The document discusses the structure and evolution of the European Union Emissions Trading System (EU ETS), the largest cap-and-trade system in the world. It describes the key design elements of the EU ETS including the declining emissions cap, allocation of allowances, and provisions to address carbon leakage. Additionally, it examines the political process around establishing the EU ETS and reforms made to the system over time.

1. Cap-and-Trade in the European Union:
Policy and Politics in the EU ETS
Guest lecture at the School of Resource and Environmental
Management, Simon Fraser University
Vancouver, BC | 15 November 2013
Stefan U. Pauer
PhD Student, Faculty of Law
The University of British Columbia
@StefanPauer

2. Roadmap
Structure and operation of the EU ETS
Important design elements
Cap, distribution of allowances, carbon leakage
Evolution and politics involved
Policy-making at EU-level
Creation of the EU ETS, changes of the system over time
Carbon market reform

3. EU ETS in a Nutshell
EU’s main climate policy instrument
Overall EU 2020 target: GHG emissions 20% below 1990
Purpose: Reduction of GHG emissions at least cost
Largest cap-and-trade system in the world
84% (value) and 76% (volume) of global carbon market
In operation since 2005
Mandatory system

4. EU ETS in a Nutshell
Coverage
>12.000 large installations in 31 countries
Incl. electricity and heat
producers, steel, chemicals, cement, glass, pulp & paper, …
~2.000 Mt CO2e per year (almost half of EU’s total emissions)
Each year, operators must report verified emissions and
hand in allowances to cover for their emissions
Cap on emissions creates scarcity and ensures allowances
have economic value
Market-based system: allowances can be traded
Long-term reduction of cap to ensure emissions reductions

5. Compliance Cycle
Operators monitor and report their emissions of
previous year
January: Preparation of report on emissions of previous
year
28 February: Free allocation for current year
By end of March: Verification of emissions of previous
year by independent verifier
By 28 April: Surrender allowances for emissions of
previous year

6. Enforcement and Compliance
No or insufficient surrendering entails high penalties
€100 per t/CO2e not covered by surrendered allowances
Payment does not release operators from surrendering
obligation
Compliance rate usually higher than 99%

7. Important Design Elements
Declining emissions cap
Distribution of allowances
Carbon leakage provisions

8. Declining Emissions Cap
EU-wide cap on total emissions in the system
Determines and guarantees environmental outcome
Declines, ensuring reduction of emissions over time (21% in 2020 compared to 2005)

9. Distribution of Allowances
Distribution via
Auctioning
Free allocation
Long-term goal to phase out free allocation

10. Auctioning
>50% of allowances auctioned between 2013 and 2020
Auctioning mandatory for power sector
Progressive phase-in for all others (manufacturing industry)
Auction platforms
European Energy Exchange (EEX), located in Germany
ICE Futures Europe (ICE), located in London
Revenues distributed to Member States based on their
share of verified emissions in 2005
At least half should be used to combat climate change

11. Free Allocation
Manufacturing industry receives allowances free of charge
on a transitional basis
No free allocation for power sector
Based on greenhouse gas (GHG) performance benchmarks
Benchmarks reflect average GHG emissions performance of
10% most efficient installations producing a product in the EU
‘One product – one benchmark’
52 industrial products benchmarked, covering ~80% of
manufacturing emissions
System rewards best practice in low-emissions production

12. Carbon Leakage
Issue: Absence of comparable carbon constraints in third
countries could lead to
Economic disadvantage for domestic industry from
international competition (competitiveness impact)
Potential overall increase in GHG emissions in case of
relocation (environmental impact)
Policy response: More free allocation for sectors at risk
Factors applied in assessing risk
Estimate increase in production costs due to EU ETS
Trade-intensity with non-EU countries

13. Evolution and Politics Involved
Policy-making at EU-level
Creation of the EU ETS
From proposal for a carbon tax in 1992…
…to adoption of cap-and-trade in 2003
Changes of the system over time
Natural evolution – or deliberate strategy?

14. Political Decision-Making and
Exertion of Influence by Stakeholders
Structure of EU political institutions akin to national institutions
Executive (Commission), legislative
(Council, Parliament), judiciary (Court of Justice)
Typical decision-making procedure
Commission department in charge drafts proposal
Inter-Service Consultation
Commission submits proposal to Council & Parliament
Negotiations between Council & Parliament
Implementation of adopted legislation
Stakeholders seek to exert influence at each stage of process
Industry, NGOs, national governments, academics

15. Attempt to Introduce an EU-wide
Carbon Tax in 1992
In 1992 EU Commission proposed a carbon-energy tax
To be phased in gradually (rising price)
Revenue-neutral
Conditional upon approval of similar measures in other
countries
Tax reductions for energy-intensive companies
But not approved in Council – main reasons:
Industry fears of loss of competitiveness
Unanimity required in tax matters

16. From Proposed Carbon Tax to
Emissions Trading
Kyoto Protocol (1997) prompted EU Commission to focus
on emissions trading (ET)
During negotiations EU was highly skeptical of ET
EU insisted on binding numerical emissions reduction targets
US not willing to accept without inclusion of ET
Compromise: binding numerical targets, inclusion of ET
EU’s insistence on binding numerical targets implied
special obligation for EU to comply with Kyoto Protocol
ET seen as economic opportunity, reducing compliance costs
Qualified majority sufficient to pass into EU-law

17. From Proposed Carbon Tax to
Emissions Trading
Commission crafted support among stakeholders
Industry: Cost-effective, economic opportunities
NGOs: Environmentally effective, cap guarantees emissions
reductions
Member States: Combination of above, highlighting ET as tool
for achieving emissions targets agreed under Kyoto Protocol
US withdrawal from Kyoto Protocol in 2001
Unified Member States and EU institutions, eager to become
leaders on global climate diplomacy
Formal proposal of EU ETS in 2001 – adoption in 2003

18. Phase I (2005-2007)
Purpose: learning by doing, “pilot” phase
Compliance entities
Administration (national governments, EU Commission)
Building up infrastructure necessary for
monitoring, reporting, and verification of emissions
Setting up registers to keep track of ownership of
allowances
National Allocation Plans (NAPs)
Allowances distributed free of charge
Sum of NAPs forms emissions cap
Based on best guesses in absence of reliable emissions data

19. Phase I (2005-2007)
Publication in 2006 of verified emissions
More allowances were distributed than installations needed
Significant drop in allowance price
No banking of allowances for carry-over into phase II
Price falls to zero at end of phase I
Bulgaria and Romania acceded to EU and thus joined ETS in
2007 (although did not have all infrastructure in place to
participate effectively in trading in that year)
Emissions became a matter of economic considerations

20. Phase II (2008-2012)
Norway, Iceland, Liechtenstein joined EU ETS in 2008
Global financial crisis in 2008/2009
Inclusion of aviation sector in 2012
International offset credits allowed (CDM, JI)
Banking of allowances for carry-over into phase III
National Allocation Plans (NAPs)
Caps tightened
Share of free allocation falls slightly (still ~95%)
Some Member States hold first auctions

21. Phase II (2008-2012)
Generous levels of free allocation
Member States had incentives to protect their own industries by
providing generous allocations (“race to the bottom”)
National variations in allocation lead to distortions of
competition within EU
Free allocation mostly based on past emissions
“Grandfathering” relatively straightforward, but…
Perverse reward: the more emissions, the more free allowances
Economic rents for electricity producers
Carbon leakage? 2013 study (Ecorys et al.) does not find any
evidence for relocation due to EU ETS between 2005 and 2012

22. Phase III (2013-2020)
Reform of EU ETS passed into law in 2009, changes
effective as of phase III
Move from decentralized to centralized system
EU-wide, declining cap (no more NAPs)
Auctioning as default allocation method, mandatory for
power sector
Common rules on free allocation, based on GHG
performance benchmarks

23. Phase III (2013-2020)
Concessions to new Member States as part of 2009 reform
Derogation from auctioning for power sector
Value of free allocation must be matched by investments
modernizing the power sectors in these Member States
Concerns 700m allowances during phase III
Redistribution of revenues from auctioning
10% of revenues to least wealthy Member States as additional
source of income for mitigation and adaptation
Croatia accedes to EU and thus joins ETS in 2013

24. Natural Evolution – or Deliberate
Strategy?
Evolution suggestive of deliberate strategy
Initial buy-in, subsequent ratcheting up
Achieve initial acceptance among stakeholders…
Member States retain autonomy (NAPs)
Compliance entities get allowances for free
…then improve the system over time
From national autonomy to centralization
Ramp up auctioning, decrease free allocation
Tightening of the cap, extensions of scope
Gradual increase of ambition from phase I to III

25. Carbon Market Reform
The problem
Causes
Consequences of inaction
Possible solutions

26. Carbon Price Evolution
2008-2012
Source: Point Carbon

27. Causes and Consequences
Some of the main causes
Over-generous free allocation by national governments
Economic recession
Increased use of (cheap) international offset credits
= Imbalance of supply and demand
Consequences
Weak price signal weakens incentive to invest in low-carbon
technology
Reduced government revenue from auctioning
Risk of fragmentation

28. Possible Solutions
Short-term: “back-loading”
Postpone auctioning of allowances
Affects temporal distribution of allowances, not their
overall number
One-off measure
Contemplated as a quick, temporary solution before
tackling long-term measures, but…
Encountered opposition in Parliament and Council

29. Possible Solutions
Long-term: structural reform
Address imbalance between supply and demand
Options
Increasing the EU’s emissions reduction target
Retiring allowances permanently
Tightening the emissions cap
Extending the scope of the system (e.g. inclusion of transport
sector, shipping)
Limiting access to international credits
Introducing discretionary price management mechanisms
(e.g. price floor)

30. Thank You
Thank you for your attention!
Any questions or comments?
@StefanPauer