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Latest Emissions Trading Developments - International Law Office

International Law Office

Environment & Climate Change - European Union

Latest Emissions Trading Developments

March 05 2007

The Phase II Trading Period
Changes to the Directive
Inclusion of Aviation
Action Items


Any hope of a reprieve from the increasing regulation of greenhouse gas emissions should be forgotten, particularly following the issue on February 2 2007 of the Fourth Assessment Report by the United Nation's Intergovernmental Panel on Climate Change (see in particular the first of the three reports in the Fourth Assessment). The report concludes, in part, that the world's temperature will increase by approximately 3° Celsius this century. In the face of these results, any forthcoming international agreements may require industrialized countries to decrease their emissions by between 60% and 80% by 2050.

The European Commission has recently taken a number of initiatives that will significantly affect the future of greenhouse gas emissions trading in the European Union. The EU Emissions Trading Directive (2003/87/EC) is a key part of the European Union's response to fulfilling its commitments under the Kyoto Protocol on climate change. The directive created an Emissions Trading Scheme (ETS) in EU allowances (EUAs). One EUA is equal to the right to emit one tonne of carbon dioxide and the total number of EUAs is capped. At the beginning of each trading phase every installation falling within the ETS is allocated a certain number of EUAs free of charge. Phase I covers 2005 to 2007 and Phase II 2008 to 2012. Crucially, the number of allowances allocated to an installation may be less than the number of tonnes of carbon dioxide it emits throughout the year. If the operator of an installation believes that it will not have sufficient EUAs, it can buy additional allowances, change its means of production to decrease the tonnes it emits and/or participate in Kyoto flexible mechanisms (eg, the clean development mechanism and joint implementation, which are explained further below).

During the first trading period, businesses excluded from the ETS may be subject to increased energy costs but are otherwise largely unaffected. This is unlikely to continue much longer for the following reasons:

  • The commission's assessments of the first and second sets of national allocation plans (NAPs) submitted by EU member states for Phase II have reduced the number of allowances that installations under the ETS will receive for free. Thus, abatement costs may be passed along to those outside the ETS to a greater extent.
  • The ETS may be expanded to include additional sectors and/or additional greenhouse gases, and industries that were previously spectators will become participants.

  • If the proposal to include aviation is adopted, distribution costs are likely to increase due to the passing on of compliance costs.

The Phase II Trading Period

On November 29 2006 the commission issued decisions on NAPs submitted by Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, Slovakia, Sweden and the United Kingdom for the Phase II trading period (as summarized in a communication of the same date); on January 16 2007 it issued decisions for Belgium and the Netherlands; and on February 5 it issued a decision in Slovenia. In each case it concluded that the proposed NAP failed to meet at least one of the mandatory criteria required by the directive. Member states' treatment of the following areas was found particularly lacking:

  • Over-allocation - in total, the commission slashed 73.3 million allowances from the proposed NAPs. The UK and Slovenian NAPs are the only plans that do not require decreases in the numbers of allowances to be allocated.

  • Ex-post adjustments - the commission has reasserted the directive's requirement that member states decide the absolute quantity of allowances allocated before the trading period starts. After installations are issued, adjustments are permissible only in two specific situations. First, where an installation is closed during the trading period, the state may determine that there is no longer an operator to which allowances will be issued. Second, new entrants will receive allocations from a reserve fixed in advance.
  • Consistency with supplementary obligations - as noted, through Kyoto flexible mechanisms member states and ETS installations may take supplementary measures in other countries and use credits from these towards their emission reduction commitments, for compliance purposes. The clean development mechanism allows an installation or member state to carry out projects to reduce emissions in developing countries. Joint implementation allows these projects within countries that have obligations under the Kyoto Protocol. The commission found that the limits on the use of these mechanisms were not always respected by installations. Installations and member states are not supposed to rely heavily on the clean development mechanism and joint implementation; they are rather supposed to reduce their emissions. The absolute percentage of credits that may be derived from these mechanisms is one-half of the reduction the respective member state must undertake, which is calculated using information from base year emissions in the 1990s and in 2004, and projected emissions for 2010. If the member state does not have to rely on the clean development mechanism and joint implementation to meet its target reduction, it may allow the installations to make use of the credits up to the limit. If the member state must partially rely on these credits, the number available to installations decreases accordingly.

  • Issues specific to individual plans - state-specific issues concern allocation guarantees which apply beyond the trading period, banking of allowances, auctioning and the definition of combustion installations. Member states draw up their NAPs under the influence of their national authorities, industries and private citizens; they must make the proposed NAPs open for public consultation. Therefore, variances exist. For example, one proposed NAP included a provision on allocation guarantees which would ensure that an installation would receive a certain number of allowances at no cost following the expiry of Phase II.

The commission had not yet released its decisions on the remaining 14 NAPs. Nonetheless, it is expected to continue to take issue with the number of allowances member states propose to allocate. A glance at the current market shows that over the past three months, the daily price of allowances has dropped from almost €12 to just below €4, which has been partially attributed to their over-allocation. The commission will, in all probability, learn from the shortcomings exposed during the first two years of trading.

Changes to the Directive

The EU Emissions Trading Directive has a built-in review mechanism. In Autumn 2007 the European Climate Change Programme Working Group will begin the process of considering amendments to the directive in order for these to be implemented through legislative amendment in time to take effect in the Phase III trading period (post-2012). As is evident from past NAP reviews, the commission is particularly concerned with the total number of allowances allocated. The entire 'cap and trade' system rests on the principle that only a limited number of allowances are on the market. The next review will be focused on four categories:

  • the scope of the Emissions Trading Directive;

  • further harmonization among member states;

  • compliance and enforcement of obligations; and

  • linking the ETS to other schemes.

Each category includes issues that could have a major impact on (potential) participating installations:

  • Scope of the directive - certain small installations may be dropped from the ETS. Additional gases and sectors that may be added to the scheme include nitrogen oxide and carbon dioxide from the production of ammonia, methane from coal mines, carbon dioxide from the production of petrochemicals, carbon dioxide and perfluorocarbons from the production of aluminium and methane from coal mines. Aside from the suggestions made by the commission, an independent report on the inclusion of additional sectors and gases into the ETS, funded by the commission and produced by Ecofys, has suggested that carbon dioxide emissions in the gypsum production, stone wool production and waste incineration sectors could all be included.

  • Further harmonization - a single EU-wide cap (as opposed to national caps) and full auctioning will be considered. If national caps are maintained, they may be determined upfront in the directive rather than in NAPs. New entrants could be required to buy allowances in the market or at auction. Benchmarking and sector-specific allocation methodologies are also possible.

  • Compliance and enforcement - more elaborate provisions governing third-party verification of emissions reports and the accreditation process for approving verifiers may be included. On-site visits may become part of the enforcement procedure.

  • Links to third countries - The ETS could become linked to both third countries' trading schemes and regional trading schemes. This would enable association with schemes such as that in California.

EU industry has only six years to prepare for these potentially major changes. Assuming, for example, that gypsum production was added to the ETS, a company considering constructing a new installation will have to address questions such as the following:

  • Do we build in a carbon dioxide-constrained member state (eg, Spain), or one that has more room to grow (eg, Latvia)?

  • Should we install more advanced, cleaner equipment or will we receive enough free EUAs?
  • If we do not receive enough EUAs to cover our emissions, will we buy them on the market or decrease production?

Such a simple example clearly illustrates that now is the time for strategic decisions to be made.

Inclusion of Aviation

There has been uproar from the aviation sector, in the European Union and beyond, in response to the commission's proposal to include the sector within the ETS. US operators in particular have challenged the idea that from 2012 the scheme would cover all flights arriving at or departing from an airport in the European Union. From 2011, all intra-EU flights will be subject to the ETS. The impact assessment on which the proposal relies states that airlines are expected to pass on, to a large extent or even in full, compliance costs to customers. The cost on intra-EU airline tickets is predicted to increase by €1.80 to €9 by 2020. Long-haul trips may see an additional cost increase by €8 to €40. The impact on cargo flights is unclear. However, one can imagine that cargo customers will bear the brunt of the compliance costs as they are analogous to a tax or fuel surcharge. All airlines benefit from passing on the costs rather than assuming them, as has been seen with the utilities sectors.

Under the commission's proposal, airline carriers would be the entities responsible for compliance with the ETS, with each airline falling under the competence of one member state. In general, member states would have to treat domestic aviation in the same way as international aviation. The allowance allocation method would be harmonized throughout the European Union. Finally, by the end of 2008 the commission will put forward a proposal addressing nitrogen oxide emissions from aviation.

Action Items

The commission's January communications entitled "Limiting Global Climate Change to 2 Degrees Celsius: The way ahead for 2020 and beyond" and "An Energy Policy for Europe" demand even more stringent policies, including a 20% reduction (as compared to 1990) in greenhouse gases by 2020, even though many member states are struggling with their current target reductions for 2012. Industry must engage at both the national level and EU level in the ongoing review and expansion of the ETS and, more broadly, the European Union's climate change policy. Involvement should include, among other things, participation in consultations and provision of relevant data. Failure to participate may result in future regulation which is unduly restrictive or impracticable.

For further information on this topic please contact Laura Atlee at Steptoe & Johnson LLP by telephone (+32 2626 0500) or by fax (+32 2626 0510) or by email (latlee@steptoe.com).

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