Strengthening the EU Emissions trading system

By Stavros Dimas, European Commissioner for Environment.

In an earlier article for World Finance I explained what the European Union has achieved with carbon trading. That article set out the developments that gave rise to the EU greenhouse gas Emissions Trading System (EU ETS), the biggest such system in the world, how the EU ETS serves as a model for emission trading systems elsewhere and how it is spurring clean development projects in emerging economies.As part of a major set of climate change and energy initiatives, the European Commission in January 2008 proposed a revision of the EU ETS to strengthen it and make it more efficient in reducing greenhouse gas emissions at least cost. This article explains our proposal and its implications.Climate change is arguably the greatest challenge facing mankind today. The world's future prosperity and social stability are under severe threat unless we take urgent and bold action to reverse the continuing rapid increase in global greenhouse gas emissions.The European Union has long been leading international action to address global warming and we have put in place a panoply of measures to limit and reduce our domestic emissions. The EU ETS, launched in 2005, is by far the most important and innovative of these and forms the cornerstone of our strategy for combating climate change cost-effectively.The system has succeeded in putting a market price on carbon – at present just under 22 euros per tonne for forward delivery - and thus given companies a clear business incentive to reduce their emissions. It is a key tool for driving investment towards clean, low-carbon technologies, both in Europe and in third countries. The EU ETS currently covers some 10,500 power plants and energy-intensive industrial installations across the 27 EU Member States plus Iceland, Liechtenstein and Norway. The aviation sector is to be brought in from 2011 or 2012.Ambitious targetsIn March 2007 the European Union's leaders underlined their determination both to tackle the climate challenge and improve Europe's energy security by committing to a set of ambitious targets. They mandated a central role for the EU ETS in achieving these goals.Europe will reduce its greenhouse gas emissions to 30 percent below 1990 levels by 2020 provided other developed countries commit to comparable efforts under a new global climate agreement that should be concluded by the end of 2009. An ambitious global agreement to succeed the Kyoto Protocol is our top priority since only decisive international action will succeed in controlling climate change.Recognising the clear competitive advantages for Europe in turning itself into a highly energy-efficient, innovative, low-carbon economy, the EU leaders also committed to an emissions cut of at least 20 percent by 2020 regardless of what other countries decide. And to support these targets and strengthen energy security, they agreed that renewable sources should be providing 20 percent of the EU's energy needs by 2020.The European Commission put forward a package of proposals for implementing these targets on 23 January after months of consultation and analysis. One of the main pillars of this so-called Climate Action and Renewable Energy package, now under active consideration by the European Parliament and EU governments, is a major overhaul of the EU ETS that will take effect at the start of the third trading period starting on January 1, 2013. Our proposals to revise the system draw on the lessons of the 'learning by doing' phase of the EU ETS that took place between 2005 and 2007. We have been guided by two main priorities: to ensure the scheme provides real emission reductions so that we meet our targets, and to increase harmonisation in order to create greater transparency and predictability for participants and reduce distortions in the EU's internal market.We are proposing a limited broadening[1] of the system's scope that will increase its cost-effectiveness and environmental efficiency by expanding the range of abatement opportunities. However, the two biggest changes we envisage are the introduction of an EU-wide cap on the total number of emission allowances - replacing the current system of national caps - and a move to full auctioning of allowances instead of allocation for free.TransparencyBy 2020 the EU cap will be reduced in a linear way by 1.74 percent each year below the level of emissions in 2005. This is the easiest and most transparent way to ensure that the system contributes effectively to achieving the EU's emission reduction targets. By 2020 emissions from the sectors covered by the EU ETS – which by then will account for about 40-45 percent of the EU's total greenhouse gas emissions - will be 21 percent lower than in 2005. Once a global agreement is reached, the EU cap will be automatically adjusted to a stricter reduction target as necessary.Free allocation of allowances to companies has been the norm so far, but we have come to recognise that auctioning constitutes the simplest and most transparent approach for distributing allowances and creates the clearest incentive for investment in a low-carbon economy. It is also the best way to prevent unwanted distributional effects such as 'windfall' profits for companies.The Commission is therefore proposing that from the beginning of the third trading period electricity generators would have to buy all their allowances at auction. For other sectors auctioning of allowances would be phased in gradually to reach 100 percent in 2020. We recognise, however, that there may need to be exceptions to full auctioning for certain energy-intensive sectors that operate in a highly competitive international market and may not be able to pass on the cost of CO2 allowances to their customers without losing market share. The risk of them moving production abroad could be particularly high if a global agreement cannot be reached or it does not succeed in levelling the playing field internationally. Carbon leakage may not only mean loss of jobs, but could result in higher emissions if production is moved out.The move to auctioning will bring governments significant revenues of up to €50bn a year by 2020 and we are recommending that they spend at least 20 percent of this on combating and adapting to climate change.Fulfilling obligationsOur proposals also have an important external dimension.The EU ETS is the main driver of demand for credits from emission-saving projects in developing countries since companies in the system can use these to fulfil part of their obligations. If the EU's reduction target were to stay at 20 percent, the option of buying credits from abroad would need to be limited in order to create incentives for innovation and real emission reductions within Europe. The Commission is therefore proposing that from 2013 only credits allowed but not used in the current trading period, which runs from this year to 2012, should be eligible.However, in the context of an international agreement with a stricter emissions reduction target than 20 percent, the limit on credits would be automatically raised so that up to half of the additional reduction effort above 20 percent could be met through their use. This increase in access to credits will help Europe meet the higher target while also creating an incentive for third countries to ratify the agreement since only credits from countries that did so would be accepted.We are introducing the possibility to link the EU ETS not only to emission trading systems set up by Parties to the Kyoto Protocol but also to systems with absolute emission caps in any other country or in sub-federal or regional entities such as US states or groups of states. In this way we aim to promote the development of a network of linked trading systems around the world that would form the backbone of a strengthened global carbon market.With these changes, we believe that the revised EU ETS will offer the transparency and predictability that companies need to make long-term investments in emissions-reduction technologies. The stronger EU ETS that will result will further underline the EU's leadership in combating climate change and make it attractive for other countries to link with our system.