The European Emissions Trading System — EXPLAINED
Introduction — Stern Review
Nicholas Stern (the former Chief Economist of the World Bank) known for his 700-page report called the “Stern Review”, states that climate change is the biggest market failure the world has ever seen. He estimates that if no action is taken, there is a 75 percent chance global temperatures will increase by 2–3°C, and a 50 percent chance the global temperatures will increase by as much as 5°C over the next 50 years, (1.5°C being the danger line for global warming). In Africa, there would be an enormous decline in crop yields, in addition to 40% of all species in the world potentially facing extinction, as well as 200 million people being permanently displaced due to rising sea levels. ¹
However, the Stern Review is not just another catastrophic scenario of global warming. It is the biggest and most widely known economic report on climate change,² and as such, also provides potential solutions to these problems. At an international level, Sir Nicholas Stern claims that a global market for carbon needs to be created, specifically by extending the European Trading Scheme (ETS or EU ETS) globally to include countries such as the USA, India, and China.
Theory — Correcting the biggest market failure by using market forces
First and foremost, as the cornerstone of the EU strategy to fight global warming³, — the European Emission Trading System creates financial incentives for firms to pollute less. This is done by setting a cap on the total amount of emissions created by a member state or the EU itself. The cap determines how many free allowances will be issued by the EU, with one allowance accounting for one tonne of CO₂ emissions. An ETS company can also trade allowances on the carbon market as a commodity, but it must have enough allowances to cover all its emissions, otherwise, it will be subject to a penalty.
In theory, the “invisible hand”, as well as the laws of supply and demand help allocate those allowances efficiently. A firm with unused allowances will be able to sell them to a firm that pollutes more, rewarding efficiency in reducing negative externalities. Therefore, in the ETS, the reduction in pollution occurs, where it costs the least. If an ETS firm needs even more allowances to cover its emissions, it can also auction them. This is deemed to be a fairer way to allocate the allowances, since the firms that need them the most will pay the most, whereas the free allowances are often distributed unfairly. Although in the short-run, the ETS may be inefficient in reducing emissions by firms where it is costly to do so, it is effective in the long-run, as the EU decreases the cap on emissions each year. This supply squeeze pushes the price of allowances higher, which incentivises the firms to invest into cleaner and more efficient energy.
However, the most difficult aspect of the ETS policy is estimating the right amount and price for the allowances. If the price is too low, the incentive to stop pollution is insufficient, and the firm is better off continuing production as is. If the price is too high, the polluter could offshore operations and produce somewhere else, creating unemployment in the ETS country. Furthermore, pollution is rather transported to another country than reduced, creating no positive net effect. Amid fears of this, the EU has decided to issue allowances for free, which as mentioned above, due to the unfairness and lack of transparency, became a subject of discussion later on.
The context of the EU ETS
The EU pledged to reduce its greenhouse gas emissions (GHG) in the Kyoto Protocol in 1997.⁴ It acknowledged that global warming was occurring and emissions from human activities were the cause. When launched in 2005, the EU ETS became the first international carbon market in the world, and to this day it is also the largest carbon market in the world, covering 50% of the EU total CO₂ emissions. It aims to reduce GHGs by 40% in 2030.⁵ To date, the ETS has consisted of three phases: the first (2005–2007), the second (2008–2012), and the third (2013–2020).
Phase 1 (2005–2007)
Phase 1, also known as the “Trial Phase”, became the first attempt in history to make an international carbon market work. As there was no precedent, EU leaders decided to adopt an approach of “learning by doing”. All EU members took part in the scheme, but only power generators and energy-intensive industries were initially included. All allowances were issued for free, and the amount was determined in the form of National Allocation Plans (NAP). They were used to set the rules for the allocation of allowances and to predetermine the EU-wide cap, which was meant to be equal to the sum of all NAPs.
The Phase 1 failed when the carbon market collapsed in early 2007, due to a significant over-allocation of allowances, which according to the EU “jeopardised the Kyoto targets”.⁶ Since there was a larger supply of allowances issued by NAPs than the total amount of emissions in the EU, the prices of allowances (EUA price) effectively plummeted to 0€.
Phase 2 (2008–2012)
Phase 2 of the ETS included Norway, Iceland, and Liechtenstein, countries not originally in the scheme, as they were not EU members. The scheme was expanded to take into account emissions from the aviation sector, in terms of flights within the European Economic Area only.
In Phase 2, the first auctions for allowances were held, which became the preferable way for allocating them, although not the most common. Roughly 90% of allowances were still allocated freely with the NAPs. Because actual numbers on emissions were now available, the cap was lowered by 6.5%, preventing the market from collapsing as did in “Phase 1”. Nevertheless, a huge dip in the EUA price occurred as a result of the Financial Crisis of 2008. It forced firms to lay off workers worldwide, due to lower demand for goods, which were now produced in smaller quantities. Consequently, the amount of GHGs and the demand for allowances fell, following the decrease in output levels.
Phase 3 (2013–2020)
The most significant changes to the scheme were introduced with the launch of “Phase 3”. The “National Allocation Plans” were replaced by the “International Allocation Plans”, and the EU-wide cap on emissions replaced the national ones. Many more sectors were included in the scheme (see the table of free allocation by sectors). Auctions became the main method of allocating allowances, and although about 50 percent of them were still allocated freely, the disparity of free allocation was tackled by implementing harmonised benchmark rules. All firms in the scheme were benchmarked against the top 10% firms of their sector and rewarded with allowances accordingly. Despite all the effort to make the allocation of allowances more “fair and square”, there was very little success in increasing the EUA price, due to the persistent oversupply of allowances.
Recently, EU policymakers seemed to find a solution. For most of Phase 3, the price for allowances fluctuated between 5–8€, not providing enough incentive for firms to reduce their GHG emissions. The EUA price started to rocket in 2018, with the EU announcing the introduction of the “Market Stability Reserve” (MSR) as a tool for a “Massive Supply Reduction”, which is meant to become the largest supply squeeze of allowances the EU ETS has ever seen.⁷ Consequently, as the fall in supply makes allowances more scarce, the market will react by pushing the EUA price higher. Already before the MSR was put in action there was an effect on EUA prices.
As a result of the announcement of the MSR, the price doubled between December 2017 and April 2018. After the launch in 2019, growth was recorded at as much as 400% compared to 2017.
The MSR can be considered to be the most crucial ETS policy implemented since Phase 1, as it has been the most robust system for ensuring that EUA prices incentivise firms to invest in cleaner energy. Not even the COVID-19 pandemic, which seemed to have a more severe short-term impact on the economy compared to the Financial Crisis in 2008, could force the EUA prices to fall to levels from the beginning of Phase 3.
Quantitative results of the EU ETS
As an environmental policy, the main aim of the EU ETS is to reduce pollution levels. Since “Phase 1” in 2005, carbon emissions have decreased by 15%. This was partially due to the financial crisis of 2008, which as mentioned above, led to layoffs, lower production and output levels, and hence lower pollution levels.
Economists from the European University Institute compared EU ETS firms with non-ETS firms using control groups, to estimate the pure impact of EU ETS was on the reduction of carbon emissions, excluding the impact of the Financial crisis. They calculated that in 2005–2015, there was a reduction of 8%. The confidence intervals are relatively large, but it was found that Phase 1 and 2 contributed roughly -5% and -8% respectively, whilst the impact of Phase 3 was statistically insignificant on emissions.
The explanation for the insignificant impact of Phase 3 is the limitation of the data set, which contained data up until 2015, well before the MSR was implemented. The impact on emissions squares with the EUA price changes. Therefore, it can be claimed that for the first 3 years of Phase 3, the price was too low to incentivise firms in the EU ETS scheme to reduce pollution. On the other hand, the introduction of the MSR could lead to an unprecedented fall in emissions in the future.
Contrary to the theory, there was no sign of a negative net effect of the EU ETS as a European unilateral environmental policy. Concerns were that if the EUA price was too high, it would force companies to relocate, and pollute elsewhere, resulting in a negative net effect. According to the Carbon Disclosure Projects, (which are publications of about 1000 multinational corporations to determine whether a fall in emissions of EU countries was compensated by an increase of others), there was no evidence of emissions being offshored to other countries. Firms either grew their emissions everywhere or decreased them everywhere. There was no shift from one country to another.
A study from Imperial College London, which surveyed entrepreneurs across the EU, suggested that free allocations should be cancelled because they are too generous. Had free allowances been replaced by auctions, the Commission could raise an extra €500m/year, without risking carbon leakage — the main reason for free allowances initially.
Overall, the EU ETS had no significant impact on employment because a company in the ETS was not more likely to go bankrupt or to exit the market than a non-ETS company. The most significant results were found in terms of revenue (6% increase) and fixed assets (9% increase). Firms that were decreasing emissions the most, recorded the highest increase in the value of their fixed assets, rising as a result of a firm’s investment into innovations. The positive significant impact on revenues was mostly driven by energy companies, which provide electricity with highly inelastic demand, and as such passed the cost of EUA onto the consumer.
Another interesting discovery about free allocations is that, when set properly, they do reduce emissions. It was found that if the amount of allowances exceeds 80% of all emissions, there will be no significant impact on the reduction of GHGs. The effect actually becomes positive in the case of an overallocation, but statistically, it is no different than 0. Alternatively, if the amount of allowances is lower than 80% of all emissions, there is a statistically significant reduction in pollution. Nonetheless, the free allowances were often criticised not because of the weak effect on GHG reduction, but because of the generous overallocation, and windfall profits that were created for the EU firms in the energy-intensive industries.
Criticism — Windfall profits, Article 10c, and Coal
Windfall profits
The EU ETS has received a lot of criticism throughout its existence. In Phase 1, there was the infamous market collapse, with EUA prices hitting rock bottom. However, the scheme was still in its trial phase and policymakers were collecting the first sets of data to work with. Hence, it was not as bad as discoveries during Phase 2, which showed windfall profits worth €24bn earned by firms in carbon-intensive industries.⁸
How did that happen? There are two main reasons: the surplus of allowances and the so-called “cost-pass through”. The surplus of allowances meant that industries received more free allowances than they needed to cover their actual emissions, and as such, they were able to sell their surplus on the market. The cost-pass through profits were generated by industries that forced the consumer to pay the price for freely obtained allowances, by passing the “cost” onto the consumer. The largest profits of €8bn were recorded by the steel industry, followed by €4.7bn in the cement industry and €4.4bn in refineries.
Hypocritically, industry leaders still complained about the EU ETS harming their competitiveness. ArcelorMittal — a steel company from Luxembourg, claimed that the EU energy and climate policy was punishing the steel sector and other energy-intensive industries, which had a profound impact on their competitiveness, despite making over €400 million from EU ETS between 2011–2016. Lafarge — a French cement company, made a similar complaint whilst making even larger profits of €485 million between 2010–2014.
Article 10c
“Cost-pass through” profits were not a new phenomenon for the EU ETS. In Phase 1 and 2, the electric power sector was also making windfall profits by passing their non-existent “cost” onto consumers. Since the beginning of Phase 3, power generators have been banned from free allocation and been forced to buy allowances through auctions, in order to prevent these companies from exploiting the inelasticity of demand for energy.
However, there is an exception for “low-income EU member states”. They can appeal to Article 10c, which enables them to receive allowances but obliges them to invest their monetary value into modernisation and diversification of their energy. Article 10c was mainly intended to mitigate the difficulties of the transition from fossil fuels to renewable energy. Eight countries that joined the EU between 2004–2007 have made use of Article 10c: Bulgaria, Cyprus, Czechia, Estonia, Hungary, Lithuania, Poland, and Romania.⁹
In Poland, Article 10c was used to fund investments for the modernisation of the existing fossil fuel capacity. “The Polish National Investment Plan” proposed an investment of only 8.5% into renewable energy (most of which included biomass co-firing), compared to 82% being invested into modernising fossil fuel capacity, such as in “Belchatów”, the second-largest coal-fired power plant in the world and the biggest in Europe. Poland, Czech Republic, and Romania together account for 85% of the Article 10c’s free allowances, and plan on investing only 10% of them into renewable energy, leaving 90% for upgrading the current fossil fuel infrastructure, such as coal-fired plants.
Coal
Ironically, Article 10c, which was supposed to make a transition from coal to renewable energy, essentially funds the dirtiest source of energy in lower-income EU member states. Air pollution causes 430 000 deaths annually in the EU and is claimed to be the biggest environmental threat to public health in the world.
“Europe’s Dark Cloud” is the first-ever analysis of cross-border health impacts on air pollution from coal use in electricity generation in the EU. It shows that the coal plants cause 23 000 premature deaths a year, compared to 26 000 premature deaths due to road accidents, the third most common cause of death in the EU. For EU countries, nearly all of which have universal healthcare, air pollution is definitely playing its role in government receipts, creating an overall bill worth as much as €62 billion.¹⁰
In the short-term, emissions from coal increase cardiovascular and respiratory hospital admissions resulting in more work days being lost. In the long-term, emissions from coal reduce the average life expectancy, increase the chance of arrhythmias, heart attacks, lung cancer, and bladder cancer.
Unsurprisingly, the biggest polluters are the countries with the largest number of coal plants, this being Germany and Poland, followed by the UK, Romania, Bulgaria, Spain, and the Czech Republic. “Belchatów” alone is estimated to cause 1270 premature deaths, the largest number for a single power plant. That said, only a fraction of deaths will occur in the country of a polluter, as the majority of the air pollution is spread across other member states, creating an EU-wide problem.
The transition from coal to renewable energy is a long process that cannot be done in a day, but it is about time that the EU implements policies to start that process instead of delaying it. The transition could be catalysed by transitioning to gas, which produces 50 percent less CO₂ emissions than coal. Fuel switching is the easiest way to reduce emissions in the short term, as many countries have spare gas capacity. The top prospects for fuel switching are Germany, Spain, Italy, and the Netherlands. Germany has the largest spare capacity, and so, should initiate this process.
In the long run, global leaders should put more effort into bringing nuclear energy back into the public discourse, as it is very efficient and clean, but also requires a relatively small amount of land (in contrast to solar power). In addition, it produces minimal waste that is also recyclable.
However, nuclear energy currently enjoys very little popularity in the general public due to the tragedies in Fukushima and Chernobyl. Interestingly though, public opinion has been recently fluctuating in reaction to domestic energy prices, showing how cheaper nuclear energy could potentially gain popularity back in the future.¹¹
In terms of security, it is important to understand that both Fukushima and Chernobyl were built in the 1960s and 70s respectively, whereas modern technology would consist of remarkably improved safety, enabling nuclear plants to be controlled remotely without human presence. So, the fear of nuclear energy is irrational.
This brings us back to Germany, which used to produce most of its energy in nuclear plants, but recently has been shutting them down and replacing them with coal-fired plants. As the most recycling nation in the world, Germans should do more to ensure the long-term sustainability not only of its consumption, but also of its energy sources, and thereby inspire other European nations to do the same.
The future of the EU ETS
Next year, the EU ETS will enter Phase 4 which will last until 2030 and is likely to become the most successful phase so far. Most importantly, the MSR will help to reduce the oversupply of allowances in the carbon market, enabling the EUA price to have its signalling function — investing into cleaner energy sources. Unlike previously, the signal is going to be strong.
The EUA price, which is currently at 28€, is claimed to rise to 40€ in 2021, with the potential to rise up to 60–70€ in later stages of Phase 4 to fulfill the GHG reductions promised by the EU in the Paris Agreement. Moreover, on the 4th of March 2020, the European Commission has proposed the first European Climate Law, which enshrines the target of carbon neutrality by 2050 into law.
Using empirical evidence from the quantitative results of the ETS, we can expect substantial reductions in pollution levels as a consequence of such significant price increases. In addition, the overall cap on emissions will decline at a faster annual rate of 2.2 percent compared to 1.74 percent in Phase 3, and the proportion of allowances obtained through auctions will increase from 50 percent to 57 percent.
Fewer countries are going to make use of Article 10c, with only Bulgaria, Hungary, and Romania being exceptions. Nevertheless, there should be a much greater emphasis on fuel switching and investing in renewables to mitigate the negative externalities of coal plants. The investments in coal-fired plants were, indeed, an unintended consequence of Article 10c, but action needs to be taken for the EU ETS to be deemed a serious policy. This action will be the new alternative to Article 10c — the EU Modernisation Fund, which will be introduced in Phase 4¹² and help countries with transitioning to cleaner energy. The leaders of the biggest coal polluters should also be more vocal about the need for fuel switching.
The EU ETS has the potential to become the prime example of an efficient and inspiring economic policy to fight global warming. In my judgement, the biggest strength of the EU ETS is the ability to learn from mistakes by objective and rational evaluation, creating a perfect environment for continuous improvement. In times of a trade war between China and the USA, Stern’s dream of a global carbon market seems very distant. Yet, it should not prevent us from finding the most effective way to reach carbon neutrality. The EU ETS represents a dream. A dream where humans are held responsible for the consequences of their actions. A dream, where logic and rationality help us to make progress. A dream, where a brighter and sustainable future awaits humanity.
Citations
[1] Stern, Nicholas, “At a glance: The Stern Review.” BBC News, 30 Oct. 2006, http://news.bbc.co.uk/2/hi/business/6098362.stm.
[2] Cairncross, Frances, “Time to get Stern on climate change.” Web.archive.org, https://web.archive.org/web/20070926221549/http://www.thefirstpost.co.uk/index.php?menuID=2&subID=1055.
[3] European Commission, “EU Emission Trading System (EU ETS)”, https://ec.europa.eu/clima/policies/ets_en.
[4] European Commission, “Phases 1 and 2 (2005–2012).”, https://ec.europa.eu/clima/policies/ets/pre2013_en
[5] European Commission, “2030 climate & energy framework.” https://ec.europa.eu/clima/policies/strategies/2030_en
[6] European Commission, “National Allocation Plans.”, https://ec.europa.eu/clima/policies/ets/pre2013/nap_en
[7] Carbon Tracker, “Carbon Clampdown: Closing the Gap to a Paris-compliant EU-ETS.”, https://carbontracker.org/reports/carbon-clampdown/
[8] Carbon Market Watch, “Industry windfall profits from Europe’s carbon market.”, https://carbonmarketwatch.org/wp-content/uploads/2016/03/Policy-brief_Industry-windfall-profits-from-Europe%E2%80%99s_web_final-1.pdf
[9] Carbon Market Watch, “Fossil fuel subsidies from Europe’s carbon market.”, https://carbonmarketwatch.org/wp-content/uploads/2016/04/Fossil-fuel-subsidies-from-Europes-carbon-market-final-web.pdf
[10] World Wide Fund For Nature, “Europe’s Dark Cloud.”, https://wwfeu.awsassets.panda.org/downloads/dark_cloud_report.pdf
[11] World Nuclear News, “US public opinion evenly split on nuclear.”, 01 Apr. 2019, https://world-nuclear-news.org/Articles/US-public-opinion-evenly-split-on-nuclear
[12] European Commission, “Revision for Phase 4 (2021–2030).”, https://ec.europa.eu/clima/policies/ets/revision_en
