Emissions trading - the concept

The rationale behind emission trading is that it enables emission reductions to take place where the cost of the reduction is lowest thus lowering the overall costs of combating climate change.  More abatement will be undertaken by operators with lower abatement costs, therefore reducing the overall costs of meeting the emissions target (cap) set by any trading scheme.

Emissions trading provides certainty regarding the level of emissions reductions which will be achieved (ie the difference between projected emissions and the cap on emissions).  What remains uncertain is where exactly emissions savings will be made (this depends upon who makes emissions reductions and on who trades with whom).  However, the nature of greenhouse gas emissions means that emissions savings have the same environmental effect wherever they are made, so the location of the saving is immaterial.

The cost of emissions allowances is determined by the carbon market, and demand for/availability of allowances.  Additional compliance options, such as the allowable use of offsets in the scheme such as JI/CDM project credits, provide greater price flexibility for installations.

The EU Emissions Trading Scheme

The EU Emissions Trading Scheme (EU ETS) is one of the key policies introduced by the European Union to help meet the EU's greenhouse gas emissions reduction target of 8% below 1990 levels under the Kyoto Protocol. 

The scheme is divided into phases for which Member States must develop a National Allocation Plan (NAP) approved by the European Commission.  These plans must set an overall 'cap' on the total amount of emissions allowed from all the installations covered by the scheme.  This is converted to allowances - 1 allowance equals 1 tonne CO2.  The allowances are then distributed by Member States to installations in the scheme.

Installations covered by the Scheme are required to monitor and report their emissions.  At the end of each year they are required to surrender allowances to account for their installation's actual emissions.  They may use all or part of their allocation and have the flexibility to buy additional allowances or to sell any surplus allowances generated from reducing their emissions below their allocation. 

Installations are covered by the EU ETS on the basis of CO2 emitting activities they carry out, and cover heavy industries such as:

• Electricity generation;
• Iron & steel;
• Mineral processing industries such as cement manufacture;
• Pulp and paper processing industries.

Linking Schemes

The UK believes that linking the EU ETS to other schemes has a number of benefits: 

• It is desirable from an economic efficiency perspective, as expanding the size of the market should improve cost-effectiveness and increase liquidity. 
• It signals a strong multilateral approach to dealing with what is a truly global issue.  
• The UK is committed to encouraging further discussion and sharing of ideas on the design and role of international trading schemes post-2012, and this is a key priority for the review of the EU ETS.

UK Experience so far

Developing the UK NAP for Phases I and II, and the results of the first year of implementation has highlighted some key areas in the design of emissions trading schemes:

• Cap setting - a scarcity of allowances is vital as this drives the price of carbon, and the incentive for emissions abatement.  The Commission has shown that it is prepared to set tight caps for Phase II to ensure there is a scarcity in the market for Phase II.
• Long Term Certainty - A long-term policy framework is necessary to create security and confidence for business, so that business can make informed long term investment decisions.
• Global Markets - The rationale of emissions trading is to make emissions savings at the point of least cost.  Linking trading schemes and so expanding the size of the market should improve cost-effectiveness and increase liquidity.
• Infrastructure and regularity framework - The year 1 results should that the infrastructure is viable and functioning as envisaged.  In the UK for example more than 99% of operators met their obligations under the Scheme.
• Market Sensitive information - Success of emissions trading is dependent on the market, therefore governments and policy makers need to consider the effect of actions / announcements on the carbon price.

Future Development of the Scheme

The Commission is carrying out a review of the EU ETS.  On 13 November 2006 the European Commission published a communication setting out the agenda and process by which their review of the Scheme will proceed. The review is the best opportunity we have to map out a long term policy framework that provides clear and convincing signals about the Scheme, indicating as part of future legislative proposals the likely level of future ambition and its potential to form the basis of a global carbon market.  From UK experience so far we believe the key goal of the review must be to increase long term certainty about the future of the Scheme and in doing so maximise the potential of the EU ETS to stimulate necessary investments in low carbon technology. 

Why emissions trading, what are the policy / economic advantages?

• The rationale behind emission trading is to ensure that emission reductions take place where the cost of the reduction is lowest thus lowering the overall costs of combating climate change.  More abatement will be undertaken by operators with lower abatement costs, therefore reducing the overall costs of meeting the emissions target set by any trading scheme.
• Emissions trading provides certainty regarding the level of emissions reductions which will be achieved.  What remains uncertain is where exactly emissions savings will be made.  However, the nature of greenhouse gas emissions means that emissions savings have the same environmental effect wherever they are made, so the location of the saving is immaterial.

Is the EU ETS working?

• Yes, the first year has shown the trading mechanism is viable and that the institutional framework is sound, we believe this is a solid base to build on for the future.
• In the UK compliance was excellent, almost all operators surrendered sufficient allowances within the deadlines.
• However, Phase I is a three year phase so it is difficult to tell whether emissions savings have been made with just one year's data. 
• The first year has shown the trading mechanism is viable and that the institutional framework is sound, we believe this is a solid base to build on for the future. 
• Market sources indicate that 2006 has seen the busiest trading so far, with a record of nearly 90 million tonnes traded in May. Around 575 million trades have been recorded up to end of September 2006, dwarfing the 263 million allowances traded in total in 2005.

EU ETS facts and figures
	Phase I	Phase II
Cap	245m allowances/yr (736m in total in the 3 years of Phase I)	237m allowances/yr to Phase I installations (246m allowances/yr including expansion) 7% auctioning
Saving	65MtCO2 (8% of BAU)	8MtC/yr below BAU 29.3MtCO2 p.a 146MtCO2 for the Phase 13% below 2005 emissions
2005 allocation	215m (after CCA & UK ETS opt-outs)
2005 emissions	242 million tonnes CO2 27m short ESI sector short by 37m allowances Other industry long by 10m 173m long across EU*
Phase II vs. Phase I		3% reduction on Phase I in drafts submitted to Cion. 10% reduction anticipated across EU following Cion decision.
Phase II NAPs notified to Commission	All Member States apart from Bulgaria have notified their NAPs to the Commission. Bulgaria have published a draft NAP.
Phase II NAP assessments	UK, Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, Slovakia, Slovenia, Sweden, Belgium and the Netherlands.