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Understanding the EU-ETS

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European Union’s Emissions Trading System (EU ETS)

Author : Shailesh Telang, EcoLogic Consultancy

Overview

The European Union Emission Trading System (EU-ETS) is the largest emissions
trading scheme in the world and also a first cap and trade system1 of CO2 started in
2005. Formerly the tradable emission allowances were first used under the United
States’ Acid Rain Program, the world’s first cap and trade program. The program, which
began in 1995, addresses Sulphur dioxide emissions from utilities. The success of this
program helped paved the way for the development of cap and trade programs
addressing green house gas emissions, the most notable of which are the European
Union’s Emissions Trading Scheme (ETS). Under the EU-ETS, large emitters of carbon
dioxide within the European Union must monitor and annually report their
CO2 emissions. EU-ETS was enacted before the Kyoto Protocol became legally binding
in international and EU law and it would have become operational even if the Kyoto
Protocol had not entered into force in February 2005. Although it is inspired by the
Kyoto Protocol but it is independent of it.

How does it operate?

The ETS system is divided into trading periods or phases. Allocation of Cap is done by
fixing the trading period. The cap for the first period (2005-07) was determined in mid-
2005 (Pilot or Trial phase). Cap for second trading period (2008-12) was not finalized
until late 2007 and the period after 2012, the European Council has declared that the
EU’s greenhouse gas (GHG) emissions will be at least 20 percent lower than the 1990
level by 2020.

Emission allowances: An emissions allowance is an authorization to emit a fixed amount

of a pollutant. It is a term commonly used to describe a unit of greenhouse gas
emissions (GHG) covered under an emissions trading, or “cap and trade” program. An
emissions allowance is sometimes also referred to as a permit. An allowance is a fully

1
In a cap and trade system a central authority sets a limit, or a cap, on the overall amount of pollutants
that are allowed to emit in one certain area and allocates permits representing the right to emit a specific
amount of pollutants to companies. Companies then can trade permits on a created market. Over time, the
limit or the cap becomes stricter, allowing less and less pollutions, until the final reduction goal is met.

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marketable commodity that may be bought, sold, or traded for use by entities covered
by the program. Currently under EU-ETS, each member state decides how many
allowances to allocate per trading period based upon criteria established by the
European Commission. The member states draw up national allocation plans (NAPs),
which the Commission must adopt. The countries, through their NAPs, set the overall
emission caps, establish a set number of allowances, and distribute those allowances to
the regulated installations within their countries.

The EU ETS is a classic cap-and-trade system. However, it also contains some significant
design differences from those reflected in cap-and-trade systems for other emissions
that have been implemented in the U.S. The common features are that
1. An absolute quantity limit (or cap) on CO2 emissions has been placed on some
12,000 emitting facilities located in the European Union,
2. Tradable allowances have been distributed to these facilities (typically for free) in an
amount equal to the cap, and
3. These facilities must measure and report their CO2 emissions and subsequently
surrender an allowance for every ton of CO2 they emit during annual compliance
periods. The primary differences from U.S. experience with cap-and-trade
mechanisms relate to how the cap is set, the process for allocating emission
allowances, banking and borrowing provisions, the monitoring, reporting, and
verification procedures, and the linking or off-system provisions.

Cap setting process

There was no initially determined overall limit. No there are separate decisions
concerning the total number of European Union Allowances (EUAs) that each member
state could distribute to affected installations within its jurisdiction. Each member state
proposed a quantity of EUAs, but that quantity was subject to review and approval by
the European Commission according to procedures and criteria specified in the EU
Emissions Trading Directive.

The main change in EU ETS is that it is a cap within a cap from 2008 on. The Kyoto
Protocol, as modified for the European Union (EU15) by the Burden Sharing Agreement
(BSA) imposes an economy-wide cap on all greenhouse gas emissions (The EU-ETS
includes only CO2 emissions). The sectors (power sector, specified industrial sectors
and all combustion facilities with a thermal input of greater than 20 MW regardless of
the sector in which they are found including commercial and institutional
establishments) included under the EU ETS comprise about half of EU CO2 emissions
and about 40 percent of the GHG emissions covered by the Kyoto Protocol. GHG
emissions from sources not included in the EU ETS.

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Incorporation of Kyoto Mechanism in EU-ETS

An important but less noticed complement to the Emissions Trading Directive is the
Linking Directive, which was formally adopted in November 2004. Up to a certain limit,
it allows affected installations to comply by submitting qualifying credits for emission
reductions accomplished outside of the European Union. The only credits allowed are
those created through the provisions of the Kyoto Protocol relating to the Clean
Development Mechanism (CDM) or Joint Implementation (JI) and known respectively as
Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs). Even so,
credits generated by certain CDM activities cannot be used for compliance in the EU
ETS, namely, those associated with nuclear power and from CO2 sinks. Interestingly,
however, credits generated by non-CO2 GHG emission reduction projects outside the EU
are acceptable.

When the Kyoto Protocol came into force on 16 February 2005, the EU ETS had already
become operational. Only later, the EU decided to accept Kyoto flexible mechanism
certificates as compliance tools within the EU ETS. The "Linking Directive" allow
operators to use a certain amount of Kyoto certificates from flexible mechanism (CDM,
JI & IET2) projects in order to cover their emissions.

How does trading occur?

Notable feature of the EU ETS is that effectively there is no restriction on banking or

borrowing of allowances within any given multi-year trading period. Allowances are
issued annually but they are valid for covering emissions in any year within the trading
period. Moreover, each year’s issuance of allowances occurs at the end of February, two
months before allowances must be surrendered for the preceding year. As a
consequence, installations can cover shortages in any given year by allowances issued
for the next year. This arrangement effectively allows year-ahead borrowing within the
trading period.

The Linking Directive allows affected installations to buy KP units but the limit on CER
and ERU use in EU-ETS is 10% only (A. Denny Ellerman & Paul L. Joskow). This limit is
specified in each member state’s National Allocation Plan (NAP) and it varies among
member states and, in some cases, even by sectors within a member state.

2
International emission trading scheme: IET allows trading of Kyoto units (credits generating from CDM
and JI) between the Annex 1 parties (Mostly European countries). IET is relevant as the reductions
achieved through CDM projects are a compliance tool for EU ETS operators.

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Trading analysis: Use of credits or allowances from outside the system for compliance,
that is, the use of anything other than the system’s own allowances. In the case of the
EU- ETS, the primary sources of such offsets are the project credits created under the
Kyoto Mechanism i.e. CDM & JI and known as Certified Emission Reductions (CERs) &
Emission Reduction Unit (ERU). The Linking Directive, enacted soon after the Emissions
Trading Directive, opened the door to the use of CERs and Joint Implementation credits
created by a similar process under the Kyoto Protocol.

In searching of low cost mitigation options: EU ETS will exploit lower cost mitigation
options wherever they are located. Since there is no necessary relationship between
individual country emissions caps and the geographic distribution of low-cost
mitigation opportunities, mechanisms must be found to facilitate the ability of countries
with relatively high-cost mitigation options to exploit relatively low-cost mitigation
opportunities in other countries.

Post 2008-12: The EU also agreed to three additional important system changes. They
agreed to extend the trading period to eight years, tighten the emissions cap so that
21% reductions (Climate Lab Website) would occur by 2020. This creates immense
opportunities in the carbon market for developing countries to implement mitigation
plans and to facilitate the industrial nations.

References
1. A. Denny Ellerman & Paul L. Joskow., Massachusetts Institute of Technology ., ‘The
European Union’s Emissions Trading System in perspective’.
2. European Commission official EU ETS website, Accessed on 2 August 2010
http://ec.europa.eu/environment/climat/emission/index_en.htm
3. Climate Lab Website, Accessed on 2 August 2010
http://climatelab.org/European_Union_Emissions_Trading_System

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About Us

EcoLogic Consultancy came into existence with the purpose of “To help our clients in
understanding, establishing sound Environment Management Systems, and pursuing
sustainable business solutions through our various services to abate direct and indirect
mpact on ecological balance.”

We have expertise in the areas of carbon accounting and management, energy

management systems, voluntary/compliance carbon markets, environment
management and sustainability and carbon branding.

To know more about EcoLogic, please visit http://www.ecologicconsultancy.in

To schedule a meeting and discussion with us, do reach us on

Kedar - +91-9665407848 – kedar@ecologicconsultancy.in

Indrajeet - +91-9028788430 – indrajeet@ecologicconsultancy.in

Shailesh - +91-9890887670 – shailesh@ecologicconsultancy.in

Understanding the EU-ETS EcoLogic Insights series