Major reform of EU’s carbon trading unveiled

The European Commission has floated radical changes to the EU emissions trading scheme including a single EU-wide emissions cap, greater auctioning and longer phases.1

A draft Directive amending the EU emissions trading scheme (EUETS) to address its flaws and strengthen the long-term carbon market was at the heart of the European Commission’s mammoth package of climate policies released at the end of January (see p 46 ).

The Commission’s proposals would see it - not member states - set an EU-wide emissions cap that would be guided by overarching EU emissions reduction targets. Overallocation of allowances by member states was behind the collapse of the carbon market in 2006 (ENDS Report 376, pp 12-13 ). The current process of national caps set by governments is widely viewed as too open to political manipulation to deliver a strong price for carbon.

The Commission claims that it will be cheaper to cut emissions from sectors covered by the EUETS than from the rest of the economy, and argues that installations should bear a larger share of the reductions.

As a result it has floated a cap in 2020 of 1.72 billion allowances - some 21% below 2005 emissions from installations currently covered by the scheme. The EU headline climate target aims to cut emissions by 20% on 1990 levels by the same date.

The scheme’s third phase will last for eight years - up from the three and five years of phases I and II respectively. Business has long argued for longer phases to provide greater certainty on the price of carbon and allow for long-term investment. The timing of the phase has been set to coincide with the expected commitment periods of a future international climate agreement.

During the scheme’s third phase (2013-2020) annual allocations of allowances would fall from 1.97 billion in 2013 at a rate of 1.74% a year to meet the 2020 cap (see table, p 48).

In order to provide certainty to the market, this rate of tightening will continue into the fourth phase but the figure will be reviewed in 2025.

  • Full auctioning: From 2013 the power generators will have to buy all their emission allowances through auctions. The one exception to this rule is good quality combined heat and power plants, which will continue to receive free allowances. This move should see the level of auctioning shoot up from around 7% of total allowances in phase II to at least 60% in 2013.

    Other sectors will also be subject to auctioning. They will receive 80% of their allowances for free in 2013, and there will be a gradual decline of free allocations as the phase progresses so that by 2020 all installations within the EUETS are buying all of their allowances.

    This level of auctioning will also extend to aviation, meaning that the recent political agreement to allow airlines to receive 90% of their allowances for free will last for just one year to the end of 2012 (ENDS Report 396, pp 46-47 ).

    In order to head off concerns about the impact of auctioning on the competitiveness of EU industry, some sectors that are particularly at risk of carbon leakage - the relocation of production to regions with less stringent climate policies - will continue to receive a proportion of their allocation for free.

    The Commission will identify vulnerable sectors by June 2010. A recent study by the Carbon Trust and the research group Climate Strategies suggested that only a handful of sectors, including cement and steel were significantly exposed to international competition. But it also identified around twenty sub-sectors where competitiveness was an issue (ENDS Report 394, pp 36-39 ).

    Other measures, including requiring importers to buy EUETS allowances to cover the emissions embodied in their products, will also be considered. But any attempt to introduce measures that would be viewed as carbon tariffs would be likely to result in an appeal to the World Trade Organization.

    The Commission will have to set out its preferred approach by 2011 and it will review the need to protect sectors every three years. It is relying on the successful conclusion of negotiations on international climate agreements to make long-term trade protection unnecessary.

    Member states will conduct the auctions and receive the revenue from allowance sales, which would run into tens of billions of euros a year.

    The Commission is proposing to give rapidly developing eastern European member states a bigger share of allowances to auction. It suggests that member states such as Germany, France and the UK, where per capita income is more than 20% above the European average, should only receive a share of the cap equal to 90% of their share of 2005 emissions. The remaining 10% would be distributed among poorer member states.

    The Commission wants member states to allocate at least 20% of the revenue they receive from auctioning to climate change measures. However, this suggestion is strongly opposed by the UK Treasury, among others.

    Another proposal is for the revenue from auctioning to be used to cover the administrative costs of the scheme. This would put an end to the UK system of permit charges, which can cost smaller installations more than their emissions allowances. The draft Directive also includes clauses to encourage the fitting of carbon capture and storage (see pp 50-51 ).

  • A bigger EUETS: The scheme will also be expanded to include new sectors and gases. From 2013 CO2 emissions from the production of aluminium, petrochemicals and ammonia will be covered by the scheme, as will nitrous oxide emissions from nitric acid, glyoxal and glyoxylic acid production and perfluorocarbons (PFCs) from aluminium smelting. Both nitrous oxide and PFCs are potent greenhouse gases.

    The Commission calculates that this will increase the coverage of the scheme by around 100MtCO2e. Once the exact level of emissions is calculated, the caps will be increased accordingly.

    The inclusion of the aluminium sector is contentious. While it is energy-intensive and a major emitter of CO2 and PFCs, it is highly exposed to international competition and has very limited options to reduce emissions (ENDS Report 389, pp 30-33 ). It is likely that the sector will receive most, if not all, of its allowances for free.

    The Directive also clarifies the definition of "combustion installation". During the first two phases, member states adopted different criteria to determine what type of combustion plant were covered by the scheme. The UK, in common with France and Germany, used a relatively narrow definition (ENDS Report 367, pp 35-36 ).

    The Commission is proposing a broader definition that would capture some installations currently not covered by the scheme and increase its coverage by 40-50MtCO2.

    On the other hand, member states will be free to exclude small installations - those with thermal capacity of less than 25MW or which emit below 10,000tCO2 a year - from the scheme as long as they are covered by "equivalent" emission control measures.

    Many of these smaller emitters have complained about the scheme’s costs and its demanding verification and reporting requirements, arguing that the administrative burden outweighs the benefit in terms of reduced emissions.

    Indeed, although the changes could see up to 4,200 of the 12,000 installations currently in the scheme opted out, the Commission calculates that this would only reduce the emissions coverage by 0.7%.

    UK installations opting out are likely to be covered by climate change agreements or the new carbon reduction commitment that will tackle emissions from large non-energy intensive organisations (ENDS Report 390, pp 41-43 ). However, it is questionable whether the CRC, also an emissions trading scheme, would be considered equivalent to the EUETS.

    CRC allowances are expected to be much cheaper than EUETS allowances, and the revenue from auctioning allowances will be recycled to participants so that organisations receive at least 90% of money back at the end of the year. What is more, the CRC is only designed to deliver emissions reductions of 4MtCO2 a year by 2020 compared to a total emissions coverage of 52MtCO2, equating to an 8% cut.

    The Commission is also proposing to ease the so-called aggregation rule so that combustion installations smaller than 3MW do not count towards the 20MW threshold for inclusion in the scheme. This would remove a further 800 very small installations from the scheme. The move would have little impact in the UK which unilaterally adopted this approach in 2006 (ENDS Report 379, p 44 ).

  • Foreign credits and schemes: The Commission also wants to limit the use of foreign emissions reductions credits from the Kyoto protocol’s joint implementation and clean development mechanisms to overseas projects approved prior to 2013.

    It points out that taken together, the national allocation plans for phase II allow up to 1.4 billion of these foreign credits to enter the scheme between 2008-2012. This is about 150 million more a year than the annual emissions reductions required by the caps.

    In order to prevent foreign credits from flooding the scheme and to encourage installations to abate more themselves during the second phase, the Commission is proposing to allow installations to swap unused credits bought during phase II for EUETS allowances that will be valid in phase III.

    The Commission expects surplus Kyoto credits from phase II to match around 30% of the effort to meet the caps in phase III. However, it retains the option to relax the limit on credits in light of tighter headline emissions reduction targets. The EU has offered to cut its greenhouse gas emissions by 30% by 2020 as part of a new international agreement as long as other developed countries agree to take similar action.

    In this event, the EUETS caps would be tightened and installations would be able to buy Kyoto credits to bridge the gap between the old and new targets.

    As expected, the draft Directive would allow the EUETS to link with a wider range of emissions trading schemes. The existing Directive already allows the facility to link with schemes, but only in countries that have ratified the Kyoto protocol. The new amendments would allow the EUETS to link with any mandatory scheme, even those run at a "sub-federal" level. This opens the door to linking with regional emissions trading schemes being developed by US states (ENDS Report 396, p 13 ).

    The Commission’s proposals now go to the European Parliament and member states for approval and could well be changed. The Commission hopes that the final Directive will be adopted some time in 2009.

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