The EU Emission Trading Scheme - a play in 4 acts

Setting the scene

The European Union, wishing to demonstrate international leadership in the fight against climate change, but worried about the impact of climate policy on its industry competitiveness, has set up an Emission Trading Scheme. This scheme allocates allowances - the right to emit a tonne of CO₂, to the 12,000 largest emitters in Europe, i.e. power generators and large industry (the covered sector). Allowances are allocated per period.

For the first phase (2005-2007), a total of 6.5 billion allowances have been allocated. A second phase is foreseen for 2008-2012. According to the European Commission, the ETS has the potential to reduce compliance cost to Kyoto from 6.8 to 2.9-3.7 billion euro/year. Allocation of allowances occurs through national allocation plans, developed by national government. Since the covered sector represents about 45% of EU emissions, governments must make an assessment of how many allowances they have under the Kyoto agreement and how many will be used by the non-covered sectors (households, commercial sector, transport). The Emission Trading Directive states that at least 95% of allowances during the first phase should be allocated free of charge. We are October 25, 2003, and Directive 2003/87/EC enters into force.

Act 1 - defining the national allocation plans (2004)

The national allocation plans are drawn up for the period 2005 - 2007. They need to strike a fine balance. On the one hand, ambitious targets are required, helping the country to achieve its Kyoto targets, while creating scarcity, and hence value for allowances. On the other hand, too much ambition affects industry competitiveness. When the plans are defined, some express concern about an overgenerous allocation of allowances to industry.

Act 2 - trading starts (First half of 2005)

From February 2005, trading of emission allowances starts, and during the first semester of 2005, monthly trading volumes increase to 30 million allowances at a price of more than 20 euro per tonne. Good news - the market works, though trading remains relative thin compared to total emissions.

Act 3 - polluter is paid and customers pay? (2nd half of 2005)

During the second half of 2005, and according to large electricity users, it becomes apparent that power generators, having received 95% of their emission allowances for free, are charging the value of emission allowances in the prices, increasing the cost of electricity. This claim receives support by many independent sources (e.g. ECN report), concluding that there is substantial evidence of pass-through pricing in several major European electricity markets. However, a joint Eurelectric-KEMA report explains that there are many factors influencing cost of electricity, and in particular fuel prices and energy taxes have increased dramatically. And to complete the picture, in its assessment of market liberalisation of the electricity and gas sector, the Commission notes that there remains a high degree of concentration in the electricity industry, impeding effective competition.

Act 4 - the bubble bursts (2006)

Trading prices collapse, from over 30 euro per tonne to almost 10, following reports from five countries that 2005 actual emissions were lower than expected. As a result, the European Commission halted the release of information from other countries, until a fuller picture emerges, and meanwhile has issued a press release. Allowance prices have recovered some ground, but still far from the 30 euro mark. The association of the German chemical industry issued a press release (in German) that electricity prices have gone down following the reduction for CO₂ allowances, but CO₂ is still being passed through. But according to the World Bank, the carbon market could be worth 25-30 billion in 2006, a 40-fold increase compared to 2004, which makes this month's price collapse look like a mere dip.

Epilogue

We do not yet well understand the design and creation of environmental markets. The pilot phase, at an average of 20 euro per tonne CO₂, has effectively allocated a value of 130 billion euro of emission allowances. The main phase 2008 - 2012 will even allocate 10 billion allowances. The German electricity users claim damages of 5 billion euro from the side effects of the scheme, just for Germany, which is already much higher than the potential benefits the ETS is expected to produce (see above).