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ETS – How does it work?
Dr Marzena Chodor, Clima East Key Expert
Moscow, 08.04.2014
Cap and trade system: main elements
Cap and trade system: how does it work and why does it work?
EU ETS: history
Legal framework
Scope of the EU ETS
ETS: main elements in 2005-2012
Carbon market in 2005-2012
Main lessons from 2005-2012
EU climate policy goals until 2020
EU approach from 2013
Aviation in emissions trading
ETS 2013 – 2020. Main features
Lessons from target setting – creating the market
Cap and trade system: main
A cap on annual emissions/ a cap on annual allocation
(of emission allowances)
Identified participants
– registered (eg. through permits)
– obliged to comply with rules
Allowances distributed or acquired (auction, market)
transferable freely/with constraints
bankable/not bankable
1 allowance equals one tonne of CO2
Cap and trade system: how does
it work?
Regulator determines allowed emissions level
(the cap), and creates and distributes allowances
corresponding to the cap
Allowances are put in circulation
Scarcity gives allowances value
Carbon market develops
– Price signal guides companies by how much to reduce
– Regulator enforces rules and levies sanctions, if needed
Cap and trade system: why does
it work?
The emissions allowance is an asset with immediate value
Some companies find it easier and less expensive to reduce
their emissions below their required limits than other
More efficient companies, which release less carbon dioxide
equivalent than their limit set in a given year/period, can sell
their surplus allowances to companies that cannot reduce
their emissions or want to increase production
Cap and trade systems reward the most efficient companies
and provide incentive to increase carbon efficiency over
The prices of allowances are visible signals of current cost
of carbon dioxide reductions
EU ETS: history
The EU ETS started in January 2005
First EU ETS phase (trial) 2005 -2007
Second EU ETS phase 2008-2012
Third EU ETS phase 2013 – 2020 (and beyond)
GHGs included:
– Carbon dioxide (2005-2012)
– N2O, PFC (from 2013)
Coverage: about 11 thousand installations
Around 45% of EU GHG emissions
28 EU Member States and 3 EEA-EFTA states
EU ETS: legal framework
Directive 2003/81/EC (adopting emissions trading)
Directive 2004/101/EC (linking directive)
Directive 2008/101/EC (including aviation activities in
Directive 2009/29/EC (ETS review – part of the climate
and energy package)
Current key implementing provisions:
– Commission Regulation No 389/2013 establishing a Union
– Draft Regulation on determining international credit entitlements
Scope of the ETS: activities
Combustion installations above 20 MW
Oil refineries
Ferrous metals production above 2,5t/hr
Cement production
Glass production above 20 t/d
Ceramics production above 75 t/day
Pulp and paper production above 20 t/d
International aviation (flights from and to the EU airports) entry into force in 2012
– A retroactive suspension applied to intercontinental flights (stop the
clock in April 2013)
PFCs from alluminium production and N2O emissions from
chemical plants included from 2013
ETS 2005-2012
Applicable since January 2005
Environmental outcome determined – puts a cap on
emissions from 10,000 energy-intensive installations
across EU (25, later 27, and 30 countries, around 2
billion tonnes/ yr)
Covering around half of EU’s total CO2 emissions
Companies can choose:
• To emit allocated emission rights (allowances) or
• To reduce emissions below allocation and sell or bank
• To emit more than allocation and buy
Cost-effective emissions reductions to the level of
the cap, because investments take place where
ETS design
Simple “downstream” cap-and-trade system for major
emitting industries that is part of a comprehensive policy
– the largest cap-and-trade scheme ever implemented
Monitoring rules for direct emissions, independent
Robust penalties to ensure compliance (€100 + shortfall)
Electronic registry system to record holdings of allowances
Market development driven by the private sector
ETS 2005-2012
Member States initially responsible for setting the cap on
national level and distribution of allowances through NAPs
(National Allocation Plans)
NAPs approved by the European Commission
– assessment of national allocation plans against agreed common criteria:
– consistency with actual and projected emissions, consistency with potential
to reduce emissions, not more allowances than needed, on track for
reduction commitments, not unfairly discriminating
– transparency, comments by the public
25 (in phase II 27) registries
National authorities overseeing compliance
only on average 5% allowances auctioned, the remainder
distributed free of charge
Dominant allocation methodology - grandfathering
In the period 2005-2012 the task of each Member
Main challenges in the inception phase:
– Identifying covered installations
– Gathering and processing of relevant data
– Fixing the national cap and deciding on the path to the Kyoto
– Elaborating allocation rules at sector and installation level
– Elaborating new entrants and closure rules
– Overcoming know-how gaps in authorities and among
– Organizing public consultation and securing political
– Tight time schedule
Member State competence, harmonized elements:
– no permit, no operation
– blocking transfers if no verified emission report by 31
– name & Shame if not surrendered sufficient allowances
– €40 penalty and compensate shortfall for insufficient
Links to the Kyoto Protocol
Art 30 ETS Directive: “emission credits from the project-based
mechanisms will be recognised for their use in this scheme subject to
provisions adopted by Parliament and Council on a proposal from the
Directive 2004/101/EC (linking directive)
Clean Development Mechanism (CDM) from 2005, Joint
Implementation (JI) from 2008
Supplementarity: from 2008, use limited to % of allocation of
allowances to each installation
Harmonised EU-wide exclusion of nuclear energy projects and
temporary forestry credits, national decisions on other types of
Double-counting guidelines – Commission Decision C(2006)5362
Large hydro: MSs to make sure that relevant international criteria
and guidelines will be respected during the development phase
Carbon market prices in 2005-2012
ETS emissions down
13.7% 2007 - 2009 2
ETS cut emissions by 2
% to 5% in Phase1 1
Source Point Carbon
assessment by Ellerman et al, ‘Pricing Carbon 2010
verified emissions data, European Commission
Main lessons from 2005-2012:
• EU ETS developed into the largest carbon market in the world
• Carbon market infrastructure operational:
• MRV, institutional capacity in EU Member States, electronic registries
• Strong, harmonised provisions to ensure compliance (€40/tonne)
• Liquid carbon market and reflective carbon pricing
• However:
Member States’ NAPs not based on verified emissions + litigation
 Reductions projected by MS proved insufficient in terms of scarcity,
which led to a price crash
• Long term - a market-based signal for low carbon investments
EU (unconditional) climate policy goals until 2020:
• 20% reduction in EU greenhouse gas emissions from 1990 levels;
• 20% increase in the share of EU energy consumption produced from
renewable resources
• 20% improvement in the EU's energy efficiency
• implemented through a package of binding legislation entering into
force from 2013
• Climate and Energy Package adopted in 2008
• contains directives to be implemented by MS (ETS, RES, CCS)
• and Effort Sharing Decision
Instruments of
EU emission
reductions from
technology specific &
targets & instruments
product policies
large industrial
installations &
Carbon capture and
storage Directive
Renewable Energy
-20% / -30% wrt
1990 levels by 2020
Fuel Quality Directive
EU approach
GHG reduction target:
-20% compared to 1990
-14% compared to 2005
-21% compared
to 2005
Non-ETS sector
-10% compared to 2005
27 national targets, from -20% to +20%
Aviation in emissions trading rationale
• Contributes to climate change through emissions of carbon dioxide,
nitrogen oxides and cirrus effects
• Taxation not blocked by 1944 Chicago Convention, but various bilateral
air service agreements historically foresee exemption from general fuel
• 1992 UNFCCC requires States to take measures to reduce
• Under Kyoto Protocol, States were asked to make progress working in
international forum: International Civil Aviation Organisation (ICAO)
• International emissions from aviation not part of States’ Kyoto
commitments for emission reductions
Aviation in emissions trading rationale
Overall EU objective: limit global warming to 2° C
above pre-industrial level to avoid dangerous
climate change
All sectors should contribute to emission reductions
Early industry preference for open emissions
trading above taxes and charges and technical
more disagreement than agreement in ICAO
discussions on any market-based action
Projections of aviation emissions growth
63% to 88%
Source: EC
290% to 667%
Aviation in emissions trading design
All flights to and from EU airports
Small aircraft and certain flights excluded
Equivalent action on aviation emissions taken by other
countries recognised
Total quantity of allowances equivalent to 97% of average
annual emissions 2004-6
From 2013, total quantity of allowances equivalent to
95% of average annual emissions 2004-6
Allocation based on commonly-agreed benchmark
(T/km) combined with harmonised level of auctioning
– 15% auctioning from 2012 until 2020
All auction revenues should be used for addressing
climate change and to adapt to its effects
ETS 2013-2020
Directive 2009/29/EC amending Directive 2003/81/EC
One single EU –wide cap (limit) set on the total GHG emitted by
installations included in the EU ETS
EU ETS cap set at 2,084,301,856 allowances in 2013
Decreasing by 1.74% anually
Reduction continued beyond 2020 (revised no later than 2025)
Aiming at -21% reduction against 2005 levels
Harmonised allocation - main allocation method: auctioning
– The proportion increasing annually
– At least 48 % in ETS phase III
The remaining allowances allocated free of charge to industry
threatened by carbon leakage, based on benchmarking
Strengthened MRV
Increased scope (new GHG, new activities)
ETS 2013-2020 – broader scope:
New sectors
– Aluminium
– Basic chemical production
New gases:
– PFCs from aluminium
– nitrous oxide from certain chemicals
Broad interpretation of “combustion”, Annex I listing only
Combined effect: approx. 6 - 7% increase of scope
compared to current trading period
Confirmation that all sectors should contribute to emission
reduction commitments
– Aviation
– Maritime transport: future action foreseen
ETS 2013-2020 – strengthened
Monitoring and Reporting Regulation
Replaced earlier guidelines
Verification and Accreditation Regulation
– New EU-wide rules replacing regulation on MS level
Harmonised €100 penalty for non-compliance
– requirement to surrender allowances remains
Single Union registry
– MS responsible for operations on MS level
ETS 2013-2020 – allocation
Harmonised allocation rules to ensure a level
playing field across the EU:
– No distortion of competition
– Fully equal treatment within sectors across EU
Auctioning as the general rule, with transitional
free allocation up to 2020
In terms of allocation rules, three categories of
– No free allocations (i.e. full auctioning)
– Partial free allocation (no carbon leakage)
– Up to 100% free allocation (carbon leakage – based on
ETS 2013-2020 – auctioning:
Basic long-term principle for allocation:
– Eliminates ‘windfall’ profits
– Simplest and most transparent allocation system
– Level playing field for new entrants and incumbents
Auctioning on the basis of harmonised rules:
– Transparency and non-discrimination
– Full access for SMEs
Full auctioning for sectors able to pass on costs:
– Power sector, except CHP and district heating (except agreed
Revenues to accrue to Member States, with 50% used to
address climate change and its effects
ETS 2013-2020 – auctioning:
Auctioning Regulation agreed unanimously by Member
States and adopted (12 November 2010, with later
MS determine use of revenues, but at least 50% should
be used for climate related purposes
MSs shall inform on use of revenues through the reports
under GHG monitoring Decision 280/2004/EC
88% of auction rights distributed according to MS’ share
in verified emissions in 2005 or average of period from
2005 – 07 (whichever is the highest)
10% for purpose of solidarity and growth (Annex IIa)
2% “Kyoto bonus”: at least 20% below Kyoto base year
emission levels
ETS 2013-2020 – transitional free
Transitional free allocation to industry
– quantities determined in accordance with Community-wide rules
– Annual reductions of free quantity
To result in full auctioning by 2020 for “normal” industry (no
carbon leakage)
Community-wide rules - benchmarking, for free allocation
– determined taking into account most efficient techniques, substitutes,
alternative production processes, etc.
Levels of allocation under rules reducing over time in line with
reduction pathway
No free allocation for electricity production (as a rule, except
transtional measures in some MS)
installations in sectors exposed to a significant risk of carbon
leakage can receive up to 100% free allocation of the quantity of
allowances determined under the general Community-wide rules
ETS 2013-2020 – transitional option of
free allocation for electricity producers
10 Member States qualify
– New EU12 except SI, SK, maximum 14% of EU power generation
For existing installations only
Conditional upon national plan to modernise energy infrastructure, clean
technologies, diversification of energy mix
– Taking into account the need to limit as far as possible directly linked prices rises
– Monitoring and enforcement provisions.
– Annual reporting (to the European Commission)
Total amount in 2013 maximised at 70% of 2005-2007 verified emissions,
gradual decrease to zero in 2020
– For the amount corresponding to gross final national consumption of the MS
Individual allocation based on 2005-2007 verified emissions/benchmark
– Option of non-transferable allowances
– Commission guidance
ETS 2013-2020 – use of JI and CDM
Use of CDM should not exceed 50% of reduction below 2005 over period
2008-2020 for existing operators and not exceed 50% of reductions below
2005 over period 2013-2020 for new sectors and aviation
– Existing operators receive no less than 11% of 2008-2012 allocation
– Least endowed operators receive additional access up to a certain %
– New entrants and new sectors receive access to no less than 4.5% of verified
– Aviation receives no less than 1.5% of actual emissions
Exact percentages determined through a regulation
EU ETS Reform
• Proposal to reform ETS to increase its effectiveness and
robustness in the next trading period from 2021
• Market stability reserve, improving the system’s
resilience to shocks and dealing with the surplus of
allowances from the previous trading periods
- a legislative proposal put forward together with the Communication
• No import of international credits from 2021
- envisaged linking with other carbon markets
• Change of the annual linear reduction factor from 2021
from 1.74% to 2.2%
• neccesary to achieve ETS contribution to -40% reduction in 2030
• Free allocation kept as a safeguard against carbon
leakage, if no comparable climate action from other
major economies
Lessons from target setting –
creating the market
Markets do not function properly without demand
Demand means scarcity
Scarcity depends on
– Getting baseline data – monitoring and reporting
– Capping emissions below demand (taking into account accuracy)
Accuracy depends on MRV and Scope
Keep systems simple
– Cover installations/ gases at the outset where sufficiently accurate
monitoring is feasible, extend later in line with technical progress
– No need to re-invent the wheel
– Use verified data as basis for any free allocation
– EU ETS development and recent review show EU’s practical experience
More information:
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