European Union Emissions Trading Scheme Case Study
Updated: Feb 5
Introduction
A cap and trade market is a system for reducing emissions in which the governing body establishes an overall cap or limit on the amount of emissions permitted by the sectors/industries covered by the market. The governing body distributes allowances to companies that act as permits for them to produce a certain amount of emissions. These allowances are able to be traded between companies in the market which serves the goal of allowing companies that are able to reduce their emissions in a more cost effective way to sell their allowances to companies that are not able to reduce emissions easily.
The impetus behind the creation of the EU Emissions Trading System (ETS) starts with the signing by European countries of the UN Framework Convention on Climate Change in 1992 and the Kyoto Protocol in 1997. As part of the signing of the Kyoto Protocol, the EU jointly agreed to reduce GHG emissions by 8% from 1990 levels between 2008 and 2012. Some countries created national emission reduction policies, but there was a lack of EU-wide policy instruments to reduce emissions at the time. Negotiations resulted in the development of the EU ETS which was signed into law by the European Parliament in 2003 with Directive 2003/87/EC and entered into effect in 2005.
Market Design
The EU ETS has been divided into four trading periods, known as Phases. Phase 1 ran from 2005 to 2007 and was intended to be a 3 year pilot period to lay the groundwork for the market and prepare for Phase 2. The sectors that were covered by the ETS in Phase 1 were power and heat generation and energy intensive industrial sectors like iron, steel, cement, and oil refining. Member States prepared National Allocation Plans (NAPs) which laid out how many allowances they would issue in total and where those allowances would be allocated, with one allowance equaling one ton of CO2e emitted. The total allowances included in each NAP were combined to create the overall cap for the ETS. Almost all of these allowances were allocated for free to companies based on historical emissions estimates. Businesses are required to report their emissions yearly and surrender enough allowances to cover their full emissions, with the penalty for non-compliance being €40/tCO2e.
Phase 1 of the ETS was successful in establishing a price for allowances, the free trade of allowances across the EU, and the infrastructure for monitoring, reporting and verifying actual emissions. However, in Phase 1 the ETS ran into major issues with overallocation of allowances. Due to the lack of reliable emissions data before the start of Phase 1, emissions levels were based on estimates which resulted in the amount of issued allowances exceeding emissions. This along with the fact that allowances were not able to be banked from Phase 1 to Phase 2 caused the price of allowances to fall to zero by the end of Phase 1.
Phase 2 ran from 2008 to 2012 and saw the incorporation of Iceland, Norway, and Liechtenstein into the market. This Phase was concurrent with the first compliance period of the Kyoto Protocol meaning the EU had to meet their concrete goal of reducing emissions by 8% from 1990 levels. Several changes were made to correct previous problems in the ETS and improve its effectiveness. Now that there was actual emissions data from Phase 1, the cap on allowances was reduced by 6.5% compared to 2005 in order to ameliorate the issue of overallocation. The scope of the ETS was expanded to also include nitrous oxide from nitric acid production from several Member States. In addition, up to 10% of allowances were able to be auctioned off by Member States rather than being freely allocated and the penalty for non-compliance was increased to €100/tCO2e. In 2012, the national registries for allowances were consolidated into a single Union Registry which served to improve the efficiency and transparency of the system. Also in 2012, aviation was added as a covered sector, covering all flights to, from, and within the European Economic Area (EEA). Due to foreign pushback, this was later limited to only flights within the EEA and from the EEA to Switzerland and the UK.
A significant addition to the ETS in Phase 2 was that businesses were allowed to use credits from the Kyoto Protocol’s Clean Development Mechanism and Joint Implementation, a change that was meant to offer cost-effective mitigation options to companies. However, since these were foreign allowances, their use did not translate into emissions reductions within the EU itself. Additionally, the influx of allowances from this change, as well as the reduction in emissions resulting from the 2008 financial crisis, resulted in a continued surplus of allowances that caused allowance prices to drop from €30 to €7.
Phase 3 ran from 2013 to 2020 and saw the inclusion of more sectors and gases to the ETS. During this Phase the ETS sought to correct four main issues. First was the fall of allowance prices which undermined the reliability of the ETS. Second was that the ETS was not generating the move towards renewable energy and low-carbon technologies to the extent desired. Third was that the ETS was not as cost effective as hoped. And lastly the system was running into issues with fraud and scams.
One of the first changes made in Phase 3 was the unification of the emissions cap under a single, EU-wide cap rather than national caps. This cap was set to be reduced by 1.74% per year until 2020, then 2.2% per year after, which would serve to limit overallocation and encourage further emissions reductions. Auctioning also became the default method of issuing allowances. The Auctioning Regulation was created to ensure the transparency of the auction process and an amendment was made to the ETS Directive to ensure that auctions match criteria like predictability, cost-efficiency, and fair access to auctions and simultaneous access to relevant information for all operators. The amended Directive also instructed Member States to use at least 50% of their auction revenues, and all revenues from aviation allowances, for climate- and energy-related purposes, which was changed in 2023 to require Member States to use all of their revenue from auctions to support the green transition. Since 2013 the ETS has generated over €200 billion in auction revenue.
The use of free allocation of allowances was limited to industrial installations using a benchmark allocation based on what they produce (steel, cement, lime, etc.). Installations would receive 80% of their benchmark allowance, reduced each year down to 30% in 2020, and for industries at high risk of leakage, they would get 100% of their benchmark allocation for the entire Phase to keep these industries from moving to areas outside the ETS. 300 million allowances were also set aside for the New Entrants Reserve to support the deployment of carbon capture and storage and innovative renewable energy technologies through the NER 300 program.
However, since allowances were able to be banked from Phase 2 to Phase 3 the ETS continued to be plagued by an oversupply of allowances. This surplus continued to depress prices to around €3-7 and lead the ETS to postpone the auctioning of 900 million allowances until the end of Phase 3. To further address this issue, the ETS created the Market Stability Reserve (MSR) in 2019 to which the 900 million backloaded allowances were transferred. The purpose of the MSR was to balance out supply and demand to safeguard the market from future major shocks. It was designed so that when the total number of allowances in circulation (TNAC) exceeds 833 million, the MSR withdraws allowances from auctions, reducing supply in the market, and when the TNAC falls below 400 million, the MSR releases 100 million allowances for auction, increasing supply in the market.
The ETS is currently in Phase 4 which is set to run from 2021 to 2030. Additional reforms were introduced in 2023 as part of the EU’s Fit for 55 package. The ambition of the ETS was increased, setting a new goal to reduce emissions by 62% compared to 2005 by 2030. The yearly reduction to the cap increased to 4.3% in 2024 and will increase again to 4.4% in 2028. There was also a tightening of the guidelines on free allocation and the scope of the ETS was expanded to include maritime emissions in 2024. The Fit for 55 package also introduced ETS 2 which will become operational in 2027 and cover buildings, road transport, and small industry. Two important reforms were also added to the MSR. The first was a change in how allowances are withdrawn when there is an oversupply that created a more gradual increase in withdrawals to limit the impact of the “threshold effect”. The second reform stipulated that if the MSR holds more than 400 million allowances at the end of the year, all additional allowances beyond the 400 million threshold are invalidated and can no longer be used in the market.
Market Evaluation
Overall the EU ETS has been largely successful. By its own reporting, the installations covered by the ETS have seen a 47.6% reduction in emissions since 2005 as of 2023 which puts it on track to meet its goal of 62% reduction by 2030. This is certainly a significant achievement though the degree to which it resulted from the ETS can be difficult to quantify. The ETS has also seen little leakage or economic downturn for installations that it covers. While it has been successful, the development of the ETS has been a masterclass in growing pains. The issues of overallocation and price drops that persisted through Phases 1 and 2, and most of Phase 3, served to undermine much of the effectiveness of the system. However, the EU was able to implement reforms like unifying caps and registries, transitioning to auctioning, and creating the MSR which managed to stabilize the market and make it an effective tool in advancing decarbonization.
With that said, there are still improvements that can be made to the system. Chiefly, these should focus on addressing the impact that technological improvements in decarbonization and complementary environmental policies have on the effectiveness of the system. The strength of the ETS comes from the scarcity of allowances, which is what serves as the driving force for companies covered by the system to make changes that permanently reduce their emissions. When new technologies or environmental policies generate (or speculatively generate) emissions reductions, this subsequently leads to a reduction in the demand for allowances. While obviously emissions reductions are the end goal of the entire system, the decrease in demand for allowances translates to a decrease in the price of allowances which means that other companies who have not reduced emissions are able to obtain them more easily and have less pressure to decarbonize.
While this is partially remedied by the built in decreases to the cap, the weakening effect of reduced overall emissions still stands. Say there is a 2% reduction in emissions in one year, there is a 2% reduction in demand as well which means that the 4.3% cap reduction becomes effectively 2.3%. While not a direct linear comparison since economic growth or other factors can introduce new demand, the EU should be conscious of this weakening effect and either plan their environmental policies to target sectors not covered by the ETS or adapt the reductions to the ETS cap to correspond with emissions reductions.
Additionally, the current system by which the MSR determines when to withdraw or release auctionable allowances should be reformed to better respond to speculative demand changes in addition to unexpected demand shocks. For example, if a new technology or policy is announced that will cause a reduction in emissions in the future, companies that will benefit from that reduction will purchase and bank fewer allowances. This will cause a decrease in the TNAC which in the current system will reduce the amount of allowances being taken up by the MSR. This will reduce the amount of allowances being surrendered by companies or cancelled by the MSR which will keep the overall supply of available allowances high and weaken the effectiveness of the ETS. To remedy this problem, the MSR should withdraw and release allowances based on price rather than volume, with the MSR withdrawing allowances when the carbon price is too low to reduce supply and releasing allowances when the carbon price is too high to increase supply. When fewer allowances are being surrendered by companies, the MSR will be cancelling more allowances which will better maintain the equilibrium and strength of the ETS.
