Climate Action Network Europe / Emission Trading in the EU

The EU has agreed to establish a cap-and-trade system to limit CO₂ emissions from large industrial point sources. This so called Emissions Trading System (ETS) came into effect on the 1st January 2005.

Emissions trading (or cap and trade) is an economic policy instrument used to control emissions by providing economic incentives for achieving emission reductions.

An emission trading system sets a limit or cap on the amount of a pollutant that can be emitted. Companies or sectors under the trading system are given credits or allowances which represent the right to emit a specific amount. The total amount of allowances distributed cannot exceed the cap, limiting total emissions to that level. Companies that emit beyond their allowances must buy allowances from those who emit less or face heavy penalties. The buyer pays for polluting (more), while the seller is being rewarded for having reduced emissions. Companies that can easily reduce emissions will do so and those for which it is more expensive will buy credits. This makes Emission trading a policy instrument is that reduces greenhouse gasses at the lowest possible cost to society.

Support for a trading based instrument, a concept previously alien to EU environmental policy-making, increased in the late 1990s, following the frustrating experience of years spent on a debate on a carbon/energy tax, without tangible results in terms of a workable climate policy instrument. This support was and is based on the EU Emission Trading Scheme delivering on the benefits it promised to maintain credibility to domestic audiences, including policy-makers, business representatives, NGOs and the general public altogether.

The European Parliament voted on 2nd July 2003 to agree a compromise with Council on the Directive on emissions trading in the EU. This deal was adopted at the Environment Council on October 13 th 2003. The text of the directive as published in the Official Journal is available here - see also the European Commission's ETS pages.

The existence of the EU emissions trading scheme (ETS) is a tremendously important achievement for European Climate Change policy. The EU ETS is a very important element of EU climate policy, as it covers presently over 40% of all greenhouse gas emissions from the 27 Member States.

The strength of a cap and trade system as a policy instrument is twofold. First of all it puts an absolute limit on the total emissions that can occur and therefore has the potential to guarantee environmental effectiveness. Furthermore it reduces emissions with the lowest possible compliance cost to all participants compared to other mechanisms. The EU ETS in particular is the most cost effective instrument for European industry and power generators to contribute to the reductions needed at EU level.

The EU ETS has been operating since January 2005. The first trading period runs until the end of 2007. In January 2008 the second trading period of the system will start. At the end of 2007 the European Commission will propose amendments to the EU ETS. In 2008 and 2009 this amendments will be decided on by the EU governments and the European Parliament. The amended EU ETS will start operating as from January 2013.

Until the end of the first trading period 2005-2007 only CO₂ emissions are covered by the EU ETS. However some member states plan to use the so called “opt-in” rule which allows them to expand the scope of the EU ETS beyond the above mentioned greenhouse gas and sectors. In particular France and the Netherlands applied for an opt-in of N₂O emissions from the production of fertilisers as from 2008.

Some Member States requested an opt-out of certain installations from participation of the EU ETS in the period 2005-2007. Such an opt-out is only allowed in the first trading period and can only be accepted by the European Commission if the concerned installations are subjected to equal reduction efforts and monitoring and reporting rules as they would have been subjected to under the EU ETS.

The EU Allowances form the currency of the EU ETS. The total amount of allowances entering the EU ETS also referred to as the cap is an essential ingredient of a cap and trade emissions trading scheme. This amount sets an absolute limit to the total amount of emissions that can occur. Without a limitation on the amount of allowances there would be no shortage in the trading market. This would lead to emission allowances with a 0 EUR price and hence no emission trading. Emission trading is built on market shortage.

In the EU ETS Member States are responsible for determining the total amount of allowances to be distributed to installations. However, to avoid unlawful state aid and to guarantee the environmental effectiveness of the EU ETS there rules for setting this cap. Therefore each Member State has to submit a National Allocation plan to the European Commission. No allowances can be distributed before a plan has been accepted and approved by the European Commission.

In the first trading period 2005-2007 a minimum of 95% of the total amount of allowances has to be allocated for free. In the period 2008-2012 this amount is 90%. This means that have the possibility to auction respectively 5 and 10% of the allowances.

Article 9 of the Emissions Trading Directive establishes that each Member State periodically has to develop a National Allocation Plan (NAP). At least 18 months before the start of each trading period a Member State has to submit its national allocation plan to the European Commission.

A national allocation plan has to contain the following information: the total amount of allowances a member state wants to allocate for the concerned trading period;

The method(s) to allocate the allowances to the individual installations;
The way in which New Entrants (i.e. new installations entering the EU ETS in a trading period) can participate in the EU ETS (e.g. through an emission allowance reserve from the Member State);
A list of installations and the amount of allowances to be allocated to each of them.

ANNEX III of the Emission Trading directive lays out the rules an allocation plan has to oblige:

The total amount of allowances has to be consistent with the Kyoto target of the Member State, the Climate Change policy of the Member State and the reduction efforts for other sectors;
There can be no unlawful discrimination between sectors and operators in the EU ETS. This leads to transparent rules for allocating allowances;
No more allowances than needed can be allocated;
The allocation has to take into account the technological and economical potential to reduce emissions;
The plan must comply with EU rules on competition and State aid;
The plan must be subjected to public consultation before submission.

The European Commission has published two NAP guidance documents which explain and elaborate the NAP rules from ANNEX III of the directive.

After the submission of an allocation plan to the European Commission this plan is first assessed by (a working group of) the EU Climate Change Committee (C.C.C.). This is a committee of 27 national experts and the European Commission established under comitology rules. The C.C.C. advises the European Commission before its assessment of the National allocation plans.

No later than 3 months after the submission of an allocation plan, the European Commission has to decide on it. A plan that is rejected has to be amended and resubmitted. In most cases the European Commission either accepted an allocation plan or accepted a plan conditionally. The latter meaning that certain (key) elements of the allocation plan have to be amended before it is accepted.

Member States can more or less choose how the allocated allowances are issued (i.e. given) to their EU ETS installations. For the periods 2005-2007 and 2008-2012 most Member States chose to issue the allowances proportionally. For the period 2005-2007 this meant that each installation annually received 1/3 rd of the allocated amount. For the period 2008-2012 this is 1/5 th. The annual issuance has to happen before 28 February of each year. So an EU ETS installation will receive the allowances for the year 2006 before 28 February of that same year.

The EU ETS provides thorough monitoring and reporting rules for installations under its scope. Each installation under the EU ETS has to have a greenhouse gas permit before it can operate. The essential part of this permit is the so called monitoring protocol. This protocol lays down the rules that have to be followed when reporting the CO₂ emissions under the EU ETS. The protocol contains a detailed description of the CO₂ sources in an installation, the way fuel use is measured and the estimated accuracy of those measurements.

Each year, before 31 March, the operator of an EU ETS installation has to report the amount of CO₂ emissions that have been emitted in the previous year. This report has to comply with the rules of the monitoring protocol and has to be verified by a company independent and government accredited verifier.

The final step in the compliance process is the obligation to match the (verified) emissions with an equal amount of allowances. This is called ‘surrendering’ of allowances. Each EU ETS installation has to surrender the allowances (of the previous year) before 30 April of the ongoing year. So before 30 April 2007 a company has to surrender the allowances that match the emissions for the year 2006 and so on… If an operator of an EU ETS installation is short of allowances he will have to buy allowances from an installation that has more allowances than needed to cover the verified emissions. Finally, the surrendered allowances are cancelled (they can only be used once).

A company that does not surrender enough allowances will be fined. In the period 2005-2007 there is a fine of 40 EUR per missing allowance. In the period 2008-2012 this fine is 100 EUR per missing allowance. The company is still obliged to surrender the missing allowances.

How does this all work in practice? Each Member State has to establish an electronic register in which each installation has an account (the operator holding account). The competent authority in each Member States is responsible for the issuance of the allowances to the holding account. When an operator of an EU ETS installation submits the verified emissions a deficit is created on another account, the so called compliance account. The operator then has to transfer an equivalent amount of allowances to this compliance account to balance the verified emissions. Every person in Europe can open a trading account in a National Register. This account can be used to trade allowances.

The National Registers are connected to a central EU hub, the Community Independent Transaction Log (CITL). All transactions of allowances pass through the CITL to make sure the checks and balances are correct.

Four months after the end of a trading period, allowances which have not been used for compliance, will be cancelled. Member States can re-issue those allowances in the period 2008-2012 but are obliged to re-issue those allowances in the third trading period. This process is called banking.

In November 2004 an amendment to the EU ETS directive (i.e. the linking directive) was published. Through this amendment Member States can allow the use of credits generated by the Clean Development Mechanism (CDM) and Joint Implementation (JI) for compliance use in the EU ETS. This means that EU ETS companies can use CERs (Certified Emission Reductions) and ERUs (Emission Reduction Units) next to EUAs to cover their emissions.

The use of the above Kyoto credits is limited to a certain percentage of the total amount of allowances to be allocated in the relevant trading period. This percentage has to be mentioned in the National Allocation Plan and has to comply with the supplementarity provisions under the Kyoto Protocol. The European Commission assesses the use of CERs and/or ERUs when deciding on the National Allocation Plans.

CERs and ERUs generated from nuclear facilities and LULUCF projects cannot be used for compliance in the EU ETS.