Climate Change: The European Union's Emissions Trading System (EU-ETS)

CRS Report for Congress
Climate Change: The European Union’s
Emissions Trading System (EU-ETS)
July 31, 2006
Larry Parker
Specialist in Energy Policy
Resources, Science, and Industry Division

Congressional Research Service ˜ The Library of Congress

Climate Change: The European Union’s Emissions
Trading System (EU-ETS)
Summary
The European Union’s (EU’s) Emissions Trading System (ETS) is a cornerstone
of the EU’s efforts to meet its obligation under the Kyoto Protocol. It covers more
than 11,500 energy intensive facilities across the 25 EU member countries, including
oil refineries, powerplants over 20 megawatts (MW) in capacity, coke ovens, and
iron and steel plants, along with cement, glass, lime, brick, ceramics, and pulp and
paper installations. Covered entities emit about 45% of the EU’s carbon dioxide
emissions. The trading program does not cover emissions of non-CO² greenhouse
gases, which account for about 20% of the EU’s total greenhouse gas emissions. The
first trading period began January 1, 2005. A second trading period is scheduled to
begin in 2008, with a third one planned for 2013. In deciding on its trading program,
the European Commission (EC) adopted a “learning-by-doing” approach to prepare
the EU for the Kyoto Protocol’s emission limitations. The EU does not have major
experience with emissions trading, and the EC felt that an initial program beginning
in 2005 would give the EU practical familiarity in operating such a system.
At first glance, it would appear that the EU may have little difficulty meeting
its Kyoto Protocol requirements during the second trading period. The anticipated
deficit between the second trading period for the original 15 Member States can be
covered by trading with the 10 newer Member States that anticipate a surplus. Also,
credits are likely to be available through Joint Implementation (JI) and Clean
Development Mechanism (CDM) projects sanctioned under the Protocol.
However, there are other considerations. The availability of surplus credits
created via JI and CDM is restricted by the EC requirement that such credits be
“supplemental” to a country’s domestic efforts. Each country is to spell out what
“supplemental” means in its National Allocation Plans (NAPs) for the second trading
period. Individual countries are likely to define that term differently — restricting
allowance trades and purchases in some countries.
Another consideration is the overall commitment of the Kyoto Protocol. As
noted earlier, the ETS covers only a percentage of the overall greenhouse gas
emissions in the various Member States of the EU. Some sectors not covered by the
ETS may grow faster than sectors covered by it, creating difficulties for compliance.
In particular, the transportation area is already a source of concern.
A final consideration for the ETS is its suitability for directing long-term
investment toward a low-carbon future — the ultimate goal of any climate change
program. It is too early to tell whether the ETS’s market signal and individual
countries’ NAPs will move investment in the appropriate direction. The early signs
are not particularly encouraging, with the 2005-2008 NAPs producing an over-
allocation of allowances and one major Member State (Germany) attempting to direct
its second NAP toward carbon-intensive, coal-fired electric-generating facilities
rather than low-carbon alternatives. Reluctance by countries to redirect their NAPs
and an inconsistent price signal from the ETS make the long-term effect of the ETS
uncertain.

Contents
Overview ........................................................1
Implementing the ETS: National Allocation Plans........................4
Results From the First Year..........................................5
Emissions Levels..............................................5
Market Activity, Prices, and Impact...............................8
Use of Clean Development Mechanism (CDM) and Joint
Implementation (JI).......................................11
Issues ..........................................................12
Tightening of Emissions Caps...................................13
Harmonizing NAPs...........................................16
New Entrants................................................18
Definition of Affected Units....................................19
Expansion of Coverage........................................20
Conclusion ......................................................20
Appendix: Norway’s Trading System.................................22
List of Figures
Figure 1. CO2 Market: Even If No “Big” News Highly Volatile .............9
Figure 2. CO2 Market: Large Price Changes in Very Short Amount
of Time.....................................................10
Figure 3. There is a Very Long-Term Correlation Between CO2 and
Electricity Price: Link Via Marginal Producer......................11
List of Tables
Table 1: Cost of Reaching Kyoto Target to EU Member States in 2010........3
Table 2. Summary Information Per Member State........................6
Table 3. Importance of EU ETS Topics...............................13
Table 4: Comparison of 1^st and 2^nd Trading Period ETS Caps...............14
Table 5: NAP Harmonization Issues..................................17
Table 6: International Supply of Emissions Credits and Allowances.........21

Climate Change: The European Union’s
Emissions Trading System (EU-ETS)
Overview
Climate change is generally viewed as a global issue, but proposed responses
typically require action at the national level. With the 1997 Kyoto Protocol now in
force, countries that ratified the protocol are developing appropriate implementation¹
strategies to begin reducing their emissions of greenhouse gases. In particular, the
European Union (EU) has decided to use an emissions trading scheme (called a “cap-
and-trade” program), along with other market-oriented mechanisms permitted under
the Protocol, to help it achieve compliance at least cost.² The decision to use
emission trading to implement the Kyoto Protocol is at least partly based on the
successful emissions trading program used by the United States to implement its
sulfur dioxide (acid rain) control program contained in Title IV of the 1990 Clean
Act Amendments.³
The EU’s Emissions Trading System (ETS) is a cornerstone of the EU’s efforts
to meet its obligation under the Kyoto Protocol. It covers more than 11,500 energy
intensive facilities across the 25 EU Member countries, including oil refineries,
powerplants over 20 megawatts (MW) in capacity, coke ovens, and iron and steel
plants, along with cement, glass, lime, brick, ceramics, and pulp and paper
installations. Covered entities emit about 45% of the EU’s carbon dioxide emissions.
The trading program does not cover emissions of non-CO² greenhouse gases, which
account for about 20% of the EU’s total greenhouse gas emissions. The first trading

¹ Six gases are included under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide,
hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. The United States has not
ratified the Kyoto Protocol and, therefore, is not covered by its provisions. For more
information on the Kyoto Protocol, see CRS Report RL30692, Global Climate Change: The
Kyoto Protocol, by Susan Fletcher.
² Norway, a non-EU country, also has instituted a CO² trading system (described in
Appendix A). Various other countries and a state-sponsored regional initiative located in
the northeastern United States involving several states are developing mandatory cap-and-
trade system programs, but are not operating at the current time. For a review of these
emerging programs, along with other voluntary efforts, see International Energy Agency,
Act Locally, Trade Globally (2005).
³ P.L. 101-549, Title IV (Nov. 15, 1990).

period began January 1, 2005. A second trading period is scheduled to begin in

2008, covering the period of the Kyoto Protocol, with a third one planned for 2013.⁴

Under the Kyoto Protocol, the then-existing 15 nations of the EU agreed to
reduce their emissions by 8% from 1990 levels under a collective arrangement called
a “bubble.” By 2001, collective greenhouse gas emissions in the EU were 2.3%
below 1990 levels, mostly the result of a structural shift from coal to natural gas in
the United Kingdom and the incorporation of East Germany into West Germany.
Several countries, including Ireland, Spain, and Portugal, experienced emissions
growth of over 30% during this period.⁵ In light of the Kyoto Protocol targets, the
EU adopted a directive establishing the EU-ETS that entered into force October 13,
2003.⁶ The importance of emissions trading was elevated by the accession of 10
additional central and eastern Europe countries to EU membership in May 2004.
Collectively, these 10 countries’ greenhouse gas emissions dropped 22.6% from
1990-2001, with only Slovenia’s emissions increasing during that time (10.4%). This
expansion of the EU trading zone to 25 countries greatly increases the opportunities
for cost-effective allowance trades.
In deciding on its trading program, the European Commission (EC) adopted a
“learning-by-doing” approach to prepare the EU for the Kyoto Protocol’s emissions
limitations. The EU does not have major experience with emissions trading, and the
EC felt an initial program beginning in 2005 would give the EU practical familiarity
in operating such a system. The EC also wanted the most comprehensive program
possible. As stated in its “Green Paper”:
The wider the scope of the system, the greater will be the variation in the costs
of compliance of individual companies, and the greater the potential for lowering
costs overall. This argues in favour of a comprehensive trading scheme across
different Member States covering all 6 greenhouse gases and sinks, and⁷
encompassing all emissions sources.
Economic analysis conducted by the European Commission confirms the
potential cost-saving available from a comprehensive trading scheme. As shown in
Table 1, a comprehensive trading program is estimated by the EC to reduce Kyoto
compliance costs to EU countries by 3 billion euro, or one-third over a compliance
scenario that does not include trading among Member countries, and by 0.9 billion

⁴ More information, including relevant directives, on the EU-ETS is available on the
European Union’s website at [http://europa.eu.int/scadplus/leg/en/lvb/l28012.htm].
⁵ Pew Center on Global Climate Change, The European Union Emissions Trading Scheme
(EU-ETS): Insights and Opportunities (no date), available at [http://www.pewclimate.org/
docUploads/EU%2DET S%20W hite%20Paper%2Epdf].
⁶ Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003
establishing a scheme for greenhouse gas emissions allowance trading within the
Community and amending Council Directive 96/61/EC.
⁷ Commission of the European Communities, Green Paper on Greenhouse Gas Emissions
Trading within the European Union (presented by the Commission), Brussels, COM(2000)

87 final (Mar. 8, 2000), p. 10.

euro, or 13% below the estimate cost of compliance with the trading scheme
ultimately chosen by the EC.
Table 1: Cost of Reaching Kyoto Target to EU Member States
in 2010
(in billions of 1999 euro)
EU-wide Trading
No TradingEU-wideTrading AmongAmong EnergyEU-wide Trading
Among EUEnergyProducers andAmong All
Member States ProducersEnergy-IntensiveSectors
Industries
9.07.26.96.0
Source: EC Green Paper (Mar. 8, 2000), p. 27.
For a variety of reasons, the EC chose a trading system with limited coverage
rather than a comprehensive system covering all sources and gases. Some European
analysts have noted that EU politics played an important role in preventing serious
consideration of a comprehensive program. As noted by Boemare and Quirion:
A significantly wider coverage could have been provided only by an upstream
system, which had been excluded by the [European] Commission at the
beginning of the process. The reason was again political: an upstream scheme⁸
would have too much looked like a tax.
Not surprisingly, this reason was not employed by the EC in explaining its
decision to create a less comprehensive trading scheme at this time. As stated by the
EC:
... there are sound scientific and practical reasons why the Community might not
wish to establish a comprehensive scheme at this stage. There are considerable
uncertainties surrounding the emissions of the fluorinated gases [HFC, PFC, SF⁶]
and the absorption of carbon dioxide by sinks. Allocating allowances,
monitoring emissions and enforcing compliance of small mobile emitters, such⁹
as private cars, raise complex technical and administrative issues.
For determining the size of the trading program, the EC looked at five criteria:
(1) environmental effectiveness, (2) economic efficiency, (3) the potential effects on
competition, (4) feasibility, and (5) existence of alternative policies and measures.

⁸ The first political decision noted by the authors was the exclusion of process emissions
from the chemical industry from the ETS. Catherine Boemare and Philippe Quirion,
Implementing Greenhouse Gas Trading in Europe: Lessons from Economic Theory and
International Experiences, Centre International de Recherche sur l’Environnement et le
Developpement, CNRS/EHESS, France (June 2002), p. 5.
⁹ Commission of the European Communities, Green Paper on Greenhouse Gas Emissions
Trading with the European Union (presented by the Commission), Brussels, COM(2000)

87 final (Mar. 8, 2000), p. 10.

It felt that starting with a relatively small number of economic sectors and sources
that contribute significantly to total emissions and for which trading could reduce
cost significantly would “substantially” satisfy these criteria.¹⁰ As noted, the six
sectors chosen emit about 45% of the EU15’s CO² emissions (which are about 80%
of the EU’s total greenhouse gas emissions). The coverage for individual countries
varies widely; only 20% of France’s greenhouse gas emissions are covered, compared
with 69% of Estonia’s emissions.¹¹
Implementing the ETS: National Allocation Plans
National Allocation Plans (NAPs) are central to the EU’s effort to achieve its
Kyoto obligations. Each Member of the EU must submit a NAP that lays out its
allocation scheme under the ETS, including individual allocations to each affected
unit. For the first trading period, each country had to prepare a NAP by March 31,
2004 (May 1, 2004 for the 10 new EU Members). NAPs for the second period were
due June 30, 2006. These NAPs are assessed by the EC to determine compliance
with 11 criteria (12 for the second period) delineated in an annex to the emissions
trading directive.¹² Criteria include requirements that the emissions caps and other
measures proposed by the state are sufficient to put it on the path toward its Kyoto
target, protections against discrimination between companies and sectors, along with
provisions for new entrants, clean technology, and early reduction credits. For the
second period, the NAP must guarantee Kyoto compliance.
For the first period, the EC approved most of the necessary NAPs by the end of
2004. The last NAP was approved June 20, 2006 (from Greece). In general, the
primary problem the EC found with NAPs that resulted in revisions were excessive
allocation of allowances and state efforts to permit “ex-post adjustments” to their
allocations. Excessive allocation problems resulted from states that left a gap in how
they would achieve their target, to be filled with measures to be defined later;
insufficiently delineated plans to purchase allowances; and unrealistic economic or
emissions growth assumptions. Ex-post adjustments by states are not allowed; such
adjustments are seen by the EC as potentially disruptive to the emissions market and
creating uncertainty for companies.

¹⁰ Commission of the European Communities, Green Paper on Greenhouse Gas Emissions
Trading with the European Union (presented by the Commission), Brussels, COM(2000)
87 final (Mar. 8, 2000), p. 13
¹¹ International Energy Agency, Act Locally, Trade Globally (OCED/IEA, 2005), p. 74
¹² Commission of the European Communities, Directive 2003/87/EC, available at
[http://ec.europa.eu/envi ronment/climat/emi ssions_plans.htm]

Results From the First Year
Emissions Levels
For the 2005-2007 period, the European Union is not attempting to meet the
Kyoto Protocol but to get experience with emissions trading with some modest
emissions targets (i.e., to put the EU on the path toward meeting the Kyoto
requirements). Table 2 provides the national emissions allocations and 2005
emissions levels for 21 EU countries as recorded by the Community Independent
Transaction Log (CITL) by the compliance deadline of April 30, 2006.¹³ For the first
trading period, the 21 countries have allocated an annual average of 1.8295 billion
allowances and set aside 73.4 million allowances for allocation to new sources or for
auctions. Verified emissions in 2005 for covered sources is 1.7853 billion metric
tons, according to the CITL.¹⁴ The 44.2 million allowances allocated in excess of
actual 2005 emissions have been characterized by EU’s Environment Commissioner
as an “over-allocation” of allowances¹⁵ and is considered responsible for a significant
drop in allowances prices in May, 2006. The 2005 emissions total reflects emissions
from 8,980 sources representing more than 99% of the allowances allocated. As of
April 30, 849 sources in the 21 countries had not surrendered sufficient allowances.
The EC will determine whether the insufficiency is the result of technical difficulties
in national registries, tardiness, or noncompliance. Noncomplying sources are
subject to a 40-euro penalty for each ton of emissions in excess of surrendered
allowances under the ETS.

¹³ Four of the 25 Member States (Cyprus, Luxembourg, Malta, and Poland) have not
submitted information because their allowance registries are not operational yet. Cyprus
and Malta do not have emissions targets under the Kyoto Protocol.
¹⁴ European Commission, EU Emissions Trading Scheme Delivers First Verified Emissions
Data for Installations (Brussels, 15 May 2006), available at[http://ec.europa.eu/comm/
envi ronment/climat/pdf/citl_pr.pdf]
¹⁵ Comments of EU Environment Commissioner Stavros Dimas, as reported by Jeff Mason
in “EU’s Dimas Says States Allocated too Much CO2 in ‘05” (Reuters, May 22, 2006).

CRS-6
Table 2. Summary Information Per Member State
^Inst^a^lla^tⁱ^oⁿ^{s t}^h^a^t^Sha^{re o}^f^inst^a^lla^tⁱ^oⁿ^s^a^Inst^a^lla^tⁱ^oⁿ^{s no}^tⁱⁿ^Annua^{l a}^v^era^g^e^Annua^{l a}^v^era^g^e^a^llo^ca^tⁱ^oⁿ^no^t
^m^b^{er State}^CO²^e^m^issioⁿ^{s f}^o^r^{2005 i}ⁿ^tonⁿ^e^s^ha^v^e^no^t^repo^r^t^e^{d by}^wⁱ^{th verified}^Iⁿ^s^t^allations^covered^com^p^{liance on 30}^al^l^o^cati^onⁱⁿ²⁰⁰⁵^b^a^llo^ca^t^e^{d a}^t^t^h^e
^{30 A}^p^ri^l^e^m^issioⁿ^{s r}^e^p^o^r^t^s^A^p^ri^l²⁰⁰⁶^{to 2007 i}ⁿ^tonⁿ^e^s^ou^ts^{et i}ⁿ^tonⁿ^e^s^c
^t^ri^a^33,372,841⁰^100.0%¹⁹⁹⁰^32,674,905^330,050
^gⁱ^u^m^55,354,096²^99.^9%³⁰⁹²^59,853,575^2,545,876
^blⁱ^c^d^82,453,727³⁹^98.4%³⁸⁹^96,907,832^348,020
ⁱ^{ki/CRS-RL33581}^m^ark^26,090,910²^98.9%³⁸⁰⁴^31,039,618^2,460,382
^g/w^oⁿⁱ^a^12,621,824⁰^100.0%⁴³¹^18,763,471^189,529
^s^.or^l^an^d^33,072,638¹⁰^100.0%⁵⁷⁸¹⁹^44,587,032^862,952
^le^ak^ce^d^131,147,905¹⁷^99.7%¹⁰⁷⁵^150,500,685^4,871,317
^://wiki^an^y^473,715,872¹³^99.8%¹⁸⁴²⁹⁰^495,073,574^3,926,426
^h^ttp^71,033,294²⁸^99.5%¹⁴¹²⁹^71,135,034^3,286,839
^r^y²⁵^,^714,574¹³^99.0%²²⁹¹⁹^30,236,166^1,424,738
^an^d^22,397,678⁰^100.0%¹⁰⁹⁰^19,238,190^3,081,180
^y^215,415,641²⁰⁸^95.4%⁹⁴³⁶⁴⁷^207,518,860^15,551,575
^vⁱ^a^2,854,424¹^99.9%⁹²¹⁴^,054,431^505,760
^u^aⁿⁱ^a⁶^,603,869²^99.9%⁹³⁴^11,468,181^797,213
^h^erl^aⁿ^d^s^80,351,292⁰^100.0%²⁰⁹⁰^86,439,031^2,503,305
^u^g^a^l^36,413,004¹^99.9%²⁴³²^36,898,516^1,262,898
^v^ak^d^25,237,739⁰^100.0%¹⁷⁵^30,364,848^7,180

^blⁱ^c

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^Inst^a^lla^tⁱ^oⁿ^{s t}^h^a^t^Sha^{re o}^f^inst^a^lla^tⁱ^oⁿ^s^a^Inst^a^lla^tⁱ^oⁿ^{s no}^tⁱⁿ^Annua^{l a}^v^era^g^e^Annua^{l a}^v^era^g^e^a^llo^ca^tⁱ^oⁿ^no^t
^m^b^{er State}^CO²^e^m^issioⁿ^{s f}^o^r^{2005 i}ⁿ^tonⁿ^e^s^ha^v^e^no^t^repo^r^t^e^{d by}^wⁱ^{th verified}^Iⁿ^s^t^allations^covered^com^p^{liance on 30}^al^l^o^cati^onⁱⁿ²⁰⁰⁵^b^a^llo^ca^t^e^{d a}^t^t^h^e
^{30 A}^p^ri^l^e^m^issioⁿ^{s r}^e^p^o^r^t^s^A^p^ri^l²⁰⁰⁶^{to 2007 i}ⁿ^tonⁿ^e^s^ou^ts^{et i}ⁿ^tonⁿ^e^s^c
^enⁱ^a^8,720,550⁰^100.0%⁹⁸⁰⁸^{,691,990 66,667}
^d^181,063,141^99.1%⁸⁰⁰^162,111,391^13,162,130
^eden^19,306,761²⁹^99.4%⁷⁰⁵³¹^22,530,831^678,149
^g^dom^242,396,039¹⁵^99.9%⁷⁶⁸¹⁶^209,387,854^15,527,484
¹^,785,337,819^99.1%^9,420^{1,829,476,015}^73,389,670
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Some commentators have suggested that annual average 2005-2007
allocations that are actually 44.1 million metric tons higher than the reported 2005
emissions are neither putting the EU on the path to the Kyoto requirements nor
developing the trading market. In addition, this “over-allocation” does not include
the 73.4 million metric tons of allowances held in reserve by the various countries
for new entrants. The Climate Action Network (CAN), a network of 365 non-
governmental organizations, stated the following:
Emissions limits set by Member States for the first phase were a major
disappointment. To ensure maximum environmental benefit of the ETS and
the overall success of the system as a whole, they need to be strengthened
considerably. The Kyoto targets require ambitious caps with absolute¹⁶
reductions for the phase 2008-2012.
In general, the EC has seen the over-allocation issue as part of the “learning-
by-doing” process that should help the EU in implementing the second trading
period beginning in 2008. As stated in its press release:
The new 2005 emissions data gives independently assessed installation-level
figures for the first time and so provides Member States with an excellent
factual basis for deciding upon the caps in their forthcoming national
allocations plans for the second trading period, when the Kyoto targets have
to be met. The plans are subject to approval by the Commission, which will¹⁷
also be making extensive use of the 2005 emissions data.
Market Activity, Prices, and Impact
According to Point Carbon’s proprietary databases, the EU-ETS traded 362
million metric tons of CO² in 2005, valued at 7.218 billion euro. Brokers were
responsible for 57% of the volume, exchange markets did 15%, and bilateral
transactions accounted for 28%. Of the exchange market volume, the European
Climate Exchange (ECX) had the largest share at 63%, followed by Nord Pool¹⁸
with 24%, and Powernext with 7.9%.
The average price for an allowance traded in 2005 was 19.9 euro, with
brokered and exchanged allowances averaging 20.6 euro and bilateral transactions
averaging 18.2 euro. However, allowance prices have been quite volatile since
trading begin in 2005, as indicated in Figure 1 below.¹⁹ In particular, allowance

¹⁶ CAN Europe, National Allocation Plans 2005-7: Do They Deliver? Summary for
Policymakers (April 2006), p. 2.
¹⁷ European Commission, EU Emissions Trading Scheme Delivers First Verified Emissions
Data for Installations (Brussels, May 15, 2006), available at [http://europa.eu.int/
luxembourg/ docs/217-2006_en.pdf]
¹⁸ Point Carbon, Carbon 2006: Towards a Truly Global Market (28 February 2006) pp. 15-
16. It should be noted that there is significant uncertainty in the estimates of the bilateral
market.
¹⁹ Margus Kaasik (CFO Eesti Energia), Carbon Market: EU ETS (May 9, 2006). Implied
(continued...)

prices dropped from almost 30 euro to about 9-11 euro in April and May, sparked
by a series of reported over-allocation of allowances in several Member States.
By July 2006, allowance prices had recovered to about 17 euro in July.
Figure 1. CO2 Market: Even If No “Big” News Highly Volatile

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006), p. 14.
There are several reasons for the overall volatility in the allowance market.
The EU-ETS is a maturing but still narrow market. Monthly volumes are
increasing, but have never exceeded a 1.6% share of phase 1 allocations.²⁰
Modest volume for a new system is not surprising; trading volumes under the U.S.
Clean Air Act Title IV sulfur dioxide trading program were very thin in the
beginning. Even after several years of operation, SO² allowances prices can
change unpredictably and inexplicably.²¹
Some reasons for ETS allowance price derivatives are explicable. As
illustrated by Figure 2, the ETS market responded to a variety of regulatory,
climatic, and economic events over the first trading period. Regulatory events
include the late approval of NAPs for several countries, along with the resulting
¹⁹ (...continued)
volatility is a measure used primarily in options analysis to estimate how much the market
expects an asset price to move for an option price. Two hundred-fifty days is commonly
used for this analysis, as it represents the number of business days in a year.
²⁰ Margus Kaasik (CFO Eesti Energia), Carbon Market: EU ETS (May 9, 2006), p. 13.
²¹ Vivian E. Thomson in collaboration with the Pew Center on Global Climate Change,
Early Observations on the European Union’s Greenhouse Gas Emissions Trading Scheme:
Insights for United States Policymakers (Apr. 19, 2006), p. 16

over-allocation causing the sudden market correction in May 2006. Climatic
events influencing prices include cold weather, which increased energy usage, and
dry conditions, which decreased the availability of hydroelectric power.²²
Figure 2. CO2 Market: Large Price Changes in Very Short Amount of
Time

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006), p. 14.
The primary economic influence on the ETS revolved around fuel prices.
During 2005, Point Carbon analysis indicates 79% of the variance (R²) in
allowance prices was explained by changes in fuel prices (particularly for electric
power), with 23% of the variance explained by the weather. This linkage between
allowance prices and the power market is not surprising, as the power sector
conducted the majority of trades in 2005 and therefore significantly influenced
price development.
Kaasik argues that the evidence from the past year indicates that fuel prices
influence carbon prices, but not the reverse. Specifically, Kaasik sees allowance
prices as a derivative of natural gas and coal pricing, at least in the short-term.
Assuming natural gas-fired and coal-fired generation are the marginal cost
suppliers of power, allowance prices will respond positively to increasing natural
gas prices or decreasing coal prices. Likewise, allowance prices will respond
negatively to decreasing natural gas prices or increasing coal prices. This creates
a correlation over time between allowance prices and electricity price by
influencing the marginal price of electricity. How this has evolved during the first
trading period is illustrated by Figure 3.
²² Point Carbon, Carbon 2006: Towards a Truly Global Market (Feb. 28, 2006) pp. 18-19.

Figure 3. There is a Very Long-Term Correlation Between CO2 and
Electricity Price: Link Via Marginal Producer

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006) p. 11.
Use of Clean Development Mechanism (CDM) and Joint
Implementation (JI)
The EU-ETS has provisions for linking its trading scheme to the Joint
Implementation (JI) and Clean Development Mechanism (CDM) components of
the Kyoto Protocol for countries that have ratified it. These project-based
instruments involve Annex 1 countries in the case of JI, and between Annex 1 and
developing countries in the case of CDM.²³ The EC’s linking directive allows
operators to fulfil their allowance obligations under the EU-ETS using credits
derived from JI and CDM projects. Their credits are equivalent to allowances in
environmental and economic terms, but are not interchangeable. “Certified
Emissions Reductions” (CERs) under the CDM must be issued by the Clean
Development Mechanism Executive Board and may be used in either the first or
banked for use in the second trading period.²⁴ Emissions Reduction Units
(ERUs) under JI are transferred from one country to another — an exchange that
cannot begin until the second trading period. Neither CERs nor ERUs are
²³ Annex 1 countries are the 36 industrialized countries and economies-in-transition listed
in Annex 1 of the United Nations Framework Convention on Climate Change and allowed
to engaged in JI and CDM projects under the Kyoto Protocol.
²⁴ The time between submission of a CDM project design document and approval can be as
much as 18 months because CDM credits must be approved by the Designated National
Authority (DNA) and the CDM Executive Board. Brown Rudnick Berlack Israels LLP,
Emissions Trading: Questions and Answers (February 2006), p. 7.

converted into EU-ETS allowances; rather, they are entered directly into the
surrendered allowance table. There are other restrictions on the use of CERs and
ERUs. In particular, for the second trading period the amount of CERs and ERUs
that can used by an affected unit is limited by a percentage specified by its
country. Several EU countries have established carbon funds to pursue JI and
CDM opportunities.²⁵
In general, CER and ERU credits have sold at a discount to ETS allowance
prices. The degree of discount has depended on the riskiness of the project. CER
and ERU credits are available only when the projects are completed. Thus, where
buyers take the risk of non-delivery, such as an emissions reduction purchase
agreement (ERPA), prices are in the range of 8-12 euro. In contrast, for CERs
already issued, or where the sellers take the risk, prices are in the range of 13-15
euro.²⁶ The real impact of CDM and JI on the EU-ETS system will not be fully
known until the second trading period, when EU demand for credits will increase
substantially and other non-EU countries would be implementing their own Kyoto
compliance strategies.
Issues
To assist its review of the ETS, the EC has surveyed stakeholders’
viewpoints on ETS implementation and long-term issues.²⁷ The report surveys
the viewpoints of participating companies, governments, industry associations,
market intermediaries, and non-governmental organizations (NGOs) from June to
September 2005. Asked which of 12 topics surrounding ETS implementation
entities felt were most important to them, companies, industry associations, and
governments all ranked topics such as emissions reduction targets, allocation
rules, and rules for new entrants and closures as the most important — topics that
all relate to long-term uncertainty. Table 3 indicates the top five topics according
to governments surveyed, along with their corresponding ranking by other
stakeholders. The five issues are discussed below.

²⁵ For a list of countries with carbon funds, see [http://carbonfinance.org/Router.cfm?Page=
Funds&ItemID=24670]
²⁶ As reported in Carbon Positive, “CER Prices Stabilise After EU Market Hit” (June 14,

2006), available at [http://www.carbonpositive.net/viewarticle.aspx?articleID=137].

²⁷ European Commission, Review of EU Emissions Trading Scheme (November 2005).

Table 3. Importance of EU ETS Topics
(ranking)
TopicGovernmentsCompaniesIndustry AssociationsMarketIntermediariesNGOs
Emissions 1^st 1^st 1^st 3^rd 1^st
reduction
targets
Further2^nd3^rd2^ndTied for 5^thTied^th
harmonizationfor 6
of allocation
plans
Treatment of3^rd2^nd5^th7^thTied^th
new entrants/for 6
closures
Definition of4^th10^thTied for 8^thTied for 8^thTied^th
combustionfor 11
installations
Inclusion of5^thTied for 6^thTied for 8^thTied for 4^th3^rd
sectors and
gases
Source: European Commission, Review of EU Emissions Trading Scheme (November

2005), p. 13.

Tightening of Emissions Caps
With the over-allocation issue in the first trading period, it is likely that the EC
will take a harder stance in reviewing NAPs for the second trading period. The
relationship between the ETS cap for the first trading period and the estimated ETS
cap for the second trading period (the Kyoto Protocol requirements) varies
substantially between countries, as illustrated in Table 4. In general, the original EU-
15 countries have to reduce their emissions caps the most to meet their share of the
EU’s requirements under the Kyoto Protocol, with several countries facing double-
digit percentage reductions. As indicated, EU-15 states, on average, have to reduce
their emissions caps 6.8% (119 million metric tons) from their current levels to meet
their requirements under the Kyoto Protocol-based second trading period. In
contrast, as a group, the newer countries and the EU as a whole are in substantially
better shape.²⁸

²⁸ Two EU countries, Malta and Cyrus, are not included here because they are non-Annex
1 countries and, therefore, do not have mandatory reduction requirements under the Kyoto
Protocol.

Table 4: Comparison of 1^st and 2^nd Trading Period ETS Caps
(in millions of metric tons of CO² Equivalent unless otherwise noted)
Average AnnualEstimated AnnualPercentage
ETS Cap (first^aETS Cap (KyotoDifference
trading period)Protocol)
Austria 33.0 24.6 -25.5%
Belgium 62.9 57.9 -8.0%
Czech Republic97.6118.621.6%
Denmark 33.5 24.9 -25.6%
Estonia 19.0 35.4 86.5%
Finland 45.5 37.5 -17.7%
France 156.5 159.6 2.0%
Germany 499.0 483.2 -3.2%
Gr eece 74.4 75.5 1.5%
Hungary 31.3 43.0 37.3%
Ir eland 22.3 20.1 -9.7%
It aly 232.5 194.7 -16.3%
Latvia 4.6 10.1 119.8%
Lithuania 12.3 33.4 171.5%
Luxembourg 3.4 2.7 -19.4%
Netherlands 95.3 88.9 -6.7%
Poland 239.1 331.0 38.4%
Portugal 38.2 35.4 -7.2%
Slovakia 30.5 38.9 27.7%
Slovenia 8.8 8.3 -5.4%
Spain 174.4 142.8 -18.1%
Sweden 22.9 24.4 6.7%
UK 245.3 247.8 1.0%
EU-ETS 151,739.11,620.1-6.8%
EU-ETS 232,182.32,239.02.6%
Source: Based on data provided in Annex 1, European Commission, “Further Guidance
on Allocation Plans for the 2008 to 2012 trading period of the EU Emissions Trading
Scheme” (Brussels, Dec. 12, 2005) p. 11.
a. These figures do not account for changes to the number of installations subsequent to the
respective Commission decision (e.g., opt-ins or opt-outs of installations).

At first glance, it would appear that the EU would have little difficulty meeting
its Kyoto Protocol requirements during the second trading period. The anticipated
deficit between the second trading period for the original 15 Member States can be
covered by trading with the newer Member States that anticipate a surplus. However,
there are other considerations. First, countries with potential surpluses may want to
retain at least some of that surplus to help fuel their countries’ economic growth,
possibly at the expense of a Member State that needs allowances. Second, the extent
to which surplus credits would be created via JI, the EC linking directive, requires
that such credits (including from CDM) be “supplemental” to a country’s domestic
efforts. Each country is to spell out what “supplemental” means in its NAP for the
second trading period.
A third consideration is the overall commitment of the Kyoto Protocol. As
noted earlier, the ETS only covers a percentage of the overall greenhouse gas
emissions in the various Member States of the EU. The analysis provided in Table
3 assumes that the ETS will have to provide a proportional amount of that reduction
based on 2003 emissions. However, some sectors not covered by the ETS may grow
faster than sectors covered by the ETS, creating difficulties for compliance. In
particular, the transportation area has become a major source of concern. The
transportation sector is not a part of the ETS and is not likely to be included before
the third trading period.²⁹ Instead, transport controls are based on voluntary
agreements with automobile manufacturers to improve fuel economy, fuel-economy
labelling of cars, and promoting fuel efficiency by fiscal measures.³⁰ The cornerstone
is the agreements with automobile manufacturers to achieve improve new car fleet
average CO² emissions rates. As announced in 1996, the objective of the EU Council
of Environmental Ministers and European Parliament was to achieve a new car fleet
average CO² emissions rate of 120 grams per kilometer (g CO²/km) by 2005, or by

2010 at the latest.³¹

This objective was not met in 2005 and is unlikely to be met by 2010.
Voluntary commitments by the European, Japanese, and Korean Automobile
Manufacturers Associations in 1998 and subsequently endorsed by the EC set targets
of 140 g CO²/km by 2008/2009. At the end of 2005, the average new car emissions
rate is about 160 g CO²/km. The rate of reduction in CO²/km for new cars would
have to double for the automobile manufacturers to achieve their commitments,
which appears unlikely.³² Indeed, despite improvements in emissions rates, CO²
emissions in the EU continue to rise because of increased miles driven, increased size
and weight of cars, and falling car occupancy rates. The EC 2005 progress report
also notes that despite EU’s effort to increase information on fuel efficiency and CO²

²⁹ EurActiv.com, Transport to Stay Out of CO² Trading until 2013 (June 21, 2006).
³⁰ European Commission, Implementing the Community Strategy to Reduce CO² Emissions
from Cars: Fifth Annual Communication on the Effectiveness of the Strategy (Brussels, June

22, 2005).

³¹ Council conclusions of June 25, 1996.
³² European Federation for Transport and Environment, Cleaner is Cheaper (Brussels,

2005). p. 1.

emissions for consumers, the effectiveness of the effort seems low: “a significant
impact on consumer’s decisions could not yet be noticed.”³³
Attempts to balance the burden between ETS and non-ETS sectors have already
created tension in Germany with respect to the second trading period. In its draft
NAP for the second trading period (NAP II) submitted June 28, 2006, Germany
proposes to reduce its ETS allocation from about 499 million metric tons to about
471 million metric tons, a decrease of 5.6%.³⁴ However, Germany’s 2005 emissions
were only 474 million metric tons; thus the reduction is only 0.6% from last year’s
emissions. In addition, Germany is proposing to permit every new power station
built between 2008 and 2012 to opt out from CO² caps and the ETS for 14 years,
generally to encourage construction of coal-fired facilities. These emissions
increases will have to be covered by the non-ETS sectors — commercial, residential,
and transportation. An assessment done for Greenpeace International states that the
German NAP II places “a disproportionate burden for emissions reductions on the
non-ETS sectors” in terms of meeting its commitments under the EU Burden Sharing
agreement.³⁵ Policies to fill in the gap reportedly include one plan to reduce
emissions by 3 million tons by training German drivers to drive more economically.³⁶
As noted by the EC Report cited above, the effectiveness of public education
programs such as this may be problematic.
Harmonizing NAPs
The EU-ETS system involves an interplay between definitions and procedures
that are EU-wide and those that are nationwide. The groundwork for the system is the
Kyoto Protocol, which (1) defines the pollutants and sets the countries’ emissions
targets; (2) defines the scope of participation: Annex 1 countries may implement
emissions trading programs, and non-Annex 1 countries may participate through the
CDM; (3) defines baseline emissions years and sinks; and (4) sets national inventory
and compliance requirements. Within this framework, the EU defines the elements
that make the EU-ETS work, including industry participants, the unit of trade
(tradeable allowances equal to 1 metric ton of CO²), trading periods, settling up
procedures, and linkages within and beyond the EU.
With respect to the individual Member’s NAPs, the EC harmonizes the NAPs
with respect to penalties, allocation method (e.g., grandfathering), monitoring, and
registries with the goal of achieving the Kyoto targets. It allows Members flexibility

³³ European Commission, Implementing the Community Strategy to Reduce CO² Emissions
from Cars: Fifth Annual Communication on the Effectiveness of the Strategy (Brussels, June

22, 2005) p. 7.

³⁴ On a like-kind basis. The NAP II cap is actually 482 million metric tons because it
include 11 million tons for facilities covered under the second phase that were not covered
under the first phase.
³⁵ Karoline Rogge, Joachim Schleich, Regina Betz, and Jos Cozijnsen, Increasing the
Ambition of EU Emissions Trading (June 2006), p. 1.
³⁶ Roger Harrabin, BBC environmental analyst, Germany to Spark “Climate Crisis” (June

28, 2006).

with respect to allocations to individual participants, the extent to which banking is
permitted, and whether to permit the auctioning of up to 10% of allowances in the
second trading period. As a result of this framework, there are significant differences
between Members with respect to participant definitions, industry level emissions
caps and allocations, and enforcement.
To increase the economic and administrative efficiency of the ETS, some
stakeholders are interested in improved harmonization of NAPs by the EC. Besides
the issue of new entrants and definition of affected units specifically identified by the
EC survey, harmonization issues include allocation methods and the use of auctions,
the degree to which JI and CDM credits may be used for compliance, and monitoring,
verification, and reporting rules. Table 5 illustrates the scope of potential
harmonization issues facing the EU-ETS.
Table 5: NAP Harmonization Issues
SubjectSource of Member Differences
Definition of allowancesFinancial and tax treatment of allowances
Reliable emissionsInventory standards
inventories
Banking of allowancesWhether and how much banking permitted
Emissions capsStringency of caps and the extent of JI and CDM creditspermitted
Monitoring, verification andProcedures and processes
reporting
AllocationAllocation methods and whether and how muchauctioning permitted
National registriesDesign details
Voluntary participantsWhether to allow pooling or opt-in/opt-out
Definition of mandatoryDefinition of sectors, size, installation, new entrant, and
participantstreatment of closures
Source: Adapted from Fiona Mullins, EU ETS Implementation: Room for Harmonisation
(The Royal Institute of International Affairs, 2005).
One issue of particular interest is the effort to increase the use of
“benchmarking” standards in setting allocations. Benchmarking generally involves
allocating allowances based on best available technology and practices, rather than
on historical emissions. However, the EC does not have the authority to scrutinize
allocations at the facility level, so any allocation harmonization would be on a
voluntary basis (“soft harmonization”). Also, allocation schemes, such as
benchmarking, may not be suitable for some industries.³⁷ The EC’s survey of ETS
stakeholders revealed that although more than two-thirds of the respondents from the

³⁷ For more, see Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness in
the EU Emissions Trading Scheme: Policy Overview,” 6 Climate Policy (2006) pp. 7-30.

cement, aluminum, and chemical industries thought benchmarking was an
“interesting alternative,” less than a third of the respondents from the pulp and paper
industry and refineries thought so.³⁸
In many ways, diversity between Member countries with respect to the ETS is
inevitable. As stated by Grubb and Neuhoff with respect to allocation:
The final way in which the EU ETS differs from many other trading systems is
in the devolution of allocation responsibilities, in this case to its 25 Member
States. This was an essential part of the deal that enabled the adoption of the
Directive: Member States would have never ceded to the European Commission
the power to distribute valuable assets to their industries. Nor is the EU ETS
unique in devolving powers of allocation: it is typical in a number of US systems.
Moreover, there are different degrees of harmonization, applicable to different
aspects of the EU ETS, and the Commission can and does seek to increase the³⁹
degree of harmonization through guidance notes. [footnote omitted]
New Entrants
The economic value of allowances is nowhere more evident than in discussions
of new entrants. Indeed, as noted above, Germany is proposing to permit new coal-
fired powerplants built between 2008-2012 to opt-out of the ETS for the first 14
years of operation in order to encourage construction. In its survey of ETS
stakeholders, the EC found that 85% of all respondents favor a harmonized approach
to new entrants and closures. Nearly 75% believed that those allowances should be⁴⁰
provided free. Likewise, an EU questionnaire conducted by the European
Environmental Agency’s Topic Centre on Air and Climate Change indicated that
most Member States would welcome harmonization of the treatment of new entrants
and closures across the EU.⁴¹
Analogous to the U.S. acid rain program, EU states have set up reserves to
provide allowances to new entrants. In general, these allowances are provided free,
as that is widely seen as helping boost new investment. However, the allocation
methods developed by the Member States differ. Most states have yet to dip into
their reserves for new entrants; however, the importance of the reserve will increase
as the ETS enters its second, and eventually third, trading period. The manner in
which new entrants receive allowances may have a significant effect on the long-term
direction of investment — whether it is directed toward low-carbon opportunities or
used to support continuation of current economic development irrespective of its

³⁸ European Commission, Review of EU Emissions Trading Scheme: Survey Highlights
(November 2005), p. 15.
³⁹ Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness in the EU
Emissions Trading Scheme: Policy Overview,” 6 Climate Policy (2006), p. 17.
⁴⁰ European Commission, Review of EU Emissions Trading Scheme: Survey Highlights
(November 2005), pp. 18-19.
⁴¹ European Environment Agency’s Topic Centre for Air and Climate Change, Application
of the Emissions Trading Directive by EU Member States, (EEA Technical Report No.

2/2006, 2006), p. 30.

carbon intensity. Allocating allowances according to output and not differentiating
according to the carbon intensity of the project would provide an incentive to develop
low carbon alternatives. An example provided by Grubb and Neuhoff:
New entrant reserves should be based on output or capacity, and avoid
differentiating according to the CO²-intensity of the new investment. In
particular, giving more to coal than gas plants rewards investment in new coal
facilities, which would conflict with objectives to tackle climate change, increase
the cost of future emissions reductions, and in the long run could lead to higher
electricity prices. The damaging effects would be amplified if carbon-intensive
new entrants not only receive free allowances for the period 2008-2012 but also⁴²
receive promises for subsequent periods.
The proposed treatment of coal-fired powerplants by the German Government
indicates how difficult it will be to direct future investment toward low-carbon
projects. However, it could be argued that the long-term success of the ETS and the
EU’s commitment to Kyoto and any subsequent agreements rests on such a
redirection with respect to new entrants and long-term investment.
Definition of Affected Units
Another area in which several Member States would like more harmonization
across the EU is the definition of a combustion installation.⁴³ Concerns revolve
around ambiguity in the current definition of a combustion installation and the
number of small installations covered under the ETS. The ETS applies to energy
activities for all sectors with combustion installations above 20 MW of thermal rated
input, oil refineries, coke ovens, and, subject to size criteria, iron and steel, cement,
lime, glass, ceramics, and pulp and paper facilities. However, Finland and Sweden
opted to include small district heating installations with a rated thermal input below⁴⁴
20 MW. In contrast, as noted previously, Germany is attempting to have some
planned coal-fired powerplants, which will be large producers of CO², able to opt-out
of the ETS for 14 years.
In addition to the consistency issue, small installations (between 20MW and

50MW) account for 30% (about 3,000) of the total facilities covered under the ETS,⁴⁵

but a very small percentage of total CO² emissions. Surveying 22 Member States,

⁴² Michael Grubb and Karsten Neuhoff, “Allocation and Competitiveness in the EU
Emissions Trading Scheme: Policy Overview” 6 Climate Policy (2006), p. 22.
⁴³ European Environment Agency’s Topic Centre for Air and Climate Change, Application
of the Emissions Trading Directive by EU Member States (EEA Technical Report No.

2/2006, 2006), p. 30.

⁴⁴ These are generally owned by larger facilities which operate several installations covered
by the ETS. See European Environment Agency’s Topic Centre for Air and Climate
Change, Application of the Emissions Trading Directive by EU Member States (EEA
Technical Report No. 2/2006, 2006), p. 16.
⁴⁵ The installation number is for 22 Member States (Poland did not provide sufficient data).
Emissions estimates were provided by only 14 States. Based on those 14 States, the
(continued...)

36% of the covered installations produced less than 10,000 metric tons of CO²

annually.⁴⁶ The somewhat weak emissions data available at the time of the EU
questionnaire suggest that while three-quarters of all emissions are produced by the
largest 7.5% of installations, the small installations (under 10,000 metric tons) are
responsible for less than 1%. Whether the ETS should continue to cover the roughly

3,500 facilities under 10,000 metric tons annually remains a hotly debated issue.

Expansion of Coverage
In choosing a gradual, incremental approach to emissions trading, the EU is
relying on other programs to control greenhouse gas emissions in other sectors, such
as transportation. The difficulties the EC may encounter in not choosing a
comprehensive approach to begin with is suggested by its survey of stakeholders.
The survey suggests that the future direction of the ETS in terms of increasing
coverage is toward incrementally adding more economic sectors, rather than
addressing the more complex issue of a comprehensive system. Based on the survey,
the focus is currently on the chemical, aviation, and aluminum industries.⁴⁷ Given
that the number-one recommendation for future implementation of the ETS is to
provide participants with a longer time frame for implementation, it is unclear when
the ETS will become as comprehensive as the European Commission would like.
Conclusion
At first glance, the ETS would appear an effective vehicle for the EU to meet
its Kyoto Protocol obligations during the second trading period. The anticipated
deficit between the second trading period for the original 15 Member States can be
covered by trading with the newer Member States that anticipate a surplus. In
addition, potential CERs and ERUs from the CDM and JI respectively may help
maintain limits on allowance costs. Table 6 provides one series of estimates of
available allowances for the Kyoto Protocol’s five-year compliance period.
Obviously, not all these allowances may be available to the EU alone; other
countries, such as Japan and Canada, may decide to incorporate emissions trading
into their implementation strategies and acquire allowances from these sources. Yet,
the totals suggest that all else being equal, the supply of allowances would be
adequate.

⁴⁵ (...continued)
allowance allocations to small installation accounted for about 2% of the total. See
European Environment Agency’s Topic Centre for Air and Climate Change, Application of
the Emissions Trading Directive by EU Member States (EEA Technical Report No. 2/2006,

2006), p. 15.

⁴⁶ European Environment Agency’s Topic Centre for Air and Climate Change, Application
of the Emissions Trading Directive by EU Member States (EEA Technical Report No.

2/2006, 2006).

⁴⁷ European Commission, Review of EU Emissions Trading Scheme (November 2005), p.

11.

Table 6: International Supply of Emissions Credits and
Allowances
(cumulative total 2008-2012, million metric tons CO²)
Source of SupplyLow EstimateHigh Estimate
Clean Development Mechanism (CERs)6801,200
Joint Implementation (ERUs120980
Surplus Kyoto Allowances from Eastern<1,000-3,0008,000
Europe, Russia, and the Ukraine (AAUs)
Source: Compiled by Grubb and Neuhoff, “Allocation and Competitiveness in the EU
Emissions Trading Scheme: Policy Overview,” p. 20.
However, there are other considerations. The availability of surplus credits
created via JI and CDM is restricted by the EC linking directive that requires that
such credits be “supplemental” to a country’s domestic efforts. Each country is to
spell out what “supplemental” means in its NAP for the second trading period.
Individual countries are likely to define that term differently — restricting allowance
trades and purchases in some countries.
Another consideration is the overall commitment of the Kyoto Protocol. As
noted earlier, the ETS only covers a percentage of the overall greenhouse gas
emissions in the various Member States of the EU. Some sectors not covered by the
ETS may grow faster than sectors covered by the ETS, creating difficulties for
compliance. In particular, the transportation area is already a major source of
concern.
A final consideration for the ETS is its suitability for directing long-term
investment toward a low-carbon future — the ultimate goal of any climate change
program. It is too early to tell whether the ETS market signal and individual
countries’ NAPs will move investment in the appropriate direction. The early signs
are not particularly encouraging, with the 2005-2008 NAPs producing an over-
allocation of allowances, and one major Member State, Germany, attempting to
direct its second NAP toward carbon-intensive, coal-fired electric generating
facilities rather than low-carbon alternatives. Reluctance by countries to redirect
their NAPs and an inconsistent price from the ETS make the long-term effect of the
ETS uncertain.

Appendix: Norway’s Trading System
Norway, a non-EU country, also has an emissions trading system that began
operating on January 1, 2005. Norway’s system covers 51 facilities in the energy and
process sectors such as oil refining and iron and steel processing, and has several⁴⁸
features in common with the EU ETS. These sectors account for about 10-15% of
the country’s emissions. Other parts of Norway’s industry, particularly its offshore
oil and gas sector, are covered by the country’s carbon tax of almost 40 euro per
metric tonne of CO² — much higher than the anticipated allowance price under the
trading program. The carbon tax is levied on about 64% of the country’s CO²
emissions — about half the country’s total greenhouse gas emissions.⁴⁹ The first
phase of the trading program covers the period 2005-2007, with a second, expanded
phase to begin in 2008.
Developing its initial trading scheme independently of the EU, Norway’s
“Quota Commission” (created in 1998) stressed that the 2008 program be as
comprehensive as possible, suggesting that the system could include close to 90% of⁵⁰
the country’s greenhouse gas emissions. To achieve this coverage, the Commission
envisioned a hybrid system of quotas, depending on cost-effectiveness and
practicality considerations. Arguing in favor of regulating CO² emissions at the
producer (upstream) level from mobile sources and some stationary sources, the
Quota Commission states:
For these emissions, regulation at the producer level will not create weaker
incentives for reducing emissions than regulation at the consumer level, because
the volume of emissions from a particular commodity is not dependent on
technology. For those process emissions which are recommended for inclusion
in the system, regulation by quotas should be imposed at the end-user level in
cases where the processes originate with major industrial companies. For
process emissions stemming from a series of small sources, e.g. emissions of
N²O from commercial fertilizers, regulation by quotas should be imposed on⁵¹
retailers, or importers in order to avoid unacceptably high system costs.
The Commission’s recommendation that “regulation by quotas be imposed in
part on the producer, in part on the sales or import chain, and in part on the end-⁵²
user” may be overtaken by development of the EU ETS, which is likely to influence

⁴⁸ International Energy Agency, Act Locally, Trade Globally (2005), p. 102.
⁴⁹ Ministry of the Environment, Report 54 to the Storting (2000-2001): Norwegian Climate
Policy, at [http://odin.dep.no/md/engelsk/publ/stmeld/022001-040012/index-dok000-b-n-
a.html]
⁵⁰ Ministry of the Environment, Trading in Greenhouse Gases (press release, Dec. 17, 1999),
at [http://www.odin.no/odinarkiv/english/bondevik_I/md/022001-990070/dok-bn.html].
⁵¹ The Quota Commission, A Quota System for Greenhouse Gases (Dec. 17, 1999), p.7, at
[ h t t p : / / odin.dep.no/odinarkiv/norsk/dep/md/1999/eng/ 022021-220003/index-dok00 0 -b -n -
a.html]
⁵² Ibid., p. 19.

the future direction of Norway’s trading system. The International Energy Agency
(IEA) states:
The government had indicated earlier that it would consider expanding the
[trading] system from 2008 to include as many sources of emissions as practical
through an upstream system allocating allowances to fossil fuel producers and
importers. With the adoption of the EU ETS design features, Norway seems to⁵³
move away from this option.

⁵³ International Energy Agency, Act Locally, Trade Globally (2005), p. 103.