eu ets phase ii allocation: implications and lessons · executive summary 2 1. the bumpy ride of...

EU ETS Phase II allocation: implications and lessons

Preface 1

Executive summary 2

1. The bumpy ride of the EU ETS 4

2. Implications for the carbon market 7

3. Distribution and Kyoto compliance 10

4. The devil in the details 12

5. Profits and the use of auctioning 15

6. Lessons and a view to the future 17

Further information 19


Contents

The European Emissions Trading Scheme (EU ETS)is the backbone of European efforts to tackleclimate change, and a central instrument forcountries to deliver their Kyoto emission targets.In setting a price for carbon, it has also becomethe focal point for industrial interest – and insome cases concern – about the impact ofmeasures to tackle climate change.

The UK Government’s Energy Review concludedthat ‘a carbon price is essential for making lowercarbon emissions a business imperative…’ andestablished the EU ETS as a centrepiece of UKenergy and climate change policy, with ‘theGovernment committed to there being acontinuing carbon price signal which investorstake into account when making decisions. The EUETS is here to stay beyond 2012 and will remainthe key mechanism for providing this signal.’

The extent to which the EU ETS can deliver onthese lofty goals – and the carbon price thatparticipating sectors will see over the next fewyears – hinges first and foremost upon the

allocation of emission allowances. Over the pasteighteen months, governments around Europehave developed their ‘National Allocation Plans’for its second phase – the Kyoto first period of2008–12. Negotiation with their own domesticbusiness and other constituencies defined theirinitial proposals; for most, attention subsequentlyturned to the European Commission, after its firstround of decisions cut back all but the UK’sallocation plan.

As the process for allocating Phase II allowancesapproaches completion, the Carbon Trust ispublishing this report to analyse both theimplications for the Phase II carbon market (andthe resulting industrial abatement incentives),and also the wider lessons to be learned from theallocation process. As with our previous EU ETSreport1, it draws upon research conducted byClimate Strategies, with detailed supportingmaterial published as academic papers.2

Preface

1 Allocation and competitiveness in the EU ETS: options for Phase II and beyond, Carbon Trust, 2006. See also The European Emissions Trading

Scheme: Implications for industrial competitiveness, Carbon Trust, 2004.

2 www.climate-strategies.org; results of Phase II NAP analysis published as three papers in Climate Policy, Vol.6 no.4., www.climatepolicy.com

EU ETS Phase II allocation: implications and lessons 1


The EU ETS has emerged as the primary instrumentfor reducing CO2 emissions across power generationand heavy industry in Europe. By setting a price oncarbon, it aims to generate incentives for companiesboth to reduce their operational emissions and toinvest in lower carbon technology. The allocationplans now agreed for Phase II (2008-12) make itlikely to succeed in the first aim, but not thesecond. The incentives for low carbon investmentcould still be improved if governments auction moreof the Phase II allowances, and define carefully thelonger term structure of the scheme.Phase II allocations and price impacts During 2006, twenty-seven EU Member Statesproposed ‘National Allocations Plans’ fordistributing allowances to emit CO2 under theEU ETS during Phase II (the Kyoto first periodof 2008-12). The plans proposed would haveenshrined an increase in EU ETS sector emissionsto 5% above verified 2005 levels. This exceeds thetrend of historic emissions and, combined withinflow of emission credits from emission-reducingprojects outside Europe (mainly certified emissionreductions under the Kyoto Protocol’s CleanDevelopment Mechanism), would probablyhave led to a virtually ‘dead market’.

The European Commission ruled that almost allthe submitted plans violated its interpretation ofthe EU ETS Directive, and proposed an allocationformula that in aggregate turns the proposed 5%increase into a 5% decrease below 2005 levels.The key criteria were Kyoto constraints in mostof the EU-15, and the imposition of a growth and

intensity formula based on independent sourcesfor most of the new Member States. The total isbelow emission trends and all ‘business as usual’forecasts, and in winning the ensuing politicalstruggle, the Commission decisions have thusestablished EU ETS Phase II as a viable carbonmarket for 2008-12.

The forward trading carbon price for Phase II hasremained steady in the range €15-20/tCO2, butthe realised price will be highly uncertain. A lowgas price or high availability of internationalemission credits would yield a “floor” price,which might be underpinned by a Chinese tax onits CDM credit sales, currently around €8/tCO2.Opposite conditions could generate prices over€20/tCO2; this appears less likely, though muchhigher price spikes are not impossible. The optionto bank allowances forward into Phase III (post2012) will also support prices, whilst making themmore dependent on the progress of internationalnegotiations.

Executive summary


Implications for abatement and investment A positive carbon price will drive someabatement, as it did during 2005-6, particularly inpower generation and cement manufacturing. Theincentive to abate may be weakened in countriesand sectors that have allocated allowances inproportion to historic or projected emissions, ifcompanies expect this approach to be carriedforward to Phase III. Greater cutbacks combinedwith more ‘benchmarking’ particularly in thepower sector in Phase II have lessened but noteliminated this risk. Nevertheless, prices below€20/tCO2 are intrinsically insufficient to drivemuch investment in low carbon power sources,and may have modest impact on energy efficiencyoutside the energy intensive sectors.

Moreover, most allocation plans withdrawallowances from plants upon closure, and offerfree allowances to new entrants. The formerdiscourages closure of old inefficient plants andthe latter partially protects new entrants fromthe impact of CO2 prices. In many allocationplans, the new entrant rules give more freeallowance to more carbon intensive fuels; theGerman plan gives even more to the mostpolluting (lignite power plants). This implicitsubsidy creates perverse incentives to constructnew, high emitting facilities that would last fordecades.

In many countries the ‘devil in the detail’ thusrisks making Phase II of the EU ETS largelyineffective as an instrument to support lowcarbon investment (as opposed to operationalemission savings).

Improvements and ways forward To some degree, the various problems identifiedcan still be fixed by (a) greater use of auctioningand (b) rapid progress to clarify a better basis forPhase III allocations.

Despite most plans cutting back allocations topower companies much more than other sectors,the power sector overall across Europe will makenet profits from the EU ETS amounting to tens ofbillions of Euros during Phase II, through itsimpact on power prices. The current NAPs only

propose a trivial volume of auctioning (around1.5%) but governments retain flexibility and canstill decide to auction more. The much higherdegree of auctioning proposed in the emissiontrading schemes being developed in the US willalso increase pressures in the EU. Where thepower sector is profiting, greater auctioningwould not increase power prices but it could helpto improve incentives for low carbon investmentin three ways: by reducing some of the perverseincentives noted; through judicious use of auctionrevenues to support such investments; and byenabling a reserve auction price that would helpto stabilise price expectations. More auctioningwould also intrinsically stabilise the system.

The biggest measure that could help the EU ETSas an incentive for low carbon investment wouldbe to pay as much attention to the details andinvestment incentives in Phase III, as theCommission paid to volumes in Phase II, and toclarify some basic common principles through theReview being conducted this year. Some keyprinciples have been elaborated in our previouspublication.3

The first phase of the EU ETS successfullyestablished the EU ETS as a functioning marketacross all the Member States, delivered significantabatement and generated awareness of theclimate change issue at the highest levels inEuropean industry; these were hugely importantachievements. The outcome of the allocationprocess for Phase II has largely succeeded indealing with the fundamental problem of over-allocation that was evident in Phase I, but at theexpense of allowing through detailed provisionsthat undermine the incentives to invest in lowcarbon technology. Phase III will have to tacklethese challenges, if the EU ETS is to deliversuccessfully on both its objectives.

3 Carbon Trust, Allocation and competitiveness in the EU ETS: options for Phase II and beyond, 2006.


History may judge 2006 as the defining year forthe EU ETS. It started with prices for Phase I(2005-7) carbon emission allowances trading atlevels higher than anyone predicted, andgovernments confidently issuing draft NationalAllocation Plans (NAPs) for how they intended toallocate allowances for Phase II, the Kyoto periodof 2008-12. The year ended with Phase I pricessinking close to zero, and several countriesthreatening to take legal action to overturn theEuropean Commission’s rejection of almost all thesubmitted NAPs as inadequate. It was certainly ayear of vast learning – as befits the middle of thefirst, learning period of a major new system.

The evolution of carbon prices for both Phase I,and Phase II forward trading, is shown in Chart 1.

Concerns from some commentators about overallshortage in Phase I proved groundless, when inMay 2006 the release of data on verified emissionsfor 2005 showed a substantial surplus. The pricehalved overnight, and as the situation clarifiedover subsequent months, it sank further. The finaltally showed that emissions in 2005 were about100Mt (5%) below the allocated amount, andshortly after the new year Phase I allowancesbecame essentially worthless. Preliminary data for2006 show that emissions increased, but nothinglike enough to absorb the excess supply ofallowances.

1. The bumpy ride of the EU ETS

Source: EEX

Chart 1. Price of CO2 in €/tonne

EU ETS Price Development

Phase I Allowances Phase II Allowances (2011) Phase II Allowances (2008)

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Chart 2. EU ETS sector emission trends since 1996 and ‘business-as-usual’ projections for 2008-12


It was against this roller-coaster backdrop thatcountries sought to define emission allowances forPhase II, the Kyoto period of 2008-12. There was agreat deal at stake. The EU ETS in Phase II wascentral to meeting Kyoto Protocol targets. ButPhase I had shown the huge potential financialvalue of emission allowances – against abackground of prices exceeding €20/tCO2, itwas plain that governments were allocating assetsworth probably more than €200bn in total.Not surprisingly, they were subject to hugelobbying pressures.

Under the terms of the EU ETS Directive, theEuropean Commission is empowered to rejectNAPs if they do not meet certain criteria laid outin the Directive, relating to the avoidance ofsurplus allocations and consistency with Kyototargets. However, the data on verified 2005

emissions were published only six weeks beforethe official deadline for submitting proposedPhase II NAPs to the European Commission –clearly insufficient to consider a wholesalerevision of allocation approaches.

To set the Phase II allocation debates in context,Chart 2 shows the historic trend of emissions fromthe EU ETS sectors, together with projections.Total EU ETS sector emissions had declined slowlyin the latter half of the 1990s, mostly as a resultof continuing moves towards gas in powergeneration and industrial restructuring includingthe tail-end of the transition process in the newMember States of eastern Europe. The declinehalted in the first half of this decade as thesefactors petered out, and rising gas prices pushedpower generators back towards coal.

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central scenario in electricity model, favouring coal

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EU ETS Phase II allocation: implications and lessons6

In the absence of any CO2 controls, all projectionssuggest a slight increase in emissions, sharply atodds with the EU-15 Kyoto targets and the widerrequirement to tackle climate change. The NAPsinitially proposed for Phase II mostly offeredmodest cutbacks relative to projections of sharplyrising emissions – but in aggregate, would haveresulted in an increase of around 5% relative tothe verified levels of 2005 after correcting fordifferences in coverage.

This was not only inconsistent with the EU’saggregate target, it would also have left aprecariously thin margin below ‘business-as-usual’emission projections. Depending upon assumedrelative energy prices (gas vs coal, as illustrated)and the inflow of emission credits from abroad –as discussed in the next section – the EU ETScould have been rendered almost impotent forthe whole of Phase II, requiring hardly any realabatement.

Faced with this risk, and an emerging view thatmost of the NAPs violated principles laid out inthe Directive, on 29 November 2006 theCommission announced a momentous decision.In evaluating the first 11 allocation plans (10,after the French government withdrew its plan afew days before), it rejected all but the UK’s asinadequate.

In fact the Commission went further than this.It clarified its interpretation of the Directive interms of specific total allocations that would bedeemed acceptable, linking allowed allocations totwo main factors. The first was an explicitnumerical formula that total allocations could notexceed 2005 levels multiplied by projectedeconomic growth, corrected for trends in energyintensity (energy per unit of economic output).Moreover, the economic growth projections andenergy intensity corrections were taken from

international (EU) sources, not those that MemberStates themselves presented. The second wasa correction to ensure that allocations wereconsistent with Kyoto targets, after takingaccount of other aspects of Member Stateimplementation plans including provisions forpurchase of international Kyoto credits.

Under the terms of the Directive, Member Stateshad three months to appeal against theCommission’s decisions. By announcing decisionson such a big group of countries simultaneously,the Commission raised the stakes enormously. Anycountry that challenged its ruling – as the GermanEconomics Minister initially threatened to do –would essentially be disputing the underlyinginterpretation of the Directive, which had beenapplied consistently across all countries; andwould thereby open the floodgates for all toappeal. This would have locked up the EU ETS inlegal disputes from which it would probably neverhave recovered – certainly not in time to be ofmuch use to investors wanting to know the rulesfor Phase II.

Threats of legal challenges slowly dissipated, andas the deadline for appeals on the first round ofdecisions passed, the Commission turned to theother allocation plans, final decisions on most ofwhich were announced by the time of this reportgoing to press. In aggregate, the Commission’sdecisions cut total allocations in Europe by 10% ascompared with the submitted and draft plans -turning a proposed aggregate increase of 5% from2005 levels into confirmed allocations 5% below2005 levels. The final allocations total almostexactly ten billion tonnes of CO2 over the period –two billion tonnes annually. The next two sectionsdiscuss first, the implications for the Phase IIcarbon market; and then, the pattern ofallocations across the different Member States.

* See original source (Neuhoff et al, 2006, Emission projections 2008-2012 versus NAPs II)

** Includes opt-ins and extensions

Chart 3a. Projected ‘business-as-usual’ CO2 emissions versus EU ETS Cap (assuming zero CO2 price)

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What do the final allocations imply for the EUETS market in Europe? One surprise is that theforward trading market for Phase II allowancesbarely flickered as the Commission imposed itscutbacks on Phase II allocation plans, and as thePhase I market slid towards zero: the forwardprice for 2008-12 remained steady in the rangeof €15-20/tCO2. Having seen the weakness ofthe submitted allocation plans and analysis fromseveral sources making a powerful case that theallocations were far too weak, it appears that themarket was already expecting the Commission tointervene forcefully, and that it did so roughly inline with market expectations.

The steadiness of Phase II prices also reflects theimpossibility, even with the aggregate NAPssettled, of knowing what the price will actually

be. This is due to several major uncertainties, onboth demand and supply side of the carbonmarket.

GDP growth or gas prices lower than centralprojections would tend to reduce emissions, andvice versa. Chart 3 shows how these uncertaintiesaround fuel prices and GDP growth may affectpotential demand, in terms of projected emissions(a) without any carbon price, and (b) takingaccount of the likely impact of a carbon price of€20/tCO2 on power sector emissions from fuelswitching (which would be the dominant, thoughnot only, source of abatement within Europe).Weather (rainfall for dams, windiness, andtemperature impacts on heating demand) is alsorelevant.

2. Implications for the carbonmarket


In most of the underlying scenarios, a €20/tCO2carbon price cuts power sector emissions byaround 130Mt/yr (the exception is very high gasprices in which case €20/tCO2 is insufficient tolead to much fuel switching). Even with generousallowance for other abatement (eg. in the energy-intensive industrial participants, and more widelythrough reduced electricity demand), the totalabatement at €20/tCO2 would be under 200Mt, or10% of the total. This is comparable to the‘central’ span of emission projections arising fromvarying just economic growth and fuel priceswithin reasonable bounds, even from this singleset of projections – and much less than the totaluncertainty in emission projections.

An additional and crucial source of uncertainty isthe supply of additional emission credits,primarily Certified Emission Reductions (CERs)from projects in developing countries under theClean Development Mechanism, which companiescan use towards their compliance with EU ETS

commitments. The high carbon price of 2005-6stimulated explosive growth of such projects,with almost two billion tonnes of such emissionreductions (cumulative up to 2012) now submittedfor registration with the relevant internationalauthorities (the CDM Executive Board thatoperates under the Kyoto Protocol). With growingsupply also from Joint Implementation projects ineastern Europe, the total grows monthly and isexpected to top three billion of CO2-equivalent.

By no means are all of the projects submittedlikely to generate Certified Emission Reductions(CERs) at the scale and timescale projected inregistration documents. In addition, others willbe competing for supply. The Japanese electricityand steel sectors have already made majorpurchases in pursuit of their ‘voluntary’commitments. Based on current domestic policiesand measures, both Japan and the EU-15 face agap between national emissions and their Kyototargets exceeding 1 billion tonnes each over the

* See original source (Neuhoff et al, 2006, Emission projections 2008-2012 versus NAPs II)

** Includes opt-ins and extensions

*** Includes opt-ins and extensions. Values are estimated for the final caps for Italy, Estonia Finland, Hungary, Portugal and Denmark, taken from

http://www.econ.cam.ac.uk/research/tsec/euets/. Cyprus Romania and Bulgaria are excluded.

Chart 3b. Projected CO2 emissions versus Cap for €20/tCO2 price

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Kyoto period, and government purchase of CERsare expected to be a major tool of compliance.Indeed, as part of its EU ETS approval process,the Commission demanded proof of nationalacquisition plans sufficient to bring countries intocompliance, and EU governments have alreadycontracted several hundred million tonnes. Thenet availability to EU industry of fully certifiedemission reduction credits thus remains uncertain,though most estimates place it at several hundredmillion tonnes – probably in the range 100-200Mt/yr on average over the period. The T-barson Figure 3 illustrate the impact of this additionalsupply.

This range is comparable to the total internal EUETS mitigation potential at around €20/tCO2, andas indicated on Chart 3 (a and b), is comparableto the central range of emission projections.To try and protect the EU ETS against a riskof excessive inflow of emission credits, MemberStates have (as required in the Directive)proposed limits on the volume of imports that anyfacility can use. The Commission decisions greatlynarrowed the range between different countries,with most of the big ones now limiting the use ofexternal credits to 10–20% of an installations’total allocation. These limits seem unlikely tobind many, though they could constrain somepower sector installations that might otherwisewant to burn coal and import credits as their onlycompliance strategy. Overall however, CDM supplywill be intrinsic to the balance of the market.

Against this combined background on supply anddemand, the original set of allocations posed amajor risk of a “dead” market, with ‘business asusual’ emissions below allocations plus existingcommitted external supplies. The crucial impactof the Commission’s decisions has been to changethis prospect from being very likely, with thedraft NAPs, to being extremely unlikely, as thefinal allocations lie well below the extreme lowerend of the range in Chart 3(a), leaving a clearneed for some combination of abatement andcredit imports.

In the last couple of years, China has dominatedCDM supply and introduced a tax on CDM creditsales that effectively sets a floor price currentlyaround €8/tCO2. This situation could wellcontinue. With net supply at the higher end,and/or demand at the lower end, this would set aprice floor on the EU ETS. The ability to ‘bank’allowances from Phase II forward into Phase IIIcould also support prices, whilst making them alsodependent upon the potentially volatile progressof negotiations on post-2012 commitments. At theopposite extreme, restricted availability ofexternal emission credits and, in particular, highgas prices could drive the price significantlyabove €20/tCO2. One consultant’s report4 offereda range of €8-26/tCO2 for the average Phase IIprice – but only assigned a 50% probability of theprice being in this range. The allocations may be(virtually) settled, the prospect of a completely“dead” market largely removed, and the Phase IIforward price steady; but the reality remains oneof huge uncertainty about the actual evolution ofcarbon prices out to 2012.

4 New Carbon Finance – EU ETS Deep Dive analysis, 15 Jan 2007


The other major impact of the EuropeanCommission decisions has been to greatly reducedisparities between the different NationalAllocation Plans, and to bring them much closerto consistency with national Kyoto targets. This isapparent from Chart 4, which shows for eachcountry the % cutback relative to 2005 levels(vertical axis), against the % cutback in nationalemissions from recent levels required for acountry to meet its Kyoto target domestically

(horizontal axis). The diagonal line indicates the“proportional share line”, i.e. if the emissionreductions for ETS sectors were proportional tothe national total cutback implied by Kyototargets. For each country, the triangle shows thefinal outcome; the square indicates the proposalin November 2006, in the allocation plansubmitted to the European Commission or (insome cases) published but not yet officiallysubmitted.

3. Distribution and Kyotocompliance

Note. For each country, the vertical axis shows the % cutback in NAPs from verified 2005 emission levels in the EU ETS sectors. The horizontal axis

shows the national % difference between 2004 total emissions and national Kyoto targets. Consequently, the diagonal line shows the

“proportional share line” if EU ETS sectors (which typically make up 40-50% of total national emissions) are cut back in proportion to the Kyoto

target. The square at the bottom of each vertical bar shows allocations proposed as of November 2006; the triangle at the top shows the final

outcome. Decisions for Italy, Estonia, Finland, Hungary, Portugal, Denmark, Cyprus and the two new Accession countries (Romania and

Bulgaria) were not finalised at time of going to press. Italy accounts for about 10% of EU emissions; the others collectively about 15%.

Source: The Carbon Trust

Chart 4. Emission cutbacks and Kyoto consistency by country

Actual reduction in EU ETS Phase II NAP

EU ETS Sector “proportional” cutback line

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The Chart reflects two main themes in the battleover allocation plans in Europe. The firstconcerned allocation in the EU-15 countries,principally the western and southern Europeancountries most of which are falling short of a pathtowards their Kyoto targets. The UK, the biggestexception to this pattern, had submitted arelatively ambitious allocation plan and the draftSpanish plan proposed even bigger cutbacks. Thedefinitive battle was around Germany, by far thebiggest single emitter, accounting for 24% of EUemissions in 2005 and therefore a dominantinfluence on the market overall.

Germany was one of few countries to submit itsallocation plan on time. Shielded by the fact thatGermany was not far from its Kyoto target, thetotal allocation proposed was virtually identical toits 2005 emissions. Many other Member Statesadopted allocation plans that echoed the ‘lighttouch’ of the German proposal, in many casesproposing significant increases.

It was widely assumed that the EuropeanCommission would not dare to challenge Europe’sbiggest power, but with many others implicitlyhiding behind the weakness of the German plan –and with the UK immediately countering witha far stronger UK allocation proposal – theCommission reached its decision to adopt aformula approach that inevitably would involverejecting the German plan. The Germangovernment reacted strongly, but the Commissionhad judged not only that it had little choice, butalso that during a year of holding both the G8 andEU Presidencies, Germany would not want to belocked in a legal dispute over its unwillingness tooffer real cutbacks in the EU ETS. As the deadlinefor challenges passed, Germany withdrew itsthreat of legal action and, without that cover, sodid other Member States.

The net effect of the Commission winning thispolitical struggle – apart from saving the EU ETSas a credible market – was to align most of thecore group of EU-15 countries close to the‘proportional share’ cutback. For a key group –Germany, France, Greece, Netherlands, andIreland – this moved them to significant cutbacksrelative to 2005. Sweden, Belgium andLuxembourg were also moved to within a few

percent of 2005 levels, in place of generousgrowth allocations.

The effort to strengthen NAPs faced a differentkind of issue in the new Member States, the tencountries of eastern Europe that had joined theEU in 2004. These countries were all (exceptSlovenia) easily on track to comply with theirKyoto obligations, thanks to the decline inemissions far below 1990 levels in the aftermathof economic transition. Here, the other elementof the Commission’s formula – the cap relative toverified 2005 emissions adjusted for economicgrowth and energy intensity changes – came tothe fore. In some cases, notably for Poland,Slovakia and the Czech Republic, this imposeddramatic cutbacks on their plans. To some degree,this turned out to be a struggle over the meaningof Accession to the EU itself. Some from the newMember States implied that they should betreated more leniently, with generous allocations(in the absence of Kyoto constraints) perhaps ascompensation for their lower GDP and rapidgrowth. The Commission insisted that all EUMembers had to abide by common rules andexpectations. Again, the Commission won,resulting in modest increases allowed roughly inline with expected economic growth afteradjusting for continuing trend improvements inthese countries energy efficiency.

The result all round is to set national aggregateallocations on a much more ‘level playing field’across Europe than in Phase I.


In terms of both aggregate impact, anddistribution, the Phase II EU ETS is thus muchimproved, but the devil remains in the details. Inparticular, some of the problems risk substantiallyundermining the EU ETS as a way of providingclear and consistent incentives for business tomake lower carbon investments. The main areasof difficulty are: the difference betweenallocations to the power sector and other sectors;discrepancies and mixed incentives in rules fordistributing allowances to existing installations;closure rules, and the potential perverseincentives arising from special rules for closureand new entrants.

In most countries, the allocation cutbacks areimposed almost exclusively on the power sector.With modest cutbacks overall, the logic for this iscompelling: it attempts to mitigate the fact thatin countries with competitive electricity markets,power companies pass on the “opportunity” costof carbon and thereby generate large net profitsat the expense of their customers – includingother sectors in the EU ETS. Unfortunately thetendency to give energy intensive sectors almosteverything they project they need, in an attemptto compensate for this, weakens the incentiveeffect. In economic theory, the companies willstill have an incentive to abate so as to sellallowances. The Phase I experience suggests thatthe extent to which they do so in practice is veryvaried. If they get all the allowances they need,they may just continue with ‘business as usual’behaviour, rather than trying to optimise –particularly if they believe that investments inlower-emitting technologies may just result inthem receiving fewer allowances in subsequentphases. This is the “early action/updating”

problem which could thereby become a moregeneral disincentive, particularly for investmentdecisions that might only be fully realised towards2012.

This points to the second area of difficulty,namely the “distortions” that can arise fromrepeated rounds of free allocations. Our previousresearch identified a “pyramid of distortions”depending upon how allowances are allocated.At the bottom, distortions are greatest ifcompanies expect to receive allowances inproportion to recent historical emissions.Allocating allowances in proportion to emissionprojections or historical output is only a littlebetter. Various “benchmarking” approaches canreduce the distortions, but to an extent thatdepends on the details of how they are defined.The purest approach (apart from auctioning) is“benchmarking” based purely on installedcapacity, not differentiated according to the planttype or its projected output.

Chart 5 summarises the approach taken in thedifferent NAPs. For incumbent installations, thegreat majority use one of the two mostpotentially distorting approaches – allocating inproportion to historic or projected emissions forboth power (P) and other (O) sectors. However,there are just enough countries experimentingwith other approaches (eg. Austria, Belgium,Spain, Hungary and the UK) that Phase II will atleast create sufficient experience to facilitatewider adoption of more efficient approaches infuture phases. In addition, given the greatercutbacks in the power sector and the greaterexperimentation with benchmarking, this is alesser problem where it matters the most, ie.power generation.

4. The devil in the details


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carbon investment, economically this amounts toa subsidy that increases for more polluting plant.Chart 6 shows that many countries offer suchfuel-specific subsidies for new entrants, butGermany is unique in the scale of subsidy offeredto the most polluting ones.

Essentially, what is happening here is that whilstthe EU ETS was designed with the intent to

reduce CO2 emissions, in many Member States thedetails of implementation have been negotiatedbetween industries and Ministries that had otherobjectives, and whose main priority was tominimise any resulting pressure on their industriesto change: they appear to have regarded their jobas protecting “business as usual” from the effectsof a carbon price in Europe. In some countries,particularly concerning new investments, theysucceeded to a remarkable degree.

Note: The Chart shows the implicit subsidy of free allocations that would accrue to new coal and gas power stations of 200MW operating at the

efficiencies indicate and that are assumed to run for 6000h. For country codes, see note to Chart 5.

Source: Climate Strategies / Neuhoff et al. (2006).

Chart 6. Implicit Subsidy arising from New Entrant Allocation rules in different Member States(last updated 1st May 2007)

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By far the biggest potential for the EU ETS togenerate perverse incentives is in the allocationsto new entrants, through the “New EntrantReserves”. The fact that new emitting sources getfree allowances but zero-carbon power sources donot obviously weakens incentives to invest in thelater. This problem is exacerbated by specificdetails in many of the plans. Most notably, theGerman NAP offers unlimited “technology

specific” free allowances to new power stations,so that coal power stations get about twice asmany as gas, and adds a “load factor” correction,in which the most polluting plants (lignite) aregranted an additional 10% more allowances,officially on the grounds that they are expectedto operate more.

The intent of such provisions is to try and protectnew investments from the price of carbon. Butsince the aim of the EU ETS is to reflect the socialcost of carbon emissions and to incentivise low


The experience in 2005-6 confirmed predictionsthat the power sector in particular, where thereare competitive power markets, passes throughthe opportunity costs of carbon emissions intoelectricity prices. This generates net profits; thecontinued high degree of free allocation in PhaseII will generate power sector profits of severaltens of billions of Euros across much of Europe.5

The extent to which other sectors can or will passthrough opportunity costs and potentially profit insimilar ways is more constrained, by internationalcompetition and by the fact that they faceincreased electricity prices without correspondingfree allowances. With the continued high level offree allocation in Phase II, the net effect could beincreased profits during Phase II for many sectors,but with potential to lose market share over time;this trade-off is being examined more fully in aseparate study by Climate Strategies.

In addition to its distributive effects, as indicatedthe very high level of free allocation createsvarious incentive problems. Greater use ofauctioning could alleviate several of theseproblems, and help to establish more cost-reflective prices than was evident in Phase I,which could also improve price stability.

Auctioning is a way of introducing allowances intothe market. In general there is no such thing asauctioning ‘to a sector’, since who buys fromauctions depends upon where governments chooseto cut back free allocations in the first place. Inpractice, most of the cutbacks in Phase IIallocation plans have been placed on the powersector. Given its profits from the system, this can

be seen as a way of distributing more fairly theeconomic ‘rents’ that are inherent in cappingemissions. About 10 Member States currently planto use some auctioning (compared to four inPhase I), though several of these only to coveradministrative costs. Auctioning can also be seenas fundamentally implementing the polluter paysprinciple, and it raises revenue for governmentswhich could be recycled creatively for example toease the distributional inequalities or to publiclyfund low-carbon investments.

The Directive limits auctioning in Phase II of theEU ETS to a maximum of 10% of issuedallowances. In its high degree of free allocation,the EU ETS contrasts sharply with the emergingRegional Greenhouse Gas Initiative for the north-east US power sector. The RGGI scheme, which isdue to start operating in 2009, requires aminimum 25% auctioning and several participatingstates are now planning to auction all theirallowances (100%). However, none of the EU ETSallocation plans yet uses in full even the option toauction up to 10% of issued allowances.

Politically, in the aftermath of the Commissiondecisions it was not easy for Member States tointroduce significant auctioning whilst also cuttingback on their initially proposed total volumes.However the Commission’s decisions on NAPsexplicitly left the degree of auctioning, within the10% limit, up to Member States; it does notrequire further approval. Therefore, under EU lawMember States are free to increase the use ofauctioning from presently proposed levels, and atthe time of writing this remains a topic of intensedebate in some countries.

5. Profits and the use ofauctioning

5 For example, at a price of €15/tCO2 and average emissions of 800g CO2/kWh, power companies in Germany collectively would need to spend about

€1bn/yr on allowance purchases (less if they can substantially cut back emissions), but would receive more than €5bn/yr from the electricity prices

that result from the power market reflecting CO2 opportunity costs. For an explanation see the Annex to our previous report (note 1). Such profit-

making occurs in competitive markets, in which prices tend to reflect ‘marginal costs’ including the opportunity cost of carbon. In these cases

auctioning makes no difference to the impact of the EU ETS on power prices. In EU countries that do not have competitive generation markets,

regulators generally do not allow pass-through of opportunity costs. In these countries, more auctioning would impact on power prices, and would

tend to level the playing field in this respect between the different regulatory structures.

In our previous work, we noted that setting aminimum reserve price to auctions in Europecould help to reduce price uncertainty andvolatility, by providing a “base price” that couldunderpin low carbon investments. At present, theproposed volume of auctions in Europe is toosmall for this to be a significant influence. A move in Germany, with almost 25% of EUallowances, towards much greater use ofauctioning could make this an operationalpossibility.

Most of EU industry has strongly opposedauctioning, though in some countries this positionis softening as attention turns also to questions ofhow auction revenues might be used. Thedilemma is that industry also wants long-termstability in the system. A structure in which onemain sector extracts almost all the economic‘rents’, at the expense of its consumers isinherently not politically stable. The betterdistribution of these rents between differentstakeholders that is afforded by auctioning isprobably key to longer term stability.

Beyond Phase II, the Directive places noconstraints on the degree of auctioning. Exactlywhat happens is likely to hinge critically on theexperience of Phase II. Given the inevitability oflarge profits for the power sector, and the extentof perverse incentives associated with freeallocation as identified in the previous section, amuch higher degree of auctioning seems not onlydesirable, but inevitable.



The combination of learning from Phase I and thePhase II allocation process yields importantlessons.

Allocations for Phase I – and the earlier stages ofPhase II allocations - were made without a solidbasis of good data for the covered facilities.Reliable, verified and comparable data are anessential input to robust allocation decisions.

Yet this does not explain the clear excesses inproposed allocation plans. A second lesson is theneed for an independent authority (for the EUETS, the Commission), that can act as a“policeman” to ensure that allocations accordwith agreed criteria. Indeed the events of 2006lead much further than this. The Commission’spolitical victory in the allocation struggle,introducing a formulaic approach to establishingacceptable volumes, represents a huge de factostep towards harmonising the allocation process inEurope, at least at the level of aggregate caps.The Member States have only themselves toblame for this: left to their own devices theyproved collectively unable to offer allocationsthat would have delivered a meaningful carbonmarket, leaving no choice other than to centralisethe cap-setting process.

However the Commission would have beenpowerless without the broad criteria agreed in theDirective, the basis upon which it made itsinterpretive decisions. In particular, the Kyototargets were the essential tool that was wieldedto ensure meaningful cutbacks. Not only was theKyoto Protocol’s existence essential impetus tocreating the EU ETS, but its specific targetsproved to be the decisive tool in the battle toestablish meaningful, if still modest, allocationcutbacks for European industry.

Some specific improvements are notable betweenPhase I and Phase II in the National AllocationPlans. Phase II Naps are generally moretransparent, and in several cases simplified.

There is more use of both benchmarking andauctioning in Phase II – though in both respects,the improvements are modest. Indeed a generalobservation is the considerable inertia in theMember States, with the structure of many PhaseII plans strongly reflecting their antecedents.

Nevertheless, combined with a general increase inmarket liquidity and the range of market services,these changes will make it easier for mostcompanies to work with the EU ETS in Phase II,and make its operational efficiency considerablybetter. Indeed market surveys already reportincreasing levels of abatement as well as tradingactivities. The introduction of aviation into thescheme is another important development, withinternal flights due to be incorporated in 2011and international flights from 2012.

Thus the scope of the EU ETS is expanding and acredible carbon price will change operationaldecisions so as to reduce emissions. The strikinglimitation of the EU ETS as currently implementedconcerns not this, but the weakness of incentivesfor lower carbon investments. That incentive isalready limited by the relatively short termnature of current commitments and thecorresponding lack of post 2012 certainty; but theproblem is far bigger than this. The New EntrantReserves intrinsically weaken the decarbonisationincentive by subsidising carbon intensiveinvestments; and some plans, as noted, inpractice promote the most polluting.

There is a general political lesson here. The majorfocus of debate has been upon volumes andprices, not the actual details that defineindividual investment incentives. The politics ofimplementation inevitably involve a risk of whatsocial scientists call “regulatory capture”, inwhich industries effectively control theirregulators; by establishing a close relationshipparticularly with industry ministries, they seek toadjust rules of implementation so that they can

6. Lessons and a view to thefuture


carry on with ‘business as usual’, or better. Thatin essence is the story of Phase II implementationdetails in much of Europe. Increasing the role ofauctioning could help, but if the EU ETS is toprovide meaningful incentives for low carboninvestment, these underlying issues will have tobe tackled forcefully in Phase III.

During 2007, the European Commission isundertaking a comprehensive review of the EUETS. Building upon this, during 2008 legislativeproposals will be developed for its design after2012. This process offers a crucial opportunity to fix the current weaknesses of the EU ETS inrelation to low carbon investment incentives. A clear and prompt resolution of these issues will have immediate benefits, by demonstrablyshifting the longer term balance of risks andrewards decisively in favour of lower carboninvestments now.

A final issue arises from the distinction betweenthe treatment of the power sector, which bearsalmost all the cutbacks, and others. This is forgood reasons, but it hides a deeper issue. Thedominant philosophy in the non-power sectors (aswas the case for all sectors in many Phase I NAPs)is of “allocation for need” – the view thatcompanies should get almost as many allowancesas they project to be needed. This is afundamentally different mindset from regardingthe primary purpose of the EU ETS as being toset a price on emissions, and free allocations asbeing simply a temporary derogation to give timefor industry to adjust to that reality, and perhapsto help address specific competitiveness threats.

The real risk of ‘allocating for projected need’ isthat it explicitly shields companies from thereality of needing to adjust to a carbon-constrained world. In most cases it reflects afundamental confusion between “ends” (to tackleclimate change) and “means” (the EU ETS as away of achieving that). European industry needsto move towards a low carbon economy. One wayor another, facing up to a carbon price will be anessential part of that process.

The analysis in this report is based principallyupon publicly-available research carried out byClimate Strategies, a European networkorganisation which convenes academic researchon key issues in international climate policy. TheCarbon Trust is a lead funder of Climate Strategiesand their analysis of Phase II allocation plans ispublished in three main papers collected as partof a Special Issue of the journal Climate Policy,Vol.6 no.4:

❥ Karsten Neuhoff, Federico Ferrario, MichaelGrubb, Etienne Gabel, Kim Keats, ‘Emissionprojections 2008–2012 versus national allocationplans II’

❥ Regina Betz, Karoline Rogge, Joachim Schleich,‘EU emissions trading: an early analysis ofnational allocation plans for 2008–2012’

❥ Karsten Neuhoff et al., ‘Implications ofannounced phase II national allocation plans forthe EU ETS’

These papers contain details of all the numericalanalysis summarised in this report. An Editorialoverviews the findings in relation to the likelyefficiency, distribution and environmentaleffectiveness of Phase II. Additional papers in thisSpecial Issue cover related topics including theefficiency gains from trading in EU ETS Phase I,variations in Phase I new entrants, the economicsof auctioning in the US RGGI scheme, and areview of energy forecasting errors anduncertainties. Individual papers are available fromwww.climatepolicy.com.

In addition, two main studies have now beenpublished of lessons from the 2005 verificationdata. These include analysis of the extent towhich the observed surplus (summarised in ourprevious report) was due to overallocationcompared to abatement, and conclude it wassome of each. These and many other researchpapers on the EU ETS are downloadable from thewebsite www.climate-strategies.org/EUETS.


Further information

19

The Carbon Trust is a UK-widecompany, with headquarters inLondon, and bases in NorthernIreland, Scotland, Wales, and theEnglish regions.The Carbon Trust is a private company set up by governmentin response to the threat of climate change, to acceleratethe move to a low carbon economy.

The Carbon Trust works with UK business and the publicsector to create practical business-focused solutions throughits external work in five complementary areas: Insights,Solutions, Innovations, Enterprises and Investments. Togetherthese help to explain, deliver, develop, create and financelow carbon enterprise.

The Carbon Trust is funded by the Department forEnvironment, Food and Rural Affairs (Defra), the Departmentof Trade and Industry (DTI), the Scottish Executive, the WelshAssembly Government and Invest Northern Ireland.

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IMPORTANT NOTICEWhilst the Carbon Trust has taken reasonable steps to ensure that the information contained in this publicationis correct, it gives no warranty and makes no representation as to its accuracy and accepts no liability for anyerrors or omissions. Nothing in this publication is intended to or should be interpreted as an endorsement of,or recommendation for, any supplier, service or product.

This information is being made available to you as part of the Carbon Trust’s general activity of promotingdeployment of, and investment in, low carbon technology. The Carbon Trust does not give investment adviceand you must take your own view on the merits of, and the risks attached to, any investment decision you mayundertake. You may wish to obtain professional advice.

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Published in the UK: May 2007.

© The Carbon Trust 2007. All rights Reserved

Any trademarks, service marks or logos used in this publication and copyright in it are the property of the CarbonTrust. Nothing in this publication shall be construed as granting any licence or right to use or reproduce any of thetrademarks, service marks, copyright or the Carbon Trust’s proprietary information in any way without the CarbonTrust’s prior written permission. The Carbon Trust enforces infringements of its intellectual property rights to thefull extent permitted by law.

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