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Renewables and Emissions Trading: Do Schemes like the EU ETS Work?

Emissions trading is growing in popularity across the globe, but doubts about its high costs and ultimate effectiveness at promoting renewable energy have hampered its adoption. The key question is whether emissions trading schemes — as exemplified by the E.U. ETS — can be made to work successfully.

More than 30 countries around the world are now using emissions trading as the primary vehicle to drive carbon pollution reduction. But while emissions trading schemes are growing in popularity, they are also coming in for heavy criticism over their cost, lack of effectiveness and because they do too little to support the growth of renewables. The key question is whether emissions trading schemes can be made to work successfully, or will they eventually be supplanted by alternative schemes aimed at reducing carbon emissions and boosting renewables growth? 

By far the largest scheme currently in place is the E.U. Emissions Trading System (E.U. ETS). This is the Europe-wide cap-and-trade scheme, which started in 2005 and it is one of the key policies introduced by the E.U. to help meet its greenhouse gas emissions target of 8 per cent below 1990 levels under the Kyoto Protocol. The E.U. ETS covers electricity generation and the main energy-intensive industries — power stations, refineries and offshore, iron and steel, cement and lime, paper, food and drink, glass, ceramics, engineering and the manufacture of vehicles.

Making the E.U. ETS work

Under the terms of the E.U. ETS, each Member State was obliged to develop a National Allocation Plan (NAP), which was then approved by the European Commission. This sets an overall cap on the total emissions allowed from all the installations covered by the system. This is then converted into allowances (one allowance equals one ton of CO2) which are then distributed by Member States to installations covered by the system.

At the end of each year, installations are required to surrender allowances to account for their actual emissions, using all or part of their allocation. Installations can emit more than their allocation by buying allowances from the market. Similarly, an installation that emits less than its allocation can sell its surplus allowances. In any case, the overall environmental outcome remains the same because the amount of allowances allocated is fixed and reduces year-on-year.

The E.U. 2020 Climate and Energy Package saw substantial changes made to the E.U. ETS after Phases I (2005-2007) and II (2008-2012) were criticized for not going far enough to tackle climate change. Consequently, Phase III, which starts in 2013, has been significantly revised to make it more ambitious.

During Phases I and II, allowances for emissions have typically been given free to firms, which has resulted in electricity getting windfall profits. Moreover, a number of design flaws have limited the effectiveness of scheme. In the initial 2005-2007 period, emission caps were not tight enough to drive a significant reduction in emissions and the total allocation of allowances turned out to exceed actual emissions. This drove the carbon price down to zero in 2007.

This oversupply was caused because the allocation of allowances by the E.U. was based on emissions data from the European Environmental Agency in Copenhagen, which uses a horizontal activity-based emissions definition similar to the UN’s. The E.U. ETS Transaction log in Brussels, however, uses a vertical installation-based emissions measurement system. This caused an oversupply of 200 million tons (equivalent to 10 per cent of the market) in the E.U. ETS in the first phase and collapsing prices.

Phase II saw some tightening, but crucially, the use of Kyoto flexible mechanism certificates as compliance tools was allowed. The “Linking Directive” allows operators to use a certain amount of Kyoto certificates from flexible mechanism projects in order to cover their emissions. These include Joint Implementation projects (JI) and the Clean Development Mechanism (CDM). JI projects produce Emission Reduction Units (ERUs). One ERU represents the successful emissions reduction equivalent to one tonne of carbon dioxide equivalent (tCO2). The CDM produces Certified Emission Reductions (CERs) with one CER representing the successful emissions reduction equivalent to one tCO2e.

Clearly, some tightening was needed, and so for Phase III (2013-2020) the European Commission has proposed a number of changes, including the setting an overall E.U. cap, with allowances then allocated to EU members; tighter limits on the use of offsets; unlimited banking of allowances between Phases II and III; and a move from allowances to auctioning.

As a result of these changes, Phase III of the E.U. ETS is expected to deliver two-thirds of the E.U.’s unilateral 20 per cent emissions reduction target by 2020 on 1990 levels. This means that by 2020, the E.U. ETS will be saving 500 MtCO2e per year, making it the biggest single policy instrument for addressing climate change in the E.U. These emissions reductions will increase further if the E.U. moves to a 30 per cent GHG emission reduction target, although this looks unlikely given the currently poor economic conditions in Europe, and despite strong support from some E.U. states, particularly Germany.

But despite high hopes for Phase III and all the tweaking that has taken place since 2005, the markets are less convinced that the scheme can ever be truly effective. The E.U. ETS has come in for particularly strong criticism from the Swiss bank UBS, which claims the E.U. ETS has cost the continent’s consumers €210 billion for “almost zero impact” on cutting carbon emissions, and has also warned that the E.U.’s carbon pricing market is on the verge of a crash in 2012.

In a report to clients, UBS Investment Research said that had the €210 billion been used in a targeted approach to replace the E.U.’s dirtiest power plants, emissions could have been reduced by 43 per cent “instead of almost zero impact on the back of emissions trading”. Describing the E.U.’s ETS as having “limited benefits and embarrassing consequences”, the report said there was fading political support for the scheme, the price was too low to have any significant environmental impact, and it had provided windfall profits to market participants, paid for by electricity customers. UBS forecast the E.U. carbon price would average €5 per ton for 2012-2013 with a floor of €3, attributing the slump to a large surplus of permits. “We see few buyers of the surplus until after a ‘crash’,” the report claims. It argued the surplus could continue until 2025, when the ETS would work as it was supposed to.

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There is some evidence to back up such claims. Recent data from the European Commission shows that there is a growing oversupply of carbon units, thanks to a record use of international carbon credits at a time of stagnant economic growth and flagging industrial output. Indeed, European carbon prices have lost around 60 per cent of their value over the 12 months due to market worries about the growing supply glut and weak demand. The benchmark carbon price hit a low of €5.99 per tonne in April 2012.

The European Commission is nonetheless keen to accentuate the positives. “ETS emissions decreased by more than 2 per cent in 2011, despite an expanding (economic) recovery. This good result shows that the ETS is delivering cost-effective emissions reductions,” the Commission said. “It also emphasizes why the ETS remains the engine to drive low carbon growth in Europe.”

The emissions data suggests the bloc is on track to achieve its 2020 climate target to cut emissions 20 per cent below 1990 levels. But this is unlikely to mollify criticism of the scheme. Critics say that it is badly designed, and that new technologies are excluded because of their small size and scale, which is bad for entrepreneurs and inventors. Moreover, critics say the E.U. ETS is too focused on regulating installations, while many believe that corporations and the demand for highly GHG emitting products should be the target of the regulators.

Also, the ETS applies to the electricity sector, but not to the heating or transport sectors, which make up part of the current 20 per cent renewables target (and transport has its own target of 10 per cent renewables). Many observers argue that these two sectors are getting inadequate attention from policymakers. According to Xavier Noyon, secretary general of the European Solar Thermal Industry Federation (ESTIF), this is a mistake. “If it’s about leading discussions on exchange of best practice and preparing guidance on support schemes, why not do the same for heating and cooling?”, Noyon asks.

There is an equally powerful argument for coordination at the E.U. level to avoid national boom/bust subsidy cycles, he says. Heating represents nearly half of E.U. final energy consumption, but unlike transport it does not have its own dedicated legislation or indeed Commission department. Noyon would like to see an E.U. heating and cooling action plan that synthesizes its roles in achieving greater energy efficiency and deploying renewables. The case of heating and transport illustrates that the future of renewables does not only depend on a potential renewables target and the ETS.

Not only that, but the trading aspects of the scheme remain fundamentally flawed. The market is unbalanced because buyers, mostly utilities, are far bigger and more concentrated than the many sellers, the project developers and industrials. This causes such a big negotiating power for the buyers that prices are pushed excessively low. For every buyer there are 10 sellers, even though the total quantity to be bought and sold can be the same. For example, a single utility may have to buy 100 tons, and has 20 sellers of five tons each to choose from. If one seller doesn’t agree, the utility simply goes to the next one.

Another cause of market imbalance is a mismatch between the structure of the carbon market, where allowances are valid for five years or more and corporations only have to go to market once in that time, and the structure of the underlying larger electricity markets, where electricity can’t be stored at all and is traded by the hour. This means that the carbon market tends to be less liquid.

With structural problems like these, can the E.U. ETS survive beyond the end of Phase III? The European Commission says a “binding supportive framework” for renewable energy is needed beyond 2020. But the Commission has not yet decided whether such a framework should be primarily based on emissions trading or on a combination of E.U. targets and national support schemes.

Energy Commissioner Günther Oettinger says the EU ETS is not sufficient to promote renewable energy on its own. “A CO2 stand-alone target is not the guarantee for ambitious investments in renewables. Maybe we should develop new renewables targets beyond 20 per cent for 2030 and 2040. Or we can say our market-oriented ETS scheme can be re-activated, can be more flexible, can send out better pragmatic price signals and induce decarbonization in this way.”

Oettinger has also cast doubt on whether the E.U. ETS can itself provide sufficient price signals to give a significant boost to renewables investment. “If you want more renewables in your energy mix, for transport or for power, you need a renewables target in addition because a CO2 stand-alone target is not the guarantee for ambitious investments in more renewables,” he said.

Industry association Eurelectric believes E.U. policymakers have two distinct choices as they start to plan energy and climate policy for 2030. One choice gives priority to the internal market and turns to the ETS as the main driver of decarbonization, complementing its action with a separate funding stream for innovation to drive those renewables that are still far from cost-competitive. The second option is to adopt a new renewables target for 2030 with harmonized subsidies across Europe for maximum cost-effectiveness. Eurelectric prefers the ETS approach, but E.U. policy could turn out to be a combination of these options.

The renewables industry would clearly prefer a target approach. “If you only follow the carbon price, you will get the lowest-cost and closest-to-market technologies,” says Josche Muth, secretary general for the European Renewable Energy Council (EREC). “We need a wider range of renewables for cost-effective decarbonization in the long term.” He points out that most stakeholders in a Commission consultation on post-2020 renewables policy supported a binding target for 2030. This is also because of its benefits beyond decarbonisation, Muth believes: “We have other targets. Energy policy is driven by energy security, competitiveness and innovation as well as decarbonization.”

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Because of the perceived failures and costs associated with the E.U. ETS, other schemes have been slow to get off the ground in major world economies. U.S. President Barack Obama confirmed last November that the U.S. would not have a cap-and-trade scheme, and Canada has also refused to implement an ETS. But the idea of emissions trading continues to gather momentum elsewhere and, in March of this year, Mexico passed a voluntary ETS. In April Italy passed a carbon tax, and China is developing pilot emissions trading schemes in a number of provinces and cities. 

Australia is also moving ahead with an ETS. A fixed price scheme, essentially a carbon tax, will operate from July 2012 for three years with an initial price of AUD$23 (US$24.14) per permit, with each permit equivalent to one tonne. The initial threshold for liable entities for this scheme will be set at 25,000 tons of CO2e per year, which will mean around 500 of Australia’s biggest polluters will be covered.

The carbon price will then transition to an ETS from July 2015 and will fluctuate, as does the E.U. ETS. But the Australian ETS will contain both a price ceiling and a price floor for the period 2015-2018. The initial price floor will start at $15 per ton in 2015 and will increase at 2.5 per cent per year.

South Korea is also introducing an ETS as it seeks to reduce emissions by 30 per cent below business-as-usual by 2020. The ETS is part of a much larger “Green Growth” agenda being pursued by the government, which has seen almost €65 billion allocated in initiatives driving investment in clean technologies. The initiative will make the country the third in the Asia-Pacific region, and the first in Asia, to pass such legislation. South Korea’s ETS is similar to Australia’s carbon pricing mechanism. Starting in 2015, the government will set emissions caps and reduction targets for each trading period. The limits will apply to companies that discharge 125,000 tons or more of carbon dioxide annually or workplaces that emit at least 25,000 tons a year. Emission limits are to be decided six months before the scheme goes into force with credits traded on an exchange, as in Europe. Companies that exceed emissions limits would pay a penalty equal to three times the credits” market value - limited to a maximum 100,000 won ($89) per ton of emission.

The Korean scheme is far from universally popular. Already, both the Korea Chamber of Commerce & Industry and the Federation of Korean Industries have lobbied the government to delay the plan, saying it will increase costs and make industry less competitive against countries that don’t impose charges on emissions. Companies may face an additional 5.6 trillion won ($5 billion) of costs if a carbon market is implemented, according to data from state-owned Korea Energy Management Corporation, which noted that Korea largely depends on heavy industries such as steel.

South Africa is looking to introduce a carbon tax in 2013, although nearly two-thirds of emissions will be tax-exempt until 2020 to lessen the impact on industry. In its 2012-2013 budget, the treasury proposed a 60 per cent tax-free threshold on annual emissions for all sectors, including electricity, petroleum, iron, steel and aluminum. All but electricity, where state-owned power utility Eskom dominates, would be able to claim additional relief of at least 10 percent.

As in Korea, companies have said a carbon tax that places too heavy a burden on the key energy, mining and manufacturing sectors — already under pressure due to rising power and wage costs — will hit profits and wider economic growth. Nearly all of South Africa’s power is generated by state utility Eskom’s coal-fired plants, making it impossible for companies to choose less carbon-heavy electricity.

“To minimize adverse impacts on industry competitiveness and effectively manage the transition to a low-carbon economy, temporary thresholds are proposed... which an exemption from the carbon tax will be granted,” the budget said. It proposed a carbon tax of 120 rand ($14.60) per tonne of CO2e for emissions above the thresholds. The levy would come into effect in 2013-2014, and increase by 10 per cent per year until 2020. 

The establishment of ETS programs in Korea, Australia and South Africa opens the possibility of linkages to other schemes as part of a global effort to curb the growth of carbon emissions. But key to the success of this will be what happens to the E.U. ETS during Phase III. If the European scheme can be made to work effectively and produce a carbon price high enough to be meaningful then it might lead to further adoption elsewhere. But if Europe decides to abandon the scheme post-2020 in order to focus on renewables targets, then it is hard to envisage a scenario whereby the global growth in emissions trading schemes will continue.

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