Emissions trading and national carbon markets – Beware of past mistakes! (Watch This! #5)

By Adela Putinelu, Carbon Market Watch

The European Union Emissions Trading Scheme (EU ETS) is the largest emissions trading market internationally and the pillar of EU climate policy. But the scheme struggles with an over-supply of 2 billion tonnes of CO2, very low demand and record low allowance prices. Despite its controversial environmental integrity, the EU ETS is regarded as a model for other emission trading schemes emerging worldwide.

The European Emissions Trading Scheme (EU ETS) is a cap-and-trade scheme comprising industrial installations from the heaviest 12.000 European emitters. Cap-and-trade means that an overall cap is set on overall industrial emissions; individual companies receive pollution permits that they can trade to lower their costs of compliance with assigned climate targets. In theory, the declining emissions’ cap will create market scarcity and hence incentivize the emitters to cut down pollution and invest in cleaner technologies.

Origins of structural problems

27 European member states and also Lichtenstein, Norway, Iceland and Switzerland are included in the EU’s cap-and-trade scheme. Problems emerged as early as 2005, when the scheme’s Phase I was implemented. Over-allocation of pollution permits and an overall inflated emissions cap raised serious concerns about the environmental integrity of the scheme. During Phase II (2008-2012) issues complicated further as emissions decreased at installation level due to the economic recession. However, the number of permits handed out for free to companies remained the same. Cheap offset credits from the United Nation’s offsetting mechanisms Clean Development Mechanism (CDM) and Joint Implementation (JI) further aggravated the over-supply of permits. To date, the EU ETS is over-supplied by about 2 billion allowances. Two thirds of the over-supply can be blamed on the use of offset credits. Consequently, the price of EU permits dropped to record lows and is currently looming around 4 Euros.

The EU should take the lead and address the design problems of offsets. To avoid that substandard credits undermine the environmental integrity of the EU ETS, it should impose quality restrictions pre 2020. With insufficient targets in place, it must also ban international offsets post 2020 and ensure more domestic action to reduce emissions.

The European Commission, the regulator of the emissions market, has a twofold plan to restore the scheme’s credibility and prop up depressed carbon prices. It first wants to temporarily withdraw 900 million permits from the market. In addition, structural measures to boost the EU ETS in the long term are currently being considered. These include a permanent withdrawal of a number of permits, decreasing the annual cap on emission levels or further restricting the use of international credits.

ETS developments around the world

Although the EU ETS is suffering structural design problems, it has become a model for emerging emissions trading schemes globally. What happens in Europe is closely observed by regulators wanting to develop similar systems in other countries. In fact, national or regional carbon markets under the form of cap-and-trade are currently being developed worldwide. Below you find an introduction to some of these schemes:

California’s cap-and-trade program is the second largest cap-and-trade system after the EU’s emissions trading scheme. Contrary to the EU, it allows offset credits from forestry activities and is currently in a bid to include credits from forest conservation projects in Brazil and Mexico. Read more about the California REDD here and in the next Watch This!

South Korea‘s cap-and-trade will take effect in 2015. It recognizes the need for domestic cuts and banned the use of international offsets until 2020.

The unlimited use of offsets in New Zealand’s cap-and-trade was partly responsible for the low carbon prices. Addressing the lack of environmental integrity from certain CDM project types, New Zealand has banned carbon credits from large hydro projects.

Starting in 2015, Australia’s carbon pricing mechanism will link to the EU’s emissions trading scheme. This move will inaugurate the first intercontinental linking of emissions trading schemes. By 2018, the two schemes will be fully linked and EU allowances are expected to be used for compliance by Australian companies and vice versa.

The appetite for emission trading in the form of cap-and-trade schemes is rapidly increasing worldwide. To date, these schemes are recognized for lowering compliance costs at company level but suffer from numerous design flaws that consequently result in a rather disappointing environmental record. More ambitious climate targets will ease the burden of over-supply of pollution permits, the characteristic of nearly all cap-and-trade schemes. As the EU’s emissions trading scheme is deemed a model for other similar schemes globally, the EU should take the lead and address the design problems of offsets. To avoid that substandard credits undermine the environmental integrity of the EU ETS, it should impose quality restrictions pre 2020. With insufficient targets in place, it must also ban international offsets post 2020 and ensure more domestic action to reduce emissions. This could get others in the loop and make cap-and-trade more environmentally effective.