Climate Change: The EU Emissions Trading Scheme (ETS): Kyoto and Beyond

Climate Change and the EU Emissions Trading
Scheme (ETS): Kyoto and Beyond
Updated November 24, 2008
Larry Parker
Specialist in Energy and Environmental Policy
Resources, Science, and Industry Division



Climate Change and the EU Emissions Trading
Scheme (ETS): Kyoto and Beyond
Summary
The European Union’s (EU) Emissions Trading Scheme (ETS) is a cornerstone
of the EU’s efforts to meet its obligation under the Kyoto Protocol. It covers more
than 10,00 energy intensive facilities across the 27 EU Member countries; covered
entities emit about 45% of the EU’s carbon dioxide emissions. A “Phase 1” trading
period began January 1, 2005. A second, Phase 2, trading period began in 2008,
covering the period of the Kyoto Protocol, with a Phase 3 proposed for 2013.
Several positives resulting from the Phase 1 “learning by doing” exercise
assisted the ETS in making the Phase 2 process run more smoothly, including: (1)
greatly improving emissions data, (2) encouraging development of the Kyoto
Protocol’s project-based mechanisms — Clean Development Mechanism (CDM) and
Joint Implementation (JI), and (3) influencing corporate behavior to begin pricing in
the value of allowances in decision-making, particularly in the electric utility sector.
However, several issues that arose during the first phase were not resolved as
the ETS moved into Phase 2, including allocation schemes, shutdown credits and
new entrant reserves, and others. In addition, the expansion of the EU and the
implementation of the directives linking the ETS to the Kyoto Protocol project-based
mechanisms created new issues to which Phase 2 had to respond. A more
comprehensive response to these issues is envisioned for Phase 3.
The United States is not a party to Kyoto. However, almost four years of carbon
emissions trading has given the EU valuable experience in designing and operating
a greenhouse gas trading system. This experience may provide some insight into
cap-and-trade design issues currently being debated in the United States.
!The U.S. requires only electric utilities to monitor CO2. The EU-ETS
experience suggests that expanding similar requirements to all facilities
covered under a cap-and-trade scheme would be pivotal for developing
allocation systems, reduction targets, and enforcement provisions.
!In the U.S. debate on comprehensive versus sector-specific reduction
programs, the EU-ETS experience suggests that adding sectors to a trading
scheme once established may be a slow, contentious process.
!As with most EU industries, most U.S. industry groups either oppose
auctions outright or want them to be supplemental to a base free
allocation. The EU-ETS experience suggests Congress may want to
consider specifying any auction requirement if it wishes to incorporate
market economics more fully into compliance decisions.
!EU-ETS analysis suggests the most important variables in determining
Phase 1 allowance price changes were oil and natural gas price changes;
this apparent linkage raises possible market manipulation issues,
particularly with the inclusion of financial instruments such as options and
futures contracts. Congress may consider whether the government needs
enhanced regulatory and oversight authority over such instruments.



Contents
Overview ........................................................1
National Allocation Plans and the ETS.................................3
Need for Further Emissions Reductions............................5
Need to Adjust ETS Allocations..................................8
Issues Arising in Phase 2 NAPs for the ETS............................10
Supplementarity ..............................................10
Auction Policy...............................................14
New Entrant Reserves.........................................16
Closure Policy...............................................17
Benchmarking ...............................................18
Allocation and Energy Policy...................................20
Looking to Phase III...............................................22
Eliminating NAPs............................................23
Expanding Coverage..........................................24
Auctions ....................................................25
Summary and Considerations for U.S. Cap-and-Trade Proposals............25
Emission Inventories and Target Setting...........................25
Coverage ...................................................26
Allocation Schemes...........................................27
Flexibility and Price Volatility...................................28
List of Figures
Figure 1. ECX CFI Futures Contracts: Price and Volume...................7
Figure 2. EU-15 Greenhouse Gas Emissions and Projections for the
Kyoto Period: 2008-2012........................................9
List of Tables
Table 1. ETS Annual Allocations for Phase 2: 2008-2012..................4
Table 2. JI/CDM Limits for Phase 2: 2008-2012........................11
Table 3. Value of Annual Allocation for New NGCC Powerplant..........17
Table 4. Annual ETS Cap Figures for Proposed Phase 3..................23



Climate Change and the EU Emissions
Trading Scheme (ETS): Kyoto and Beyond
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 and setting emissions objectives for 2008-2012, countries that ratified the
protocol are developing appropriate implementation strategies to begin reducing their1
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 program3
contained in Title IV of the 1990 Clean Act Amendments.
The EU’s Emissions Trading System (ETS) covers more than 10,000 energy
intensive facilities across the 27 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 covers neither CO2 emissions from the transportation sector,
which account for about 25% of the EU’s total greenhouse gas emissions, nor
emissions of non-CO2 greenhouse gases, which account for about 20% of the EU’s4


total greenhouse gas emissions. A “Phase 1” trading period began January 1, 2005.
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 RL33826, Climate Change: The Kyoto
Protocol and International Actions, by Susan Fletcher and Larry Parker.
2 Norway, a non-EU country, also has instituted a CO2 trading system. 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 (November 15, 1990).
4 For further background on the ETS and its first year of operation, see CRS Report
RL33581, Climate Change: The European Union’s Emissions Trading System (EU-ETS),
by Larry Parker.

A second, Phase 2, trading period began January 1, 2008, covering the period of the
Kyoto Protocol, with a Phase 3 planned to begin in 2013.5
Under the Kyoto Protocol, the then-existing 15 nations of the EU agreed to
reduce their aggregate annual average emissions for 2008-2012 by 8% from the
Protocol’s baseline level (mostly 1990 levels) under a collective arrangement called
a “bubble.” By 2006, collective greenhouse gas emissions in the EU were 2.7%
below Kyoto baseline levels (2.2% 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.6 In light of the Kyoto Protocol targets, the EU
adopted a directive establishing the EU-ETS that entered into force October 13,
2003.7 The importance of emissions trading was elevated by the accession of 12
additional central and eastern Europe countries to EU membership from May 2004
through January 2007. Collectively, the 27 Members of the expanded EU’s
greenhouse gas emissions dropped 7.7% from 1990 to 2006.
The EC believes that the Phase 1 “learning by doing” exercise prepared the
community for the difficult task of achieving the reduction requirements of the Kyoto
Protocol. Several positives resulted from the Phase 1 experience that assisted the
ETS in making the Phase 2 process run smoothly, at least so far. First, Phase 1
established much of the critical infrastructure necessary for a functional emission
market, including emissions monitoring, registries, and inventories. Much of the
publicized difficulties the ETS experienced in the first phase can be traced to
inadequate emission data.8 Phase 1 significantly improved those data in preparation
for Phase 2 implementation.
Second, the ETS helped jump-start the project-based mechanisms — Clean
Development Mechanism (CDM) and Joint Implementation (JI) — created under the
Kyoto Protocol.9 As stated by Ellerman and Buchner:


5 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].
6 European Environment Agency, Greenhouse Gas Emissions Trends and Projections in
Europe 2008 (October 2008), p. 5.
7 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.
8 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), pp. 69-70; and, International Emissions Trading Association, “IETA
Position Paper on EU ETS Marking Functioning,” (no date), p. 3.
9 For more on the effect of the ETS on Kyoto mechanisms, see A Denny Ellerman and
Barbara K. Buchner, “The European Union Emissions Trading Scheme: Origins,
Allocations, and Early Results,” 1 Environmental Economics and Policy 1 (Winter 2007),
p. 84; and, International Emissions Trading Association, “IETA Position Paper on EU ETS
Market Functioning,” (no date), p. 2. For more information on the Kyoto Protocol
mechanisms, see CRS Report RL33826, Climate Change: The Kyoto Protocol and
International Actions, by Susan Fletcher and Larry Parker.

The access to external credits provided by the Linking Directive has had an
invigorating effect on the CDM and more generally on CO2 reduction projects
in developing countries, especially in China and India, the two major countries
that will eventually have to become part of a global climate regime if there is to10
be one.
Third, according to the EC, a key result of Phase 1 was its effect on corporate
behavior. An EC survey of stakeholders indicated that many participants are
incorporating the value of allowances in making decisions, particularly in the electric
utility sector where 70% of firms stated they were pricing in the value of allowances
into their daily operations, and 87% into future marginal pricing decisions. All
industries stated that it was a factor in long-term decision-making.11
However, several issues that arose during the first phase remain contentious as
the ETS implements Phase 2, including allocation (including use of auctions and
reliance on model projections), shutdown credits and new entrant reserves, and
others. In addition, the expansion of the EU and the implementation of the linking
directives create new issues to which Phase 2 has had to respond. These new and
continuing challenges for Phase 2 implementation are discussed below.
National Allocation Plans and the ETS
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 second trading period, these NAPs were assessed by the EC to
determine compliance with 12 criteria delineated in an annex to the emissions trading
directive.12 Criteria included requirements that the emissions caps and other
measures proposed by the Member State were sufficient to put it on the path toward
its Kyoto target, protections against discrimination between companies and sectors,
delineation of intended use of CDM and JI credits for compliance, along with
provisions for new entrants, clean technology, and early reduction credits. For the
second trading period, the NAP must guarantee Kyoto compliance.
NAPs for the second trading period were due June 30, 2006. By October 26,
2007, the EC had reviewed and approved (sometimes conditionally) all 27 Member
States’ NAPs. As indicated by Table 1, the EC reduced the proposed allocations of
individual Member States by an average of 10.5% to increase the probability that the
EU will achieve its target under the Kyoto Protocol. The need to reduce the


10 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 84.


11 European Commission, Directorate General for Environment, Review of EU Emissions
Trading Scheme: Survey Highlights, (November 2005), pp. 5-7.
12 Commission of the European Communities, Directive 2003/87/EC, available at
[ h t t p ://eur-l ex.europa.eu/LexUriServ/LexUr iServ.do?uri=OJ :L:2003:275 : 0032:0046:EN:
PDF].

requested allocations reflects both the structure of the ETS and the lessons the EC
learned during the first phase.
Table 1. ETS Annual Allocations for Phase 2: 2008-2012
Member2005EmissionsProposedKyoto CapEC ApprovedKyoto CapApproved asPercent of
State (MMTCO 2 E) (MMTCO 2 E) (MMTCO 2 E) P r oposed
Austria 33.4 32.8 30.7 93.6%
Belgium 55.4 63.3 58.5 92.4%
Bulgaria 40.6 67.6 42.3 62.6%
Czech Rep.82.5101.986.885.2%
Cyprus 5.1 7.12 5.48 77%
Denmark 26.5 24.5 24.5 100%
Estonia 12.62 24.38 12.72 52.2%
Finland 33.1 39.6 37.6 94.8%
France 131.3 132.8 132.8 100%
Germany 474 482 453.1 94%
Gr eece 71.3 75.5 69.1 91.5%
Hungary 26.0 30.7 26.9 87.6%
Ir eland 22.4 22.6 22.3 98.6%
It aly 225.5 209 195.8 93.7%
Latvia 2.9 7.7 3.43 44.5%
Lithuania 6.6 16.6 8.8 53%
Luxembourg 2.6 3.95 2.5 63%
Malta 1.98 2.96 2.1 71%
Netherlands 80.35 90.4 85.8 94.9%
Poland 203.1 284.6 208.5 73.3%
Portugal 36.4 35.9 34.8 96.9%
Roma nia 70.8 95.7 75.9 79.3%
Slovakia 25.2 41.3 30.9 74.8%
Slovenia 8.7 8.3 8.3 100%
Spain 182.6 152.7 152.3 99.7%



Member2005EmissionsProposedKyoto CapEC ApprovedKyoto CapApproved asPercent of
State (MMTCO 2 E) (MMTCO 2 E) (MMTCO 2 E) P r oposed
Sweden 19.3 25.2 22.8 90.5%
UK 242.4 246.2 246.2 100%
T otal 2122.16 2325.34 2080.93 89.5%
Source: European Commission, Emissions Trading: EU-wide cap for 2008-2012 set at 2.08 billion
allowances after assessment of national plans for Bulgaria,” EC Press Release, October 26, 2007.
Need for Further Emissions Reductions
It is unclear to what degree the first phase of the ETS achieved real emissions
reductions. Emissions are dynamic over time; a product of a country’s population,
economic activity, and greenhouse gas intensity.13 To capture these dynamics, the
Member States of the EU develop emissions baselines from models that project
future trends in a country’s emissions based on these and other factors, such as14
anticipated energy and greenhouse gas policies. During the first phase, the
emissions goal was to put the EU on the path to Kyoto compliance — not actually
comply with the Protocol (which wasn’t necessary until the 2008-2012 time period).
Thus, countries developed “business as usual” baselines based on projected growth
in emissions. Such a projected baseline suffers from two sources of uncertainty: data
uncertainties, and forecasting uncertainties. On data, Phase 1 suffered from
uncertainties with respect to data collection and coverage, in monitoring methods for
historic data, and data verification. On projecting future emissions, Phase 1 faced
uncertainties with respect to economic or sector-based growth rates. Fueled in many
cases by over-optimistic economic growth assumptions, these uncertainties increased15
the probability of inflated business as usual baselines.
The combination of these factors and modest reduction requirements resulted
in the emissions allocations for the 2005-2007 trading period being higher than16
actua1 2005 emissions. This result has raised questions about how much reductions
achieved during Phase 1 were real as opposed to being merely paper artifacts. On the
positive side, verified emissions in 2005 were 3.4% below the estimated 2005


13 For more information, see CRS Report RL33970, Greenhouse Gas Emission Drivers:
Population, Economic Development and Growth, and Energy Use, by John Blodgett and
Larry Parker.
14 On the role of modeling in the first phase, see A Denny Ellerman and Barbara K. Buchner,
“The European Union Emissions Trading Scheme: Origins, Allocations, and Early Results,”

1 Environmental Economics and Policy 1 (Winter 2007), pp. 72-73.


15 Regina Betz and Misato Sato, “Emissions Trading: Lessons Learnt from the 1st Phase of
the EU ETS and Prospects for the 2nd Phase,” 6 Climate Policy (2006), p. 354.
16 For a further discussion, see Climate Change: The European Union’s Emissions Trading
System (EU-ETS), CRS Report RL33581, by Larry Parker.

baseline used during the allocation process. In addition, the allowance prices for 2005
stayed persistently high, suggesting some abatement was occurring and raising
questions of “windfall” profits. As stated by Ellerman and Buchner:
First, and most importantly, the persistently high price for EUAs [EU emissions
allowances] in a market characterized by sufficient liquidity and sophisticated
players must be considered as creating a presumption of abatement. It would be
startling if power companies did not incorporate EUA prices into dispatch
decisions that would have shifted generation to less emitting plants. There is
plenty of anecdotal evidence that this was the case, and the prominent charges
of windfall profits assume that the opportunity cost of freely allocated
allowances was being passed on (without noting the implications for abatement).
Similarly, it would be surprising if there were no changes in production17
processes that could be made by the operators of industrial plants.
However, EU emissions allowances (EUAs) during Phase 1 did not maintain
value. Phase 1 EUAs were basically worthless during the final six months of 2007.
This decline in EUA prices at least partially reflected the general non-transferability
of Phase 1 EUAs to Phase 2. Only Poland and France included limited banking in
their Phase 1 NAPs. The EC further restricted use of Phase 1 EUAs in Phase 2 with
a ruling in November, 2006.18 As a result, excess Phase 1 EUAs were worthless at
the end of 2007.19


17 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 83.


18 European Commission, Communication from the Commission to the Council and to the
European Parliament on the assessment of national allocation plans for the allocation of
greenhouse gas emission allowances in the second period of the EU Emissions Trading
Scheme, COM(2006) 725 final, (November 29, 2006), p. 11.
19 For a further discussion, see Joseph Kruger, Wallace E. Oates, and William A. Pizer,
“Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy, 1
Environmental Economics and Policy 1 (Winter 2007), p. 126; and, Frank J. Convery and
Luke Redmond, “Market and Price Development in the European Union Emissions Trading
Scheme, 1 Environmental Economics and Policy 1 (Winter 2007), pp. 96-7, 107.

CRS-7
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Source: ECX Exchange.

One consequence of the non-transferability of Phase 1 EUAs is that prices for
Phase 2 EUAs have been relatively firm, as indicated by Figure 1 above. This
firmness may reflect the ability of the EC to certify Phase 2 NAPs using more
verifiable baseline data than were available for Phase 1.20 Scarcity is critical for the
proper functioning of an allowance market. A major reason the EC rejected ex post
adjustments21 was fear that such adjustments would have a disruptive effect on the2223
marketplace. Phase 1 did not firmly establish this foundation of markets; based on
the Phase 2 EUA future’s market, further market development appears to be
occurring, although several challenges to that development will be discussed later.
Need to Adjust ETS Allocations
While the environmental performance of Phase 1 may be disputed, the need for
additional reductions to achieve Kyoto is not. As indicated by the orange line in
Figure 2, the European Environment Agency (EEA) projects that the EU-15 existing
measures will halt the projected increase in greenhouse gases; however, as indicated
by the red line, they are insufficient to reduce EU-15 emissions to their Kyoto
requirements that began in 2008. To achieve this target the EU envisions three
actions: (1) further reductions by EU-15 countries, (2) the use of Kyoto mechanisms
(Joint Implementation (JI) and Clean Development Mechanism (CDM); and, (3) the
use of carbon sinks.24 As indicated by the blue line, the EEA projects EU-15


20 International Emissions Trading Association, “IETA Position Paper on EU ETS Market
Functioning,” (no date), p. 2.
21 Once the EC has approved a country’s NAP, including the total number of allowances and
the allocation to each covered entity, the allocations can not be re-visited. Attempts to
include provisions permitting such post-approval adjustments to a facility’s allocation have
been uniformly rejected by the EC.
22 European Commission, Communication from the Commission to the Council and to the
European Parliament on the assessment of national allocation plans for the allocation of
greenhouse gas emission allowances in the second period of the EU Emissions Trading
Scheme, COM(2006) 725 final, (November 29, 2006), p 8; and, A Denny Ellerman and
Barbara K. Buchner, “The European Union Emissions Trading Scheme: Origins,
Allocations, and Early Results,” 1 Environmental Economics and Policy 1 (Winter 2007),
p. 71.
23 On the mixed record of the EU-ETS and the need for allowance scarcity to a functioning
emissions market, see Eric Haymann, EU Emission Trading: Allocation Battles Intensifying,
Deutsche Bank Research (March 6, 2007). For a generally positive view of ETS market
development, see Frank J. Convery and Luke Redmond, “Market and Price Development
in the European Union Emissions Trading Scheme, 1 Environmental Economics and Policy
1 (Winter 2007), pp. 97-106. For a more negative view, see Karsten Neuhoff, Federico
Ferrario, Michael Grubb, Etienne Gabel, and Kim Keats, “Emissions Projections 2008-2012
Versus NAPs II,” 6 Climate Policy 5 (2006), pp. 395-410.
24 For more information on the Kyoto Protocol mechanisms, see CRS Report RL33826,
Climate Change: The Kyoto Protocol, Bali ‘Action Plan,’ and International Actions, by
Susan Fletcher and Larry Parker.

emissions at 11.3% below Kyoto baseline levels by 2010 — 3.3 percentage points
below its commitment of 8%.25
Figure 2. EU-15 Greenhouse Gas Emissions and Projections for the
Kyoto Period: 2008-2012


Source: European Environmental Agency, Greenhouse Gas Emissions Trends and Projects in Europe
2008, (October 2008) p. 5.
As discussed earlier, the EU-27 as a whole does not have an emissions target
comparable to the EU-15 bubble. By 2010, EU-27 emissions are projected at 7.7%
below Kyoto baseline levels assuming current policies. This reduction is projected
at 10% if additional measures are included. Currently, 22 of the 25 countries with26
reduction requirements are projected to meet them. Only three countries are not
projected to meet their requirements even with additional planned measures:27
Denmark, Italy, and Spain.
25 European Environment Agency, Greenhouse Gas Emissions Trends and Projections in
Europe 2008, (October 2008) p. 5.
26 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Luxembourg, Netherlands,
Portugal, Sweden, United Kingdom, Bulgaria, Czech Republic, Estonia, Hungary, Latvia,
Lithuania, Poland, Romania, Slovak Republic, and Slovenia. Cyprus and Malta are not
Annex 1 countries.
27 European Environmental Agency, Greenhouse Gas Emission Trends and Projections in
Europe 2008 (October 2008), p. 9.

As indicated by Table 1 earlier, part of the EC response to the need for
additional measures to meet the Kyoto requirements was to reduce Member States’
proposed ETS allocations. In the case of new Members, these reductions were
substantial in some cases. Only four countries — Denmark, France, Slovenia, and
the United Kingdom — had no reductions made in their proposed ETS allocations.
Other responses include an EC-approved proposal to impose mandatory CO228
emissions standards on light-duty vehicles.
Issues Arising in Phase 2 NAPs for the ETS
Supplementarity
As noted earlier, for Phase 2, the EC has issued a linking directive permitting
the use of Kyoto mechanisms for compliance. Including the linking directive has had
beneficial effects on the development of JI and CDM markets and more generally on29
CO2 reduction projects in the developing world.
This emerging JI/CDM supply has the potential to largely compensate for the
projected EU-15 shortfall in meeting the Kyoto Protocol requirements.30 According
to the World Bank, the estimated aggregate shortfall (“distance to target”) for the EU-

15 for Phase 2 ranges from 900-1,500 million metric tonnes of CO2e (CO2


equivalent) with an average estimate of 1,250 million. This represents an 8%-10%
further reduction from projected levels and is in line with the EU estimated shortfall31
discussed above. The World Bank cites estimates that 1,000-1,200 million metric
tonnes of CO2e credits from CDM and JI projects are likely to be imported into the
EU-ETS: “Put in perspective, it means that installations, using credits from CDM and
JI, could be in a balanced position or a marginally short one. In the latter case, fuel32


switching would help bridge the gap.”
28 See European Commission, Proposal for a Regulation of the European Parliament and
of the Council: Setting emission performance standards for new passenger cars as part of
the Community’s integrated approach to reduce CO2 emissions form light-duty vehicles,
COM(2007) 856 final (December 19, 2007); and, European Commission, Results of the
review of the Community Strategy to reduce CO2 emissions from passenger cars and light-
commercial vehicles, (Brussels, February 7, 2007).
29 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy
1 (Winter 2007), p. 84. Also, see International Emissions Trading Association, “IETA
Position Paper on EU ETS Market Functioning,” (no date), p. 2.
30 The ten other Annex 1 EU countries (mostly Eastern European “economies in transition”)
are estimated by the World Bank to have an excess of Assigned Amount Units (AAUs) of
700-1,500 million metric tonnes of CO2e. The two other EU countries — Cyprus and Malta
— are non-Annex 1 countries.
31 The World Bank, State and Trends of the Carbon Market 2007, (Washington, D.C., May

2007) pp. 14-16, 39-40.


32 Ibid., p. 16.

However, a potential barrier to this scenario is the “supplementarity”
requirements of the Kyoto Protocol which is embodied in criterion 12 of the EC NAP
approval process. Supplementarity requires that developed countries, such as most
EU countries, ensure that their use of JI/CDM credits is supplemental to their own
domestic control efforts. In defining supplementarity for Phase 2, the EC used 10%
of a country’s allowance allocation as a rule of thumb in approving NAPs — with a
greater limit possible based on a country’s domestic efforts to reduce emissions. As
indicated in Table 2, this process resulted in some significant reductions in some
countries’ proposed limits (e.g., Ireland, Poland, Spain), but some increase in others
(e.g., Italy, Latvia, Lithuania). Although these reductions appear substantial in
individual cases, most analysts agree that they do not represent a major barrier to the
cost-effective use of JI/CDM. As stated by the World Bank:
The Commission assessed NAPs for imports of carbon assets (including planned
and substantiated governmental purchases) ostensibly with a view to limit
imports to no more than 50% of the “expected distance to target” for each
Member State. According to the vast majority of analysts, this does not place
any practical constraints on the demand for CDM/JI from EU installations: The
market received the November 2006 EU decision to impose tighter caps with an
immediate increase in the price of EUA-II, while uncertainty at that time about
supplementarity caps immediately dampened prices for CERs [i.e., CDM credits]
(secondary CER market reacted more quickly than the more stable primary33
market).
Table 2. JI/CDM Limits for Phase 2: 2008-2012
Member StateProposed JI/CDM Limit(% of allocation)Approved JI/CDM Limit(% of allocation)
Austria20%10%
Belgium8%8.4%
Bulgaria 20% 12.6%
Czech Rep.10%10%
Cyprus(not included)10%
Denmark19%17%
Estonia00
Finland12%10%
France10%13.5%
Germany12%20%
Greece9%9%


33 Ibid., p. 16.

Member StateProposed JI/CDM Limit(% of allocation)Approved JI/CDM Limit(% of allocation)
Hungary10%10%
Ireland50%10%
Italy25%15%
Latvia5%10%
Lithuania9%20%
Luxembourg 10% 10%
Malta(not included)(to be determined)
Netherlands 12% 10%
Poland25%10%
Portugal10% (50% in some cases)10%
Romania10%10%
Slovakia7%7%
Slovenia(not included)15.8%
Spain39%20%
Sweden20%10%
United Kingdom8%8%
Source: Source: European Commission, “Emissions Trading: EU-wide cap for 2008-2012 set at 2.08
billion allowances after assessment of national plans for Bulgaria,” EC Press Release, October 26,
2007. Proposed JI/CDM Limits from Cambridge University, Second Phase National Allocation
Plans: A Comparative Analysis, at [http://www.econ.cam.ac.uk/research/tsec/euets/].
The advantage of EU access to the JI/CDM market is lower costs under current
market conditions. Guaranteed CDM and JI credits are currently selling at a 10%-
30% discount to EUAs, a discount that reflects risks involved in CDM/JI
transactions. The degree to which this discount continues depends to some degree on
the efforts of participating governments and the CDM and JI Executive Boards to
streamline procedures and regulations, firm up methodological assessments, and
integrate the different markets. The Chinese government has set a credit price floor
of 8-9 euro — price setting that reflects its dominant role in the CDM market.34 The
ability of CDM host countries to raise this floor to reflect more fully the 15-25 euro
EUA price depends on supply. In contrast to the World Bank, Point Carbon reports
that its survey of respondents claimed that CDM/JI supply will be insufficient to meet
EU demand. As a result, price will be set by the marginal cost of EU domestic


34 In 2006, China supplied 70% of CDM credits. Point Carbon, Carbon 2007, (March 13,

2007), p. 18.



emissions reductions (which in turn sets the ceiling on EUA prices). The availability
of JI/CDM credits will reduce that marginal cost (reducing the price of EUAs), but
the survey suggests that JI/CDM prices are likely to rise.35 In contrast, if the JI/CDM
availability exceeds the need of the EU, the price would be set by the marginal cost
of JI/CDM credit supply — a considerably lower price as reflected by the Chinese
price floor.
Some observers praise the broadening and increased flexibility that CDM and
JI represent in helping Annex 1 countries meet their Kyoto requirements. The World
Bank argues that the flexibility enshrined in the Kyoto flexibility mechanisms and
other market mechanisms (e.g., banking) is a better “safety valve” for cost concerns
than a price cap as suggested in some U.S. legislation. As stated by the World Bank:
Flexibility is key to ensuring that there is a built-in safety valve for compliance
without resort to market distortion through price caps.... It would be appropriate
to recall here that flexibility is not the goal of climate policy; rather it is a tool
to help achieve the most stringent targets. In this regard, the use of flexibility
mechanisms in Phase II coupled with much stronger reductions in Phase III and
the unilateral European target announced for 2020 should be at stringent enough
levels that can help stimulate a low carbon clean investment future. Setting an
arbitrary price cap distorts the level of innovation required to meet the
compliance target and dilutes the ability to meet the environment target [footnote36
omitted].
In contrast, some environmental groups are concerned that widespread use of
CDM and JI will prevent the investment in domestic efforts that the Kyoto Protocol
envisioned and that will be necessary as emission caps become more stringent and
more countries participate.37 In addition to concerns about the volume of outside
credits that may be used in the ETS, there are issues over the quality of the credits,
particularly with respect to “additionality” — the requirement in the Kyoto Protocol
that project credits represent reductions that would not have occurred in the absence
of the CDM program. In expressing concern about CDM not being additional to
current policies, WWF-UK states: “It is important to remember that CDM projects
do not themselves reduce net global greenhouse gas emissions — they merely allow
the project investor to pollute more at home. Ensuring that projects are additional is
therefore crucial to maintaining the environmental integrity of the whole system as
a breach of this means that global emissions actually increase.”38 Such concerns may
prevent full exploitation of CDM opportunities for some time.


35 Ibid., p. 42.
36 The World Bank, State and Trends of the Carbon Market 2007 (Washington, DC, May

2007), p. 39.


37 For example, see World Wildlife Fund — UK, Emission Impossible: Access to JI/CDM
Credits in phase II of the EU Emissions Trading Scheme (June, 2007).
38 Ibid., p. 7.

For Phase 2, eleven EU countries have announced their intention to use Kyoto
mechanisms to meet their commitments: Austria, Belgium, Denmark, Finland,
Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, and Slovenia.39
Auction Policy
In general, allowances have been allocated free to participating entities under
the ETS. During Phase 1, The EU-ETS Directive allowed countries to auction up to
5% of allowance allocations, rising to 10% under Phase 2.40 Under Phase 1, only
four of twenty-five countries used auctions at all, and only Denmark auctioned the
full 5%. The political difficulty in instituting significant auctioning into ETS
allowance allocations is the almost universal agreement by covered entities in favor
of free allocation of allowances and opposition to auctions.41 Free allocation of
allowances represents a one-time transfer of wealth to the entities receiving them
from the government issuing them.42 The resulting transfer of wealth has been
described by several analysts as “windfall profits.”43 As summarized by Ellerman and
Buchner: “Allocation in the EU ETS provides one more example that,
notwithstanding the advice of economists, the free allocation of allowances is not to
be easily set aside.”44
Despite concerns about windfall profits and economic distortions resulting from
the free allocation of allowances, there is little change in basic allocation philosophy
for Phase 2. No country proposed auctioning the maximum percentage of allowances
allowed (10%). Most do not include auctions at all.45 The unwillingness of
governments to employ auctions as an allocating mechanism revolve around equity
considerations, including: (1) inability of some covered entities to pass through cost
because of regulation or exposure to international competition; (2) potential drag on


39 European Environmental Agency, Greenhouse Gas Emission Trends and Projections in
Europe 2008 (October 2008), p. 9.
40 For a further discussion of auctioning and the ETS, see Cameron Hepburn, et. al.,
“Auctioning of EU ETS phase II allowances: how and why?” 6 Climate Policy (2006), pp.

137-160.


41 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 73.


42 Joseph Kruger, Wallace E. Oates, and William A. Pizer, “Decentralization in the EU
Emissions Trading Scheme and Lessons for Global Policy,” 1 Environmental Economics
and Policy 1 (Winter 2007), p. 114.
43 E.g., Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying,
(March 6, 2007) pp. 2-3; and, Regina Betz and Misato Sato, “Emissions Trading: Lessons
Learnt from the 1st Phase of the EU ETS and Prospects for the 2nd Phase”, 6 Climate Policy
(2006), p. 353.
44 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 85.


45 For a review of proposed NAP 2 auction proposals as of January 12, 2007, see Karsten
Neuhoff, EU ETS Auction Workshop, (Cambridge, January 12th, 2007), p. 26.

a sector’s economic performance from the up-front cost of auctioned allowances;
and, (3) the potential that government will not recycle revenues to alleviate
compliance costs, international competitiveness impacts, or other equity concerns,
resulting in the auction costs being the same as a tax.46
Against these concerns, economic analysis provides several arguments in favor
of auctions in general, and in the case of the EU ETS in particular. General
arguments in favor of auctions include:47
!Purest embodiment of the “polluter pays” principle;
!Reduces distributional distortions that free allocation (and
accompanying “windfall profits”) can create;
!Creates a “level playing field” for existing and new covered entities;
!Gives the potential for reducing the impact of compliance on the
economy as a whole if auction revenues are used to reduce more
distorting taxes on investment (i.e., “double dividend”); and
!Can improve emission market liquidity and transparency.
In the case of the EU-ETS, the use of free allocations rather than auctions has
created some perverse incentives for covered entities and unnecessary complexity to
the ETS. As discussed later in more detail, providing allowances free to existing
entities can encourage the continued use of inefficient plant, and reduce the incentive
for investing in efficiency improvements. The degree to which this occurs depends
on the specific allocation approach taken. In contrast, an auction can help create a
price floor, particularly if coupled with a reserve price, that encourages development
of new technologies and efficiency improvements in existing plant.
A free allocation scheme generally has to make some provision for new entrants
in addition to allocating allowances to existing entities. It also raises issues with
respect to existing sources that later decide to shutdown. This added complexity to
the ETS is discussed next.
New Entrant Reserves
Unlike previous cap-and-trade programs, the Member States of the EU have
included provisions for the allocation of allowances to new entrants to the system.48


46 Martina Priebe, Distributional Effect of Carbon-allowance Trading, (Cambridge, January

12, 2007). Also, see Eurochambres, Review of the EU Emission Trading System (June,


2007), p. 5.


47 Michael Grubb, The Growing Role of Auctioning in the Economy? Or Allocation Theory
and the Practice in Europe: the Great Divide, (Paris, September 25, 2006), p 4.
48 For example, the U.S. acid rain program provides no allocation of allowances to new
(continued...)

The reasoning behind this decision is based on equity: (1) it isn’t fair to allocate
allowances free to existing entities while requiring new entrants to purchase them,
and (2) the EU doesn’t want to put Member States at a disadvantage in competing
for new investments.49 These equity concerns trumped concerns about economic
efficiency.
As is the case for existing entities, the free allocation of allowances to new
entrants is a subsidy. For the ETS, the size and distribution of this subsidy is left to
the individual Member States. For Phase 1, the reserve varied widely from the
average of 3% of total allowances: Poland set aside only 0.4% of its allocation for
new entrants while Malta set aside 26%. For Phase 2, the spread continues with
Poland reserving 3.2% of its allowances for new entrants in contrast to 45% proposed
by Latvia.50
The decision to employ a new entrant reserve adds complexity to Member
States’ allocation plans and influences the investment decisions of covered entities.
Rules have to be promulgated with respect to the reserve’s size, manner in which the
allowances are dispensed, and how to proceed if the demand either exceeds the
supply, or vice versa. As indicated, countries have not harmonized new entrant
reserve rules with respect to size. Likewise, there is no standardization on dispensing
allowances and replenishing the reserve: first-come, first-serve with no replenishment
is one approach used, but a variety of procedures have been developed both to
dispense allowances and to replenish the reserve if supply is inadequate.51 Member
States also have different formulas for determining how many allowances a new
entrant should receive. Member States claim to use a form of “benchmarking” to
determine allowance allocations — an approach based on a standard of “best
practices” or “best technology” that is applied to the new entrant’s anticipated
production or capacity. However, the definitions and application of the benchmarks
used by the Member States are not uniform.
This diversity in approaches to addressing new entrants results in technology or
fuel-specific subsidies, which vary by country. Table 3 presents the results of a study
of the value of annual allocations for a natural gas combined-cycle power plant under
different countries’ Phase 2 new entrant allocation rules. Assuming an allowance
value of 10 euro, the plant’s allocation would vary between 0 in Sweden (no free


48 (...continued)
entrants; instead, an EPA sanctioned auction is held annually to ensure that allowances are
available to new entrants. New entrants can also obtain allowances from existing sources
willing to sell them, either directly, through the EPA auction, or via a broker.
49 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 75.


50 Karoline Rogge, Joachim Schleich, and Regina Betz, An Early Assessment of National
Allocation Plans for Phase 2 of EU Emission Trading, Fraunhofer Institute System and
Innovation Research (January 2006).
51 For a summary of 18 proposed NAPs with respect to new entrant reserves, see ibid., pp.

46-47.



allocation) to 11 million euro annually in Germany.52 At the current Phase 2
allowance price of 20 euro, this annual subsidy is equivalent to the fixed annual costs
of the power plant.53 Subsidies of this magnitude are likely to affect investment
decisions. As noted by Schleich, Betz, and Rogge, these subsidies: “run counter to
the logic of emission trading systems, where market prices and flexibility are
supposed to guide investment decisions rather than subsidies for particular types of
installations.”54
Table 3. Value of Annual Allocation for New NGCC Powerplant
(millions of euro, allowance price of 10 euro)
CountryValue of Free Allocation
Finland2.7
Germany11.0
Latvia8.3
Lithuania10.0
Poland10.3
Sweden0.0
Source: Markus Ahman and Kristina Holmgren, “New entrant allocation in the Nordic energy sectors:
incentives and options in the EU ETS,” 6 Climate Policy (2006), p. 430.
Closure Policy
The reverse side of the new entrant allocation issue is the what to do with the
allocations to existing plants that shut down. Under U.S. cap-and-trade programs,
those allowances are retained by the company, based on the assumption that a new
power plant will be built to replace the closed one. For most countries in the ETS,
closure policy is directly linked to the new entrant reserve: allowances allocated to
existing sources that shut down are fed into the entrant reserve to be allocated to new
sources. Thus, free allowances to existing facilities are tied to continued operation
of that facility. One reason for this approach may be the multiple country aspect of
the ETS and the political fear that owners of facilities could shut down plants in one
country, keep the allowance allocation, and move to another Member State.55


52 Markus Ahman and Kristina Holmgren, “New entrant allocation in the Nordic energy
sectors: incentives and options in the EU ETS,” 6 Climate Policy (2006), p. 430.
53 Ibid., p. 431. Estimated at 19.5 million euro (2003$).
54 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better Job
Second Time Around? Fraunhofer Institute System and Innovation Research (February,

2007), p. 23.


55 Ibid., p. 19.

Unfortunately, this closure policy encourages inefficient facilities to continue
operating to maintain the subsidy that the free allowance allocation represents. As
examined by Ahman, et al.:
The withdrawal of allocation based on reduced economic activity or closure
makes the loss of the allocation into an additional opportunity cost affecting the
production decision. In considering the marginal cost of operation, the firm will
recognize that it receives the allocation if and only if it continues to operate.
Consequently, the firm will not maximize its profits only with respect to the cost
of production (including resource cost and the opportunity cost of allowances);
in addition, it will take into account the value of the allowances that it will lose
should it cease to produce output. Imposing a condition that the allocation
depends on continued operation of the installation transform the allocation into56
a production subsidy [footnote omitted].
One response to the perverse incentives of the closure rule has been pioneered
by Germany and adopted by a few countries. Under the “transfer rule,” owners of
existing facilities being shut down can transfer the allocation from that facility to a
new replacement facility.57 For Phase 1, seven countries — Germany, Greece,
Hungary, Luxembourg, the Netherlands, Poland, and the UK — included transfer
rules in their NAP. For Phase 2, Cyprus, Flanders (part of Belgium), and Malta have
joined in including such rules in their NAPs.58
Benchmarking
A third aspect of free allocation is benchmarking. As noted earlier, for new
entrants benchmarking involves allocating allowances based on a standard of “best
practices” or “best technology” that is applied to the new entrant’s anticipated
production or capacity. Environmental and other groups have advocated the
expansion of benchmarking to allocations for existing facilities in addition to new
entrants. However, benchmarking is very difficult given the diversity of processes
involved and subject to manipulation in favor of one technology or fuel-source over
another. For example, The Netherlands made a serous attempt to use benchmarks in
its allocation scheme, but abandoned the effort after 125 benchmarks were
developed.59
Benchmarks can also be used to encourage investment in one fuel-source over
another. This issue has arisen in the case of Germany’s proposed Phase 2 NAP. As


56 Markus Ahman, Dallas Burtraw, Joseph Kruger, Lars Zetterberg, “A Ten-Year Rule to
guide the allocation of EU emission allowances,” 35 Energy Policy (2007), p. 1721.
57 For a further discussion of the German NAP II, see Christoph Kuhleis, The German NAP
II (London, September 13, 2006).
58 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February,

2007), p. 19.


59 A Denny Ellerman and Barbara K. Buchner, “The European Union Emissions Trading
Scheme: Origins, Allocations, and Early Results,” 1 Environmental Economics and Policy

1 (Winter 2007), p. 77.



part of Germany’s overall energy policy, the NAP provides for the “fuel-neutral”
allocation of allowances to new powerplants based on benchmarks reflecting current
best practice for each fuel. For a coal-fired facility, the benchmark is 750 grams
CO2/Kwh reflecting a conversion efficiency of 45%. For natural gas-fired facility, the
benchmark is 365 grams CO2/Kwh, reflecting a conversion efficiency of 55%. These
are benchmarks that current technology can achieve without the addition of any
carbon capture and sequestration technology or purchase of offsets from other
sources. In addition, the government proposed to provide new entrants with a
guaranteed allocation of allowances based on actual emissions for 10 years after a 4
year allocation based on an 85% capacity factor. As a result, the NAP would provide
almost no incentive to utilities to reduce CO2 emissions by fuel shifting, and to
essentially encourage the use of lignite — Germany’s most abundant and least
expensive fossil fuel.60 This policy reflects concerns about Germany becoming too
dependent on imported Russian natural gas, the price of which tracks oil.61 Indeed,
economic analysis suggests that the price of an EUA would have to reach 45 euro
before lower-carbon emitting natural gas-fired facilities become more economic than
coal.62 As summarized by German utility RWE’s chief financial officer:
The name of our oil is lignite. We want to develop this energy source using new
technology and based on environmentally friendly processes. However,63
governments will have to create the right political framework for this to occur.
In reviewing the German proposed NAP, the EC disapproved the guarantee of
allowances to new entrants that extended beyond the Kyoto compliance period
(2008-2012), but approved the fuel-specific allocation formulas.64
Allocation and Energy Policy
As suggested above, the conflict between national energy policies and the free
workings of a carbon market are reflected in most countries’ allocation schemes. The
combination of free allocations to existing facilities and new entrants, along with


60 Klaus Traube, Germany’s NAP — Perspectives of Concerned Actors, (Salzburg,
September 30, 2004), p. 5. As noted by the EC: this approach”encourages investment in new
power plants but not automatically in low CO2 emitting ones.” European Commission,
Questions and Answers on Emissions Trading and National Allocation Plants for 2008 to

2012 (Brussels, November 29, 2006) p. 4.


61 Reported by Vera Eckert, “Germany’s Coal Power Plans Threaten EU Climate Goal,”
Reuter News Service, (May 15, 2007).
62 Analysis by Booz Allen as reported by Vera Eckert, “Germany’s Coal Power Plans
Threaten EU Climate Goal,” Reuter News Service, (May 15, 2007).
63 Statement of Klaus Sturany, “RWE Slams German NAP Decision,” Carbon Finance,
(March 16, 2007), p. 1.
64 European Commission, On the assessment of National Allocation Plans for the allocation
of greenhouse gas emission allowances in the second period of the EU Emission Trading
Scheme accompanying Commission Decision of 29 November 2006 on the National
Allocation Plans of Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta,
Slovakia, Sweden and the United Kingdom in accordance with Directive 2003/87/EC.
(Brussels, November 29, 2006).

closure and benchmarking policies, allow countries to maintain substantial control
over energy policy and related economic investment regardless of the price signals
the carbon market might send if the market economics of carbon emission reductions
were the sole determinant of future investments. This control has been used to
preserve existing investment and jobs, encourage exploitation of domestic resources
(e.g., coal, lignite) and lower energy prices. Economists argue that such a strategy
is based on an economic misconception about how prices are set,65 and is inherently
contradictory. As stated by Deutsche Bank Research:
The political objective frequently expressed in both the EU and Germany of
achieving lower energy prices at the same time as implementing climate
protection measures should be rejected. The objectives of climate protection and
lower energy prices (for fossil fuels) are contradictory. Higher energy prices are
desirable from an ecological point of view. Although more competition in the
electricity and gas sectors could — ceteris paribus — lead to a reduction in
prices, this will probably be more than outweighed in the medium term by rising
commodity prices and higher fiscal burdens. In this respect, more honesty is66
needed from all parties.
The EC has put some limitations on countries’ efforts to influence investment,
including disallowing any ex post adjustments and allowance guarantees. As noted
above, the EC explicitly disallows any provision of a country’s NAP that guarantees
allowances to covered entities beyond the phase for which the allowances are
allocated. The EC argues that allocation guarantees give such installations an unfair67
advantage over other installations that do not get such guarantees.
Proponents of allocation guarantees argue it is difficult to plan new investment
based on five-year allowance allocations.68 Yet, it is precisely the long term effects
of new investments and the potential that they will lock-in high carbon emitting
technologies that worry some, including the EC and member governments. As stated
in the Stern Review:
The next 10 to 20 years will be a period of transition, from a world where
carbon-pricing schemes are in their infancy, to one where carbon pricing is


65 As stated by Cameron Hepburn, et al., in the context of auctions: “One of the widest
economic misconceptions about auctioning is that it would simply add costs which would
be passed through to ‘downstream’ companies and consumers. [footnoted example omitted].
Yet, if firms maximize profits, then even with free allocation they pass on the opportunity
costs of allowances to downstream prices. Changing from free allocation to auctioning will
have little impact on product prices. [further explanatory footnote omitted] However,
because auctioning raises revenue that may be reallocated, it has, prima facie, the potential
to correct distributional impacts.” Cameron Hepburn, et al., “Auctioning of EU ETS phase
II allowances: how and why?” 6 Climate Policy (2006), p. 140.
66 Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying (March

6, 2007) p. 8.


67 European Commission, Questions and Answers on Emissions Trading and National
Allocation Plans for 2008 to 2012 (Brussels, November 29, 2006), pp. 3-4.
68 For example, see “RWE slams German NAP decision,” Reported in Carbon Finance
(March 16, 2007).

universal and is automatically factored into decision making. In this transitional
period, while the credibility of policy is still being established and the
international framework is taking shape, it is critical that governments consider
how to avoid the risks of locking into a high-carbon infrastructure, including
considering whether any additional measures may be justified to reduce the69
risks.
Avoiding locking-in high carbon energy technology by encouraging deployment
of advanced low carbon energy technology under the ETS would involve two
elements: (1) reducing behavioral distortion resulting from the current free allocation
system, and (2) energy pricing that reflects carbon costs. As indicated by the previous
discussions, the NAP 2 submitted to and approved by the EC generally have not
reduced the distortions from the free allowance system. The primary means of
reducing such distortions would be to increase the use of auctions and/or by more
extensive use of benchmarking based on capacity alone (not differentiated by fuel
source). As indicated above, no country has submitted a NAP that requires the full
10% auctioning allowed by the EC for Phase 2, although the number of countries
auctioning at least some percentage of their allocations has grown from four in Phase
1 to nine in Phase 2. In addition, the EC allows countries to institute or expand
auctions at any time without its pre-approval. Uniform benchmarks are also rare with
only four countries intending to use them to any significant degree.70
With respect to a price signal for energy development, the Phase 1 experience
was instructive with respect to the value of accurate emissions inventories and
registries, but not in terms of developing a price floor that would stimulate
development of new technology. One mechanism to develop such a floor, banking,
was not used extensively during Phase 1; indeed, as noted earlier, the lack of Phase
1 to Phase 2 banking contributed to the collapse in Phase 1 prices in 2007. It is likely
to be far more important in Phase 2.
In the context of the ETS, options to provide a price floor beyond banking
include expanding use of auctions (including incorporating a reserve price into
auctions), financial instruments (such as options and futures contracts), and
expansion of industries covered by the ETS. The EC is moving very slowly with
respect to auctions, despite support for them by environmental groups and
economists. Financial instruments are being made available to entities by the major


69 Nicholas Stern, The Economics of Climate Change: The Stern Review (Cambridge, 2006),
p. xix. As stated by the EC with respect to fossil fuel power plants: “The expectations of
higher costs associated with CCS-equipped power plants after 2020 give rise to a tangible
risk. This is the risk of a “non-CCS technology lock-in” as the result of ill-considered
investment decisions with respect to the coal-fired capacity due for replacement in the
coming 10-15 years. It is imperative to avoid a situation where much of the new build
before 2020 is undertaken in a way that would either preclude or insufficiently guarantee
the addition of CCS components on a sufficiently wide scale after 2020.” European
Commission, Sustainable power generation from fossil fuels: aiming for near-zero
emissions from coal after 2020 (Brussels, January 10, 2007), p. 7.
70 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February

2007), p. 17.



emission exchange, although not extensively used as of yet.71 It is the third option,
expanding coverage, that the EU has stated as an important goal for Phase 3.72
With respect to longer-term planning and investment, the EC apparently agrees
that a five-year allowance allocation may be too short and believes that in order to
provide greater predictability for long-term investment decisions, a longer allocation
period should be considered for Phase 3.73
Looking to Phase III
The European Union is committed to achieving a 20% reduction in greenhouse
gas emissions by 2020 from 1990 levels. A strategic component of the effort to
achieve this target is a revised ETS. Table 4 indicates the proposed EU-wide ETS
cap for the next Phase of EU greenhouse gas program (Phase 3). As indicated, the EC
envisions a linear reduction in the ETS cap to match the reductions target under the
overall 20% reduction program. These numbers will change as individual countries
decide to include more facilities under the ETS and as the EC expands ETS coverage
to include other sectors and non-CO2 greenhouse gases. The following discusses
some of the major changes the EU envisions for the ETS in responding to this
aggressive target.


71 For example, see European Climate Exchange, The Carbon Market: How to Trade ECX
Emissions Contracts (July 2007).
72 European Commission, Limiting Global Change to 2 degrees Celsius: The Way Ahead for

2020 and Beyond (Brussels, January 10, 2007), pp. 6-7.


73 Ibid., p. 6.

Table 4. Annual ETS Cap Figures for Proposed Phase 3
YearBillion metric tonsof CO2e
Annual limit for Kyoto compliance period (2008-2012)2.083
20131.974
20141.937
20151.901
20161.865
20171.829
20181.792
20191.756
20201.720
Source: European Commission, Questions and Answers on the Commission’s Proposal to revise the
EU Emissions Trading System, (Brussels, January 23, 2009), response to question 12.
Note: Figures are based on the current Phase 2 scope of the ETS. These need to be adjusted for three
reasons: (1) extensions of ETS scope during phase 2 by Member states; (2) extensions of ETS scope
by the EC for third trading period, and (3) the figures do not include inclusion of aviation, nor the
emissions from Norway, Iceland, and Liechtenstein — non-EU countries that have linked their
programs to the ETS.
Eliminating NAPs
The EC is proposing to re-shape the ETS to improve its efficiency and eliminate
some of the problems discussed above.74 The improved emissions inventories
resulting from Phase 1 allowed the EC to harmonize the types of installations
covered by the ETS across the various Member States.75 In addition, as noted above,
the EC imposed a uniform rule on the Member States preventing the use of ex-post
adjustments. However, Phase 2 made little advancement in harmonizing individual76
countries’ allocations schemes. As with Phase 1, countries continue to differ widely
on the use of auctions; design and use of benchmarks; design, size, and allocation for
new entrant reserves; and rules for closure.


74 European Commission, Proposal for a Directive of the European Parliament and of the
Council amending Directive 2003/87/EC so as to improve and extend the greenhouse gas
emission allowance trading system of the Community (Brussels, January 23, 2008).
75 European Commission, Limiting Global Change to 2 degrees Celsius: The Way Ahead for

2020 and Beyond (Brussels, January 10, 2007), p. 23.


76 Joachim Schleich, Regina Betz, and Karoline Rogge, EU Emissions Trading — Better
Job Second Time Around? Fraunhofer Institute System and Innovation Research (February

2007), p. 23.



For Phase 3, the EC is proposing to eliminate NAPs, replacing them with EU-
wide rules with respect to allowance availability and allocations. There would be one
EU-wide cap instead of the 27 national caps under Phase 1 and 2. Allowances would
be allocated under EU-wide, fully harmonized rules, including those governing: (1)
auctions, (2) transitional free allocations for greenhouse gas intensive, trade-exposed
industries, and (3) new entrants. No free allocations would be made to installations
that have shut down.77
Expanding Coverage
Despite the EC interest in expanding the ETS, its coverage in terms of industries
included for Phase 2 is essentially the same as for Phase 1. The exception is for
aviation. In December, 2006, the EC proposed bringing greenhouse gas emissions
from civil aviation into the ETS in two phases.78 As agreed to by the European
Parliament in July, 2008, all intra-EU and international flights will be included under
the ETS beginning in 2012. Emissions would be capped at 97% of average 2004-
2006 emissions with 85% of the allowances being allocated free to operators. The
cap would be reduced to 95% in 2013. The cap and auctioning of allowances would
be reviewed as a part of Phase 3 implementation.
In proposing changes for the third trading period, the EC has identified three
CO2 emitting sectors for inclusion under the ETS: petrochemicals, ammonia, and
aluminum. The ETS would also expand beyond CO2 to include nitrous oxide (N2O)
emissions from nitric, adipic, and glyoxalic acid production, and perofluorocarbon
(PFC) emissions from the aluminum sector. This would expand ETS covered
emissions by 4.6% over Phase 2 allowance allocations, or about 100 million metric
tons.79 The harmonization and codification of eligibility criteria for combustion
installations is expected to increase the coverage by a further 40-50 million metric
tons.
To improve the cost-effectiveness of the ETS, the EC proposes the Phase 3
provide a small installation exemption from the scheme. Currently, the smallest
1,400 (10% of total installations covered) installations emit only 0.14% of total
emissions covered. The EC proposes that combustion size limitations of 20Mw be
modified to include an emissions threshold of 10,000 metric tons of CO2 annually


77 European Commission, Proposal for a Directive of the European Parliament and of the
Council amending Directive 2003/87/EC so as to improve and extend the greenhouse gas
emission allowance trading system of the Community (Brussels, January 23, 2008) p. 9.
78 European Commission, Proposal for a Directive of the European Parliament and of the
Council amending Directive 2003/87/EC so as to include aviation activities in the scheme
for greenhouse gas emission allowance trading within the Community (Brussels, December

12, 2006).


79 European Commission, Proposal for a Directive of the European Parliament and of the
Council amending Directive 2003/87/EC so as to improve and extend the greenhouse gas
emission allowance trading system of the Community (Brussels, January 23, 2008), p. 4.

(provided the facilities is less than 25 MW). The EC estimates that 4,200 installations
would opt out — accounting for 0.70% of total ETS emissions.80
Auctions
As noted above, the EU has made little progress on expanding the use of
auctions during Phase 2. Under Phase 3, auctioning would be the “basic principle for
allocation subject to the need to avoid carbon leakage.”81 Specifically, the EC
proposes to auction at least two-thirds of available allowances, beginning in 2013.
The introduction of auction would be differentiated by sector. In general, for the
power sector, full auctioning would beginning in 2013. For other sectors, a more
gradual phase-in would be envisioned with 80% of a sector’s allocation provided free
in 2013, declining linearly to zero by 2020. Concern that stringent EU carbon policies
may encourage production and related greenhouse gas emissions to shift to countries
without carbon policies (i.e., carbon leakage), exceptions to this phase-out of free
allowances will be made in sectors where carbon leakage may occur.
The EC proposal also provides for the allocation of revenues from allowance
auctions. Member states will conduct the auctions and receive the revenues in
proportion to their 2005 emissions and per capital income. The EC states that a
percentage of the proceeds should be used to fund emission reductions, adaptation
activities, renewable energy, carbon capture and storage (CCS), the Global Energy
Efficiency and Renewable Energy Fund, developing countries assistance, and
mitigate increases in electricity prices on lower and middle incomes.
Summary and Considerations for U.S. Cap-and-
Trade Proposals
The United States is not a party to the Kyoto Protocol and no legislative
proposal before the Congress would impose as stringent or rapid an emission
reduction regime on the United States as Kyoto would have. However, through
almost four years of carbon emissions trading the EU has gained valuable experience.
This experience, along with the process of developing Phase 3, may provide some
insight into current cap-and-trade design issues in the United States.
Emission Inventories and Target Setting
The ETS experience with market trading and target setting confirms once again
the central importance of a credible emissions inventory to a functioning cap-and-82
trade program. The lack of credible EU-wide data on emissions was a direct cause


80 Ibid., p. 5.
81 Ibid., p. 7.
82 As stated by CRS in 1992: “For an economic incentive system to be effective, several
preconditions are necessary. Perhaps the most important is data about the emissions being
(continued...)

of the ETS Phase 1 allowance market collapse in 2006. Arguably, the most
important result of Phase 1 was the development of a credible inventory on which to
base future targets and allocations.
In the United States, section 821 of the 1990 Clean Air Act Amendments
requires electric generating facilities affected by the acid rain provisions of Title IV
to monitor carbon dioxide in accordance with EPA regulations.83 This provision was
enacted for the stated purpose of establishing a national carbon dioxide monitoring
system.84 As promulgated by EPA, regulations permit owners and operators of
affected facilities to monitor their carbon dioxide emissions through either
continuous emission monitoring (CEM) or fuel analysis.85 The CEM regulations for
carbon dioxide are similar to those for the acid rain program’s sulfur dioxide CEM
regulations. Those choosing fuel analysis must calculate mass emissions on a daily,
quarterly, and annual basis, based on amounts and types of fuel used. As suggested
by the EU-ETS experience, expanding equivalent data requirements to all facilities
covered under a cap-and-trade program would be the foundation for developing the
allocation systems, reduction targets, and enforcement provisions.
Coverage
Despite economic analysis to the contrary, the EU decided to restrict ETS
coverage to six sectors that represent about 45% of the EU’s CO2 emissions.86 This
restriction was estimated to raise the cost of complying with Kyoto from 6 billion
euro annually to 6.9 billion euro (1999 euro) compared with a comprehensive trading
program. A variety of practical, political, and scientific reasons were given by the
EC for the decision.87
The experience of the ETS up to now suggests that adding new sectors to an
existing trading program is a difficult process. As noted above, a stated goal of the
EC is to expand the coverage of the ETS. However, the experience of Phase 1 did
not result in the addition of any new sector until the last year of Phase 2 when
aviation will be included. The EU is attempting to expand its coverage with Phase
3, but the ETS will still cover fewer sectors emitting greenhouse gases than provided
under most U.S. proposals.


82 (...continued)
controlled. Such data are important to levy any tax, allocate any permits, and enforce any
limit.” CRS Issue Brief IB92125, Global Climate: Proposed Economic Mechanisms for
Reducing CO2, by Larry Parker (archived November 16, 1994), p. 9.
83 Section 821, 1990 Clean Air Act Amendments (P.L. 101-549, 42 USC 7651k).
84 S.Rept. 101-952.
85 See 40 CFR 75.13, along with appendix G (for CEMs specifications) and appendix F (for
fuel analysis specifications.
86 For more background, see CRS Report RL33581, Climate Change: The European Union’s
Emissions Trading System (EU-ETS), by Larry Parker.
87 Ibid., p 3.

U.S. cap-and-trade proposals generally fall into one of two categories.88 Most
bills are more comprehensive than the ETS, covering 80% to 100% of the country’s
greenhouse gas emissions. At a minimum, they include the electric utility,
transportation, and industrial sectors; disagreement among the bills center on the
agricultural sector and smaller commercial and residential sources. In some cases
discretion is provided EPA to exempt sources if serious data, economic, or other
considerations dictate such a resolution.
A second category of bills focuses on the electric utility industry, representing
about 33% of U.S. greenhouse gases and therefore less comprehensive than the ETS.
Sometimes including additional controls on non-greenhouse gas pollutants, such as
mercury, these bills focus on the sources with the most experience with emission
trading and the best emissions data. Other sources could be added as circumstances
dictate.
As noted, the EU’s experience with the ETS suggests that adding sectors to an
emission trading scheme can be a slow and contentious process. If one believes that
the electric utility sector is a cost-effective place to start addressing greenhouse gas
emissions and that there is sufficient time to do the necessary groundwork to
eventually add other sectors, then a phased-in approach may be reasonable. If one
believes that the economy as a whole needs to begin adjusting to a carbon-
constrained environment to meet long term goals, then a more comprehensive
approach may be justified. The ETS experience suggests the process doesn’t
necessarily get any easier if you wait.
Allocation Schemes
Setting up a tradeable allowance system is a lot like setting up a new currency.89
Allocating allowances is essentially allocating money with the marketplace
determining the exchange rate. As noted above, the free allocation scheme used in
the ETS has resulted in “windfall profits” being received by allowance recipients.
As stated quite forcefully by Deutsche Bank Research:
The most striking market outcome of emissions trading to date has been the
power industry’s windfall profits, which have sparked controversy. We are all
familiar with the background: emissions allowances were handed out free of
charge to those plant operators participating in the emissions trading scheme.
Nevertheless, in particular the producers of electricity succeeded in marking up
the market price of electricity to include the opportunity-cost value of the
allowances. This is correct from an accounting point of view, since the


88 For an overview of cap-and-trade proposals under the 110th Congress, see CRS Report
RL33846, Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry
Parker and Brent D. Yacobucci. For an overview of multi-pollutant control bills, see CRSth
Report RL34018, Air Quality: Multi-pollutant Legislation in the 110 Congress, by Larry
Parker and John E. Blodgett.
89 Unlike a carbon tax which uses the existing currency system to control emissions — be
it euro or dollars.

allowances do have a value and could otherwise be sold. Moreover, emissions90
trading cannot work without price signals.
The free allocation of allowances in the ETS incorporates two other mechanisms
that create perverse incentives and significant distortions in the emissions markets:
new entrant reserves and closure policy. Combined with an uncoordinated and spotty
benchmarking approach for both new and existing sources, the result is a greenhouse
gas reduction scheme that is influenced as much or more by national policy than by
the emissions marketplace.
The proposed expansion of auctions for Phase 3 of the ETS could simplify
allocations and permit market forces to influence compliance strategies more fully.
Most countries did not employ auctions at all during Phase 1 and auctions continue
to be limited under Phase 2. No country combined an auction with a reserve price to
encourage development of new technology. The EC limited the amount of auctioned
allowances to 10% in Phase 2: a limit no country chose to meet. Efforts to expand
auctions met opposition from industry groups, but attracted support from
environmental groups and economists. The EC proposed increase of auctioning to
two-thirds of total allowances for Phase 3 would represent a major development for
the scheme.
Currently, all U.S. cap-and-trade proposals have some provisions for auctions,
although the amount involved is sometimes left to EPA discretion. Most specify a
schedule that provides increasing use of auctions from 2012 through the mid-2030s
with a final target of 66%-100% of total allowances auctioned. Funds would be used
for a variety of purposes, including programs to encourage new technologies. A
couple of proposals include a reserve price on some auctions to create a price floor
for new technology.
Like the situation in the ETS, most U.S. industry groups either oppose auctions
outright or want them to be supplemental to a base free allocation. Given the
experience with the ETS where the EC and individual governments have been
unwilling or unable to move away from free allocation, the Congress, like the EC,
may ultimately be asked to consider specifying any auction requirement if it wishes
to incorporate market economics more fully into compliance decisions.
Flexibility and Price Volatility
Despite EU rhetoric during the Kyoto Protocol negotiations, it moved into Phase
2 without a significant restriction on the use of CDM and JI credits. This embracing
of project credits will significantly increase the flexibility facilities have in meeting
their reduction targets. In addition, Phase 2 includes the use of banking to increase
flexibility across time by allowing banked allowances to be used in Phase 3. Each
of these market mechanisms is projected to reduce both the EU’s Kyoto compliance
costs and allowance price volatility. As a further defense against price volatility, the


90 Deutsche Bank Research, EU Emission Trading: Allocation Battles Intensifying (March

6, 2007), p. 2.



European emission exchanges are creating financial instruments, such as futures
contracts and options, to permit entities to hedge against price changes.
Unfortunately, Phase 1 experience with the ETS does not provide much useful
information on the value of market mechanisms or financial instruments in reducing
costs or price volatility. The combination of poor emissions inventories, non-use of
project credits, and time-limited allowances with effectively no banking resulted in
extreme price volatility in Spring 2006, and virtually worthless allowances by mid-
2007. The real test for the mechanisms employed by the ETS to create a stable
allowance market is Phase 2. Initial indications are that a mature market for
allowances appears to be developing,
Like the ETS, U.S. cap-and-trade proposals would employ a combination of
devices to create a stable allowance market and encourage flexible, cost-effective
compliance strategies by participating entities. All include banking. All include use
of offsets, although some would place substantial restrictions on their use. One
proposal incorporates a “safety valve” that would effectively place a ceiling on
allowance prices. Other proposals would create a Carbon Market Efficiency Board
to observe the allowance market and implement cost-relief measures if necessary.
Some see this as a more flexible response with the potential for avoiding or
mitigating the environmental impacts of a safety valve (i.e., increased emissions).
Additionally, concern has been expressed in the United States about the
regulation of allowance markets and instruments. Based on experience with the ETS,
the potential for speculation and manipulation could extend beyond the emission
markets. Analysis of ETS allowance prices during Phase 1 suggests the most
important variables in determining allowance price changes were oil and natural gas
price changes.91 This apparent linkage between allowance price changes and price
changes in two commodities markets raises the possibility of market manipulation,
particularly with the inclusion of financial instruments such as options and futures
contracts. Congress may ultimately be asked to consider whether the Securities and
Exchange Commission, Federal Energy Regulatory Commission, the Commodities
Futures Trading Commission, or other body should have enhanced regulatory and
oversight authority over such instruments.92


91 Maria Mansanet-Bataller, Angel Pardo, and Enric Valor, “CO2 Prices, Energy and
Weather,” 28 The Energy Journal 3 (2007), pp. 73-92.
92 For a discussion of regulation of allowances as a commodity and implications for a
greenhouse gas emissions market, see CRS Report RL34488, Regulating a Carbon Market:
Issues Raised by the European Carbon and U.S. Sulfur Dioxide Allowance Markets, by
Mark Jickling and Larry Parker.