The European Union has mapped out its plan for the third phase of its carbon dioxide (CO2) emissions trading scheme (ETS), which will begin in 2013. It is clearly evident that lessons have been learned from the first two phases of the program. The E.U. has embraced a regulatory design that should enable substantial emissions reductions in the future, at least for the roughly 50 percent of total emissions covered by the trading program. This was not the case in the earlier design of the ETS.
The E.U. began a cap-and-trade program covering the power sector and major industrial sources in 2005, and the first phase of the program stretched through 2007. The program excludes transportation, small businesses, and direct fuel consumption by firms and households. The first phase has been maligned because after all the attention it received, in the end only minor emissions reductions were achieved. But I see the situation somewhat differently. Much of the problem was that actual country emissions turned out to be lower than expected when accurate inventories were taken for the first time. The trading program is expected to last for decades, and the initial emissions reductions will be relatively trivial in the long run, when very substantial emissions reduction targets are possible.
More important than the emissions reductions that are achieved in the near term is the architecture of the program itself, specifically the incentives created under the program. The fact that the emissions cap in Phase 1 required few reductions should not be fatal in a well-designed program, because ideally the program would enable allowances to be banked for use in future compliance periods. This would provide firms with an incentive to harvest low-cost emissions reductions in the near term, because the allowances saved would have value in the future and the number of new allowances issued could be reduced accordingly. This approach also would provide clear price signals to guide innovation and investment into the future.
Phase 1’s weak environmental performance should not obscure the fact that there were important measures of success. The program was put together at a break-neck pace to demonstrate a commitment to the world that the E.U. would pursue climate policy goals. The first phase constituted a learning period for policymakers and stakeholders, with the introduction of emissions inventory and electronic reporting of environmental statistics in many of the 27 countries covered by the program.
Phase 2 of the program, which runs from 2008-2012, fixes two important problems. The cap is tightened, insuring that meaningful emissions reductions will be achieved, and compliance periods for banking of allowances into future are allowed. These changes create better incentives for innovation by supporting a higher allowance price, allowing investors to capitalize on low-hanging fruit in the near term and by curbing allowance price volatility in the long run. Today, a healthy allowance price hovers around 20 euros per metric ton of CO2 ($30 per ton). Whether this is a reasonable price or not is not the question I mean to address here, but it is close enough to the price level that many Europeans seek in order to drive reduction of CO2 emissions.
The major problem in Phase 1, however, also remains in Phase 2—namely, the initial distribution, or allocation, of allowances. In Phase 1, 99 percent of allowances were given away for free to emitters, and in Phase 2 this figure dropped slightly to 96 percent. But free allowances to emitters were not free to consumers! The regulated firms that received allowances for free increased the price of their products to reflect the opportunity cost of allowances (for example, their market value) because this is the value firms have to surrender in order to produce their goods.
Typically, firms have charged customers for allowances that they received for free, thereby leading to windfall profits, especially in the electricity sector where power prices rose to incorporate allowance values. In the E.U., those windfalls totaled many billions of euros, coming at the expense of consumers. Just as important, this revenue was not available for other purposes that would help reduce program costs, and the overall economic cost of the program was much higher as a consequence.
Phase 3 promises several important changes. First, the E.U. now embraces the principle of auctioning allowances rather than giving them away for free. Full auctioning for the power sector will begin in 2013, and full auctioning for other covered sectors will be phased in through 2020. Second, the compliance period lengthens to eight years, 2013 – 2020, providing a better planning horizon for investors. Third, the program’s emissions targets are tighter and would ramp up significantly if there is expanded commitment from other nations to reduce emissions. Finally, there is a well-conceived effort to achieve equity among the E.U. member states by redistributing allowance allocations from wealthier states to poorer ones, which should help maintain support for the program.
The plan for the E.U. is part of an overall package of measures to implement climate and energy policy for Europe. The central aim is to reduce E.U. emissions by 20 percent from their 1990 levels by the year 2020 and by 30 percent if other industrialized countries agree to do the same. The policy governing sectors outside the trading program proposes a broad array of regulatory policies, including support for renewable technologies. These sectors are not directly covered by an emissions cap or fee, and consequently the emissions target for these sectors is not as convincing as for those sectors covered by the trading program. The next step is for the plan to be approved by the Council of Ministers and the European Parliament, where support for the plan is apparently strong.
The intended reform for Phase 3 of the trading program addresses a variety of concerns head on. Most significant of these is the extended compliance period and the transition to full auctioning. The result is a regulatory design that should enable substantial emissions reductions in the future in those sectors of the European economy. The encouraging result should attract the attention of U.S. policymakers.
Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.
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The best introduction may be the set of papers in the special issue of the Review of Environmental Economics and Policy, Volume 1, Number 1, in Winter 2007.
Information about the E.U. ETS can be found at