allocate allowances include a requirement that the overall amount of allocations in the trading program should put a country on track to meet its Kyoto obligation.

Still, considerable freedom is left to the individual Member States to decide the magnitude of allowances to be allocated and the method by which allowances should be distributed among participants in the trading scheme. Ultimately, each Member State develops its own National Allocation Plan (NAP), which must be approved by the EU Commission ahead of each trading period. Controversy has brewed over whether the first phase of allocation has provided too much flexibility, giving some Member States a competitive advantage over others. There has also been considerable debate about whether free allocations to the electric power sector in some countries have created an economic windfall for the sector. 

Also controversial as the first year of operation comes to an end are issues of reporting, monitoring, and verification of emissions. Monitoring is left largely to the European Union’s 25 Member States, under guidelines considerably more flexible than rules used in past U.S. trading programs for sulfur dioxide and nitrogen oxides. One reason for the flexibility is that the European permit market will encompass a much wider range of industries than its American counterpart. But another is that the Europeans have chosen, consistent with past European environmental policy, to keep the administration decentralized.

Emissions are to be verified independently, either by agencies within the EU Member States or by third parties, firms certified by the Member States that specialize in that work. Use of these third party verifiers could provide an important source of expertise for those Member States with limited internal capability to verify emissions. But because there are no uniform, mandatory standards for certification of qualified verifiers, there is the prospect that different verifiers will have inconsistent capabilities. Many technical and process questions lie ahead for a system that uses third party verifiers. When interpretations differ, who will resolve them? Will there be a case law of decisions that all verifiers must follow? If not, companies will be tempted to shop for the verifiers who provide the most lenient treatment of emissions accounting. That could quickly lead to a race to the bottom of the enforcement scale.

Among the 25 different EU Member States, there are dramatically different legal systems, enforcement cultures, and administrative capabilities. Uneven enforcement from one country to another would create unfair competitive advantages for companies where the enforcement regime is weaker. This possibility has already begun to generate concern in Europe. In most of the 10 countries joining the EU this year, environmental institutions have been weak historically.  

A final source of controversy has been higher than expected allowance prices.  As of November 2005, prices hovered around €22 per allowance. A variety of reasons are cited for higher prices, including high natural gas prices, lack of liquidity from the Clean Development Mechanism because of a cumbersome approval process, and delays in the start of trading by some of the new EU countries such as Poland and Czech Republic, which have some of the lowest-cost emissions reductions. In addition, restrictions on banking between the first two phases of the program and uncertainty about the post-2012 period may be inhibiting cost-effective, longer-term investments in greenhouse gas mitigation. 

Despite the controversies,  the European trading system could be an essential element of efforts to reduce the world’s emissions of greenhouse gases and to reduce the impact of human activity on the global climate. It could also provide a wealth of data and experience on the cost of emissions reduction in an advanced industrial society. The European experience with trading will undoubtedly influence what comes next in the world’s struggle to get control of the gases that are changing the climate. The United States has demonstrated that, in one country, emissions trading is not only possible but effective. The Europeans are now exploring the possibilities when trading crosses national boundaries.

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Joe Kruger is a Visiting Scholar and Billy Pizer  is a Fellow at Resources for the Future, a Washington, D.C.-based energy and environment think tank.