Greenhouse gas trading in Europe

Almost a decade has passed since the United States began operating the first large-scale emissions trading program in 1995. The U.S. sulfur dioxide (S[O.sub.2]) cap-and-trade program has been studied extensively and has become the benchmark for evaluating subsequent emissions trading proposals. Based on the success of this "Grand Policy Experiment," emissions trading has become an increasingly accepted approach for addressing air pollution control. (1)

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Beginning in 2005, however, Europe will launch a cap-and-trade program for greenhouse gases that is substantially larger and more complex than the pioneering U.S. effort. Although strongly influenced by the design of the U.S. S[O.sub.2] trading program, the European Union Emissions Trading System (EU ETS) will dwarf existing U.S. trading programs in size and complexity and will encompass a variety of new features. Because of its scope and multijurisdictional political structure--and because it is the first large-scale attempt to regulate greenhouse gases--the EU program is in many ways the "New Grand Policy Experiment." As such, it has the opportunity to advance the role of market-based policies in environmental regulation and to form the basis for future European and international climate change policies. For example, EU ETS will be the first emissions trading program to grapple with the many issues associated with linking different national-level programs.

Yet there are also many pitfalls along the way and, should it not work out as planned--or, worse yet, out-right fail--EU ETS could set back efforts to advance market-based policies and to address global climate change. Perhaps the most significant challenges faced by the EU member states are the uncertainties surrounding the future international climate regime and the tight timetable they have given themselves to implement the trading program. Moreover, implementing and enforcing EU ETS could be particularly difficult in those European countries with weaker environmental institutions. Provisions that provide flexibility in monitoring and compliance could be important innovations, but they raise a whole suite of new questions about whether there will be enough consistency from one member state to another. Finally, there is considerable uncertainty about the ultimate costs of the program, particularly in the second phase of the program when EU member states must meet their targets under the Kyoto Protocol. Implementation, technology and behavioral response, and external events could affect these costs in unexpected ways. These uncertainties may be compounded by an overly generous allocation of emissions allowances in the first phase of the program and the lack of an adequate banking provision between the first two phases.

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Summary of Provisions

The EU program will begin on 1 January 2005 and will apply to 25 countries, including the 10 accession countries, most of which are former members of the Soviet bloc (see Figure 1 on page 11). (2) The first phase will run from 2005 through 2007 and is sometimes referred to by EU officials as a "warm-up" phase. (3) The second phase will begin in 2008 and continue through 2012, coinciding with the five-year Kyoto commitment period. (Under the Kyoto Protocol, emissions targets have been negotiated for developed countries for the five year period from 2008 through 2012. Starting in 2005, negotiations will begin on emissions targets for the period after 2012.) The EU program continues in five-year phases thereafter.

Initially, EU ETS will cover only carbon dioxide (C[O.sub.2]) emissions from four broad sectors: production and processing of iron and steel; minerals (such as cement, glass, or ceramic production); energy (such as electric power and direct emissions from oil refineries); and pulp and paper. Installations are included in the program if they exceed industry-specific production or capacity thresholds specified in the EU Directive (the legal document setting forth the rules for EU ETS). Current estimates are that more than 12,000 installations will be included in the program. (4) (In EU parlance, an installation is defined as "a stationary technical unit where one or more activities [in industry sectors covered by the trading program] are carried out and any other directly associated activities which have a technical connection with the activities carried out on that site and which could have an effect on emissions and pollution." (5)) The European Union may subsequently add additional greenhouse gases, sectors, and installations in the second phase of the program. (For a description of other key features of the EU program, see the box on page 12.)

Comparing EU ETS with Past Programs

In general, the design of EU ETS builds upon the lessons of the economics literature and the experience of earlier emissions trading programs. (See the boxes on pages 13 and 14.) However, the scope and complexity of the EU program is far greater than past efforts. The EU trading program will require member states to develop the administrative infrastructure to implement a complex system in a relatively short period. Table 1 on page 15 illustrates several ways in which the scope of the EU program is broader and more complex than past U.S. efforts. For example, the EU program covers a much larger number of sources in terms of absolute numbers and variety. Some of the sectors covered, such as cement or iron and steel, have emissions sources where measurement and verification is not as straightforward as the utility and industrial boilers that make up the bulk of the U.S. programs. EU ETS could also include multiple greenhouse gases in the second phase of the program and will include emissions reductions from projects undertaken in developing countries.

Analysis of Allowance Distribution Issues

Probably the most difficult step in the development of EU ETS is the preparation and review of National Allocation Plans. By 31 March 2004, the 15 original EU member states (EU-15) were required to submit a plan to the European Commission that contained a list of installations with their proposed allocations and an extensive justification of the decisions and methodologies used to make the allocation. The new accession states were required to submit their plans by 1 May 2004. Although only a few of the 25 member states met these deadlines, most have now submitted their plans. The EU Directive provided member states with general criteria for allocation, including ensuring that the allocation is "consistent with achieving the overall Kyoto target." (6) In addition, the allocation is to take into account a variety of technical and policy considerations and must include an opportunity for public participation in the review of the National Allocation Plans.

After the European Commission receives the plans, it reviews whether they meet the allocation criteria. Of particular concern to the commission is the evaluation of "state aid" considerations related to allowance allocation. "State aid" is a term of art within the European Union that refers to public subsidies that give industry within one member state an unfair competitive advantage over industry within another country.

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In the United States, the term "allocation process" usually refers to decisions about allocating to firms after a cap has already been set. However, in the EU's National Allocation Plan (NAP) process, there are three decisions that must be made by each member state more or less simultaneously.

The first is how much of a member state's Kyoto target will be given to the sectors participating in the emissions trading program--that is, the level of the cap for EU ETS sources within their borders. Each of the EU-15 states has national targets for Kyoto compliance that have been negotiated under the European Union's burden-sharing agreement. EU ETS is essentially a "cap within a cap," covering a subset of emissions sources and sectors. Therefore, as they decide how much of this burden the EU ETS sectors will meet, member states are deciding (either implicitly or explicitly) how much the non-capped sectors will contribute to meeting the national target. (7)

A second decision that must be made by member states is how to set allocations for each of the sectors involved in the trading system. This is a particularly difficult decision because a sector's allocation will determine its net burden (mitigation expense, plus allowance purchases, minus any increase in revenue) and may have implications for competitiveness within the European Union. In other words, industrial sectors in two different EU member states with different allocations would have differing profitability, which could affect their liquidity and ability to raise capital, if not directly affect relative prices.