During the first and second phase the trading scheme will only cover CO2 emissions from large emitters in the heat and power generation industry and in selected energy intensive industrial sectors. A size threshold based on production capacity or output was used to determine which installations in the covered sectors participated in the scheme. This process resulted in the first two phases being confined to CO2 emissions from combustion installations with a rated thermal input in excess of 20 MW (except municipal or hazardous waste incinerators), oil refineries, production and processing of ferrous metals, manufacture of cement (capacity > 500 tonnes/day), manufacture of lime (capacity > 50 tonnes/day), ceramics including brick, glass, and pulp, paper and board (>20 tonnes per day). It is estimated that the sources to which the trading scheme applies will account for 45 per cent of carbon dioxide emissions in 2010, and 30 per cent of total greenhouse gas emissions in that year (European Commission, 2005).
In 2008 the European Commission in its Climate and Energy package announced that coverage of the ETS, in terms of covered sectors and gases, would be expanded. For the 2013 – 2020 period ETS coverage will be expanded to include two new sectors (chemical and aluminium) and gases (nitrous oxide and perfluorocarbons) from 2013. The aviation sector will become part of the trading scheme from 2012 onwards.

During the third phase of the ETS the Commission will permit Member States to exclude certain installations from participating in the trading scheme. Member States are permitted to exclude installations from the ETS on the premise that they will be subject to some form of policy measure that will achieve an equivalent contribution to emission reductions on the basis of/compared to ETS participation. Installations seeking exclusion from the ETS must have annual verified CO2 emissions of 25,000 tonnes of CO2e over a three year period preceding the year in which they intend to apply for ETS exclusion. Combustion installations seeking exclusion must comply with a capacity threshold of 35MW or less in addition to the annual 25,000 CO2e tonnes criteria.

The Commission have estimated that approximately 4,200 installations, accounting collectively for around 0.7 per cent of total ETS emissions, could be opted out of the system under these provisions. It is estimated that the proposed extension of the scope, together with the possibility for Member States to exclude small installations, will lead to a net increase in coverage of around 6 per cent, or up to 120 to 130 million tonnes of CO2-equivalent, compared with the current trading period (2008-2012).

Presently the Emissions Trading Directive only allows for the linking of the EU ETS with other national emissions trading schemes provided the country in question has ratified the Kyoto Protocol. The Commission intend to amend the Directive to allow the linking of the EU ETS to sub-federal and other regional schemes. Where external trading schemes have absolute emission caps, the EU ETS would recognise allowances from such schemes with these schemes expected to recognise EU ETS allowances.

The process of allowance allocation is one of the most controversial aspects in getting an emissions trading scheme operational as the allocation a participant receives represents their emissions target. An EUA is the official allowance unit of the EU ETS. An EU allowance (EUA) permits its holder to emit one tonne of CO2 within a given period.

For the first and second phases of the EU ETS the allocation process in the EU ETS was to a large extent decentralised by the European Commission to each Member State and played out through the National Allocation Plan process. Each Member State had to develop a National Allocation Plan (NAP) for each of the first two trading periods detailing the total quantity of allowances they intended allocating and how they proposed to distribute them. Member States were directed by the Commission to allocate at least 95 per cent of allowances for free during the pilot phase with the figure reducing to 90 per cent for the 2008 – 2012 trading period. Annex III of the emission-trading Directive specified the criteria for the implementation and development of National Allocation Plans. To assist Member States in developing their plans and successfully implementing the Annex III criteria the Commission provided Member States with guidance on this subject. Before a Member State could actually allocate allowances amongst its participating installations it had to submit its NAP to the Commission for review and approval. The Commission had the right to reject a plan in its entirety or certain aspects of it. The Commission’s decision was based on whether it felt the NAP was consistent with the Annex III criteria and the guidelines that it established for the implementation of these criteria.

From the beginning of the third trading period (2013-2020) there will be just one EU-wide cap (instead of 27 national caps) on the number of emission allowances available for allocation within the EU ETS. The allowance cap will be determined by the Commission on an annual basis from 2013 with the total number of allowances decreasing annually in a linear manner. The starting point of this line is the average total quantity of allowances (phase 2 cap) allocated by Member States for phase 2 of the EU ETS (2008-12 trading period), adjusted to reflect the change in ETS coverage from 2013 onwards. The linear factor by which the annual amount shall decrease is 1.74 per cent in relation to the phase 2 cap. The starting point for determining the linear factor of 1.74 per cent is the 20 per cent overall reduction of greenhouse gases compared to 1990 that is outlined in the Energy and Climate Change package.(European Commission, 2008a) The average allowance allocation during phase 3 of the ETS will be 1846 million allowances, a reduction of 11% compared to the phase 2 cap.

The third period of the ETS will see allowance allocation governed by a set of fully harmonised rules thus removing the need for Member States to develop their own National Allocation Plans (NAP). The Commission are of the belief that this step will ensure a level playing field across the EU because the NAP process in the first and second phases generated significant differences in allocation rules, creating an incentive for each Member State to favour its own industry. The European Commission plan to adopt an EU wide allocation methodology by December 31st 2010. In as far as is possible the allocation methodology will seek to promote carbon efficient technologies with most allocations based on benchmarking.

Auctioning will have a much greater role in the allocation process from the beginning of the third phase in 2013. The Commission estimate that approximately 50 per cent of allowances will be auctioned in 2013 and that this proportion will increase in later years. Installations in the power sector will initially be subject to a more stringent application of the auctioning approach compared to installations in other ETS sectors which will initially be allocated allowances for free. The Commission intend to progressively phase out free allocation to all non-power ETS sectors over the course of phase 3. Initially auctioning will be set at 20% for these sectors in 2013 with this figure rising to 70% for 2020. The Commission hope that 100% auctioning will be in place by 2027 when the ETS is in a fourth phase (2020 – 2028). However, an exception may be made for installations in industries deemed as “vulnerable”. The Commission intend to evaluate the possibility of the need to continue free allocation to industries particularly vulnerable to international competition (“carbon leakage”). A decision on this issue will be determined by December 31st 2009. All auction revenue will accrue to the Member States and it is the desire of the Commission that at least 50 per cent of this revenue is reinvested to finance the fight against climate change and help Member State movement towards a low carbon economy and support R&D and innovation in areas like renewables and carbon capture and storage (CCS). (European Commission, 2008b)

Emissions trading in each Member State shall be overseen by a Government approved “Competent Authority”. One of the primary functions of the selected authority is to establish and manage an allowance registry. These registries ensure the accurate accounting of the issue, holding, transfer and cancellation of allowances. All registries are overseen by a Central Administrator at EU level who, through the Community independent transaction log (CITL), will check each transaction for any irregularities. By the 30th of April at the latest each year, the operator of each installation must surrender a quantity of allowances equal to the total CO2 emissions from that installation during the previous calendar year.
Monitoring, reporting and verification rules are an integral part of a sound trading scheme. Member States must ensure that each operator of an installation reports the emissions from that installation during each calendar year to their competent authority after the end of that year. In order for an emission trading scheme to operate effectively it is necessary for the scheme to have built in penalties that will discourage non-compliance with the scheme. Where operators do not surrender allowances equal to their annual verified emissions by the 30th of April of each year, it will be liable for the payment of an excess emissions penalty. The excess emissions penalty shall be €100 for each tonne of CO2 emitted by that installation for which the operator has not surrendered allowances. However, for the first three years of the scheme, beginning 1 January 2005, the penalty shall be €40 for each tonne of excess CO2 emitted. Payment of the excess emissions penalty shall not release the operator from the obligation to surrender an amount of allowances equal to those excess emissions when surrendering allowances in the following calendar year, and they will be “named and shamed” by having their names published.

Allowances are valid for compliance during the period for which they are issued, i.e. the first three-year phase (2005-2007) or the subsequent periods. Therefore, while compliance is assessed on an annual basis, banking and borrowing of allowances within each three or five-year phase is permitted. Banking is allowed as unsurrendered allowances are still valid for compliance in the next year(s) of the phase. Borrowing is allowed as allowances for each year are to be issued before 28th February while compliance for the previous year is assessed after 30th April.

EU ETS Participant CDM/JI Use

During the second phase of the EU ETS Member States permitted ETS participants to use limited quantities of CDM and JI credits in addition to EU allowances for part of their emission compliance obligations. Under the ETS revisions outlined in the climate and energy package the Commission intend to continue with the limits on installation CDM/JI credit use during the third trading period. However, the Commission plan to permit a limited additional quantity of credits to be used such that the overall use of credits is limited to 50% of EU-wide emission reductions over the 2008 – 2020 period. According to the European Commission (2008b) this will result in installations that were part of the ETS during the 2008 – 2012 trading period being able to make use of approximately 1.6 billion credits for compliance purposes over the 2008 – 2020 period.

EUROPA – Rapid – Communiqués de presse

Communication from the Commission on guidance to assist Member States in the Implementation of the criteria listed in Annex III to Directive 2003/87/EC Council establishing a scheme for greenhouse gas emission allowances trading within the Community and amending Council Directive 96/61/EC, and on the circumstances under which force majeure is demonstrated. In all Annex III contained 11 criteria relating to NAP development.
See ETS Coverage section.

The 20% overall reduction of greenhouse gases compared to 1990 is equivalent to a 14% reduction compared to 2005.

EUROPA – Rapid – Communiqués de presse

The European Commission are to report on “carbon leakage” by 2011 and will make a proposal if appropriate to review free allocation levels and/or introduce a system to neutralise distortive effects to EU industry from having to compete with non-EU competitors who are not subject to binding emission constraints.
The CDM (Clean Development Mechanism) and JI (Joint Implementation) are two project-based mechanisms provided for under the Kyoto Protocol. The CDM provides an opportunity for project developers to generate emission reductions from projects carried out in developing countries without quantitative emission reduction targets – so-called non-Annex I countries. Under the CDM project developers from Annex I countries receive Certified Emissions Reduction (CERs) units for the actual amount of greenhouse gas emissions reduction achieved subject to a host country project developer agreement, third party assessment, and registration by the CDM Executive Board. The CDM should allow for the transfer of advanced environmentally sound technologies to developing countries, while assisting them in achieving their sustainable development objectives. CDM is project specific, based on a baseline and credit approach with an ex-post verification of emissions reductions achieved. A key component of the CDM is the requirement of additionality. CERs generated under the CDM will only be recognised when the reductions of greenhouse gas emissions are additional to any that would occur in the absence of the certified project activity.

Joint Implementation (JI) projects are to be undertaken in developed countries or countries with economies’ in transition (Annex I Parties to the UNFCCC). They involve at least two countries that have accepted an emission target, i.e. their emissions are limited. Emission reductions from JI projects are called emissions reduction units (“ERUs”) and are issued by the country in which the project is implemented (the “host country”). The implementation of a JI project results in a transfer of ERUs from one country to the other, but the total emissions permitted in the countries remains the same (a “zero sum operation”). The host country benefits from minimising the part of its assigned amount to transfer, while the investor country benefits from maximising the number of assigned amounts units it acquires. It is expected that both countries will strike a fair balance. JI is expected to be a good vehicle for the transfer of advanced environmentally sound technologies, in particular in Russia where there is a great potential for JI investments in the energy sector. JI is project specific, based on a baseline and credit approach with an ex-post verification of emissions reductions achieved.

The implementation of the EU ETS will impact primarily on the environment, society and the trading scheme participants themselves.

• Societal costs – direct administrative costs
• consumer product price increase
• ETS Participant costs – emission reduction costs
• allowance purchase costs
• allowance market activity costs
• monitoring, reporting and verification costs

The implementation of the EU ETS will impact on participants in a number of ways. Participants must ensure that at the end of a designated period they have enough allowances to cover their emissions for the required reporting period. Where participants do not possess sufficient allowances, they must enter the allowance market to purchase allowances or else face the imposition of a significant penalty. For ETS participants entry into allowance market comes at a cost as allowances have to be purchased and brokers and traders paid a fee for facilitating allowance transactions.

The main impact of the EU ETS on society is felt where ETS participants pass through the cost of allowances to consumers in the form of higher prices. Electricity prices increased during the first phase of the EU ETS when allowances were allocated for free. Sijm et al. (2006) documented CO2 cost pass through and the generation of windfall profits in the power sector during the first phase of the EU ETS.

The environment will benefit from the introduction of the EU ETS since the allowance allocation process guarantees a cap on the quantity of CO2 that may be emitted by trading scheme participants over the course of the trading scheme. Since the primary aim of a trading scheme is to bring about emissions reductions the quantity of allowances and thus emissions rights allocated to ETS participants will decline from one trading period to the next. This ensures that emissions from the ETS sectors will follow a downward trajectory.