The EU ETS: The EU ETS: current problems and possible current problems and possible

ways to move forwardways to move forward

drs. Stefan Weishaar, M.Sc., LL.M.Metro, University Maastricht

OutlineOutline

• The EU ETSThe EU ETS

• Present situation and current Present situation and current problemsproblems

• Possible ways to move forwardPossible ways to move forward

The EU ETSThe EU ETS

EU Action EU Action

• Since 1991 Commission is taking action to Since 1991 Commission is taking action to reduce GHG emissions and improve energy reduce GHG emissions and improve energy efficiencyefficiency– Renewable energyRenewable energy– Voluntary commitments (car makers)Voluntary commitments (car makers)– Taxation (energy products and electricity)Taxation (energy products and electricity)

• In 2000 launch of European Climate Change In 2000 launch of European Climate Change Program (ECCP) to meet Kyoto Protocol goals Program (ECCP) to meet Kyoto Protocol goals of reducing emission levels during 2008 – 2012 of reducing emission levels during 2008 – 2012 to 8 percent below 1990 levelsto 8 percent below 1990 levels

• Measures of the 1Measures of the 1stst phase of the phase of the ECCPECCP– Proposal for ratifying the Kyoto ProtocolProposal for ratifying the Kyoto Protocol– Proposal for establishing the EU ETSProposal for establishing the EU ETS– Regulating certain fluorinated gasesRegulating certain fluorinated gases– Action Plan: linking EU ETS with CDM Action Plan: linking EU ETS with CDM

and JIand JI

The EU ETSThe EU ETS

• European Emission Trading System (EU European Emission Trading System (EU ETS) is a part of the ECCPETS) is a part of the ECCP– 11stst January 2005 January 2005– 5000 operators5000 operators– 12.000 installations12.000 installations– Sectors: energy, ferrous metals, minerals, pulp Sectors: energy, ferrous metals, minerals, pulp

and paperand paper– Time periods: Time periods:

• 2005 – 2007 (learning by doing phase (!))2005 – 2007 (learning by doing phase (!))• 2008 – 2012 (Kyoto)2008 – 2012 (Kyoto)• 5 year periods5 year periods

EU ETS peculiaritiesEU ETS peculiarities

• 15 Old MS: Burden sharing 15 Old MS: Burden sharing agreementagreement

• 10 New MS: Kyoto commitments10 New MS: Kyoto commitments

• Malta and Cyprus: Malta and Cyprus: – Very few installationsVery few installations– No Kyoto commitments => bound by EU No Kyoto commitments => bound by EU

ETS, business as usual scenarios ETS, business as usual scenarios

Directive 2003/87/ECDirective 2003/87/EC

• Obliges MS to:Obliges MS to:– Identify operatorsIdentify operators– Monitoring, Verification and ReportingMonitoring, Verification and Reporting– Draw up a ‘National Allocation Plan’Draw up a ‘National Allocation Plan’

=>Allocate emission allowances=>Allocate emission allowances

- subject to: criteria listed in Annex III- subject to: criteria listed in Annex III

– Legislative tool Legislative tool Directives are binding upon their result but leave Directives are binding upon their result but leave

choice of form and methods, Article 249 EC Treatychoice of form and methods, Article 249 EC Treaty

Learning by doing (!)Learning by doing (!)

• Commission wants legislative Commission wants legislative changes to take effect 2013changes to take effect 2013

• Review working group under ECCP II Review working group under ECCP II => legislative proposals in 2007=> legislative proposals in 2007

• Review process considers post Kyoto Review process considers post Kyoto period and international contextperiod and international context

Present situation and Present situation and Current problemsCurrent problems

Present situationPresent situation

• 21 Member States do have an 21 Member States do have an electronic registryelectronic registry– 99% of allowances (9000 installations) 99% of allowances (9000 installations)

complied with Directive as of 30 April 2006complied with Directive as of 30 April 2006– 320 million allowances were traded320 million allowances were traded– 6.5 billion Euros6.5 billion Euros– Greenhouse gas emissions lower than Greenhouse gas emissions lower than

expectedexpectedSuccess or over allocation?Success or over allocation?

Problematic issuesProblematic issues

• Price signalsPrice signals

• Linking EU ETS and ‘Kyoto’Linking EU ETS and ‘Kyoto’

• Design choicesDesign choices– ScopeScope– New entrantsNew entrants– Windfall profitsWindfall profits– Closure and transfer rulesClosure and transfer rules

Long run price signalLong run price signal

• Long run prices -> trigger behaviorLong run prices -> trigger behavior– Sufficiently high pricesSufficiently high prices– Price stabilityPrice stability– PredictabilityPredictability

• Price fluctuation is normal Price fluctuation is normal – Allocation rulesAllocation rules– ComplianceCompliance– Supply and demand Supply and demand – Emission capEmission cap– Political developmentsPolitical developments– Alternative supply sourcesAlternative supply sources

EAU price developmentEAU price development

0

5

10

15

20

25

30

09.0

3.20

05

12.0

4.20

05

13.0

5.20

05

15.0

6.20

05

15.0

7.20

05

16.0

8.20

05

15.0

9.20

05

18.1

0.20

05

17.1

1.20

05

19.1

2.20

05

19.0

1.20

06

20.0

2.20

06

22.0

3.20

06

25.0

4.20

06

29.0

5.20

06

29.0

6.20

06

31.0

7.20

06

30.0

8.20

06

29.0

9.20

06

01.1

1.20

06

01.1

2.20

06

05.0

1.20

07

06.0

2.20

07

08.0

3.20

07

11.0

4.20

07

14.0

5.20

07

15.0

6.20

07

17.0

7.20

07

16.0

8.20

07

EUR/EAU

Source: http://www.eex.com

Unannounced pre-release of verified emissions data

• May 2006 unannounced pre-release of May 2006 unannounced pre-release of verified emissions data by several Member verified emissions data by several Member StatesStates

• Lower than expected actual level of emissions Lower than expected actual level of emissions

• Current price below 10 centsCurrent price below 10 cents

• Oversupply of perhaps 160 million tons CO2Oversupply of perhaps 160 million tons CO2

• Dim prospects for environmental Dim prospects for environmental effectiveness in the 1effectiveness in the 1stst trading period… trading period…

EAU futuresEAU futures

Source: http://www.eex.com

Scarcity in the 2Scarcity in the 2ndnd phase phase

• Market seems to expect sufficient scarcity Market seems to expect sufficient scarcity in phase 2 – despite linkingin phase 2 – despite linking– Strong political massage at G8 meetingsStrong political massage at G8 meetings– Downward corrections of 2008-2012 allocations Downward corrections of 2008-2012 allocations

demanded by Commission, ca. 9% demanded by Commission, ca. 9% – 8 Member States have taken / consider taking 8 Member States have taken / consider taking

legal action: Lithuania, Malta, Poland, Hungary, legal action: Lithuania, Malta, Poland, Hungary, Czech Republic, Slovakia, Estonia and LatviaCzech Republic, Slovakia, Estonia and Latvia

– Preliminary question from a French Court to the Preliminary question from a French Court to the ECJ => non-coverage of aluminum and plastics ECJ => non-coverage of aluminum and plastics industries vs. principle of equal treatmentindustries vs. principle of equal treatment

Linking EU ETS and ‘Kyoto’Linking EU ETS and ‘Kyoto’

• The Linking Directive (2004/101/EC) The Linking Directive (2004/101/EC) grants MS discretion to allow grants MS discretion to allow operators to use CERs (from CDMs, operators to use CERs (from CDMs, 11stst period) and ERU (from JIs, as of period) and ERU (from JIs, as of 2008) for their EU ETS obligations2008) for their EU ETS obligations

• Percentage is based on the allocation Percentage is based on the allocation to each firmto each firm

• Limits for usage of CERs and ERUs binding Limits for usage of CERs and ERUs binding upon installations are expected to be wideupon installations are expected to be wide

• For the second trading period they For the second trading period they average around 11.5%average around 11.5%

• 220 million tons of Kyoto Mechanisms can 220 million tons of Kyoto Mechanisms can be imported annuallybe imported annually

• Despite Commission’s reductions, supply Despite Commission’s reductions, supply surplus of 6% (2008-2012) if contrasted to surplus of 6% (2008-2012) if contrasted to actual demand in 2005actual demand in 2005

• Supplementarity:Supplementarity:Meaningful reduction domestically?Meaningful reduction domestically?

• Kyoto Protocol binding upon states Kyoto Protocol binding upon states If margins for EU ETS sectors are set If margins for EU ETS sectors are set

widely widely

=> other sectors have a higher burden=> other sectors have a higher burden

Environmental soundnessEnvironmental soundness

• Allowing CDMs under EU ETS may give rise Allowing CDMs under EU ETS may give rise to leakageto leakage– Additionally criterionAdditionally criterion– Environmental integrityEnvironmental integrity

• Credible baseline to quantify reductionsCredible baseline to quantify reductions• MonitoringMonitoring• VerificationVerification• ComplianceCompliance• Impact assessment + evaluation of projects done by Impact assessment + evaluation of projects done by

host country (partly assessed by CDM Executive host country (partly assessed by CDM Executive Board)Board)

• Disincentives to promulgate environmentally Disincentives to promulgate environmentally stringent legislation? stringent legislation?

Distortions of CompetitionDistortions of Competition

• If prices of CERs and ERUs are lower If prices of CERs and ERUs are lower than EAUs and MS legislation differs -than EAUs and MS legislation differs -> distortions of competition> distortions of competition– Lower operating costsLower operating costs– Windfall profitsWindfall profits

Market priceMarket price

• Unless demand during 2008-2012 Unless demand during 2008-2012 lies at least 6% above the 2005 lies at least 6% above the 2005 emissions EAU prices would be emissions EAU prices would be comparable to those of CERs and comparable to those of CERs and ERUsERUs

• Price incentive sufficient to trigger Price incentive sufficient to trigger environmentally friendly behavior?environmentally friendly behavior?

• Yet: low cost burden on industry Yet: low cost burden on industry mitigates leakagemitigates leakage

Design choicesDesign choices

• DirectiveDirective

• Cap and trade systemCap and trade system

• Scrutiny by the CommissionScrutiny by the Commission– CriteriaCriteria

• Limitation of auctioning => free Limitation of auctioning => free allocation mandatory allocation mandatory (‘grandfathering’)(‘grandfathering’)

• Ex postEx post allocations allocations

Scope of the DirectiveScope of the Directive

• Definitions / criteria are vague => Definitions / criteria are vague => different interpretations of the legal textdifferent interpretations of the legal text

• Different allocation methodologies => Different allocation methodologies => comparable installations are treated comparable installations are treated differentlydifferently

• Distortions of competition, distortions Distortions of competition, distortions between sectors, impacts on the between sectors, impacts on the Common Market, scope of covered Common Market, scope of covered industriesindustries

New entrantsNew entrants

• Directive obliges MS to include rules for Directive obliges MS to include rules for new entrants in NAPsnew entrants in NAPs

• Commission’s guidance noteCommission’s guidance note– BuyingBuying– AuctioningAuctioning– Reserve + free allocationReserve + free allocation

• Commission’s position: Commission’s position: Having new entrants pay satisfies equal Having new entrants pay satisfies equal

treatment because new entrants do not incur treatment because new entrants do not incur stranded costs, and subsequently benefit from stranded costs, and subsequently benefit from free allocation => cost burden limitedfree allocation => cost burden limited

• Not affording equal treatment can Not affording equal treatment can give rise to:give rise to:– Direct financial disadvantageDirect financial disadvantage– Barriers to entryBarriers to entry

•Higher consumer pricesHigher consumer prices

•X-inefficiencyX-inefficiency

• Equally authentic language versions of the Equally authentic language versions of the Directive differ in clarityDirective differ in clarity– Obligation to take into account the need…(England)Obligation to take into account the need…(England)– Necessity to keep allowances available… (Netherlands)Necessity to keep allowances available… (Netherlands)

• Substantial differences in relative size of new Substantial differences in relative size of new entrance reservesentrance reserves

• Different strategies to deal with depletion of Different strategies to deal with depletion of reservesreserves

• Incumbent top performers can receive up to 10% Incumbent top performers can receive up to 10% more allowances while new entrants cannot more allowances while new entrants cannot

• MS seek to attract new entrants MS seek to attract new entrants

• Allocation for free makes Allocation for free makes environmentally friendly technology environmentally friendly technology less attractiveless attractive

• Need for scrutiny and harmonizationNeed for scrutiny and harmonization

Windfall profitsWindfall profits

• Overcompensating incumbents for Overcompensating incumbents for stranded costs is seen as ‘unfair’stranded costs is seen as ‘unfair’

• Ability to generate windfall profits is Ability to generate windfall profits is unevenly distributedunevenly distributed– Dependent upon demand elasticitiesDependent upon demand elasticities– Competition on the marketCompetition on the market

Closure and transfer rulesClosure and transfer rules

• The European legislator did not The European legislator did not regulate discontinuation of regulate discontinuation of production and not address transfers production and not address transfers from one plant to anotherfrom one plant to another

• MS enjoy discretionMS enjoy discretion– Distortions of competition Distortions of competition – Environmental incentivesEnvironmental incentives

• NetherlandsNetherlands– Scraping production or transfer => Scraping production or transfer =>

retaining of allowances for the whole retaining of allowances for the whole period (2005 - 2007)period (2005 - 2007)•Receiving allowances on different production Receiving allowances on different production

statisticsstatistics•Operator may enjoy new entry benefits from Operator may enjoy new entry benefits from

another MSanother MS

=> comparative advantage vs. new => comparative advantage vs. new entrants and incumbentsentrants and incumbents

• GermanyGermany– Transfer => retaining of allowances for Transfer => retaining of allowances for

1 year only if replacement installation in 1 year only if replacement installation in GermanyGermany•Eligibility -> distortions of competitionEligibility -> distortions of competition

•Free movement of companies (?)Free movement of companies (?)

SummarySummary

• The EU ETS does not (yet?) provide a The EU ETS does not (yet?) provide a stable and sufficiently high market stable and sufficiently high market price that encourages environmentally price that encourages environmentally friendly research and investmentfriendly research and investment– Over allocationOver allocation– Information asymmetry Information asymmetry

• Sobering experience of 1Sobering experience of 1stst trading trading phase but price of 2phase but price of 2ndnd period is period is strongly positivestrongly positive

• Substantial amounts of CDMs and JIs Substantial amounts of CDMs and JIs – Environmental effectiveness?Environmental effectiveness?– Distortions of competitionDistortions of competition– Sufficient cost incentive?Sufficient cost incentive?

• Clear preference for free allocationClear preference for free allocation– Heterogeneous interpretation of the DirectiveHeterogeneous interpretation of the Directive– Distortions of competitionDistortions of competition– Differential treatment of new entrantsDifferential treatment of new entrants– Diverging Closure and transfer rulesDiverging Closure and transfer rules– Windfall profitsWindfall profits

Possible ways to move Possible ways to move forwardforward

Policy considerationsPolicy considerations

Information Asymmetry

Member States Rent seeking

• Grandfathering:Grandfathering:– Support of covered sectorsSupport of covered sectors– MS are able to protect domestic interestsMS are able to protect domestic interests– Lack incentives for operators to reveal Lack incentives for operators to reveal

true valuations => information true valuations => information asymmetryasymmetry

– Environmental effectiveness questionable Environmental effectiveness questionable if EAU price is lowif EAU price is low

• Performance Standard Rate Performance Standard Rate – Credit and trade approach Credit and trade approach

•No Windfall profitsNo Windfall profits•No unequal treatment of new entrantsNo unequal treatment of new entrants•No distortions from closure and transfer rulesNo distortions from closure and transfer rules•Emphasizes competition on the meritsEmphasizes competition on the merits

– Credit and trade criticized as less Credit and trade criticized as less efficient than cap and tradeefficient than cap and trade

– Relative targets more acceptable Relative targets more acceptable

• PSR and EU ETSPSR and EU ETS– PSR must operate under cap-and-tradePSR must operate under cap-and-trade

•Long trading period reduces rent seeking Long trading period reduces rent seeking costscosts

•Effective adjustments of benchmarksEffective adjustments of benchmarks

– Ex postEx post adjustments adjustments•Emissions dependent upon production => no Emissions dependent upon production => no

direct link between installation and EAU to be direct link between installation and EAU to be allocated at the start of the trading period => allocated at the start of the trading period => at odds under current at odds under current ex postex post interpretation interpretation

• PSR preferable to grandfatheringPSR preferable to grandfathering– Contingent upon Contingent upon

•Rent seeking costsRent seeking costs

•Costs of negotiationsCosts of negotiations

•Benchmark adjustment costsBenchmark adjustment costs

•Benefits of exposed sectors vs. Benefits of exposed sectors vs. disadvantages of sheltered sectors?disadvantages of sheltered sectors?

• PSR PSR – May mitigate / avoid some shortcomings May mitigate / avoid some shortcomings

of grandfatheringof grandfathering– May foster support of industryMay foster support of industry– Political support? Political support? – Rent seeking costs / operating costs?Rent seeking costs / operating costs?– Information asymmetry remainsInformation asymmetry remains

• Only market based instruments can Only market based instruments can overcome information asymmetryovercome information asymmetry– Auctions gain more attention in the Auctions gain more attention in the

second trading period but remain second trading period but remain limited to 10% under the present limited to 10% under the present DirectiveDirective

– Lack of political supportLack of political support– Lack support of industryLack support of industry

Thank you for your kind attention!Thank you for your kind attention!