Member states were criticised for setting overly generous caps in the first phase of the scheme. In May, more than half of the value of the EU carbon market was wiped out when it emerged that most installations had been allocated far more allowances than needed (ENDS Report 376, pp 12-13).
The price of carbon has not recovered and currently hovers around ¤7 per tonne, compared with prices of more than €20 for most of 2005.
In spite of this, most member states have proved reluctant to set demanding caps for the EUETS’s second phase which runs from 2008 to 2012. Early analysis of their national allocation plans (NAPs) suggested they were too weak to support a viable carbon market and the price of carbon could fall to zero (ENDS Report 281, p 13).
In October, the Commission revealed the first 17 NAPs together set caps 15% higher than the verified emissions for 2005 (ENDS Report 382, pp 46-47). It responded by cutting 64 million tonnes of CO2 - or nearly 7% - off the annual caps proposed by Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, Slovakia and Sweden. These nine countries and the UK account for 42% of the emissions covered by the scheme.
The Commission accepted the cap proposed by the UK. Germany experienced the largest absolute cut (see table). But proportionally, Latvia was hardest hit, seeing its allocation reduced by more than half. Five member states saw their allocations cut by more than 25%.
Each NAP was assessed systematically against 12 criteria laid down in the EUETS Directive. This approach has clarified the Commission’s interpretation of the Directive and should lead to more harmonisation in setting caps and allocating allowances.
A systematic and transparent approach also sends a warning message to governments yet to submit a NAP.
Key issues that emerged from the process are:
- Kyoto progress: The Directive states that each member state’s cap should be consistent with its progress towards meeting its emissions reduction target under the Kyoto Protocol. Just two countries - Sweden and the UK - are on track to meet their targets with existing measures.
The Commission has developed a series of formulae to calculate the contribution installations covered by the EUETS should make to meeting the commitments and applied them to each of the caps to determine by how much they should be cut.
- Verified emissions: Similarly, the allowances should not be more generous than the expected emissions over the phase. The Commission says member states should take into account the first year’s verified emissions when calculating projected emissions. In fact, every NAP proposed more allowances than were required to cover the first year’s emissions.
Hundreds of extra installations and emissions will enter the scheme in the second phase and some member states used this to justify their allocations. But the Commission’s figures suggest only NAPs from the UK and Germany proposed caps lower than the CO2 emitted by existing and new installations in 2005.
- Kyoto credits: Installations are allowed to meet part of their emissions caps with credits from Clean Development Mechanism (CDM) and Joint Implementation (JI) emissions reduction projects.
The Commission insists Kyoto credits should only supplement domestic action and has decided to limit their use. It says "as a general rule" they should make up no more than 10% of an installation’s allocated allowance. This limit can be increased if a country is struggling to meet its Kyoto commitments.
This decision has caused problems for Ireland, which was planning to allow installations to use Kyoto credits to meet up to half of their caps. The Commission has cut this to 21.9%.
It also spells trouble for Italy, Portugal and Spain which rely heavily on Kyoto credits in their draft NAPs and which are next in line to be assessed.
- Future allocations: The Commission has come down hard on so-called "ex-post adjustments" whereby member states revise their allocations in light of new information. It has ruled out adjustments once a NAP has been approved. It argues that being able to change caps once a phase has started "contradicts the essential concept of a cap-and-trade system". It also introduces uncertainty and makes planning difficult for companies.
The only adjustments the Commission is prepared to allow are the retirement of allowances if an installation closes or the allocation of allowances to individual new entrants.
The Commission has also ruled out the guaranteeing of allocations from one phase to the next. Earlier this year, Germany promised to a provide free allowances to cover emissions from new power stations for 14 years (ENDS Report 378, p 42).
The Commission says this distorts competition and prevents further harmonisation of allocation methodologies. What is more, it claims the approach contravenes internal market legislation and would probably fall foul of state aid rules.
The Commission’s tough stance was welcomed by market analysts and NGOs who see demanding caps as essential to maintaining the scheme’s credibility.
"I think it’s a really positive move," said James Wilde, head of strategy at the Carbon Trust. "There is now a far greater chance that the EUETS will deliver a sensible price for carbon."
But it was not received well in some capitals. Germany is preparing to legally challenge the Commission’s decision. In the meantime, it will stick with the cap proposed in its draft NAP. It is unclear whether other member states will follow suit.
A protracted legal battle could damage the scheme by introducing uncertainty and discouraging firms from factoring carbon prices into long-term investment decisions.