EU Carbon Trading, Phase Two

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

The European Commission is getting serious about reducing greenhouse gasses. On November 29th, it announced that it wanted much deeper cuts in carbon emissions from its member states during stage two of the EU's Emissions Trading Scheme (EU ETS) that runs from 2008 to 2012. The credibility of the EU ETS has been on the line since 2005 when it became clear that pollution rights had been far too generous. The much-anticipated new set of limits are important not only to restore the scheme's own viability, but to lead global efforts to combat global warming in the absence of full US involvement or support from fast-growing, high polluting Asian markets such as China.

The EU ETS is the largest carbon trading system in operation, and its success will be crucial to attracting other countries either to establish their own system, or to join the EU scheme. It works by setting a so-called National Allocation Plan comprising industry-wide, upper limits of permissible carbon emissions. It then distributes carbon credits (or "pollution rights") to some 10,000 companies and installations, allowing them to buy and sell any unused allocations on an open market. The system currently covers energy generation, refining and large manufacturing firms--which together account for almost half of all carbon emissions.

However, the problem in the 2005-07 trading period was that allocations were set too high, as industries and companies were able to manipulate their expected usage beforehand, and thus apply for an overly generous allocation of pollution rights. As a result, the scheme proved to have little impact on emissions targets, and in 2005, the price of carbon emissions credits collapsed. This initial period was, nonetheless, widely viewed as an experimental phase. However, the targets currently being set for 2008-12 are critical for the long-term success of the project.

The response of the Commission to plans submitted by member states indicates that it is determined to hit its pledged target under the Kyoto agreement that by 2012 EU emissions would be 8% below 1990 levels.

The Commission assessed the plans of 10 member states--the UK, Germany, Sweden, Greece, Ireland, Luxembourg, Latvia, Lithuania, Malta and Slovakia--which together accounted for some 42% of the total 2005-07 allocations. Other states were reprimanded for late delivery of their plans and are now sure to be subjected to harsh scrutiny. The only plan to be accepted was from the UK, often viewed a leader in carbon emission reductions, which set its level at 246.2m tonnes per year. However, the Commission added that UK plans must include polluting plants based in Gibraltar.

The caps proposed by other nine member states were sent back for revision. Germany, Europe's biggest carbon polluter, was ordered to reduce its cap by a further 6%, and to end a 14-year exemption for new coal-fired power stations. Lithuania was required to reduce its own proposed cap by almost half, to 8.8m tonnes. The Commission also curbed states from hitting their quotas through emissions-reducing investments abroad. Ireland, for example, was told that only 22% of its emissions cuts could come from overseas operations. The Commission is still looking at the plans submitted by France and Poland, and is taking action against Austria, Czech Republic, Denmark, Hungary, Italy and Spain, for submitting their plans late.

Creating momentum

Environmentalists appear happy with the Commission's position. But several point out that this alone may be insufficient to meet Kyoto targets. Even the relatively advanced UK is behind its own domestic target of reducing missions by 20% by 2010, while others are much further adrift. This has led to increasing pressure to extend the scheme to more industries and even to individual consumers. Major retail and hotel chains are in policy-makers' sights, but the most controversial and complicated extension would be to the aviation industry. Flights release nitrous oxide and water vapour which may be more harmful than carbon emissions, but which are not covered in the EU ETS. Given current airline growth trends emissions from flights will account for up to one-quarter of total pollution by 2030.

Perhaps the bigger question, though, is whether a well-functioning EU trading system can win support in the US at state or federal level. This might then create sufficient momentum to bring China and India, potentially the biggest polluters of all, into some form of scheme. Without their support any savings from the EU ETS would in the long run serve little purpose in combating global warming. The tough stance by the Commission indicates that it has the political will to turn the EU system into a global role model.

Whilst every effort has been taken to verify the accuracy of this information, The Economist Intelligence Unit Ltd. (http://www.eiu.com/) cannot accept any responsibility of liability for reliance by any person on this information.

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