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Forest Carbon Portal
EU Emissions Trading Scheme turns One
Author: Mark Nicholls

On 1 January, 2006 the EU's pioneering carbon trading scheme turned one year old. It may not have saved the planet yet, but neither has it brought Europe's economy to its knees, as some believed it could. The Ecosystem Marketplace considers the scheme's impact thus far, and looks forward to the next 12 months.

On 1 December, 2005, a major milestone was passed--with little note or fanfare--in the development of international carbon markets. That day was the 'settlement date' for thousands of 'over-the-counter' forward contracts in European Union Allowances (EUAs)--the currency of the EU Emissions Trading Scheme (ETS), the world's first mandatory carbon dioxide (CO2) emissions trading scheme.

Since 1 January 2005, the ETS has imposed CO2 emissions targets on around 4,500 industrial companies across the 25 countries of the European Union. With the legislation pushed through the EU policy process at a near record pace, the development of the infrastructure underpinning the market has, at times, struggled to keep pace.

As such, most market participants have tended thus far to transact via contracts for forward delivery--typically with the market standard 1 December settlement date--to ensure that, when the contracts matured, they would be physically able to transfer their allowances from seller to buyer.

On that date, tens of millions of allowances were successfully transferred--with Shell alone claiming to have transferred some 25 million. "It's been an excellent start," said Claire Byers, a director of environmental products at Fortis Bank, a Belgian-Dutch financial institution that is an active participant in the carbon markets. "Billions of euros of EU Allowances were delivered, and transferred, and the [market] infrastructure held up."

On the day itself, she adds, "pretty much everyone was done by lunchtime".

A working market


It was in similar terms that Arthur Runge-Metzger, a senior European Commission official with responsibility for climate change, spoke of the scheme's first year at a meeting of the Parties to the UN Framework Convention on Climate change this past December. "Around 6.6 billion allowances [each entitling the holder to emit a tonne of CO2] were allocated. More than 230 million, with a notional value of €3-4 billion, have changed hands. We got over 1 December--the registries worked."

It may seem strange for the officials that created the scheme, and the market intermediaries that trade in it, to focus on the apparently arcane mechanics of the trading system. But the registries--which each member state is required to set up to track each transaction--and the process of allocating allowances to each industrial installation covered by the scheme, form the foundations of the ETS. And, for the many critics of what is the world's largest environmental market, failures here would have provided valuable ammunition with which to attack this bold initiative.

However, by and large, the market infrastructure has developed reasonably smoothly. There have been delays: despite the scheme's 1 January, 2005 launch date, a handful of member states have yet to finalise the 'national allocation plans' that lay out the targets that installations in each of the 25 member states face for the first phase, which runs until the end of 2007.

Some registries--particularly in Eastern Europe--have not been completed, meaning that many installations can't yet buy or sell allowances. And--for reasons beyond the control of the EU ETS' architects--carbon credits from the Clean Development Mechanism (CDM) cannot currently be imported into the scheme, as the United Nations secretariat responsible has yet to complete its part of the infrastructure jigsaw.

Overall, however, a functioning market has developed, with daily trading in allowances regularly exceeding one million tonnes each day. A number of exchanges have either been set up to offer regulated markets for trading standardised contracts--such as the European Climate Exchange--or, like Norway's Nordpool, have added CO2 contracts to their existing suites of products (for a story on these schemes see Creating a "Wall Street" for Carbon).

The success of this aspect of the scheme is evidenced by the reaction of the financial sector--which has enthusiastically embraced this new market, said Runge-Metzger. "In Brussels, we're thrilled with the private sector's approach to the scheme. It's created new jobs--carbon traders, carbon analysts--and is expanding and moving the whole thing forward. There's an entire new sector of business that has been created, very quickly."

But what about the wider objectives of the scheme--namely, to help the European Union meet its Kyoto Protocol emissions reduction targets in the most cost-effective manner possible? Is it changing corporate behaviour? Is it making the EU less competitive, as some critics--particularly in the US--argue? And how is it affecting the wider international debate about tackling global warming using market-based mechanisms?

Environmental effectiveness


It is, the scheme's architects argue, far too soon to assess the scheme's success in its over-riding objective of reducing emissions. The first phase is, in some regards, a pilot for phase II, which runs in parallel with the first Kyoto Protocol commitment period (2008–12). As such, governments were under less pressure from the European Commission--which regulates the ETS--to set tough targets on industry.

Indeed, environmental groups have been highly critical of the allocation process, arguing that in most EU countries, industry proved able to lobby for more generous emissions targets than was justified by the challenges most face in reducing greenhouse gases to meet their Kyoto targets.

"The EU ETS is the first carbon trading market in the world and as such, can and must set an example for countries and regions across the globe to follow," said Matthew Davis, climate change campaign director at WWF, launching a report in November analysing how six major European economies had approached the first phase of the scheme.

The report found that "all six major countries analysed fell short of meeting all the criteria for environmental effectiveness and economic efficiency in phase I, failing to deliver sufficient emissions reductions, fair, transparent and simple plans for the scheme and providing the necessary investment signals to tackle climate change seriously."

The Commission counters that its review of each NAP before it was approved--a power the Commission has under the directive establishing the ETS--enabled some of the most egregious over-allocations to be addressed. It says that it shaved some 10% off the targets originally proposed by member states, helping to ensure that the market is essentially short of allowances in the first phase.

The electricity generation sector certainly argues that the scheme is forcing it to reduce emissions. Because electricity generation is to a large extent insulated from overseas competition, most EU governments decided that their generating sectors should bear the brunt of reductions, on the assumption that they could pass costs through to their clients. And, according to figures from Eurelectric, the industry association for European generators, the sector's phase I allocation is 300 million tonnes of CO2 below its business--as-usual emissions trajectory--a 10% reduction over three years.

"The EU ETS imposes a price of carbon on all industry affected by the scheme," said John Scowcroft, head of sustainable development at Eurelectric. "Operators take carbon into account, reflected in plant dispatch"-- that is, by running less-carbon intensive natural gas-fired generation ahead of coal-fired plants.

The evidence is mixed, however, as to whether power generators are actually beginning to reduce emissions. Because they can by and large pass costs through to their customers, they don't face direct pressure to reduce their own emissions. In fact, in recent months, the scheme has singularly failed to encourage a shift away from dirty coal to cleaner gas. High prices for gas, and low prices for coal, have seen generators ramp up coal-fired generation, and enter the carbon market to buy the extra allowances they will need to cover their higher emissions.

Power traders argue that this is perfectly rational market behaviour and, eventually, this will force the price of carbon to a point where it is no longer economic to increase coal-fired generation.

Shifts in corporate behaviour


Where all observers agree that the scheme has had a dramatic environmental effect is that it has created a 'cost of carbon'. And, whenever business faces a cost, it tends to respond. Two consultancies--McKinsey & Company and Ecofys--have carried out a survey for the Commission to inform the latter's review, which it is due to complete by June 2006. That survey--of some 300 companies, NGOs, government bodies and market intermediaries--found that 48% already price in the cost of carbon in their daily operations. That figure rises to 71% when respondents were asked if they plan to price in carbon in future.

Given that most companies have few opportunities for emissions reductions in the short-term, the full environmental impact of the scheme is likely to become apparent via longer-term investment decisions. Here, the McKinsey-Ecofys survey found that the EU ETS is "one of the key issues" in investment issues for half of respondents, with 48% identifying it as "one of many other issues". Only 2% said it was not relevant at all.

Equally, around half of the companies questioned said it would have a "strong or medium impact on decisions to develop innovative technology". This figure rose to 84% among steel companies, and 60% among refineries.

For most companies covered by the scheme, the actual allocation of allowances, and their likely surplus or shortfall at the end of each annual compliance period, is not material--at least at carbon prices where they currently stand (around €20/tonne of CO2) and given the relatively generous allocations awarded in phase I.

The scheme is, however, influencing corporate behaviour in three areas. The first is that the ETS directive mandates the monitoring, measuring and reporting of greenhouse gas emissions by affected installations. For the first time, thousands of plants across the EU are accurately measuring their emissions--and, as the old adage goes, "what is measured can be managed".

The second related issue is that the ETS has raised the issue of greenhouse gas (GHG) emissions to boardroom level, and has lead to boards commissioning studies to look at how the scheme will impact their businesses. A good example is the France-based tire manufacturer, Michelin. In mid-2004, it began an assessment of how the scheme would affect the company. It soon concluded that it was likely to be neither particularly short of allowances, nor would it be left with a surplus.

But, while Michelin does not feel the need to access the carbon market particularly actively, the scheme has alerted the company to the inter-relationships between energy use, emissions, and the bottom-line. It has now established a committee to keep an eye on the issue, and manage its energy efficiency more actively-- especially with the knock-on effect the scheme has had on power prices.

And it is this third area that is causing most controversy. A number of trade associations representing energy-intensive industries have been complaining bitterly that the EU ETS, by raising power prices, will force--indeed, is forcing--companies to pull down their shutters and either relocate outside the EU or cease trading altogether.

Harming European competitiveness?


Earlier this year, Robert Jeekel, manager of trade and economic affairs at trade association Eurometaux, claimed that European metals producers "are going broke" because of high power prices, exacerbated by the EU ETS.

Speaking at a conference in London in July, he said that as much as half of the EU's primary aluminum capacity is in danger of closure in the next few years, if electricity and metals prices remain as they are. He cited three out of five aluminum smelters in Germany, and one in Hungary, which have said they will have to close if power prices do not come down.

The scheme has faced criticism from numerous industrial quarters for adding costs. Analysts say it is probably too early to accurately assess the impact of the ETS on competitiveness, but one early report suggests that they are marginal.

In a report from McKinsey & Company, whose preliminary findings were released in May, the consultancy said the EU ETS was likely to have a "limited impact" on European industry, with the exception of primary aluminum production. While it noted that the scheme has increased costs, most industries are able to pass through those costs to their customers, but it added that while the average impact was limited, some individual companies could be hit harder.

These early findings were, to some degree, reflected in the later McKinsey-Ecofys survey. That suggested that the ETS is not having a particularly dramatic effect on some of the EU's most energy-intensive sectors. Only 29% of steel companies, 33% of pulp and paper firms, and one in four chemicals companies are factoring in CO2 in their current marginal pricing decisions.

Indeed, some more outspoken supporters of emissions trading argue that these are complaints that badly-managed companies use to justify poor performance. "Europe's regulators should wave these companies off from the airport tarmac," James Cameron, director of boutique merchant bank Climate Change Capital told a side event in Montreal.

Supporting global efforts to tackle greenhouse gases


While it may be too early to assess the scheme's environmental effectiveness, or the real burden it places on European industry, the scheme has already scored a clear success in demonstrating the EU's intent to tackle GHGs. The Commission, and member state governments, are well aware of this 'propaganda value' of the scheme.

"The EU ETS has no end date," Runge-Metzger said. "It is part of EU environmental law, and it will remain so. The Linking Directive, too, will stay there after 2012 as well."

The scheme is not only designed to help the EU meet its Kyoto target--it is also designed to be complementary to the Protocol's flexible mechanisms. The Linking Directive is a supplementary piece of legislation that allows for the use of credits from CDM projects (and from 2008, credits from projects that qualify under Joint Implementation, another of the Kyoto Protocol's flexible mechanisms).

"The EU ETS has really provided serious impetus to the CDM," said the Commission's Olivia Hartridge in Montreal. Much of the demand for credits from CDM projects, say brokers, has been generated by companies within the EU ETS, and a relatively high price of carbon has provided incentives for project developers to come forward to seek CDM registration.

The theory of emissions trading states that, the wider the coverage of any one scheme, the more economically efficient it is likely to be, as there are a wider range of abatement opportunities to be tapped. As such, some enthusiasts would like to see the ETS become the core of an international carbon market, and the Commission is already in discussions with Norway and Switzerland to link their domestic programmes to the scheme.

There are, however, likely to be design issues that make it difficult to link other schemes (such as Canada's planned scheme--which begins operating in 2008) to the ETS, in particular when the schemes (again, such as Canada's proposed scheme) have 'price cap mechanisms, and allow for the use of forestry credits (which the EU currently excludes from its system).

Also, efforts by some in the EU policy community to show solidarity with planned state-level schemes in the United States and Australia, by offering to link with them, are unlikely to amount to more than political gestures, say analysts. Reductions made in non-Kyoto countries would not count towards the EU Kyoto targets and, in the unlikely event of carbon prices rising higher in Australia and the US, EU governments might be reluctant to see the export of credits to those two systems.

But the fact that the EU scheme is up and running, is operating largely successfully, and has not--thus far --caused the collapse of the bloc's economy, has provided a useful practical lesson in support of the Kyoto Protocol, its flexible mechanisms, and in addressing GHG emissions generally.

So where does the future lie for the scheme?

The year to come


Once more, the scheme faces another test of its market infrastructure. Companies have until February or March of 2006 (depending on the jurisdiction) to submit verified emissions records for the previous year, alongside the requisite number of allowances to match their emissions in the 2005 calendar year.

Because of the way allowances are doled out--companies will receive their 2006 allocation before they are required to submit 2005's allowances--it is highly unlikely that any companies will find themselves short either this year, or next. (The crunch will come at the end of 2007, when allowances cannot be 'borrowed' from the 2008–12 period.) However, the market infrastructure faces another hurdle, as the compliance mechanisms are tested.

By the end of June, national governments are due to submit the national allocation plans for the scheme's second phase. Business was highly critical of how the last allocation process was handled, with "interaction between government bodies and companies during the preparation of the first NAPs [seeming] to have been unsatisfactory," according to the McKinsey-Ecofys survey.

This process is likely to be even more fraught than the last, with most governments facing tough decisions in how to bring emissions under control. The Commission is due shortly to release new guidance on how governments should approach the process. One UK civil servant, Chris Dodwell, claims that "the process will be more transparent this time," arguing that governments are likely to be required to submit "uniform information" allowing the Commission--and other stakeholders--to better assess the assumptions they make when allocating allowances.

Around about the same time, the Commission is due to publish its review of the EU ETS so far, including suggestions for its reform. As might be expected with a scheme of this scope, there is a large number of suggestions for improvements--many of which are conflicting--from businesses, think-tanks, environmentalists and governments.

Many of these relate to the thorny issue of the allocation of allowances. But other issues are to be considered: the expansion of the scheme from CO2 to the other five Kyoto greenhouse gases; its expansion to other sectors, with aviation, aluminium and chemicals most commonly discussed; and, potentially, the admittance of forestry-related carbon sinks credits from CDM projects (which are currently excluded).

The Commission is keeping its cards close to its chest in advance of the review's completion. Speaking in Montreal, Runge-Metzger said that "we believe the most important thing is to keep the EU ETS simple." Few analysts, therefore, expect root-and-branch reform--indeed, with just one year of operation, it is too early to assess many of the scheme's characteristics and effects, let alone to suggest considerable overhaul.

The ultimate assessment of the scheme's worth--whether is does contribute to the EU meeting its emissions targets--is, in other words, some years from being made. But the sense in the Commission is that, one year in, the scheme has got off to a more successful start than many were predicting.

Mark Nicholls, a regular contributor to The Ecosystem Marketplace, is the London-based editor of Environmental Finance magazine, and consulting editor to its sister publication, Carbon Finance.

First posted: January 3, 2006