Moving Forward with the “Cap and Trade System” (Emissions Trading System) in the EU

April 5, 2019



The EU Emissions Trading System, also known as the European Union Emissions Trading Scheme (EU ETS), was the first large greenhouse gas emissions trading scheme in the world and remains the biggest of 25 carbon cap-and-trade systems in place word wide today.


The Cap-and-trade system ensures a declining emissions cap on the total amount of pollution that sectors within an economy are “permitted” to make over time. It increases the certainty that emissions will fall below the pre-determined emissions target. It covers three gases: carbon dioxide, nitrous oxide and perfluorocarbons. A carbon unit is a permit to emit one ton of CO2. These permits are distributed to companies either for free or through an auction.  


Some entities covered by ETS are so successful in reducing their carbon emissions that they simply don’t need the excess credits. They can then sell them at a market determined price to those that struggle to reduce their emission. In addition to this, entities are also allowed to purchase limited international credits from emission saving projects around the world. The limit on the total number of allowances ensures that they have a value.


EU ETS allocates tradable emissions permits to over 14,000 power stations and industrial plants in 31 countries (28 EU countries plus Iceland, Liechtenstein and Norway) accounting for about half of EU’s greenhouse gas emissions or 5% global emissions.


Currently it accounts for three-quarters of international carbon trading and covers about half of EU’s greenhouse gas emissions. It is expected that by 2020, emissions from sectors covered by the system will be 21% lower than in 2005 and by 2030, under phase 4 (2021-2030), will be 43% lower.


EU ETS is part of EU’s commitment to the 2015 Paris agreement. A new phase- 4 was designed to enable it to achieve its 2030 emission reduction targets in line with its climate and energy policy framework. Phase 4 focuses on increasing the pace of annual reductions in allowances to 2.2% as of 2021 and reinforcing the market stability reserve – a mechanism established by the EU in 2015 to reduce the surplus emission allowances in the carbon market and improve EU ETS’s resilience to future shocks.


The EU ETS has been a poster child for market-based policies to tackle climate change but, its development over time has faced many conceptual challenges. Some critics believe that the policy has failed to deliver on its objectives. They argue that a weak reduction target and the massive use of international credits have led to build up of enormous surplus of emission allowances. This has led to a drop in their prices to a point that it no longer drives change. Over the life cycle of the system, prices have varied considerably, from EUR.5/ton to about EUR.30/ton in 2008. When the financial crisis struck, European economic activity declined and so did emissions. Entities were left with excess free permits that tanked carbon prices. It’s only in Sept. 2018 that it moved past its highest point in a decade surpassing EUR.20/ton. This is still too low to do anything but give industry a gentle nudge toward using cleaner fuels. According to International Energy Agency - at least EUR.50/ton is needed to stimulate the most crucial technologies that halt the flood of greenhouse gas emissions into the atmosphere.


Moreover, carbon prices are too narrowly applied to meaningfully curb emissions. The existing carbon schemes only punish certain sectors of the economy leaving other with a free-hand to pollute. World Bank calculates that the system covers just 15% of global emissions. It may jump to 25% once China makes good on its promise of implementing a nationwide carbon-pricing program. This figure is still short of 50% mark, set by the bank, that must be achieved in a decade to meet the global carbon-reduction goals set forth in the Paris climate accord.


The result is that a policy prescription widely billed as a panacea is acting as a narcotic. It’s giving politicians and the public the warm feeling that they’re fighting climate change even as the problem continues to grow.


In recent years, the EU has somewhat amended the system to make it stronger. It has expanded its reach over a greater number of entities that require to purchase permits and have included airline routes within the EU under the system. Yet, the prices remain too low for industry to act effectively on it. In 2017, emissions from the entities covered in the system rose due to a stronger than expected industrial output.


Despite its shortcomings, carbon pricing has accustomed powerful imagined entities to the idea that they will have to integrate decarbonization in their decisions. It has prodded actors to initiate efforts to build new technologies and business models that can economically cut emissions to a meaningful extent. In its present form, the system seems to be failing at its task and the time for course correction is running out quickly. Deep cuts in emissions is crucial to reduce the impact of global warming. As countries continue to post record economic growth on the back of burning coal and cheap fossil fuels, thousands of miles apart, ice is silently turning into water.


A strong political will, effective policy, robust carbon pricing, reduced protectionism and deep investments in technology for renewables along with carbon capture is imperative. There is strong evidence that cleantech innovation creates more knowledge ‘spillovers’ than dirty technologies. A policy intervention that encourages cleantech while discouraging dirty tech has the potential to increase overall rate of innovation. As long-term growth is entirely driven by innovation and technological progress, it follows that such policies would also boost economic growth.


The innovative activity caused by the effect of EU ETS is estimated to have resulted in more cleantech patents than would have otherwise emerged. Moreover, the positive impact on innovation decreases with the number of permits obtained for free. As a proxy for research and innovation, patent data potentially understates the true scale of the activity.


Micro-data at the company and plant levels is becoming more available. These data sets will prove an important stimulus for researching the impact of the EU ETS in the years to come. There will also be an emphasis on understanding the channels and mechanisms through which companies respond to the policy. The academic literature remains in its infancy for addressing cost-effectiveness credibly but, with time, such analysis should become possible.


We have successfully dealt with large environmental issues in the past but, this requires a collective effort from individual, political, technological and economical wings at a global scale. Once we accept the pressing need for action, only then can we pressure for a more robust EU ETS.


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