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.