World Watches EU's Carbon Trading Scheme

The first stage of Europe's emissions strategy resulted in higher prices and higher oil company profits. Will the new plan fare better?

Cutting emissions of greenhouse gases—in particular carbon dioxide—is the heart of any strategy to combat the potential for catastrophic climate change. A key pillar of the European Union's climate and energy battle plan is the emissions trading scheme (ETS), by far the largest multinational emissions trading operation in the world.

The ETS, as originally launched in 2005, came under assault from all sides as an over-generous allocation of emissions permits resulted in windfall profits for energy companies—some of the biggest polluters in the Union—to the tune of some €1.2 billion, according to Franck Schuttelar, an analyst at the energy-trading firm Gaselys.

The over-allocation caused the price of carbon to drop to almost nothing in the first phase, which ended in 2007. Meanwhile, consultancy Point Carbon estimated Europe's emissions actually rose by 1.1 percent last year.

The cheap permits also created a disincentive for industry to increase expenditure on clean energy infrastructure and greater energy efficiency measures. By 2007, almost half the EU member states were off-course to meeting their Kyoto obligations.

Consumer prices were up, energy company profits were up, and carbon emissions were up—an excellent result for the EU's flagship climate change policy, as some wags noted at the time.

With this in mind, the European Commission unveiled an ambitious series of proposals to combat climate change in January, the heart of which new measures was a sharp tightening up of the existing ETS.

Specifically, carbon allowances are to be set at the EU level, rather than at the member state level—a significant, but they argue necessary, centralising of authority in a key policy area. Auctioning of permits will gradually replace the current free allocation. All permits in the power sector are to be fully auctioned by 2020, according to the proposals.

Auctioning will also eventually be extended to other energy-intensive industries, and over the period 2012 to 2020, the ETS will extend the number of industrial sectors it covers, including aviation.

Petrochemicals, ammonia and the aluminium sector, will also be covered, while road transport and shipping are to remain outside the system, along with agriculture and forestry.

Additionally, for those economic sectors not covered by the ETS such as agriculture, waste, buildings and transport, member states will receive binding national emissions targets, with richer countries receiving stricter targets than poorer ones.

Nonetheless, environmentalists, who have offered tempered support to the ETS so far, still worry that the ETS target—that firms reduce their emissions by 21 percent on 2005 levels by 2020—is not strict enough.

The world looking to the EU

Despite its failures to date, however, other areas of the world are looking to the ETS as a model of how to achieve carbon reductions at the lowest cost.

Some €50 billion in carbon credits are traded every year through ETS, with associated carbon market financial products, including carbon futures and derivatives, showing impressive growth, and other regions of the planet want to get in on the act.

Analysts expect a federally co-ordinated emissions trading market in the US to get off the ground depending on who wins the November presidential election, while Australia is to launch its own version of the ETS in 2010.

At the same time, the very elements that the commission has proposed to make the ETS effective, are those measures that are most controversial within the industry. Many companies worry that they will be at a competitive disadvantage compared to their counterparts in other countries that do not have to comply with such stringent targets, in particular, the aluminium, steel and chemicals sectors.

This in turn could lead to 'carbon leakage', whereby companies simply set up shop outside the EU to avoid the ETS, but still produce the same carbon emissions.

In response, the EU is hoping to see an international agreement that would see all developed countries legislate similar emissions reductions measures—this 'carbon equalisation system'—could see companies beyond the EU borders required to purchase carbon permits within the ETS as well.

However, commission president Jose Manuel Barroso has suggested that if no international ETS-like system can be established in short order, then certain sectors under threat from carbon leakage continue to be awarded permits to pollute free of charge.

Vote in December

Other options that have been suggested include an EU 'border tax' on foreign competitors, with a tax refund delivered upon exportation—a system that would mirror that already in place for VAT. However, analysts warn that great care would have to be taken in the design of any such 'border adjustments' to ensure conformity with international law.

In any case, the commission has yet to specify what carbon-leakage counter measures it favours, and a battle is brewing over how 'energy-intensive' sectors are defined.

The European Parliament is currently considering the commission's proposals—its first major hearing on the future of the ETS took place on Thursday (15 May).

In October, the parliament's environment committee will vote on the ETS revision based on a report by Irish centre-right MEP Avril Doyle, the deputy responsible for shepherding the legislation through the assembly. Then in December, the plenary of the parliament will vote on the measures.

Unsurprisingly, a veritable army of lobbyists—both corporate and environmentalist—have set up camp there. The battle over the future of the European Union's emissions trading scheme is far from over.

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