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Greenhouse Gases: Reviewing the European Trade

Lessons from the EU Emissions Trading Scheme emerge after two years.

Fortnightly Magazine - February 2007

Despite assertions to the contrary, the European Union Emissions Trading Scheme (EU ETS) is working. Industry has changed both short-term behavior and longer-term plans to reduce compliance costs—the driving down of greenhouse-gas emissions being the intended and achieved result. In this article, we review examples of the ETS affecting both planned and actual behavior. The other side of the coin is how regulatory and political uncertainty undermines this. We also note how forward market prices can deviate from expectations of future spot prices, how the market’s design caused this, and how it could be avoided. We believe that despite any criticism, cap-and-trade is easily the most cost-effective method of achieving societal environmental goals and the issues presented so far may be addressed readily. 1

The European ETS was set up to achieve compliance with European commitments to reduce emissions under the Kyoto greenhouse gas treaty. In operation for almost two years now, and covering only a subset of those industries producing greenhouse gases (GHGs), its success is driving calls for expansion to cover other sectors within the EU.

Large industry and the utility sectors must participate in the EU ETS. The ETS is broken into two phases. Phase 1 covers 2005 through 2007. Phase 2 covers 2008 through 2012 and coincides with the initial Kyoto compliance period. Phase 1 certificates, absent changes, generally will not be fungible into Phase 2 and either must be used or will expire. Certificates are denominated in metric tons of carbon dioxide, but each type of greenhouse gas is assigned a factor to convert it to the same deemed level of effectiveness (tonne-equivalent) as carbon dioxide in acting as a greenhouse gas. 2

The scheme is sizeable and well worth studying for lessons in how markets develop and operate. Meeting GHG emission-reduction targets involves long-term investment, as well as short-term operating decisions, so this market offers valuable lessons in how spot and forward markets operate and interact.

Rationale

A market-based system ensures the lowest societal cost of compliance with the Kyoto targets. No central planner could as accurately select the mix of lowest-cost reductions nor the sharing of costs. Cap-and-trade legislation simply creates the target number of allowances. These allowances or emission rights may be legally bought or sold, but ultimately, each polluter must surrender the right number against actual emissions. The allowance market provides an observable allowance-market price. Those who can reduce emissions at a cost lower than the market price of the allowances will do so. The remainder prefer to buy allowances.

The last allowance bought will be that which sets price and is equal in price to the lowest in cost of all remaining compliance methods. So all required reductions are made at a cost lower than the allowance price. Those who can’t spend less than the allowance price to reduce emissions buy allowances instead. In this way, the reduction

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