European Union Emission Trading Scheme

The European Union Emission Trading Scheme (EU-ETS) is the world’s largest and highest-valued cap-and-trade market for carbon emissions. This European Union-regulated market was launched in 2005 as Europe’s response to the Kyoto challenge and includes 27 countries.

The EU ETS is subdivided into successive phases or trading periods. The EU ETS requires each EU member state government to agree to national emission caps or a national allocation plan approved by the European Commission and allocate allowances to their industrial installation operators based on this plan for the duration of a trading period.  At the end of each year, emitters must surrender a number of allowances equivalent to their total emissions for that year. State governments must track and validate actual emissions in comparison with the relevant assigned amount and require the allowances to be retired after the end of each year. 

Phase 1 (2005 to 2007) functioned as a trial or learning trading period, during which 2.2 billion (ton) allowances/yr. were allocated.  Most Phase 1 allowances were allocated by grandfathering -- given at no cost based on historical emissions -- which created an excess of supply and led to windfall profits in some sectors.  Some countries, such as the Netherlands, allocated more allowances than would be required under a business as usual scenario.  The first phase regulated only CO2 emissions and focused on high energy-consumption installations, of which nearly 12,000 were covered. This included approximately half of total EU CO2 emissions and 40% of all GHG emissions. Other GHG emissions will be included as the EU ETS moves forward. Phase II (2008-2012) significantly expands the scope and represents a fully implemented emissions trading system in which 2.083 billion allowances/yr. are to be allocated.   The Phase II national allocation plans represent an average reduction of 7% compared to 2005 levels.  However, many were still too lenient, causing the European Commission to request edits to make further reductions.Emissions from aviation will be included beginning in 2010.  The EU ETS has already caused emissions reduction through internal abatement despite somewhat over-allocating allowances in Phase 1, which has recently concluded. 

The six industries regulated by the EU ETS, power, paper, metals, mining, oil and cement, are all direct emitters of CO2. The EU ETS allocates European Union Allowances (EUAs) for free to covered installations.  The scheme allows operators to use traded project-based credits called Emission Reduction Units (ERU) for compliance.  The "Linking Directive" allows operators to use a certain amount of Kyoto certificates from flexible mechanism projects in order to cover their emissions. Operators may sell or purchase additional allowances to/from other market participants depending on their circumstances and needs. Trading of EUAs occurs in both bilateral OTC exchanges and the regulated market, with the European Carbon Exchange (ECX) representing almost 90% of such activity.  The market has also evolved a wide range of financial instruments including forwards, futures and options contracts based on EUAs.  National registries and the European Commission must be informed regarding each change of ownership of an allowance and must then validate the transaction.

In January 2008, the European Commission proposed a number of changes to the scheme, including replacing national allocation plans with centralized allocation by an EU authority, auctioning a greater share of permits, likely over 60%, and regulating the greenhouse gases nitrous oxide and perfluorocarbons. These changes are still in a draft stage and are only likely to become effective from January 2013 onwards, once the 3rd trading period begins. Proposals dealing with this period work from a forecast of an overall reduction of greenhouse gases of 21% in 2020 compared to 2005.  The Commission aims for the ETS to include all greenhouse gases and all sectors, including aviation, maritime transport and forestry.

See also: "Retrospective on Phase 1 of the European Union Emissions Trading Scheme (EU ETS) -- Lessons Learnt," by Donald Sunderland, V.P. Open Source Solutions, Misys plc