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Green to Gold: Carbon Trading in Europe

Neil Baker | April 29, 2008

Some day, the United States may adopt a regulatory system to cap greenhouse gas emissions and let companies trade credits to emit such pollution. Until then, advocates for corporate sustainability must look to Europe to get a sense of how such a cap-and-trade system might work.

Since the European Union launched a cap-and-trade approach to emission reductions in 2005, carbon dealing has become a multibillion-dollar industry there; indeed, it dominates the world’s fast-growing carbon market. Last year, for example, global carbon trading increased a whopping 80 percent from 2006, with a $60 billion price tag, according to Point Carbon, a firm that provides market analysis.

The EU’s Emissions Trading System (ETS) has played a particularly important role, accounting for 62 percent of the world market by volume of carbon trading and 70 percent by financial value.

Cap-and-trade aims to cut greenhouse gas emissions 20 percent by 2020 and operates on a simple idea: Every large power station or energy-intensive industrial plant is entitled to emit a certain volume of carbon. If it reduces its carbon emissions and therefore doesn’t need its full allowance, it can sell rights to emit that surplus to brokers, who trade them in an open market. Companies that cannot reduce their emissions and use up their full allowance must either buy those credits in the market, or pay a fine.

The practical operation of the scheme is not so simple, however. Each of the EU’s 27 member states is obligated to write a “National Allocation Plan” that sets the total volume of carbon its companies can emit each year and explain how it will allocate those allowances. Governments then have some discretion about whether to sell the allowances or give them away free.

Rocky Start

The first trading period ran from the start of 2005 to the end of 2007. The European Commission (the EU’s executive arm) regarded this as a “learning by doing” period.

Carbon caps were set too high during the first phase because there was a lack of data about emission levels, a point the Commission readily admits. With no great incentive to reduce emissions, the environmental benefits of the scheme were limited.



Seyfarth

Because there was no measurable reduction in carbon emissions, the scheme cannot be called a success, says Martin Seyfarth, an environmental lawyer in the Berlin office of law firm WilmerHale. “I am in favor of the system, but at the moment I do not see any positive results,” he says. “As long as we don’t see positive results, it is just a tax increase on certain industries.”

The scheme also raises questions of fairness. Widely different national methods for allocating allowances gave member states an incentive to favor their own industries, which led to great complexity, the Commission said in a briefing note.

Approaches to monitoring have also been inconsistent. “If you don’t treat every one equally, then those who suffer most feel they have been treated unfairly and it doesn’t help the system to become a success,” Seyfarth says. “That’s why the critics say it is just a tax increase and nothing more.”

The European Commission has also struggled to manage the ways that member states publish information about emission levels, which is now market-sensitive data. The price of carbon fluctuated wildly in May 2006, when some states released emissions data earlier than expected.


“It is naïve to think that you can create something like this and it is going to work perfectly. It’s like criticising Ford for producing the Model T.”


— Anthony Hobley,

EU Environmental Lawyer,

Norton Rose



Still, Commission officials say the ETS has been a success. The first trading period established the free trading of emission allowances across Europe, created necessary infrastructure and developed a dynamic carbon market, they say. For the second trading period—which started in January and runs until 2012—regulators have capped national emissions at an average of 6.5 percent below 2005 levels, to ensure that emissions fall.



Hobley

Anthony Hobley, a specialist in EU environmental law at the law firm Norton Rose, agrees that the plan has been a success. “You have to look at what the scheme has done,” he says. “It has put a price on carbon and put carbon as an issue into the boardroom of many companies. It means that all the big industrial companies across Europe now legally have to measure their emissions and have them verified.”

He continues: “It is naïve to think that you can create something like this and it is going to work perfectly. It’s like criticising Ford for producing the Model T. The ‘learning by doing phase’ has allowed the regulators to identify many of the problems and start fixing them. The fundamentals of the way the scheme works are right.”

Many of those fixes will not be in place until the third phase, which will run from 2012 onward. The Commission recently set out proposals for how the third phase would work: Brussels will harmonize the way that member states monitor compliance with the scheme and scrap the national allocation of emission allowances. More companies would bid for emission rights in auctions. (The United Kingdom recently said it would auction all of its allowances after 2012).

The Commission also wants the ETS to be a building block in the development of a global network of emission trading systems. European law currently allows the ETS to link only with other industrialized countries that have ratified the Kyoto Protocol on climate change—which most notably excludes the United States. The Commission wants to extend this to any country or group of states in a federal system that has a compatible cap-and-trade system. That could include the Regional Greenhouse Gas Initiative operated by nine Northeast and Mid-Atlantic U.S. states or the whole country, should U.S. lawmakers ever enact a nationwide cap-and-trade system.

New Industries

The ETS is not the only form of carbon trading that goes on in Europe. The plan expanded at the start of 2008 to include new industries (aluminium and chemicals, for example), but still only covers about half of Europe’s carbon emissions. European companies outside of the ETS can earn tradable credits in the parallel voluntary carbon market; Britain is introducing its own compulsory scheme.

Hobley says the jury is still out on whether such national schemes will help companies or only confuse them. But he says most companies believe a compulsory cap-and-trade scheme like the ETS is preferable to a carbon tax or stricter regulation.

One common criticism of cap-and-trade plans like the ETS is that they put companies at an unfair disadvantage to rivals outside the plan’s jurisdiction. But research from the Carbon Trust, an independent company created by the British government, suggests this has not happened. A few sectors—including the cement, paper, and steel industries—might suffer, but the Commission could manage this by slowing the withdrawal of free carbon permits to these sectors, it says.



Grubb

But for the vast majority of companies, Carbon Trust says, the effect on competitiveness will be neutral. “This analysis is a nail in the coffin for the myth that the EU ETS presents a threat to overall business competitiveness,” says Michael Grubb, the Trust’s chief economist.

If that is indeed the case, and the EU manages to cut harmful emissions while creating a multibillion-dollar carbon-trading industry, and without damaging economic competitiveness in the process, it will have succeeded where the alchemists of history failed, and turned a waste element into gold.