“The European Union’s Emissions Trading System (EU-ETS)”

Order Code RL33581CRS Report for CongressReceived through the CRS WebClimate Change: The European Union’s

Emissions Trading System (EU-ETS)July 31, 2006Larry ParkerSpecialist in Energy PolicyResources, Science, and Industry DivisionCongressional Research Service

˜ The Library of Congress

Climate Change: The European Union’s Emissions Trading System (EU-ETS)SummaryThe European Union’s (EU’s) Emissions Trading System (ETS) is a cornerstoneof the EU’s efforts to meet its obligation under the Kyoto Protocol. It covers morethan 11,500 energy intensive facilities across the 25 EU member countries, includingoil refineries, powerplants over 20 megawatts (MW) in capacity, coke ovens, andiron and steel plants, along with cement, glass, lime, brick, ceramics, and pulp andpaper installations. Covered entities emit about 45% of the EU’s carbon dioxideemissions. The trading program does not cover emissions of non-CO2 greenhousegases, which account for about 20% of the EU’s total greenhouse gas emissions. Thefirst trading period began January 1, 2005. A second trading period is scheduled tobegin in 2008, with a third one planned for 2013. In deciding on its trading program,the European Commission (EC) adopted a “learning-by-doing” approach to preparethe EU for the Kyoto Protocol’s emission limitations. The EU does not have majorexperience with emissions trading, and the EC felt that an initial program beginningin 2005 would give the EU practical familiarity in operating such a first glance, it would appear that the EU may have little difficulty meetingits Kyoto Protocol requirements during the second trading period. The anticipateddeficit between the second trading period for the original 15 Member States can becovered by trading with the 10 newer Member States that anticipate a surplus. Also,credits are likely to be available through Joint Implementation (JI) and CleanDevelopment Mechanism (CDM) projects sanctioned under the r, there are other considerations. The availability of surplus creditscreated via JI and CDM is restricted by the EC requirement that such credits be“supplemental” to a country’s domestic efforts. Each country is to spell out what“supplemental” means in its National Allocation Plans (NAPs) for the second tradingperiod. Individual countries are likely to define that term differently — restrictingallowance trades and purchases in some r consideration is the overall commitment of the Kyoto Protocol. Asnoted earlier, the ETS covers only a percentage of the overall greenhouse gasemissions in the various Member States of the EU. Some sectors not covered by theETS may grow faster than sectors covered by it, creating difficulties for particular, the transportation area is already a source of concern.A final consideration for the ETS is its suitability for directing long-terminvestment toward a low-carbon future — the ultimate goal of any climate changeprogram. It is too early to tell whether the ETS’s market signal and individualcountries’ NAPs will move investment in the appropriate direction. The early signsare not particularly encouraging, with the 2005-2008 NAPs producing an over-allocation of allowances and one major Member State (Germany) attempting to directits second NAP toward carbon-intensive, coal-fired electric-generating facilitiesrather than low-carbon alternatives. Reluctance by countries to redirect their NAPsand an inconsistent price signal from the ETS make the long-term effect of the ETSuncertain.

1Implementing the ETS: National 4Results From the 5Market Activity, Prices, 8Use of Clean Development Mechanism (CDM) and Joint

Implementation (JI)........................................12Tightening of 18Definition of 19Expansion 20Appendix: Norway’s 22List of FiguresFigure 1. CO2 Market: Even If No “Big” News Highly Volatile .............9Figure 2. CO2 Market: Large Price Changes in Very Short Amount

10Figure 3. There is a Very Long-Term Correlation Between CO2 and

Electricity Price: Link Via 11List of TablesTable 1: Cost of Reaching Kyoto Target to EU Member States 3Table 2. Summary Information Per 6Table 3. Importance of EU 13Table 4: Comparison of 1st and 2ndTrading Period 14Table 5: NAP 17Table 6: International Supply of Emissions Credits .21

Climate Change: The European Union’s Emissions Trading System (EU-ETS)OverviewClimate change is generally viewed as a global issue, but proposed responsestypically require action at the national level. With the 1997 Kyoto Protocol now inforce, countries that ratified the protocol are developing appropriate implementationstrategies to begin reducing their emissions of greenhouse gases.1 In particular, theEuropean Union (EU) has decided to use an emissions trading scheme (called a “cap-and-trade” program), along with other market-oriented mechanisms permitted underthe Protocol, to help it achieve compliance at least cost.2 The decision to useemission trading to implement the Kyoto Protocol is at least partly based on thesuccessful emissions trading program used by the United States to implement itssulfur dioxide (acid rain) control program contained in Title IV of the 1990 CleanAct Amendments.3The EU’s Emissions Trading System (ETS) is a cornerstone of the EU’s effortsto meet its obligation under the Kyoto Protocol. It covers more than 11,500 energyintensive facilities across the 25 EU Member countries, including oil refineries,powerplants over 20 megawatts (MW) in capacity, coke ovens, and iron and steelplants, along with cement, glass, lime, brick, ceramics, and pulp and paperinstallations. Covered entities emit about 45% of the EU’s carbon dioxide trading program does not cover emissions of non-CO2 greenhouse gases, whichaccount for about 20% of the EU’s total greenhouse gas emissions. The first trading1 Six gases are included under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide,hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. The United States has notratified the Kyoto Protocol and, therefore, is not covered by its provisions. For moreinformation on the Kyoto Protocol, see CRS Report RL30692, Global Climate Change: TheKyoto Protocol, by Susan Fletcher. Norway, a non-EU country, also has instituted a CO2 trading system (described inAppendix A). Various other countries and a state-sponsored regional initiative located inthe northeastern United States involving several states are developing mandatory cap-and-trade system programs, but are not operating at the current time. For a review of theseemerging programs, along with other voluntary efforts, see International Energy Agency,Act Locally, Trade Globally (2005).

32 P.L. 101-549, Title IV (Nov. 15, 1990).

CRS-2period began January 1, 2005. A second trading period is scheduled to begin in2008, covering the period of the Kyoto Protocol, with a third one planned for 2013.4Under the Kyoto Protocol, the then-existing 15 nations of the EU agreed toreduce their emissions by 8% from 1990 levels under a collective arrangement calleda “bubble.” By 2001, collective greenhouse gas emissions in the EU were 2.3%below 1990 levels, mostly the result of a structural shift from coal to natural gas inthe United Kingdom and the incorporation of East Germany into West l countries, including Ireland, Spain, and Portugal, experienced emissionsgrowth of over 30% during this period.5 In light of the Kyoto Protocol targets, theEU adopted a directive establishing the EU-ETS that entered into force October 13,2003.6 The importance of emissions trading was elevated by the accession of 10additional central and eastern Europe countries to EU membership in May tively, these 10 countries’ greenhouse gas emissions dropped 22.6% from1990-2001, with only Slovenia’s emissions increasing during that time (10.4%). Thisexpansion of the EU trading zone to 25 countries greatly increases the opportunitiesfor cost-effective allowance deciding on its trading program, the European Commission (EC) adopted a“learning-by-doing” approach to prepare the EU for the Kyoto Protocol’s emissionslimitations. The EU does not have major experience with emissions trading, and theEC felt an initial program beginning in 2005 would give the EU practical familiarityin operating such a system. The EC also wanted the most comprehensive programpossible. As stated in its “Green Paper”:The wider the scope of the system, the greater will be the variation in the costsof compliance of individual companies, and the greater the potential for loweringcosts overall. This argues in favour of a comprehensive trading scheme acrossdifferent Member States covering all 6 greenhouse gases and sinks, andencompassing all emissions sources.7Economic analysis conducted by the European Commission confirms thepotential cost-saving available from a comprehensive trading scheme. As shown inTable 1, a comprehensive trading program is estimated by the EC to reduce Kyotocompliance costs to EU countries by 3 billion euro, or one-third over a compliancescenario that does not include trading among Member countries, and by 0.9 billion4 More information, including relevant directives, on the EU-ETS is available on theEuropean Union’s website at [/scadplus/leg/en/lvb/].

Pew Center on Global Climate Change, The European Union Emissions Trading Scheme(EU-ETS): Insights and Opportunities (no date), available at [/docUploads/EU%2DETS%20White%20Paper%2Epdf].65 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003establishing a scheme for greenhouse gas emissions allowance trading within theCommunity and amending Council Directive 96/61/EC. Commission of the European Communities, Green Paper on Greenhouse Gas EmissionsTrading within the European Union (presented by the Commission), Brussels, COM(2000)87 final (Mar. 8, 2000), p. 10.7

CRS-3euro, or 13% below the estimate cost of compliance with the trading schemeultimately chosen by the 1: Cost of Reaching Kyoto Target to EU Member States

in 2010(in billions of 1999 euro)EU-wideTrading AmongEnergyProducers7.2EU-wide TradingAmong EnergyProducers andEnergy-IntensiveIndustries6.9No TradingAmong EUMember States

9.0EU-wide TradingAmong AllSectors6.0Source: EC Green Paper (Mar. 8, 2000), p. a variety of reasons, the EC chose a trading system with limited coveragerather than a comprehensive system covering all sources and gases. Some Europeananalysts have noted that EU politics played an important role in preventing seriousconsideration of a comprehensive program. As noted by Boemare and Quirion:A significantly wider coverage could have been provided only by an upstreamsystem, which had been excluded by the [European] Commission at thebeginning of the process. The reason was again political: an upstream schemewould have too much looked like a tax.8Not surprisingly, this reason was not employed by the EC in explaining itsdecision to create a less comprehensive trading scheme at this time. As stated by theEC:... there are sound scientific and practical reasons why the Community might notwish to establish a comprehensive scheme at this stage. There are considerableuncertainties surrounding the emissions of the fluorinated gases [HFC, PFC, SF6]and the absorption of carbon dioxide by sinks. Allocating allowances,monitoring emissions and enforcing compliance of small mobile emitters, suchas private cars, raise complex technical and administrative issues.9For determining the size of the trading program, the EC looked at five criteria:(1) environmental effectiveness, (2) economic efficiency, (3) the potential effects oncompetition, (4) feasibility, and (5) existence of alternative policies and measures. The first political decision noted by the authors was the exclusion of process emissionsfrom the chemical industry from the ETS. Catherine Boemare and Philippe Quirion,Implementing Greenhouse Gas Trading in Europe: Lessons from Economic Theory andInternational Experiences, Centre International de Recherche sur l’Environnement et leDeveloppement, CNRS/EHESS, France (June 2002), p. 5. Commission of the European Communities, Green Paper on Greenhouse Gas EmissionsTrading with the European Union (presented by the Commission), Brussels, COM(2000)87 final (Mar. 8, 2000), p. 10.98

CRS-4It felt that starting with a relatively small number of economic sectors and sourcesthat contribute significantly to total emissions and for which trading could reducecost significantly would “substantially” satisfy these criteria.10 As noted, the sixsectors chosen emit about 45% of the EU15’s CO2 emissions (which are about 80%of the EU’s total greenhouse gas emissions). The coverage for individual countriesvaries widely; only 20% of France’s greenhouse gas emissions are covered, comparedwith 69% of Estonia’s emissions.11Implementing the ETS: National Allocation PlansNational Allocation Plans (NAPs) are central to the EU’s effort to achieve itsKyoto obligations. Each Member of the EU must submit a NAP that lays out itsallocation scheme under the ETS, including individual allocations to each affectedunit. For the first trading period, each country had to prepare a NAP by March 31,2004 (May 1, 2004 for the 10 new EU Members). NAPs for the second period weredue June 30, 2006. These NAPs are assessed by the EC to determine compliancewith 11 criteria (12 for the second period) delineated in an annex to the emissionstrading directive.12 Criteria include requirements that the emissions caps and othermeasures proposed by the state are sufficient to put it on the path toward its Kyototarget, protections against discrimination between companies and sectors, along withprovisions for new entrants, clean technology, and early reduction credits. For thesecond period, the NAP must guarantee Kyoto the first period, the EC approved most of the necessary NAPs by the end of2004. The last NAP was approved June 20, 2006 (from Greece). In general, theprimary problem the EC found with NAPs that resulted in revisions were excessiveallocation of allowances and state efforts to permit “ex-post adjustments” to theirallocations. Excessive allocation problems resulted from states that left a gap in howthey would achieve their target, to be filled with measures to be defined later;insufficiently delineated plans to purchase allowances; and unrealistic economic oremissions growth assumptions. Ex-post adjustments by states are not allowed; suchadjustments are seen by the EC as potentially disruptive to the emissions market andcreating uncertainty for companies. Commission of the European Communities, Green Paper on Greenhouse Gas EmissionsTrading with the European Union (presented by the Commission), Brussels, COM(2000)87 final (Mar. 8, 2000), p. 13111210 International Energy Agency, Act Locally, Trade Globally (OCED/IEA, 2005), p. 74 Commission of the European Communities, Directive 2003/87/EC, available at[/environment/climat/emissions_]

CRS-5Results From the First YearEmissions LevelsFor the 2005-2007 period, the European Union is not attempting to meet theKyoto Protocol but to get experience with emissions trading with some modestemissions targets (i.e., to put the EU on the path toward meeting the Kyotorequirements). Table 2 provides the national emissions allocations and 2005emissions levels for 21 EU countries as recorded by the Community IndependentTransaction Log (CITL) by the compliance deadline of April 30, 2006.13 For the firsttrading period, the 21 countries have allocated an annual average of 1.8295 billionallowances and set aside 73.4 million allowances for allocation to new sources or forauctions. Verified emissions in 2005 for covered sources is 1.7853 billion metrictons, according to the CITL.14 The 44.2 million allowances allocated in excess ofactual 2005 emissions have been characterized by EU’s Environment Commissioneras an “over-allocation” of allowances15 and is considered responsible for a significantdrop in allowances prices in May, 2006. The 2005 emissions total reflects emissionsfrom 8,980 sources representing more than 99% of the allowances allocated. As ofApril 30, 849 sources in the 21 countries had not surrendered sufficient EC will determine whether the insufficiency is the result of technical difficultiesin national registries, tardiness, or noncompliance. Noncomplying sources aresubject to a 40-euro penalty for each ton of emissions in excess of surrenderedallowances under the ETS.

13 Four of the 25 Member States (Cyprus, Luxembourg, Malta, and Poland) have notsubmitted information because their allowance registries are not operational yet. Cyprusand Malta do not have emissions targets under the Kyoto Protocol. European Commission, EU Emissions Trading Scheme Delivers First Verified EmissionsData for Installations (Brussels, 15 May 2006), available at[/comm/environment/climat/pdf/citl_]

Comments of EU Environment Commissioner Stavros Dimas, as reported by Jeff Masonin “EU’s Dimas Says States Allocated too Much CO2 in ‘05” (Reuters, May 22, 2006).1514

CRS-6Table 2. Summary Information Per Member StateCO2 emissions for2005 in tonnes33,372,84155,354,09682,453,72726,090,91012,621,82433,072,638131,147,905473,715,87271,033,29425,714,57422,397,678215,415,6412,854,4246,603,86980,351,29236,413,00425,237,739Installations thatShare of installationshave not reported bywith verifiedInstallations covereda30 Aprilemissions reports02392 2.0%99.9%98.4%98.9%100.0%100.0%99.7%99.8%99.5%99.0%100.0%95.4%99.9%99.9%100.0%99.9%100.0%1759 024119Installations not incompliance on 30April 200602Annual averageallocation in 2005to 2007 in tonnesb32,674,90559,853,57596,907,83231,039,61818,763,47144,587,032150,500,685495,073,57471,135,03430,236,16619,238,190207,518,8604,054,43111,468,18186,439,03136,898,51630,364,848Annual averageallocation notallocated at theoutset in tonnesc330,0502,545,876348,0202,460,382189,529862,9524,871,3173,926,4263,286,8391,424,7383,081,18015,551,575505,760797,2132,503,3051,262,8987,180Member StateAustriaBelgiumCzechRepublicdDenmarkEstoniaFinlandFranced

GermanyGreeceHungaryIrelandItalyLatviaLithuaniaNetherlandsPortugalSlovakRepublicd

CRS-7CO2 emissions for2005 in tonnes8,720,550181,063,14119,306,761242,396,0391,785,337,8192915Installations thatShare of installationshave not reported bywith verifiedInstallations covereda30 Aprilemissions reports0100.0%99.1%99.4%99.9%99.1%988007057689,4203116Installations not incompliance on 30April 20060Annual averageallocation in 2005to 2007 in tonnesbAnnual averageallocation notallocated at theoutset in tonnesc13,162,130678,14915,527,48473,389,670Member StateSloveniaSpaind

SwedenUnitedKingdomTotal8,691,990 66,667162,111,39122,530,831209,387,8541,829,476,015Note: As all data are held in the CITL and national registries, no data are available for those Member States without an active registry.a. The figures in this column indicate the number of installations with active registry accounts on 30 April 2006. They differ from figures communicated in earlier press releasesbecause they are updated for installations that opted-out for the first trading period, opted-in, and installations without open accounts.b. The figures in this column are allowances allocated to existing installations at the start of The figures in this column are allowances not allocated to existing installations at the start of the scheme but put aside mainly for new entrants and auctioning (in the cases ofDenmark, Hungary, Ireland, and Lithuania).d. Due to technical problems in the national registries of the Czech Republic, France, the Slovak Republic, and Spain, the CITL did not receive wholly reliable information on theinstallation level surrenders from these Member States. Therefore, some fields are empty for these Member States. All data represented in the table were communicateddirectly to the European Commission by the respective authorities of these Member States.

CRS-8Some commentators have suggested that annual average 2005-2007allocations that are actually 44.1 million metric tons higher than the reported 2005emissions are neither putting the EU on the path to the Kyoto requirements nordeveloping the trading market. In addition, this “over-allocation” does not includethe 73.4 million metric tons of allowances held in reserve by the various countriesfor new entrants. The Climate Action Network (CAN), a network of 365 non-governmental organizations, stated the following:Emissions limits set by Member States for the first phase were a majordisappointment. To ensure maximum environmental benefit of the ETS andthe overall success of the system as a whole, they need to be strengthenedconsiderably. The Kyoto targets require ambitious caps with absolutereductions for the phase 2008-2012.16In general, the EC has seen the over-allocation issue as part of the “learning-by-doing” process that should help the EU in implementing the second tradingperiod beginning in 2008. As stated in its press release:The new 2005 emissions data gives independently assessed installation-levelfigures for the first time and so provides Member States with an excellentfactual basis for deciding upon the caps in their forthcoming nationalallocations plans for the second trading period, when the Kyoto targets haveto be met. The plans are subject to approval by the Commission, which willalso be making extensive use of the 2005 emissions data.17Market Activity, Prices, and ImpactAccording to Point Carbon’s proprietary databases, the EU-ETS traded 362million metric tons of CO2 in 2005, valued at 7.218 billion euro. Brokers wereresponsible for 57% of the volume, exchange markets did 15%, and bilateraltransactions accounted for 28%. Of the exchange market volume, the EuropeanClimate Exchange (ECX) had the largest share at 63%, followed by Nord Poolwith 24%, and Powernext with 7.9%.18The average price for an allowance traded in 2005 was 19.9 euro, withbrokered and exchanged allowances averaging 20.6 euro and bilateral transactionsaveraging 18.2 euro. However, allowance prices have been quite volatile sincetrading begin in 2005, as indicated in Figure 1 below.19 In particular, allowance CAN Europe, National Allocation Plans 2005-7: Do They Deliver? Summary forPolicymakers (April 2006), p. 2. European Commission, EU Emissions Trading Scheme Delivers First Verified EmissionsData for Installations (Brussels, May 15, 2006), available at [/luxembourg/docs/217-2006_] Point Carbon, Carbon 2006: Towards a Truly Global Market (28 February 2006) pp. 15-16. It should be noted that there is significant uncertainty in the estimates of the bilateralmarket.19181716 Margus Kaasik (CFO Eesti Energia), Carbon Market: EU ETS (May 9, 2006). )

CRS-9prices dropped from almost 30 euro to about 9-11 euro in April and May, sparkedby a series of reported over-allocation of allowances in several Member States.

By July 2006, allowance prices had recovered to about 17 euro in 1. CO2 Market: Even If No “Big” News Highly Volatile

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006), p. are several reasons for the overall volatility in the allowance EU-ETS is a maturing but still narrow market. Monthly volumes areincreasing, but have never exceeded a 1.6% share of phase 1 allocations.20

Modest volume for a new system is not surprising; trading volumes under the Air Act Title IV sulfur dioxide trading program were very thin in thebeginning. Even after several years of operation, SO2 allowances prices canchange unpredictably and inexplicably.21Some reasons for ETS allowance price derivatives are explicable. Asillustrated by Figure 2, the ETS market responded to a variety of regulatory,climatic, and economic events over the first trading period. Regulatory eventsinclude the late approval of NAPs for several countries, along with the resulting (...continued)volatility is a measure used primarily in options analysis to estimate how much the marketexpects an asset price to move for an option price. Two hundred-fifty days is commonlyused for this analysis, as it represents the number of business days in a year.202119 Margus Kaasik (CFO Eesti Energia), Carbon Market: EU ETS (May 9, 2006), p. 13. Vivian E. Thomson in collaboration with the Pew Center on Global Climate Change,Early Observations on the European Union’s Greenhouse Gas Emissions Trading Scheme:Insights for United States Policymakers (Apr. 19, 2006), p. 16

CRS-10over-allocation causing the sudden market correction in May 2006. Climaticevents influencing prices include cold weather, which increased energy usage, anddry conditions, which decreased the availability of hydroelectric power.22Figure 2. CO2 Market: Large Price Changes in Very Short Amount ofTimeSource: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006), p. primary economic influence on the ETS revolved around fuel 2005, Point Carbon analysis indicates 79% of the variance (R2) inallowance prices was explained by changes in fuel prices (particularly for electricpower), with 23% of the variance explained by the weather. This linkage betweenallowance prices and the power market is not surprising, as the power sectorconducted the majority of trades in 2005 and therefore significantly influencedprice argues that the evidence from the past year indicates that fuel pricesinfluence carbon prices, but not the reverse. Specifically, Kaasik sees allowanceprices as a derivative of natural gas and coal pricing, at least in the ng natural gas-fired and coal-fired generation are the marginal costsuppliers of power, allowance prices will respond positively to increasing naturalgas prices or decreasing coal prices. Likewise, allowance prices will respondnegatively to decreasing natural gas prices or increasing coal prices. This createsa correlation over time between allowance prices and electricity price byinfluencing the marginal price of electricity. How this has evolved during the firsttrading period is illustrated by Figure 3.22 Point Carbon, Carbon 2006: Towards a Truly Global Market (Feb. 28, 2006) pp. 18-19.

CRS-11Figure 3. There is a Very Long-Term Correlation Between CO2 andElectricity Price: Link Via Marginal ProducerSource: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006) p. of Clean Development Mechanism (CDM) and Joint

Implementation (JI)The EU-ETS has provisions for linking its trading scheme to the JointImplementation (JI) and Clean Development Mechanism (CDM) components ofthe Kyoto Protocol for countries that have ratified it. These project-basedinstruments involve Annex 1 countries in the case of JI, and between Annex 1 anddeveloping countries in the case of CDM.23 The EC’s linking directive allowsoperators to fulfil their allowance obligations under the EU-ETS using creditsderived from JI and CDM projects. Their credits are equivalent to allowances inenvironmental and economic terms, but are not interchangeable. “CertifiedEmissions Reductions” (CERs) under the CDM must be issued by the CleanDevelopment Mechanism Executive Board and may be used in either the first orbanked for use in the second trading period.24 Emissions Reduction Units(ERUs) under JI are transferred from one country to another — an exchange thatcannot begin until the second trading period. Neither CERs nor ERUs are Annex 1 countries are the 36 industrialized countries and economies-in-transition listedin Annex 1 of the United Nations Framework Convention on Climate Change and allowedto engaged in JI and CDM projects under the Kyoto Protocol. The time between submission of a CDM project design document and approval can be asmuch as 18 months because CDM credits must be approved by the Designated NationalAuthority (DNA) and the CDM Executive Board. Brown Rudnick Berlack Israels LLP,Emissions Trading: Questions and Answers (February 2006), p. 7.2423

CRS-12converted into EU-ETS allowances; rather, they are entered directly into thesurrendered allowance table. There are other restrictions on the use of CERs andERUs. In particular, for the second trading period the amount of CERs and ERUsthat can used by an affected unit is limited by a percentage specified by itscountry. Several EU countries have established carbon funds to pursue JI andCDM opportunities.25In general, CER and ERU credits have sold at a discount to ETS allowanceprices. The degree of discount has depended on the riskiness of the project. CERand ERU credits are available only when the projects are completed. Thus, wherebuyers take the risk of non-delivery, such as an emissions reduction purchaseagreement (ERPA), prices are in the range of 8-12 euro. In contrast, for CERsalready issued, or where the sellers take the risk, prices are in the range of 13-15euro.26 The real impact of CDM and JI on the EU-ETS system will not be fullyknown until the second trading period, when EU demand for credits will increasesubstantially and other non-EU countries would be implementing their own Kyotocompliance To assist its review of the ETS, the EC has surveyed stakeholders’viewpoints on ETS implementation and long-term issues.27 The report surveysthe viewpoints of participating companies, governments, industry associations,market intermediaries, and non-governmental organizations (NGOs) from June toSeptember 2005. Asked which of 12 topics surrounding ETS implementationentities felt were most important to them, companies, industry associations, andgovernments all ranked topics such as emissions reduction targets, allocationrules, and rules for new entrants and closures as the most important — topics thatall relate to long-term uncertainty. Table 3 indicates the top five topics accordingto governments surveyed, along with their corresponding ranking by otherstakeholders. The five issues are discussed below. For a list of countries with carbon funds, see [/?Page=Funds&ItemID=24670]

As reported in Carbon Positive, “CER Prices Stabilise After EU Market Hit” (June 14,2006), available at [/?articleID=137].

272625 European Commission, Review of EU Emissions Trading Scheme (November 2005).

CRS-13Table 3. Importance of EU ETS Topics(ranking)TopicEmissionsreductiontargetsGovernmentsCompanies1st1stIndustryMarketNGOs AssociationsIntermediaries1st3rd1stFurther2ndharmonizationof allocationplansTreatment ofnew entrants/closuresDefinition ofcombustioninstallationsInclusion ofsectors andgases3rd3rd2ndTied for 5thTiedfor 6th2nd5th7thTiedfor 6thTiedfor 11th3rd4th10thTied for 8thTied for 8th5thTied for 6thTied for 8thTied for 4thSource: European Commission, Review of EU Emissions Trading Scheme (November2005), p. ning of Emissions CapsWith the over-allocation issue in the first trading period, it is likely that the ECwill take a harder stance in reviewing NAPs for the second trading period. Therelationship between the ETS cap for the first trading period and the estimated ETScap for the second trading period (the Kyoto Protocol requirements) variessubstantially between countries, as illustrated in Table 4. In general, the original EU-15 countries have to reduce their emissions caps the most to meet their share of theEU’s requirements under the Kyoto Protocol, with several countries facing double-digit percentage reductions. As indicated, EU-15 states, on average, have to reducetheir emissions caps 6.8% (119 million metric tons) from their current levels to meettheir requirements under the Kyoto Protocol-based second trading period. Incontrast, as a group, the newer countries and the EU as a whole are in substantiallybetter shape.28 Two EU countries, Malta and Cyrus, are not included here because they are non-Annex1 countries and, therefore, do not have mandatory reduction requirements under the KyotoProtocol.28

CRS-14Table 4: Comparison of 1st and 2nd Trading Period ETS Caps(in millions of metric tons of CO2 Equivalent unless otherwise noted)

Average AnnualETS Cap (firsttrading period)aAustriaBelgiumCzech RepublicDenmarkEstoniaFinlandFranceGermanyGreeceHungaryIrelandItalyLatviaLithuaniaLuxembourgNetherlandsPolandPortugalSlovakiaSloveniaSpainSwedenUKEU-ETS 15EU-ETS 2333.062.997.633.519.045.5156.5499.074.431.322.3232.54.612.33.495.3239.138.230.58.8174.422.9245.31,739.12,182.3Estimated AnnualETS Cap (KyotoProtocol)24.657.9118.624.935.437.5159.6483.275.543.020.1194.710.133.42.788.9331.035.438.98.3142.824.4247.81,620.12,239.0PercentageDifference

-25.5%-8.0%21.6%-25.6%86.5%-17.7%2.0%-3.2%1.5%37.3%-9.7%-16.3%119.8%171.5%-19.4%-6.7%38.4%-7.2%27.7%-5.4%-18.1%6.7%1.0%-6.8%2.6%Source: Based on data provided in Annex 1, European Commission, “Further Guidanceon Allocation Plans for the 2008 to 2012 trading period of the EU Emissions TradingScheme” (Brussels, Dec. 12, 2005) p. 11.a. These figures do not account for changes to the number of installations subsequent to therespective Commission decision (e.g., opt-ins or opt-outs of installations).

CRS-15At first glance, it would appear that the EU would have little difficulty meetingits Kyoto Protocol requirements during the second trading period. The anticipateddeficit between the second trading period for the original 15 Member States can becovered by trading with the newer Member States that anticipate a surplus. However,there are other considerations. First, countries with potential surpluses may want toretain at least some of that surplus to help fuel their countries’ economic growth,possibly at the expense of a Member State that needs allowances. Second, the extentto which surplus credits would be created via JI, the EC linking directive, requiresthat such credits (including from CDM) be “supplemental” to a country’s domesticefforts. Each country is to spell out what “supplemental” means in its NAP for thesecond trading period.A third consideration is the overall commitment of the Kyoto Protocol. Asnoted earlier, the ETS only covers a percentage of the overall greenhouse gasemissions in the various Member States of the EU. The analysis provided in Table3 assumes that the ETS will have to provide a proportional amount of that reductionbased on 2003 emissions. However, some sectors not covered by the ETS may growfaster than sectors covered by the ETS, creating difficulties for compliance. Inparticular, the transportation area has become a major source of concern. Thetransportation sector is not a part of the ETS and is not likely to be included beforethe third trading period.29 Instead, transport controls are based on voluntaryagreements with automobile manufacturers to improve fuel economy, fuel-economylabelling of cars, and promoting fuel efficiency by fiscal measures.30 The cornerstoneis the agreements with automobile manufacturers to achieve improve new car fleetaverage CO2 emissions rates. As announced in 1996, the objective of the EU Councilof Environmental Ministers and European Parliament was to achieve a new car fleetaverage CO2 emissions rate of 120 grams per kilometer (g CO2/km) by 2005, or by2010 at the latest.31This objective was not met in 2005 and is unlikely to be met by ary commitments by the European, Japanese, and Korean AutomobileManufacturers Associations in 1998 and subsequently endorsed by the EC set targetsof 140 g CO2/km by 2008/2009. At the end of 2005, the average new car emissionsrate is about 160 g CO2/km. The rate of reduction in CO2/km for new cars wouldhave to double for the automobile manufacturers to achieve their commitments,which appears unlikely.32 Indeed, despite improvements in emissions rates, CO2emissions in the EU continue to rise because of increased miles driven, increased sizeand weight of cars, and falling car occupancy rates. The EC 2005 progress reportalso notes that despite EU’s effort to increase information on fuel efficiency and CO22930 , Transport to Stay Out of CO2 Trading until 2013 (June 21, 2006). European Commission, Implementing the Community Strategy to Reduce CO2 Emissionsfrom Cars: Fifth Annual Communication on the Effectiveness of the Strategy (Brussels, June22, 2005).3132 Council conclusions of June 25, 1996. European Federation for Transport and Environment, Cleaner is Cheaper (Brussels,2005). p. 1.

CRS-16emissions for consumers, the effectiveness of the effort seems low: “a significantimpact on consumer’s decisions could not yet be noticed.”33Attempts to balance the burden between ETS and non-ETS sectors have alreadycreated tension in Germany with respect to the second trading period. In its draftNAP for the second trading period (NAP II) submitted June 28, 2006, Germanyproposes to reduce its ETS allocation from about 499 million metric tons to about471 million metric tons, a decrease of 5.6%.34 However, Germany’s 2005 emissionswere only 474 million metric tons; thus the reduction is only 0.6% from last year’semissions. In addition, Germany is proposing to permit every new power stationbuilt between 2008 and 2012 to opt out from CO2 caps and the ETS for 14 years,generally to encourage construction of coal-fired facilities. These emissionsincreases will have to be covered by the non-ETS sectors — commercial, residential,and transportation. An assessment done for Greenpeace International states that theGerman NAP II places “a disproportionate burden for emissions reductions on thenon-ETS sectors” in terms of meeting its commitments under the EU Burden Sharingagreement.35 Policies to fill in the gap reportedly include one plan to reduceemissions by 3 million tons by training German drivers to drive more economically.36As noted by the EC Report cited above, the effectiveness of public educationprograms such as this may be izing NAPsThe EU-ETS system involves an interplay between definitions and proceduresthat are EU-wide and those that are nationwide. The groundwork for the system is theKyoto Protocol, which (1) defines the pollutants and sets the countries’ emissionstargets; (2) defines the scope of participation: Annex 1 countries may implementemissions trading programs, and non-Annex 1 countries may participate through theCDM; (3) defines baseline emissions years and sinks; and (4) sets national inventoryand compliance requirements. Within this framework, the EU defines the elementsthat make the EU-ETS work, including industry participants, the unit of trade(tradeable allowances equal to 1 metric ton of CO2), trading periods, settling upprocedures, and linkages within and beyond the respect to the individual Member’s NAPs, the EC harmonizes the NAPswith respect to penalties, allocation method (e.g., grandfathering), monitoring, andregistries with the goal of achieving the Kyoto targets. It allows Members flexibility European Commission, Implementing the Community Strategy to Reduce CO2 Emissionsfrom Cars: Fifth Annual Communication on the Effectiveness of the Strategy (Brussels, June22, 2005) p. 7. On a like-kind basis. The NAP II cap is actually 482 million metric tons because itinclude 11 million tons for facilities covered under the second phase that were not coveredunder the first phase. Karoline Rogge, Joachim Schleich, Regina Betz, and Jos Cozijnsen, Increasing theAmbition of EU Emissions Trading (June 2006), p. 1. Roger Harrabin, BBC environmental analyst, Germany to Spark “Climate Crisis” (June28, 2006).36353433

CRS-17with respect to allocations to individual participants, the extent to which banking ispermitted, and whether to permit the auctioning of up to 10% of allowances in thesecond trading period. As a result of this framework, there are significant differencesbetween Members with respect to participant definitions, industry level emissionscaps and allocations, and increase the economic and administrative efficiency of the ETS, somestakeholders are interested in improved harmonization of NAPs by the EC. Besidesthe issue of new entrants and definition of affected units specifically identified by theEC survey, harmonization issues include allocation methods and the use of auctions,the degree to which JI and CDM credits may be used for compliance, and monitoring,verification, and reporting rules. Table 5 illustrates the scope of potentialharmonization issues facing the 5: NAP Harmonization IssuesSubjectDefinition of allowancesReliable emissionsinventoriesBanking of allowancesEmissions capsSource of Member DifferencesFinancial and tax treatment of allowancesInventory standardsWhether and how much banking permittedStringency of caps and the extent of JI and CDM creditspermittedMonitoring, verification andProcedures and processesreportingAllocationNational registriesVoluntary participantsDefinition of mandatoryparticipantsAllocation methods and whether and how muchauctioning permittedDesign detailsWhether to allow pooling or opt-in/opt-outDefinition of sectors, size, installation, new entrant, andtreatment of closuresSource: Adapted from Fiona Mullins, EU ETS Implementation: Room for Harmonisation(The Royal Institute of International Affairs, 2005).One issue of particular interest is the effort to increase the use of“benchmarking” standards in setting allocations. Benchmarking generally involvesallocating allowances based on best available technology and practices, rather thanon historical emissions. However, the EC does not have the authority to scrutinizeallocations at the facility level, so any allocation harmonization would be on avoluntary basis (“soft harmonization”). Also, allocation schemes, such asbenchmarking, may not be suitable for some industries.37 The EC’s survey of ETSstakeholders revealed that although more than two-thirds of the respondents from the For more, see Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness inthe EU Emissions Trading Scheme: Policy Overview,” 6 Climate Policy (2006) pp. 7-30.37

CRS-18cement, aluminum, and chemical industries thought benchmarking was an“interesting alternative,” less than a third of the respondents from the pulp and paperindustry and refineries thought so.38In many ways, diversity between Member countries with respect to the ETS isinevitable. As stated by Grubb and Neuhoff with respect to allocation:The final way in which the EU ETS differs from many other trading systems isin the devolution of allocation responsibilities, in this case to its 25 MemberStates. This was an essential part of the deal that enabled the adoption of theDirective: Member States would have never ceded to the European Commissionthe power to distribute valuable assets to their industries. Nor is the EU ETSunique in devolving powers of allocation: it is typical in a number of US er, there are different degrees of harmonization, applicable to differentaspects of the EU ETS, and the Commission can and does seek to increase thedegree of harmonization through guidance notes.39 [footnote omitted]New EntrantsThe economic value of allowances is nowhere more evident than in discussionsof new entrants. Indeed, as noted above, Germany is proposing to permit new coal-fired powerplants built between 2008-2012 to opt-out of the ETS for the first 14years of operation in order to encourage construction. In its survey of ETSstakeholders, the EC found that 85% of all respondents favor a harmonized approachto new entrants and closures. Nearly 75% believed that those allowances should beprovided free.40 Likewise, an EU questionnaire conducted by the EuropeanEnvironmental Agency’s Topic Centre on Air and Climate Change indicated thatmost Member States would welcome harmonization of the treatment of new entrantsand closures across the EU.41Analogous to the U.S. acid rain program, EU states have set up reserves toprovide allowances to new entrants. In general, these allowances are provided free,as that is widely seen as helping boost new investment. However, the allocationmethods developed by the Member States differ. Most states have yet to dip intotheir reserves for new entrants; however, the importance of the reserve will increaseas the ETS enters its second, and eventually third, trading period. The manner inwhich new entrants receive allowances may have a significant effect on the long-termdirection of investment — whether it is directed toward low-carbon opportunities orused to support continuation of current economic development irrespective of its European Commission, Review of EU Emissions Trading Scheme: Survey Highlights(November 2005), p. 15. Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness in the EUEmissions Trading Scheme: Policy Overview,” 6 Climate Policy (2006), p. 17. European Commission, Review of EU Emissions Trading Scheme: Survey Highlights(November 2005), pp. 18-19. European Environment Agency’s Topic Centre for Air and Climate Change, Applicationof the Emissions Trading Directive by EU Member States, (EEA Technical Report No.2/2006, 2006), p. 30.41403938

CRS-19carbon intensity. Allocating allowances according to output and not differentiatingaccording to the carbon intensity of the project would provide an incentive to developlow carbon alternatives. An example provided by Grubb and Neuhoff:New entrant reserves should be based on output or capacity, and avoiddifferentiating according to the CO2-intensity of the new investment. Inparticular, giving more to coal than gas plants rewards investment in new coalfacilities, which would conflict with objectives to tackle climate change, increasethe cost of future emissions reductions, and in the long run could lead to higherelectricity prices. The damaging effects would be amplified if carbon-intensivenew entrants not only receive free allowances for the period 2008-2012 but alsoreceive promises for subsequent periods.42The proposed treatment of coal-fired powerplants by the German Governmentindicates how difficult it will be to direct future investment toward low-carbonprojects. However, it could be argued that the long-term success of the ETS and theEU’s commitment to Kyoto and any subsequent agreements rests on such aredirection with respect to new entrants and long-term tion of Affected UnitsAnother area in which several Member States would like more harmonizationacross the EU is the definition of a combustion installation.43 Concerns revolvearound ambiguity in the current definition of a combustion installation and thenumber of small installations covered under the ETS. The ETS applies to energyactivities for all sectors with combustion installations above 20 MW of thermal ratedinput, oil refineries, coke ovens, and, subject to size criteria, iron and steel, cement,lime, glass, ceramics, and pulp and paper facilities. However, Finland and Swedenopted to include small district heating installations with a rated thermal input below20 MW.44 In contrast, as noted previously, Germany is attempting to have someplanned coal-fired powerplants, which will be large producers of CO2, able to opt-outof the ETS for 14 addition to the consistency issue, small installations (between 20MW and50MW) account for 30% (about 3,000) of the total facilities covered under the ETS,but a very small percentage of total CO2 emissions.45 Surveying 22 Member States,42 Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness in the EUEmissions Trading Scheme: Policy Overview” 6 Climate Policy (2006), p. 22. European Environment Agency’s Topic Centre for Air and Climate Change, Applicationof the Emissions Trading Directive by EU Member States (EEA Technical Report No.2/2006, 2006), p. 30. These are generally owned by larger facilities which operate several installations coveredby the ETS. See European Environment Agency’s Topic Centre for Air and ClimateChange, Application of the Emissions Trading Directive by EU Member States (EEATechnical Report No. 2/2006, 2006), p. 16.

454443 The installation number is for 22 Member States (Poland did not provide sufficient data).Emissions estimates were provided by only 14 States. Based on those 14 States, )

CRS-2036% of the covered installations produced less than 10,000 metric tons of CO2annually.46 The somewhat weak emissions data available at the time of the EUquestionnaire suggest that while three-quarters of all emissions are produced by thelargest 7.5% of installations, the small installations (under 10,000 metric tons) areresponsible for less than 1%. Whether the ETS should continue to cover the roughly3,500 facilities under 10,000 metric tons annually remains a hotly debated ion of CoverageIn choosing a gradual, incremental approach to emissions trading, the EU isrelying on other programs to control greenhouse gas emissions in other sectors, suchas transportation. The difficulties the EC may encounter in not choosing acomprehensive approach to begin with is suggested by its survey of survey suggests that the future direction of the ETS in terms of increasingcoverage is toward incrementally adding more economic sectors, rather thanaddressing the more complex issue of a comprehensive system. Based on the survey,the focus is currently on the chemical, aviation, and aluminum industries.47 Giventhat the number-one recommendation for future implementation of the ETS is toprovide participants with a longer time frame for implementation, it is unclear whenthe ETS will become as comprehensive as the European Commission would sionAt first glance, the ETS would appear an effective vehicle for the EU to meetits Kyoto Protocol obligations during the second trading period. The anticipateddeficit between the second trading period for the original 15 Member States can becovered by trading with the newer Member States that anticipate a surplus. Inaddition, potential CERs and ERUs from the CDM and JI respectively may helpmaintain limits on allowance costs. Table 6 provides one series of estimates ofavailable allowances for the Kyoto Protocol’s five-year compliance sly, not all these allowances may be available to the EU alone; othercountries, such as Japan and Canada, may decide to incorporate emissions tradinginto their implementation strategies and acquire allowances from these sources. Yet,the totals suggest that all else being equal, the supply of allowances would beadequate. (...continued)allowance allocations to small installation accounted for about 2% of the total. SeeEuropean Environment Agency’s Topic Centre for Air and Climate Change, Application ofthe Emissions Trading Directive by EU Member States (EEA Technical Report No. 2/2006,2006), p. 15. European Environment Agency’s Topic Centre for Air and Climate Change, Applicationof the Emissions Trading Directive by EU Member States (EEA Technical Report No.2/2006, 2006).474645 European Commission, Review of EU Emissions Trading Scheme (November 2005), p.11.

CRS-21Table 6: International Supply of Emissions Credits and Allowances(cumulative total 2008-2012, million metric tons CO2)Source of SupplyClean Development Mechanism (CERs)Joint Implementation (ERUsSurplus Kyoto Allowances from EasternEurope, Russia, and the Ukraine (AAUs)Low Estimate680120<1,000-3,000High Estimate1,2009808,000Source: Compiled by Grubb and Neuhoff, “Allocation and Competitiveness in the EUEmissions Trading Scheme: Policy Overview,” p. r, there are other considerations. The availability of surplus creditscreated via JI and CDM is restricted by the EC linking directive that requires thatsuch credits be “supplemental” to a country’s domestic efforts. Each country is tospell out what “supplemental” means in its NAP for the second trading dual countries are likely to define that term differently — restricting allowancetrades and purchases in some r consideration is the overall commitment of the Kyoto Protocol. Asnoted earlier, the ETS only covers a percentage of the overall greenhouse gasemissions in the various Member States of the EU. Some sectors not covered by theETS may grow faster than sectors covered by the ETS, creating difficulties forcompliance. In particular, the transportation area is already a major source ofconcern.A final consideration for the ETS is its suitability for directing long-terminvestment toward a low-carbon future — the ultimate goal of any climate changeprogram. It is too early to tell whether the ETS market signal and individualcountries’ NAPs will move investment in the appropriate direction. The early signsare not particularly encouraging, with the 2005-2008 NAPs producing an over-allocation of allowances, and one major Member State, Germany, attempting todirect its second NAP toward carbon-intensive, coal-fired electric generatingfacilities rather than low-carbon alternatives. Reluctance by countries to redirecttheir NAPs and an inconsistent price from the ETS make the long-term effect of theETS uncertain.

CRS-22Appendix: Norway’s Trading SystemNorway, a non-EU country, also has an emissions trading system that beganoperating on January 1, 2005. Norway’s system covers 51 facilities in the energy andprocess sectors such as oil refining and iron and steel processing, and has severalfeatures in common with the EU ETS.48 These sectors account for about 10-15% ofthe country’s emissions. Other parts of Norway’s industry, particularly its offshoreoil and gas sector, are covered by the country’s carbon tax of almost 40 euro permetric tonne of CO2 — much higher than the anticipated allowance price under thetrading program. The carbon tax is levied on about 64% of the country’s CO2emissions — about half the country’s total greenhouse gas emissions.49 The firstphase of the trading program covers the period 2005-2007, with a second, expandedphase to begin in ping its initial trading scheme independently of the EU, Norway’s“Quota Commission” (created in 1998) stressed that the 2008 program be ascomprehensive as possible, suggesting that the system could include close to 90% ofthe country’s greenhouse gas emissions.50 To achieve this coverage, the Commissionenvisioned a hybrid system of quotas, depending on cost-effectiveness andpracticality considerations. Arguing in favor of regulating CO2 emissions at theproducer (upstream) level from mobile sources and some stationary sources, theQuota Commission states:For these emissions, regulation at the producer level will not create weakerincentives for reducing emissions than regulation at the consumer level, becausethe volume of emissions from a particular commodity is not dependent ontechnology. For those process emissions which are recommended for inclusionin the system, regulation by quotas should be imposed at the end-user level incases where the processes originate with major industrial companies. Forprocess emissions stemming from a series of small sources, e.g. emissions ofN2O from commercial fertilizers, regulation by quotas should be imposed onretailers, or importers in order to avoid unacceptably high system costs.51The Commission’s recommendation that “regulation by quotas be imposed inpart on the producer, in part on the sales or import chain, and in part on the end-user”52 may be overtaken by development of the EU ETS, which is likely to influence4849 International Energy Agency, Act Locally, Trade Globally (2005), p. 102. Ministry of the Environment, Report 54 to the Storting (2000-2001): Norwegian ClimatePolicy, at [/md/engelsk/publ/stmeld/022001-040012/] Ministry of the Environment, Trading in Greenhouse Gases (press release, Dec. 17, 1999),at [/odinarkiv/english/bondevik_I/md/022001-990070/]. The Quota Commission, A Quota System for Greenhouse Gases (Dec. 17, 1999), p.7, at[/odinarkiv/norsk/dep/md/1999/eng/022021-220003/]525150 Ibid., p. 19.

CRS-23the future direction of Norway’s trading system. The International Energy Agency(IEA) states:The government had indicated earlier that it would consider expanding the[trading] system from 2008 to include as many sources of emissions as practicalthrough an upstream system allocating allowances to fossil fuel producers andimporters. With the adoption of the EU ETS design features, Norway seems tomove away from this option.53

53 International Energy Agency, Act Locally, Trade Globally (2005), p. 103.