The world’s first international emissions trading system is the EU Emissions Trading System (EU ETS). The European Union became the CO2 market pioneer when it launched the program to put price on carbon in 2005. It is a cost-effective tool for reducing greenhouse gas emissions (GHGs) by setting a cap. That is, the carbon price established by an ETS guarantees that the cap is met at minimum cost. The EU ETS has a cap-and-trade principle. This principle allows companies to receive or buy certain GHGs emission allowances. The cap is reduced over time. They can trade these allowances with each other when needed. The supply of emission allowances is determined by the cap of an Emissions Trading System. Output and emission intensity levels of regulated entities determine the demand of emission allowances. All EU countries and EEA-EFTA states are part of the EU ETS. These include Iceland, Liechtenstein, and Norway. The system limits CO2 emissions from power and heat generation. It also covers energy-intensive industries like oil refineries and steel works. Other sectors include the production of iron, aluminum, and metals. Other included sectors are the production of cement, lime, glass, and ceramics. It also includes pulp, paper, cardboard, acids, and bulk organic chemicals. Additionally, it covers the commercial aviation sector. Sometimes companies are incentivised to less emission and penalized for more emissions.
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History of EU Emissions Trading Policy
The drafted emission trading proposal was submitted to the EU Council of Ministers and the European Parliament in 2001. The Emissions Trading Directive was formally adopted in October 2003. This occurred after more than a year of negotiations between the European Parliament and key stakeholders. These stakeholders were both industrial and political (European Parliament and Council of the European Union, 2003). Under EU law, such type of trading program would be considered an environmental policy rather than a tax policy. Since its commencement in 2005, the EU climate policy has incorporated decarbonizing the economy. This aims at attaining sustainable economic prosperity. Thus, the EU ETS scheme is ultimately pursuing its commitment to fulfill the Kyoto protocol. There are four phases EU ETS, existed in the current time frame.
Phase 1 of EU Emissions Trading Policy
Phase 1 started from 2005 to 2007 as a pilot program. It aimed to establish market price for CO2. Additionally, it sought to build administrative capacity within the EU Commission, within national governments, and within industry. This was done ahead of the Kyoto Protocol’s first commitment period (2008–2012). In phase 1, the cap on allowances was set at the national level. It only considered CO2 emissions from power generators and energy-intensive industries. There were free allowances to business. Although forward price was above spot price, the supply exceeded demand. As a result, the market price for carbon was close to zero.
Phase 2 of EU Emissions Trading Policy
Phase 2 from 2008 to 2012, was designed to incorporate lessons learned from phase 1. The credible installation-level emissions data came from the reporting and verification process in phase 1. This data was used to guide the formation of phase 2. Although the price of EUAs had collapsed in phase 1, the commission raised the limit. This action allowed countries to auction up to 10 of their allowances in phase 2. This resulted in EUA futures rising to 25 euro. It further climbed to 30 euro as phase 2 got underway in 2008. In this phase, the cap was lowered and new countries joined: Iceland, Liechtenstein and Norway. The free allocation was reduced and introduced auctions. The penalty for non-compliance was increased from 40 Euro to 100 Euro per tonne
Phase 2 can be coincided with the first commitment period of the Kyoto Protocol. Since January 2012 the aviation sector is covered under the ETS. The demand for emission allowances were depressed due to the financial crisis between 2007 and 2012. In contrast, the supply remained fixed. It was further expanded through international carbon credits. This surplus caused a collapse in the price for European emissions allowances (EUA). Lessons learned from phase 1 and 2 weakened the political case of ‘grandfathering.’ Many firms had earned windfall profits. They raised prices while receiving their allowances for free. This was common in the electricity sector.
Phase 3 of EU Emissions Trading Policy
Phase 3 from 2013 to 2020 began with a major change in the allocation process. The change had centralized allocation under the European commission. This centralized process further strengthened the EU’s claim to deliver what is offered in global negotiations. This phase introduced a single EU-wide cap through auctioning. It made auctioning the default method of distributing allowances. The rules for free allocation were also harmonized. This scope was also spread through more sectors and gases. The emission was reduced by 41% in 2020 compared to 2005, though the target was a 21% reduction by 2020. This phase introduced EU-wide cap on emissions and auctioning instead of free allocation.
Phase 4 of EU Emissions Trading Policy
Phase 4 from 2021 to 2030 is a reform package. It made important changes to shore up price expectations. It also aims to stabilize them. It accelerated the tightening of the emissions cap, moving from an annual linear reduction of 1.74%–2.2%. The annual free allocation volume continues to decline in line with the overall cap. Thus, more of the revenue from allowance auctions would also be hypothecated to support innovation and modernization.
Conclusion
The 2030 target of European Climate Law is to reduce net emissions by 55%. This will be achieved by lowering the cap. There will also be further extension by including other sectors and improved functioning of the ETS. These goals are align with the legislative proposal in the ‘Fit for 55’ package. In earlier phases, the decisions of grandfathering allowances under national regulators were targeting the intense lobbying. The intention of lobbying was to ensure that each firm would have enough allowances to compete. However, the rent seeking exercise ultimately contributed to crippling system-wide over-allocation (Quirion, 2021). This further depressed CO2 prices and helped to paralyze the EU ETS for many years. As the system lacked the necessary flexibility to address the excess supply of allowances within commitment periods, the longer commitment advises of economists were failed (Grosjean et al., 2016). The political compromise and economic refinement were iterated by many ways and thereby, it was observed fruitful results.
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