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ITEM 6 - Emissions Trading

The creation of scarcity: an overview of emissions trading2

By Peter Vis3

1. What is emissions trading?

Trading the right to pollute is a concept that still engenders much misunderstanding, even downright hostility, in Europe. And yet in spite of that, the European Union is the first region of the world to have introduced a greenhouse gas emissions trading scheme across a multi-country area. A new common currency has been “invented” that extends not just to the 12 countries of the Euro-zone, but to all 25 EU Member States, and, in all probability, even beyond the EU within a matter of months4. The EU’s emissions trading scheme was adopted in record time for such an ambitious project. As one of the firsthand witnesses to this process over the last 7 or 8 years, I am often asked what was it that made it happen so quickly? The answer is rather simple. Essentially, emissions trading is a good idea whose time had come. Europe, and some other major industrialised economies, had signed up to ambitious international commitments on climate change. The question was no longer “whether”, but “how”, and in this context emissions trading stood out as being the instrument of choice.

To summarise, emissions trading basically requires that polluters hold an entitlement to emit a given quantity of pollution. Entitlements, or “quota” as they are aptly referred to in the French language, are then limited, and there are penalties for those who emit without having a corresponding entitlement. At the heart of emissions trading, therefore, is the ending of an unlimited entitlement to pollute. Similar things have happened other areas of life. When all open land had been fenced off and appropriated by someone, the free acquisition of land ended, and land became scarce. Land was henceforth transferred against payment. Unlike land, however, emissions entitlements are not tangible assets. The markets created by emissions trading are an invention of man. For emissions trading to work, there are certain pre-requisites that need to be fulfilled. This article endeavours to review what these are, and have a look at practical examples of these new emerging markets.

1.1 Five components of emissions trading

Emissions trading is an instrument that centres on five elements: a commitment, an option to trade entitlements to emit, a monitoring of performance, a compliance exercise underpinned by sanctions, and scarcity. When asked to describe emissions trading, there is much interest in the mechanics of how the entitlements to emit are awarded, and then transferred from one participant to another. A whole service industry is emerging, of traders, brokers, exchanges, and specialist commentators. While such service providers are necessary and are to be welcomed, the heart of emissions trading in environmental terms is about setting an environmental goal, and ensuring that it is met.

1.1.1 The commitment

The commitment is fundamental. There are four essential elements.

In the European Union’s greenhouse gas emissions trading scheme, as in other instances of emissions trading such as the sulphur dioxide emissions trading scheme in the United States, the commitment is determined by the allocation of entitlements at the outset of a trading period. This is also what the Kyoto Protocol has done in fixing commitments for industrialised countries for the period 2008-2012. Determination of such future commitments has one obvious disadvantage, and that is, like all expectations about the future, they are liable to be “wrong”.

1.1.2 Transfer of entitlements

This is where the market mechanism of emissions trading becomes so interesting. The most notable feature of the instrument of emissions trading is the ability to transfer entitlements between different participants in the market. What this means in practice is that participants in a trading scheme can “adjust” their entitlement to emit by buying parts of the entitlement of others or by selling parts of their own entitlement. These parts of entitlement are referred to as “allowances” in the European Union’s scheme. They are denominated in metric tonnes of CO2 equivalent. The word “allowance” conveys well that the holder is allowed, or entitled, under the scheme to emit an equivalent amount of greenhouse gas into the atmosphere5. Generally speaking, emissions trading schemes should not proscribe how the transfers of entitlements are agreed or priced between the various participants. Given the existence of sufficiently liquidity, market forces should determine the price at which entitlements are transferred, and modern free market economies are sufficiently developed to be left to find their own ways of bringing potential buyers and sellers together.

When a programme is being made for television or radio, it is often this ability to transfer entitlement, and how this is undertaken, that attracts the most attention. While trades are not done by open outcry, as was once the method for transacting certain financial instruments and assets, there is a picturesque image of traders shouting and making frenetic hand signals at one another, and, the audience might suppose, making or losing large amounts of money. This image sits in stark contrast to that of a pure and unspoilt environment and the idealism often associated with environmental movements. It is a sign of the times, however, that in North America, Europe and many other parts of the world, environmental NGOs are increasingly embracing the concept of emissions trading as a worthwhile means to an end. By reducing costs, emissions trading maintains the willingness to act to protect the environment.

While at first sight, the transfer of entitlements might look like an adjustment of the level of the commitment, thereby contravening the principle of the commitment being fixed, one must realise the level at which an outcome is being fixed. In any emissions trading scheme, the aggregate quantity of emissions allowed will always equal the aggregate number of entitlements issued. It is this aggregate commitment that determines the environmental outcome. Below the aggregate level, there may be individual emitters that emit more, and others than emit less, and entitlements will be transferred – against payment – from one to the other. Overall, the reductions made by one actor are cancelled out by the extra emissions of another. The regulator of the scheme must concentrate not on individual outcomes, but rather on fulfilment of the overall environmental objective set at the outset. Given the need that commitments should be fixed, the regulator must accept that once fixed, the aggregate commitment cannot be changed, even if emissions allowed by this level of commitment prove later to be too high, or too low.

1.1.3 Monitoring

If there is a commitment, then clearly there must a monitoring of whether the commitment is fulfilled or not. Like the commitment itself, proper monitoring is one of the fundamental building-blocks without which the environmental outcomes will not be attained.

For too long, emitters “did not measure what did not matter”. Once emissions trading is in place, what is being monitored above all is actual performance as compared with the commitment. Good monitoring, to pre-determined standards, is as important to the environmental integrity of an emissions trading scheme as the level of ambition of the commitments themselves. What use an over-ambitious target if the monitoring of compliance is lax? Through weak monitoring, the environmental outcome can be compromised, accountability and certainty are weakened, scarcity is reduced and the proper functioning of emissions trading will be impaired. If an emitter can understate emissions so as to need less entitlement, then recourse does not have to be made to the market to buy additional entitlement. Similarly, it would be just as detrimental to the success of the scheme if an emitter were to sell part of his own entitlements and then understate his own emissions.

There are two ways to have “enough” entitlements: either to acquire more entitlement, possibly for free in the initial allocation, or to report fewer emissions. If an emissions trading scheme intends to impose a scarcity equivalent to 10% below expected needs; the intended objective would clearly not be reached if actual emissions were understated by 10% as well. While this seems perfectly obvious, the point is that emissions trading is as much about monitoring as it is about the determination of commitments. Furthermore, what is equally important to the perceived fairness of a scheme is that all participants in the scheme monitor their emissions on a comparable basis. Just as differentiated allocations can give rise to perceived unfairness, so can monitoring to different standards of stringency.

1.1.4 Compliance and sanctions

Having fixed the level of commitment and having monitored the outcome, there needs to be a comparison between what was intended and what actually occurred. Underlying this comparison is the premise that there ought to be an acceptance, whether voluntary or mandatory, that actual emissions should be matched an equivalent quantity of entitlements. This comparison is generally referred to as the moment of “compliance” or “reconciliation”.

While the four “golden rules” of a commitment mentioned in section 1.2 above may be desirable, there is a necessary counterpart that, in the case the commitment is not met, there is a sanction or penalty applied. At first sight this may seem unduly harsh on companies that are engaged in emissions trading. But behind this is a simple fact. There is no incentive to buy allowances to make up a shortfall, if no sanctions are incurred for not doing so. The sanction – in combination with the commitment - is what ultimately underpins the market. The type of sanction depends on the type of scheme. A mandatory scheme is likely to have a more severe sanction than a voluntary scheme, which in its mildest form might be a “name and shame” sanction. But there should be no doubt that emissions trading without any sanction will not work. The more severe the sanction, the more likely it is that a pre-determined environmental outcome will be reached.

What is so powerful about emissions trading is that it “translates” into financial terms the need to address a particular environmental objective. In companies, this means that taking the environment into account extends beyond the remit of the Environment, Health and Safety Manager, to the Financial Director, and even into the Boardroom itself, where the deployment of capital is tested also against the financial consequences of environmental constraints. Entitlements to emit have a value, reflecting that there are limits on what the environment can bear in terms of pollution without serious adverse consequences, that themselves impose financial costs. The historical fact that unlimited amounts of pollution could be emitted for free was a blatant case of mispricing, with the result that companies – acting in economically rational ways – disregarded the value of what they were lawfully being allowed to do because there was no price signal. The scarce common resource of a clean environment has a value, and this value must be made apparent.

1.1.5 Scarcity

Emission trading is a market instrument, and free markets are based upon the notion of scarcity. Before something has a value, there must be demand for it. A clean environment that allows sustainable development is increasingly recognised as something of immense value. This value goes far beyond “amenity value” but extends to quality of life, health and biodiversity. If only a certain amount of pollution is acceptable, or deemed appropriate, the entitlement to emit this pollution is a scarce entitlement. It is logical that such an entitlement has a value. As entitlement is no longer free, additional emissions imply additional cost, through having to buy additional entitlement, and reductions of emissions imply value, through having less need for entitlements.

As a market instrument, emissions trading will only work properly, indeed will only work at all, if there are fewer entitlements than there is demand for these entitlements. The quantity of entitlement must, of course, reflect the level of ambition of the commitment. Not only will too many entitlements result in too much pollution, but if there are more entitlements issued that there is need by those who pollute, then, like any market which is over-supplied, the value of the entitlements will reduce to zero, and the incentive effect of the scheme will be lost. It is essential, therefore, that the commitment implies a scarcity of the entitlement to emit. So, for participants to complain that they have not received as much entitlement as they need would be to miss the whole point.

1.2 Alternative policy instruments

While “command and control” policies may have been used to address environmental problems in the past, and while they may still have their place in the armoury of environmental policy tools in future, it is striking to see how prominent emissions trading is becoming, in spite of it not being the only economic instrument that might be applied. So what are its advantages over these other instruments?

The economic instruments with which emissions trading is most often compared are taxes and voluntary agreements. Emissions trading offers something extra to both of these. Taxes and emissions trading are generally compared in the following terms: while both require monitoring, taxes fix the price of emissions but leave the environmental outcome uncertain, whereas emissions trading determines the environmental outcome but leaves the price of compliance uncertain. The only way to reduce the tax burden is by limiting emissions. Taxes can never been seen as an “opportunity”, or as a potential additional revenue stream. Taxes always accrue to Governments, so cannot but be a burden on competitiveness. On the other hand, emissions trading can be designed in such a way that companies can sell entitlements and use the revenues from these sales to offset the cost of investments, or even as an additional return on investment to shareholders. Furthermore, on the macro-economic level, the money exchanged for the transfer of entitlements from one emitter to another does not accrue to Governments, but is transferred from one industry actor to another. Overall, the impacts are revenue neutral. Governments are not “enriched” by emissions trading unless they decide to allocate entitlement for payment (most commonly referred to as “auctioning”).

Voluntary agreements, while they do centre on targets and require monitoring, give no incentive for individual installations to over-achieve. Companies have no incentive to beat the target. Furthermore, if the target proves to be too ambitious, then recourse cannot be made to buy entitlements from others who may have been able to reduce their emissions at lower cost. Finally, there is no transparent mechanism for compensating good performance as compared to bad. The dilemma appears whereby it is not in any company’s individual interest to act for the common good if others (sometimes competing companies) do not act likewise but still share the benefits. Emissions trading provides a compensation mechanism whereby the “good” performers are compensated by the “bad”.

2. What kind of emissions trading?

Emissions trading is an instrument that can be implemented in different ways, while each of these ways will incorporate the key characteristics outlined above. The different ways are closely linked to different types of commitment.

2.1 Cap and trade

The first way, which is the most common, is for what is generally known as a “cap and trade” method. Such a method involves an allocation of entitlement taking place before the trading period begins. This ex ante allocation may be done a number of ways, but essentially an allocation is made based on informed choices, and that once made this determination of entitlement is fixed for the duration of the trading period. The European Union’s greenhouse gas emissions trading scheme is done in this way, with the first trading period extending from 2005 to 2007, and the second period from 2008 to 2012. Each period is preceded by an allocation of entitlements. The US sulphur dioxide trading scheme is also done in this way, allocating entitlements for a period extending for as long as 30 years. Finally, the Kyoto Protocol’s emissions trading, as referred to in Article 17 of the Protocol, is based upon an initial allocation of entitlement to industrialised countries6 for the 5-year period 2008 to 2012.

The advantage with this way of doing it is that once the initial allocation of entitlements is over, it is simpler to administer. That in itself is a big advantage. However, another powerful argument in favour of this method is that it ensures with greater certainty a given environmental outcome. The environmental result is set at the outset, and the price of entitlements will adjust in order that this outcome is reached. The total quantity of entitlement to be issued is known at the outset, and the market can develop with greater certainty.

2.2 Baseline and credit

Another way of doing emissions trading is referred to as the “baseline and credit” approach. Participating sources are set a goal regarding what their emissions ought to be in a future period. When such a method is discussed, it is often in the expectation of rising future emissions levels, although this does not necessarily need to be the case. It is also important to emphasise that the baseline can be set a number of ways, and that establishing a baseline can be just as controversial as determining what quantity of entitlement to issue under a cap and trade programme. The pre-determined baseline, however, represents the level of commitment.

Under the baseline and credit approach, over-performance in relation to the baseline gives rise to credits, which can be issued and traded. As time progresses, actual performance either over-achieves or under-achieves in relation to the baseline, giving a corresponding obligation or opportunity to adjust entitlement by the buying and selling of credits. These credits can be transferred between and used by all the participating sources as entitlements that adjust individual targets, or “baselines”, at the moment of reconciliation.

Practical examples of limited baseline and credit trading regimes include the project mechanisms of the Kyoto Protocol that are known as “Joint Implementation”7 and the “Clean Development Mechanism”8. While the Kyoto Protocol’s project mechanisms pre-suppose baselines determined by project, any participant can use the credits that are generated for compliance with obligations under the Protocol. Given that the international emissions trading regime foreseen by Article 17 of the Protocol is a cap and trade scheme, this demonstrates that the baseline and credit method and cap and trade method of emissions trading are not incompatible. New Zealand is also developing a project baseline and credit system that it would like to link with other schemes, including the EU’s emissions trading scheme9.

Advocates of the baseline and credit approach often do so in the belief that it can more easily integrate targets that allow for a continued growth of emissions in absolute terms. Opponents of this method believe that it is more complex, and more bureaucratic to administer. The comparability of baselines is also an issue of concern to some, but in fairness, the same issue of comparability can arise with a cap and trade programme that allocates according to individual circumstances rather than by using a common method for all sources.

2.3 Ex-post verification

“Ex-post verification trading” is a variation of the baseline and credit approach. It allows trading only after the end of a given period and after the actual performance of the emitter has been reported, verified and compared to the pre-determined baseline. The trading of credits is permitted for a limited period only prior to the final moment of compliance, and it is at this stage that participants with a surplus of credits can sell to participants whose emissions have exceeded their entitlement. The trading still allows entitlements to be adjusted, but by the time the trading takes place, it is too late to change actual emissions.

This method was discussed in earnest during the negotiations on the implementing provisions of the Kyoto Protocol, as it was felt by some that the Kyoto Protocol’s compliance provisions were not sufficiently robust. This method is considered to provide much greater certainty in terms of compliance, and thereby in reaching the commitment. The major disadvantage is that such a method seriously limits the extent of trading10, and by so doing, limits the flexibility that reduces the costs of achieving a predetermined environmental outcome.

The purpose of mentioning this method is to show how different the ways are of doing emissions trading. But there are other fundamental differences too that should be looked at briefly.

2.4 Type of target

A major component of any emissions trading scheme is the type of commitment that it sets. The simplest to understand, and the most common, are “absolute targets”. Absolute targets are used in the context of “cap and trade” type schemes. These commitments are expressed as an aggregate number of tonnes of pollution that cannot be exceeded. Within this overall “cap”, entitlements are distributed among the participants. However much trading subsequently follows, the amount of pollution permitted will never exceed the aggregate total authorised.

Another possibility are “relative”, or output-based targets, that are also sometimes referred to as “specific” targets. These commitments are expressed as a given number of tonnes of pollution per unit of output produced. Such targets are usually envisaged in the context of baseline and credit trading schemes and they do not limit the amount of pollution in an absolute way, but rather limit emissions per unit of output. Output can be defined as tonnes of steel or cement, megawatt hours of electricity produced, and can be further refined by technology or type of primary fuel used.

Such commitments are intrinsically more complex, but are favoured by some because precisely because they do not fixed an absolute limit on the amount of pollution. The setting and monitoring of such commitments require two parameters, emissions and output, rather than just emissions. The decision how the output-based targets should look is in itself a sensitive decision, as depending on how commitments are fixed, the distributional impacts can be considerable. Whether to have targets that take into account the primary fuel used, or whether to consider steel or lime as a homogenous product or a collection of specific products are difficult choices.

So while the distribution of entitlements under an absolute target is difficult, it would be a mistake to think that the use of output based targets is any easier. On the contrary, the need to determine more parameters is a source of additional complexity. If production is higher than forecast, more emissions can also be allowed. While this may indeed seem appealing for businesses that fear a “cap on growth”, there are disadvantages too. The environmental outcome is uncertain. In the case that production is lower than expected, then such commitments may actually be more constraining than an absolute target would have been and produce a better environmental outcome. However, as the total number of entitlements is uncertain – depending as it would upon levels of output – the market does not know until the end of the trading period exactly how much “supply” of entitlement there is, which is an extra uncertainty that may imply a loss of efficiency and liquidity. Finally, in some cases, the disclosure of production data can entail the sharing of commercially sensitive information, which can add a further complicating factor, even if this can be overcome.

It is possible to envisage even more sophisticated output based targets, where the higher the output, the more stringent becomes the commitment expressed in emissions per unit of output. Such a self-tightening cap may go some way to answering the concerns of environmentalists, but such targets would be significantly more complex, and the loss of transparency would undermine confidence in compliance.

Still on the subject of the type of target, distinction needs to be made between commitments set by law, commitments that come with advantages of some kind, such as tax rebates or subsidies, collective voluntary commitments and self-imposed individual voluntary commitments. Examples of each of these can be found within the European Union. The EU greenhouse emissions trading scheme is a mandatory scheme embodied in law. In the UK, the national greenhouse gas emissions trading scheme – that for the moment is not connected to the EU scheme – involves the granting of subsidies to participating entities that would be lost in the case of non-fulfilment of the commitments. The European Car Manufacturers Association has a collective voluntary commitment that comprises of ensuring that the average fuel efficiency of new cars sold into the European market perform to an emissions standard of 140 grams of CO2 per kilometre driven by 200811. The Commission has not been notified12 whether, within the context of this agreement, emissions-trading-like mechanisms are used to compensate manufacturers that over-achieve this target in relation to manufacturers that under-achieve. The fact is, however, that such compensation mechanisms would be compatible, and, as already referred to above, would discourage “free-riders” who shelter within a voluntary agreement but who individually contribute little or nothing to meeting the collective commitment.

Finally, the European Union has had examples of self-imposed individual agreements encompassing emissions trading. The two most notable examples were company-wide emissions trading schemes introduced by the major oil companies BP and Shell. Mention must also be made of a North American initiative organised by the Chicago Climate Exchange that is a voluntary programme where participants from a variety of sectors set themselves commitments, and subsequently trade entitlements with other participants. While a voluntary scheme will always operate differently from a mandatory scheme, it is worth emphasising that many of the lessons being learnt from both voluntary and mandatory schemes are reinforcing and surprisingly consistent. Such lessons include the fact that commitments are always limited to what is considered acceptable by the companies concerned and their political representatives, taking into account also other imperatives, such as the security of energy supply or employment. The theory of “low hanging fruit” being harvested when the attention of plant managers is focussed on emissions is also confirmed. In spite of the ambitious commitment undertaken by BP to reduce emissions in absolute terms by 10% between 1990 and 2010, the company achieved its target 8 years early and recovered all the costs and more of putting in place its own emissions trading scheme just because of the efficiency improvements that were secured as a result.

Further variations that should be mentioned include whether commitments take account of emissions only, of whether avoided emissions or sequestrations can be taken into account. The EU’s emissions trading scheme looks at “emissions”, these being defined as “the release of greenhouse gases into the atmosphere from sources in an installation”. No account is allowed to be taken for sequestration or avoidance, except insofar as such “carbon capture” is made within the boundaries of the installation, and the release into the atmosphere is avoided.

2.5 Direct or indirect emissions

The other major decision to make at the outset of an emissions trading scheme is whether only the “direct” emissions of the participants are to be taken into account of whether “indirect” emissions should also be taken into account. The easiest way to understand what is meant by “direct” emissions is to consider them as the emissions coming out of a particular installation’s or country’s chimney stacks, whereas “indirect” emissions are the emissions adjusted to take into account emissions attributable to electricity consumed by an installation or country. By way of example, the UK’s national greenhouse gas emissions trading scheme takes an indirect emissions approach, whereas the EU’s greenhouse gas emissions trading scheme and the Kyoto Protocol both take a direct emissions approach. Under Kyoto, even if Denmark produces emissions by generating electricity that it then exported to its neighbouring countries, as often happens, no adjustment is made for the emissions of the exported electricity. The assumption is that the exported electricity will have to be a little more expensive in order to factor-in the additional costs implied by being accountable for emissions in Denmark.

The UK’s national scheme takes its different approach essentially because UK electricity generators are not covered by the domestic trading scheme. This choice was made for political reasons, in particular the wish to maintain an indigenous coal industry. There is no doubt, however, that an indirect emissions approach is considerably more burdensome due to the greater complexities of monitoring emissions. Indeed, in the context of an increasingly liberalised electricity market in Europe, the tracking of electricity’s originating country – so as to apply that country’s specific emissions factor – is unduly burdensome in a context of an European internal market that for 15 years or more has been striving for the removal of internal frontiers between the Member States, and the abolition of the notion of “imports” and “exports” between Member States of the Union.

The supporters of indirect emissions measurement believe that such an approach creates more incentive to improve energy efficiency at the point of energy consumption, which is indeed an admirable goal. There is also the fear that on-site Combined Heat and Power (CHP) units will no longer be built if the direct emissions from a particular installation rise as a result. As, generally speaking, Europe wants to see more good quality CHP, some fear that the direct emissions approach can act counter to such an objective. However, there are two basic responses that can be made to such criticism. First, as new capacity, new CHP may in practice be allocated free of charge from reserves put aside for new entrants. It is notable that all the EU Member States have chosen to have reserves for new entrants even though the EU Directive does not require this. Second, electricity generated from good-quality CHP should be cheaper than electricity generated from conventional fossil fuel power stations, assuming that the conventional generators will have to price electricity in accordance with the cost of emissions caused from the fuels used for generation.

The most powerful argument in favour of the direct emissions approach is its relative simplicity, and many feel that emissions trading is already complicated enough. If an indirect emissions approach was carried through to its logical conclusion, the transfer of many kinds of goods, from electricity, to steel, to concrete and glass, would give rise to adjustments in the emissions of the “exporting” and “importing” companies and countries. This would be excessively complicated, and, like “life-cycle” monitoring of emissions, will engender far too much bureaucracy and approximation.

3. The Kyoto Protocol

Many references have been made already to the Kyoto Protocol. Whatever its faults, or “flaws”, it remains a unique multilateral environmental agreement, with regard to its wide-ranging relevance, its compliance provisions and in particular its flexibility (multiple gases, multi-annual targets, the netting of emissions with capture, the combination if different flexible mechanisms (emissions trading in various guises)). The former Executive Secretary of the United Nations Framework Climate change Convention Secretariat, Ambassador Michael Zammit Cutajar has said: “The essence of the Kyoto Protocol – its genius – is that it encourages recourse to the market to achieve environmental objectives at least economic cost. … It is not an exaggeration to brand the mechanisms of the Kyoto Protocol as « Made in the USA »”.

One of the disappointments about the United States not having ratified the Kyoto Protocol is that they are not now showing the rest of the world how well emissions trading can be done. The US is still far ahead of any other nation or group of nations in using the instrument. The European Union has learnt a great deal about the instrument of emissions trading from the United States, and whenever in the future the US engages again in multilateral efforts to address climate change, flexible instruments like emissions trading will surely be at the very heart of the process. Meanwhile, the European Union, and other parts of the world will have gained invaluable expertise in the operation of such instruments.

There is in Europe still a misunderstanding about the costs of the greenhouse gas emissions trading scheme. There are costs, of course. If there were not there would be little incentive for any change in behaviour. However, some people fail to see that the cost of complying with Kyoto without the EU’s emissions trading scheme at the level of individual companies would be higher – notwithstanding the ingenuity of the Protocol’s use of market mechanisms and other flexibilities. There is a false belief that if a European steel producer, for example, were not covered by emissions trading the costs borne by the steel produced would be lower. This belief is mistaken. First, if emissions trading is not to be used in order to comply with Kyoto, then other more costly instruments may be applied to energy-intensive industry. If, however, for a moment we imagined that energy-intensive industry would not be subject to any alternative measures, then clearly that would mean that other sectors of the economy, such as households, transport, the tertiary sector and light industry would have to bear the brunt of fulfilling the Kyoto commitments. All available economic analysis suggests that the measures applied to these other sectors would be more costly than emissions trading in the energy-intensive industry sectors. More costly measures for these sectors means that the higher costs for them will feed their way through into higher costs for energy-intensive industry too. Higher costs for transport will impact on energy-intensive industry too, higher costs for households will feed through into higher wage demands, higher costs on the tertiary sector will raise prices and thereby inflation. Higher costs for the economy as a whole spell a less competitive economy, and energy-intensive industry is as much part of this European economy as any other sector. It makes no sense for Europe to comply with Kyoto without making use of the most cost-effective instruments at its disposal. This is why we will always come back to economic instruments, and, in particular, emissions trading.

The economic analysis carried out by the European Commission suggests that the cost of fulfilling our international commitments would be at least a third higher if every Member States had its own domestic emissions trading scheme but that such domestic schemes were not linked to each other. The fact that 25 countries are working together, and that allowances can be issued by one Member States and used for compliance in another, reduces the costs of complying with the Kyoto Protocol by 1.3 billion €13. If the more realistic assumption were made that every Member State would not have introduced a domestic emissions trading scheme of its own, the cost savings become significantly greater. It is notable, also, that the schemes of the two EU Member States that did have pre-existing domestic emissions trading schemes, the UK and Denmark, developed such different schemes that the two could not feasibly be linked.

4. The European Union’s scheme: the EU as pioneer

Recital 5 of the preamble to the European Union’s emissions trading Directive reads: “This Directive aims to contribute to fulfilling the commitments of the European Community and its Member States more effectively, through an efficient European market in greenhouse gas emission allowances, and with the least possible diminution of economic development and employment”14. The EU understood the good sense of doing emissions trading together. For such a diverse range of countries, with a multitude of industries and energy mixes, and a so-called “internal market”, a common instrument that was flexible enough to suit the specific circumstances of each Member State and yet which could attain economies of scale was in the interest of all. It is a remarkable fact that, although the Directive only needed a qualified majority of Member States to vote in favour for it to become law, it secured the unanimous agreement of all the Member States15 and a resounding endorsement of the directly elected European Parliament16.

The EU’s greenhouse gas emissions trading scheme has been in operation since 1 January 2005. It covers approximately 12 000 installations across the 25 Member States of the European Union, and the installations emit approximately a third of the EU’s emissions of greenhouse gases, and approximately 45% of Union’s emissions of carbon dioxide. The scheme is built around trading periods. The first trading period goes from 2005 until 2007, and from then on there are 5-year periods from 2008 to 2012, from 2013 to 2018, and so on. Each period is preceded by an entitlement allocation round. In effect, it is these allocations that determine the level of commitment that the Member States wish to see achieved. For the moment, the reference is the levels of commitment that Member States have assumed under the Kyoto Protocol. In the future, the levels of commitment will reflect the degree of ambition that Member States choose to assume in the context of the next steps beyond the commitment period of the Kyoto Protocol.

In addressing the largest emitters, the scheme focuses on energy-intensive industry. The sectors covered are the power generation sector, which alone represents four-fifths of the covered emissions, mineral oil refineries, steel, building materials such as cement, lime, glass, ceramics, and finally the pulp and paper sector. While the direct emissions of the chemical sector are not covered at this stage, the energy units of chemical plants are covered as power-generation units (whether supplying electricity, heat or steam). In the first 3-year period, which is sometimes described as the “learning-by-doing phase”, only carbon dioxide emissions are covered, but from 2008, Member States are allowed to extend the scheme to other greenhouse gases and other activities than those covered initially. As of the start of the scheme, most CDM credits that are issued within the context of the Kyoto Protocol can be used, irrespective o the greenhouse gas being addressed. The notable exclusions are CDM credits from nuclear and “sinks” projects. For the first time under EU law, there is a harmonised penalty rate (applied per tonne emitted in the absence of a corresponding entitlement) of € 40 in the first period and € 100 a tonne from 2008.

The Member States have to decide how much to allocate to installations on their territory. In doing this, they are required to follow criteria laid down in the European Directive, and the European Commission has to either approve these plans or require that amendments are made prior to the Member States being able to proceed. So far, the national allocation plans of 23 out of the 25 Member States have been approved, that – after adjustment in some cases at the insistence of the European Commission – foresee the issuance of 5.65 billion tonnes of entitlement from January 2005 until December 2007. At present, each allowances, or entitlement to emit a tonne of CO2, is being traded in the market at approximately 16 € each. Just to multiply the number of tonnes so far approved by the market price suggests that the value of this market will be in excess of € 90 billion, which is a huge market to have been created in such a timescale17.

The last piece of the EU’s emissions trading jigsaw to fall into place is the building of the registries by Member States18. Registries are electronic accounts in which the allowances, or entitlements, are held. When there is trading, there will be a corresponding transfer of allowances from one account to another, which represents the transfer of entitlement. The registries are no more than a sophisticated tracking tool, and they do not provide settlement facilities, there is no price disclosure required, and nor does the registry in any way organise the market. Market organisation is a matter than is left to the private sector to work out. All the evidence suggests that this is being done very effectively, and that there are competing exchanges and market-intermediaries offering their services. The level of trading at the moment is in the region of 3 to 4 million tonnes of entitlement per week, but this figure is still growing exponentially, and is expected to continue doing so for many months.

5. Relevant issues for the forestry products industry

The purpose of this paper is not to go into the implications of emissions trading for the forestry products industry in Europe. Suffice it to flag a few of the key issues that are of relevance. Most obviously the Directive specifically covers the pulp, paper and board sector. The power generation activities of pulp and paper manufactures will in all likelihood be covered – as it is assumed that many of these power units will exceed the size threshold set down by the Directive. However, much of the power generated by such power unit comes from biomass, which is treated as having zero emissions by the Directive. This is important both in terms of the actual emissions that the pulp and paper industry has to account for, but also because there may be increased demand for biomass, and the paper industry is the owner of considerable forest assets in Europe as elsewhere.

There are also indirect effects of the EU’s emissions trading scheme for the forestry products industry, in particular the impact of the scheme on electricity prices. This has been, and remains, a major concern of large consumers of electricity in Europe. There has been extensive debate about the « windfall » profits accruing to the power sector. Some of this debate is linked more with the functioning of electricity markets, where it is the marginal cost of producing the last MWh that sets the market price. Such concerns have been rather over-played in recent months. Electricity prices are still being driven much more by the costs of primary energy, such as natural gas and coal prices, and by weather, than by the scarcity of entitlements to emit carbon dioxide. If there were such big profits accruing the power generators, it would be better for companies consuming electricity to own their own generation assets, so as to avoid price rises and share these profits. In the medium term, higher profits will attract new investment, and unsustainable profits will be squeezed down.

The European Commission is having a study carried out by McKinsey & Co on the impacts on competitiveness of the EU emissions trading scheme. The preliminary conclusions are that the impact on the pulp and paper industry will be modest, and unlikely to have a significant impact on the competitiveness of the European pulp and paper industry. However, the consultants will disclose more details in June, and industry will be invited to respond to these hypotheses.

It is understandable that, with its considerable forestry assets, the forestry products industry would wish to see credit being allowed under the EU emissions trading scheme for carbon sequestered. As mentioned above, the European legislation specifically excludes the use of CDM credits from “sinks” projects by companies covered by the scheme19. However, the Member State governments themselves, as Parties to the Kyoto Protocol, may use sinks credits to comply with their commitments under the Koto Protocol in accordance with the Protocol’s implementing rules. It would not be true to say, therefore, that Europeans will not be buyers of “sinks” credits. The reason why CDM credits from sinks projects have not been admitted into the EU’s trading scheme is basically due to concerns about the permanence of carbon sequestered by forests. Everyone can understand that a tree represents a depository of carbon during its life, but that trees do not last forever. Trees are also sometimes blown or burnt down, in which case the carbon is no longer captured. There are methodological challenges too, in monitoring the amount of carbon sequestered. However, there is also in Europe a fear in some quarters that CDM should not encourage monocultures of alien tree species, which are not as good as indigenous tree varieties in preserving biodiversity and local eco-systems. A careful reading of the European legislation reveals traces of each of these concerns.

Rome was not built in a day. Before anyone needs to buy carbon credits, there must be an obligation somewhere that can be honoured by such credits. The EU’s emissions trading scheme is a novel instrument in Europe. Having it at all represents a considerable achievement. It sets the scene by creating new obligations upon energy-intensive industry in Europe. We are embarking on an era where carbon emissions carry a cost, where emissions reductions have a value. It would appear to be only a matter of time before carbon sequestered has a value that is linked to the obligations that have been created by the scheme. Consider what we have now as a first step. There will be subsequent steps. There is already increasing talk about carbon sequestration. You, the owners of forestry assets, can be confident that it is not going to be very many years before well-managed forests that you own will produce a further revenue stream from the carbon sequestered20. Unquestionably, the entry into force of the Kyoto Protocol in February this year represents the beginning of this process. Furthermore, forestry credits are gaining ground anyway, with credits having been sold in conjunction with some makes of new car in Belgium, or voluntary commitments already recognising such value.

6. Future issues

Emissions trading as an instrument does not of itself reduce emissions. Emissions trading is a tool that, by allowing greater flexibility to participants in a commitment, allows for lower costs. What results in environmental improvement is the stringency of the commitments that are incorporated into a scheme. These commitments will logically reflect the level of ambition of companies or Governments. Given that, in Europe at least, there is an acceptance that climate change targets will have to be more ambitious over time, then it is logical to expect the stringency of the commitments under the EU’s emissions trading scheme to increase overtime. A company that relies only upon the current market price for carbon when considering the economic viability of a new investment that would last 20 or 30 years would be very unwise. Companies should already see that carbon constraint is here to stay, and is likely to increase in the future.

The process of designing the future begins now. There will be a review of the operation of the EU’s greenhouse gas emissions trading scheme completed in 2006. This review will be informed by stakeholders and specialised consultants. The review will set the scene for the future amendment of the scheme, and no one has ever dared claim that it cannot be significantly improved. The acceptance of CDM credits from sinks projects is just one of the many items that the review is specifically mandated to look at21. The review process is one to watch, and to be involved in, because it is about shaping the instrument for the future – with all the points of relevance there are for the forestry products industry.

7. Conclusion

Emissions trading is a remarkable instrument that is now being used to address climate change. Emissions trading is an instrument that has been successfully applied to environmental protection and fisheries management in several parts of the world, but in particular by the United States. The European Union is now embracing this instrument wholeheartedly, and has done so in particular by putting in place a permanent scheme relating to emissions of greenhouse gases that will continue beyond the end of the Kyoto Protocol’s first commitment period in 2012. It is an open scheme that can develop linkages with other schemes elsewhere in the world. It is, therefore, both an instrument of the present and an instrument of the future. As the stringency of environmental commitments increase, it makes ever more sense to use the instrument of emissions trading to reduce the costs of meeting those commitments.

It will have to become an article of faith for businesses in free market economies to know their emissions and the costs of reducing these emissions. There will be a comparative advantage for businesses that emit less than their competitors. The use of low-emissions technologies will be encouraged. Businesses that are proactive will have an advantage over those who reluctantly follow. Investment strategies will be developed in conjunction with carbon strategies.

The world is changing, and we must change with it.

2 The views expressed in this paper are those of the author writing in his private capacity, and in no circumstances should be interpreted as representing the official position of the European Commission. Copyright belongs to the author, who reserves the right to publish this article elsewhere in either its present form or amended as appropriate.
3 Principal Administrator Climate Change & Energy Unit, Environment DG, European Commission, Brussels
4 Discussions are now taking place between the European Union and Norway on the possible linking of their respective emissions trading schemes, thereby mutually recognising each other’s allowances.
5 It should be noted that the word “right” was not chosen by the European Union, no doubt for the reason that no legal or moral person is deemed to have a God-given “right” to pollute without regard to the effects of that pollution.
6 These entitlements are determined for industrial countries listed in listed in Annex B to the Protocol on the basis of their emissions in a reference year, which in most cases is 1990.
7 See Article 6 of the Kyoto Protocol.
8 See Article 12 of the Kyoto Protocol.
9 Other than public statements to this effect made by New Zealand’s Environment Minister, talks with the European Union have not yet developed beyond exploratory contacts at a technical level.
10 Even in the case that forward trades are allowed.\
11 Similar agreements have been agreed also with the Associations of Japanese and Korean car manufacturers respectively for new cars sold into the European market, with a target set for 2009
12 No such notification is required.
13 This figures rests on several assumptions that are explained more fully in the impact assessment form attached to the Commission’s proposal COM (2001)581 final of 23.10.2001 for the emissions trading scheme. Among these assumptions is that of there being 15 Member States, whereas the number has since increased to 25.
14 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowances trading within the Community and amending Council Directive 96/61/EC (O.J. L 275 of 25.10.2003, pages 32-46).
15 At the time of adoption, on 13 October 2003, the EU comprised of 15 Member States.
16 Only 4 votes were cast against the scheme in the Directive’s second (and final) reading in the European Parliament on 2 July 2003.
17 The total amount approved for issuance will further increase when the Commission completes its assessment of the national allocation plans of Italy and Greece, and the market price is obviously expected to vary.
18 At the time of writing, 7 May 2005, 5 Member States have registries that are fully up and running. Several other Member States are in the process of the final testing of their registries.
19 Article 11a (3)(b) as amended by Directive 2004/101/EC (O.J. L 338 of 13.11.2004, pages 18-23).
20 Even if you will also need insurance to cover carbon liabilities in the case of forest fires, for example.
21 Article 30(2)(o) of Directive 2003/87/EC as amended by Directive 2004/101/EC.

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