Doubts grow over the effectiveness of Europe’s flagship climate instrument

The EU Emission Trading Scheme: can it deliver?

There is growing doubt over whether the EU’s flagship climate policy instrument, its emissions trading scheme (ETS), will drive the green investment needed for Europe to reach its long-term climate and energy goals. Carbon prices in the ETS are lower than many had hoped for and threaten to stay that way for many years to come. Some argue that emission limits should be lowered to drive up the carbon price, but industry representatives strongly resist this idea. Other observers are more optimistic and suggest that the mere existence of a price for carbon is getting things moving. ‘What is critical is to create confidence that the ETS is here to stay.’

EU Climate Commissioner Connie Hedegaard
Is the European climate cup half full or half empty? Jules Kortenhorst, CEO of the European Climate Foundation, a private organisation that gives financial support to climate initiatives, sounded a frustrated note at a conference in Brussels recently. ‘How can we say we are leaders in the green economy if we reduce our emissions by only 2.5% from now to 2020?’

What Kortenhorst was referring to is the fact that last year greenhouse gas emissions in the EU-27 were 17.3% lower than in 1990 (according to data published by the European Environment Agency), leading to the strange situation that the EU has almost achieved its 20% reduction target for 2020 already! That could be considered good news of course, but it could also be interpreted as evidence that the targets have not been ambitious enough in the first place. Indeed, many who feel strongly about the climate cause – including the Prince of Wales’ Corporate Leaders Group as well as EU Climate Commissioner Connie Hedegaard herself – have pleaded for the reduction target to be raised from 20% to 30%. Industry associations, however, argue that such a move would severely damage the EU’s competitive position in the world and could hurt employment.

The debate ultimately revolves around the effectiveness of the EU’s major climate policy instrument, its Emission Trading Scheme (ETS), which has been effective since 2005. Under the ETS, each power station and industrial plant in the EU is accorded a limited number of carbon emission permits (allowances). Companies that stay within their limits can sell their surplus allowances, while those that exceed their limits must buy allowances to meet their obligations. The resulting market price for carbon emissions is supposed to stimulate companies to invest in emission reductions. The idea behind the system is that the market will ensure that cuts are made in the most efficient way (i.e. where they are easiest and cheapest to make). The overall cap is set to decline steadily (energy and industrial emissions must be 21% below 2005 levels by 2020) with a view to driving ever greater cuts.

Spanner in the works

That’s the theory at any rate. In practice, the ETS has so far proven to be a bumpy ride. In the scheme’s first trading phase, which ran from 2005 to 2007, the carbon price first reached a pretty convincing level of €30 per tonne, but then in the final stages crashed to zero. The main reason for this was that too many allowances had been handed out: companies ended up emitting less than they were allowed to, so demand for allowances collapsed.

With hindsight, this first period has been labelled a trial phase and indeed allowances were distributed based entirely on estimated emissions from the past, in the absence of data on actual emissions. This changed in the current, second phase, which runs from 2008 to 2012. For this phase allowances have been distributed based on emissions reported in the first period. But an unexpected happening has thrown a new spanner in the works: the recession.

With the global economic slowdown, production plummeted and emissions followed. Greenhouse gas emissions from power stations and industrial plants fell by 4-6% in 2008 and 11% in 2009, analysts estimate. Yet the carbon price has remained relatively stable at around €15 per tonne. This is largely

‘Of course there could always be things that it could do even more, even better, but I think this is so far the best solution the world has seen’
because there is a third trading phase looming round the corner, from 2013 to 2020. Power companies in particular, less affected as they have been by the recession, have started buying ahead. Nevertheless, the slowdown has created a large surplus of allowances in the system, so the carbon price today is lower than it might otherwise have been and is expected to remain so for some time. So the question is, can the EU ETS still drive green investments? And if not, should policymakers intervene to put it back on track?

Best solution

The European Commission has insisted all along that the EU ETS is working as it should. Former EU environment commissioner Stavros Dimas said as much on the day the commission released the 2008 emissions data. He cited a report from private research group New Carbon Finance attributing 40% of the 2008 drop in emissions to the price on carbon. Current EU climate commissioner Connie Hedegaard was equally categorical in her response to the question “is it working?’ earlier this autumn. ‘Yes. Of course there could always be things that it could do even more, even better, but I think this is so far the best solution the world has seen’, she told Internet-based TV channel viEUws. The commissioner was clear she believes the scheme is both cutting emissions and driving low-carbon investment.

Carbon market analysts emphasize that a clear distinction must be made between the energy (power) sector and the industrial sector. Even in 2008, when the recession kicked in, emission reductions in the power sector were due at least in part to the high carbon price in the first half of the year, according to research manager Kjersti Ulset of Point Carbon, a private media and research agency. The carbon price led producers to switch from burning carbon-intensive coal to less carbon-intensive natural gas, particularly in Germany, the UK, Poland and Spain, according to a report from Deutsche Bank. But the same analysts point out that in the industrial sector it was the economic decline in the second half of the year that mainly caused the decrease in emissions.

Party for industry

Most analysts agree that the problem of excess emission credits pertains primarily to the industrial sector rather than the power sector. The British environmentalist NGO Sandbag has issued a series of reports over the last two years to make this point. Most recently in September, the group argued that the large allowance surplus in the EU ETS risks becoming a liability for Europe because it removes a key driver for low carbon investment. Sandbag estimates the EU ETS will cut emissions by a negligible amount in 2008-12 because 1.1 billion tonnes of emission reductions in the power sector will be nearly

‘The reality of the transition to a low-carbon economy means conceiving a future that is totally inconceivable to the incumbents. When the incumbents say we can’t do it, it should be taken as encouragement’
entirely “cancelled out” by “extravagant” leftover allowances in industry. These leftovers are a result of the recession combined with an over-generous allocation of emission permits, according to the NGO. Sandbag estimates that about 1.8 billion emission allowances (including allowances bought in developing countries through the Kyoto Protocol’s Clean Development Mechanism) will be carried over from the second into the third trading phase – nearly equal to a year’s worth of emissions. As a result, despite the establishment of lower emission ceilings, Europe’s actual energy and industrial emissions could continue to grow until as late as 2016, the group warns, at which point they would be about a third higher than they are today.

This may sound like a party for industry, but Sandbag points out that the allowance surpluses will actually put some industrial firms at a severe competitive disadvantage: there are big differences between individual companies in how many spare allowances they have. For example, Sandbag calculates that as a proportion of its emissions to date, Heidelberg Cement has a five-fold allowance advantage over its competitors in Europe and German steel producer Salzgitter has a four-fold advantage over other steelmakers. In absolute terms, ArcelorMittal dominates the industrial surplus, expected as it is to accrue some 102 million excess permits worth €1.4bn over the second phase of the trading scheme, according to Sandbag.

On top of this, Dutch consultancy CE Delft has accused industry of making windfall profits from their allowances – much as the power sector is said to have done – by passing on allowance costs to customers even though they had received them for free. CE Delft presents what it calls “ample” evidence that a higher carbon price led to higher diesel and gasoline prices within two weeks in Germany, and that the price of two steel products, hot and cold rolled coil, significantly increased within a month. Refineries and the iron and steel sector may have earned €14bn from passing on costs in 2005-8, says CE Delft, and windfall profits are likely to continue even after 2013.

Power station at Rybnik, Poland
Industry has strenuously denied this, arguing that international competition makes it impossible for them to pass on cost increases to customers. The European associations for refineries (Europia), iron and steel (Eurofer) and petrochemicals and chemicals (APPE/Cefic) commissioned a study by consultancy NERA which concluded that the CE Delft report makes unsupported claims. The whole issue is a sensitive one for industry, because they are slated to receive more free allowances for the period 2013-20, whereas the power sector will have to start buying allowances. The distinction is made because industry has to compete worldwide, which means companies might flee Europe if they are forced to pay for all their carbon emissions, whereas European power companies do not compete with power suppliers from outside Europe.

30% solution

Rémi Gruet, climate change advisor at the European Wind Energy Association (EWEA), is one person who is not happy with the way the ETS is playing out. ‘The scheme was originally designed to reduce emissions at lowest cost’, he says, ‘but in fact the enormous quantity of spare allowances on the market due to the crisis and the low carbon price provide no real incentive for electricity, cement and steel producers to fundamentally change what they do, while customers are paying for emission permits industry is getting for free.’ The ETS should be the basis for moving forward, Gruet argues, but the crisis has undermined its effectiveness.

One obvious measure to “improve” the system, at least from the point of view of the EWEA, is to raise the emission reduction target. ‘Moving to a 30% emission reduction target for 2020 is the most effective way to tighten the emissions cap and establish a higher and stable carbon price,’ the organisation says in a position paper.

Actually, in March 2007 EU leaders committed to increase the bloc’s emission reduction target for 2020 from 20% to 30%, but on the condition that other developed countries make “comparable” cuts. A 30% target would mean that the ETS cap for 2020 is tightened from 21% below 2005 levels to 34%. It would remove 1.4 billion emission permits – most of the estimated 1.8 billion carried over from phase two – from the 2013-20 trading period, according to calculations from Sandbag.

Many have spoken out in favour of a 30% target for 2020, including EU climate commissioner Connie Hedegaard, the Prince of Wales’ Corporate Leaders Group and countless NGOs and analysts. Hedegaard has said that it is in Europe’s own interest to move to 30% if it wants to remain competitive with the likes of the US and China.

Kortenhorst of the European Climate Foundation puts the matter even more starkly: ‘The reality of the transition to a low-carbon economy means conceiving a future that is totally inconceivable to the incumbents. When the incumbents say we can’t do it, it should be taken as encouragement.’

If Kortenhorst is right, climate advocates can take plenty of encouragement, because neither the power sector nor most of industry is in favour of a move to 30%. The power sector’s opposition comes

‘We’re almost back to 100% production now, we need these allowances’
perhaps as more of a surprise since as we have seen there are considerable reductions already being made there and the sector has committed itself to decarbonise by 2050. Yet the adjustments in the power sector so far are primarily what EWEA calls “business-as-usual solutions” – namely, fuel-switching.

Out of sync

Energy company representatives argue that the time frame for more substantial change extends well beyond 2020 and putting the screws on power firms before then will have little effect. ‘It’s becoming clear for almost everybody that 2020 is very short-term – almost tomorrow – so expecting big changes just because of higher targets will not happen,’ says Nicola Rega, environment and sustainable development advisor at European power association Eurelectric. The big step changes, including for example big wind farms, will all happen after 2020. He adds: ‘Gas is the only short-term solution we have.’

Going from a 20% to 30% reduction target in 2020 would only have an impact of 2% on cumulative emissions from 2005-50, Eurelectric calculates. It is equivalent to one week’s emissions from China. Instead of focusing on 2020, Eurelectric is looking ahead to a debate on a 2030 target as part of the European Commission’s 2050 decarbonisation strategy due out next spring.

Industry is equally opposed to the 30% option. Axel Eggert, public affairs director at iron and steel association Eurofer, told EER in September: ‘We’re almost back to 100% production now, we need these allowances.’ Adeline Farrelly, Secretary-General of container glass association FEVE, says: ‘30% only adds to the pain, puts us out of sync with everyone else. We are the only region in the world with a carbon price cap – if anyone pulls ahead, it should be here. 30% will not change that.’

Like Eurelectric, the industry associations say a longer term perspective is needed for real change. The steel sector for example believes emission cuts of up to 80% are possible in 2050, but the breakthrough technologies to achieve these will not be ready before 2020. Industries expect the third EU ETS trading phase to be tough, even if the 20% emission reduction target stays and many companies are starting with big allowance surpluses. ‘Yes the recession has diminished the carbon price incentive,’ says deputy secretary general Chris Beddoes at refineries association Europia, ‘but businesses also have less capacity to act, because of much reduced margins.’ EU refineries did not carry over any spare allowances from 2008 to 2009, he adds.

Fears over the economic impact of a move to 30% have delayed wider support for such a move within the European Commission and among member states. Only the British and Danish governments have come out clearly in favour, although France and Germany’s environment ministers have also backed it.

‘The ETS will certainly drive investments in new low-carbon technologies, but whether it will do so quickly enough for political priorities is another question’
But Italy and Poland want to stick with the EU’s original position of not moving to 30% until other developed nations make “comparable” commitments to reduce emissions. This seems unlikely to happen any time soon. The 30% debate is off the table for UN climate talks in Cancun, Mexico, in December and looks set to be revived in spring next year at the earliest, as part of the discussion over a 2050 decarbonisation roadmap for Europe. In reality, it may end up being replaced by a debate over a 2030 target.

Need for speed

In the meantime, the ETS faces an uncertain future. The European Commission is aiming for what it calls a ‘major overhaul’ of the Clean Development Mechanism. As a first step, it proposed a regulation last week that will ban certain types of CDM credits (allowances bought in developing countries through the Clean Development Mechanism) companies in the EU are allowed to use. (See box below)

Deutsche Bank is predicting a carbon price of €30 per tonne by 2020, and says the Commission’s CDM restriction, if it is accepted, would raise this to €37. If a 30% target were added, the price might go to up €67, which would be certain to have major effects on the market.

Other solutions that have been suggested for improving the effectiveness of the ETS:

  • adjusting phase three emission caps to reflect actual phase two emissions rather than phase two emission caps
  • taking into account allowance surpluses when judging the need for extra free allowances in future
  • introducing a carbon price floor

But all these proposed interventions garner little support from either policymakers or business.

'ETS may drive investment in new low-carbon technologies, the question is whether it will do so quickly enough'
Some suggest the carbon price is not the most important thing after all. Felix Matthes from the German Oeko Institut reminded delegates at a green investment workshop in the parliament in November that the EU ETS directive sets a steadily decreasing emissions cap until 2020 and indeed beyond: the legislation proposes a revision but not an end-date. ‘So we have in legislation a long-term cap,’ says Matthes. ‘We have in fact a cap for 2050 – 71% below 2005 levels. What can be more accountable than this?’

Others argue that the mere existence of a carbon price, whatever its level, is already getting things moving. ‘It is definitely creating a signal that is taken into account in the way existing [generation] capacity is used,’ says Alexandre Marty, head of policy for carbon and environmental markets at EDF Trading. ‘And this is regardless of whether the market at any given moment is long or not. What is critical is to create confidence that the ETS and a carbon price signal underpinned by increasing scarcity are here to stay in the long-term.’

But the big question at the end of this is, can bigger changes be set in motion soon enough to save us from climate disaster? Not everyone is convinced of that. ‘The ETS will certainly drive investments in new low-carbon technologies, but whether it will do so quickly enough for political priorities is another question,’ admits Rega from Eurelectric.

A “major overhaul” of the Clean Development Mechanism? (and what it means for the ETS)

The European Commission last week came out with a draft regulation that, if accepted, would put certain restrictions on companies’ use of international carbon credits in the Emission Trading System (ETS). We will return to this subject soon, but for now we want to give a brief explanation of how this issue relates to the future of the ETS.

Under the Kyoto Protocol, mechanisms were set up (the Clean Development Mechanism and Joint Implementation) through which developed countries can achieve emission reductions in developing countries. The UNFCCC, a body from the United Nations, has the task of monitoring and approving these CDM and JI projects.

The EU allows European companies to engage in these international projects and then to trade the resulting credits within the ETS, up to certain limits. (Between 2008 and 2020, the ETS allows the use of international credits for up to 50% of overall reductions.)

Certain CDM-projects, however, have long been criticised by environmental organisations, who charge that they do not really lead to lower emissions, but are only carried out to generate credits. These are specifically projects involving the destruction of hydrofluorocarbon 23 (HFC-23), a waste product in the production of the refrigerant HCFC-22, and nitrous oxide (N2O) from adipic acid production. Both HFC-23 and N2O are highly potent greenhouse gases. Sixty to eighty per cent of these projects take place in China, the rest mostly in India.

European Commissioner for Climate Action, Connie Hedegaard, last Thursday announced that the Commission wants to ban credits from these “industrial gas projects” as of 2013. In other words, even if these projects are approved by the UNFCCC, companies could not use them anymore in the ETS. (The UNFCCC, incidentally, is also considering whether it should take action on the HFC-23 projects, but has not made a final decision yet.) The Commission’s draft regulation will now be discussed in the so-called “Climate Change Committee” (experts from the Member States) on 15 December and will then have to be approved by the Parliament and the Council of Ministers.

For European industry, a restriction on the CDM credits could lead to higher compliance costs. The Italian energy company Enel, the largest worldwide player in the CDM market, rejects the criticisms of the HFC-23 projects and argues that they are ‘truly additional’ (that is, the reductions would not have taken place if the company had not invested in the projects).

It should be noted that the issue goes further than just the issue of industrial gas projects. In fact, the Commission is aiming for what it calls a ‘major overhaul’ of the entire CDM and JI mechanisms. This could have a major impact on the ETS. The Commission, however, says that ‘there are enough credits available from the 2300 other non-HFC-23 and non-N2O projects to supply the ETS over the next ten years’. Therefore, carbon prices ‘should be relatively unaffected.’ Our Brussels correspondent Sonja van Renssen will have more to say on this in a follow-up article which we will soon publish on this website. Stay tuned.

Note This is the second article in a short series about the Emission Trading Scheme (ETS). In the first article, “Emission Trading Scheme is starting to bite”, which appeared on 7 October, Sonja van Renssen analysed how the third phase of the ETS (2013-2020) will be organised. A third, soon-to-appear follow-up article will zoom in on the controversy around the Clean Development Mechanism, which is linked to the ETS but which the European Commission would like to see overhauled.
Sonja van Renssen, who has many years of experience as a journalist specalised in energy and climate, is our new Brussels correspondent. Hughes Belin, who has been our correspondent since the start of EER in November 2007, will continue to write for us, but on a more irregular basis, as he wants to have more time to pursue other interests.