Europe’s CO2 Trading Scheme: Is It Time for a Major Overhaul?

Now in its seventh year, the EU’s carbon emissions trading system is the only international program designed to use market mechanisms to control CO2 emissions. But critics contend it has done little to slow the release of CO2 and argue that it should be significantly reformed — or scrapped.

When it was launched in 2005, the European Union’s Emissions Trading Scheme (EU ETS) was hailed as a major step forward in the fight against climate change. Covering 12,000 power plants, factories, and other industrial facilities — and nearly half of EU CO2 emissions — it was the world’s largest cap-and-trade project to date. EU officials saw it as the first of many carbon-pricing schemes that would eventually cover the globe.

Six years later that vision is looking a little clouded. With the EU ETS accused of failing to reduce carbon emissions, countries outside Europe delaying companion cap-and-trade systems, and critics charging that the carbon-trading mechanism has opened the door to fraud, profiteering, and “gaming” by participants, serious questions have arisen about the future of the EU’s grand emissions plan.

As EU members debate the parameters of the next phase, from 2013 to 2020, campaigners are calling for fundamental reforms, or for the EU ETS to be scrapped. Groups such as Friends of the Earth describe carbon trading as a “distraction,” and argue that other measures, such as carbon taxes, would be more effective and less susceptible to abuse.

The most serious problem, say campaigners, is that allowances were doled out too generously.

Others are more sanguine. EU politicians, companies covered by the scheme, and traders in carbon markets argue that the EU ETS is working — at least on its own terms. Whatever its faults, emissions have fallen since 2005, and proponents argue that the EU should be praised for establishing a wide-ranging climate initiative, while other countries have not achieved half as much.

“As an American, I’m struck by the extent of unhappiness in Europe about what I think is a fairly exemplary program,” says Denny Ellerman, co-author of “Pricing Carbon,” a study of the first phase, which ran from 2005 to 2007. “I think it’s because people want to see a more visible transformation. It’s not enough that it’s just slowing or reducing emissions.”

The EU ETS sets a continent-wide limit on carbon emissions, and then apportions CO2 allowances based on plans agreed to by member states. The idea is to reduce the cap over time, encouraging companies to curb their emissions, or face buying permits on a market. In 2005, the EU set a target of reducing CO2 emissions 20 percent below 1990 levels by 2020.

The most serious problem, say critics, is that allowances were doled out too generously. During the first phase, when allowances were free, companies received 7 percent more credits than they needed, allowing some to generate significant windfall profits, according to Sandbag, a London-based group that monitors emissions trading.

In response, for the second phase, from 2008 to 2012, the EU set a cap 6 percent lower than the 2005 level. But critics say the problem of over-allocation has continued, both because of the economic downturn — which has caused a reduction of emissions of its own accord — and other EU policies, such as one to allow carbon offsetting.

Sandbag says because emissions are lower than forecast at the time the cap was set, there is now a surplus of allowances. In 2010, 65 percent of EU ETS sites had more permits than they needed, Sandbag estimates. The effect has been to depress carbon prices — reducing the incentive to invest in cleaner technologies — and lessen the downward pressure on emissions. Sandbag forecasts that CO2 emissions will decline by less than 2 percent in the second phase of the EU ETS, which ends next year.

Moreover, companies could carry over 1.8 billion permits when the next phase begins in 2013, obviating the need to buy any new credits before 2016. “The big flaw is that there isn’t a mechanism to respond when the economy has slowed and emissions have dropped, and you’ve still got the same amount of allowances,” says Michael Buick, Sandbag’s acting director.

Carbon offsets, says one critic, give ‘rich countries an escape hatch from their carbon reduction commitments.’

The use of offsets, such as those derived under the UN’s Clean Development Mechanism (CDM), is particularly controversial. The CDM allows companies to invest up to 50 percent of their emissions cuts via offsets in projects in developing countries that reduce carbon emissions. The idea is to execute emissions reductions where they are cheapest, spreading green technology in the process, and many EU enterprises have enthusiastically embraced such schemes. By the end of 2012, the number of issued CDM credits is expected to rise to 1.6 billion, up from 311 million in 2009.

But critics of offsets point to several flaws. They say that oversight is weak, with insufficient distance between firms verifying projects and those profiting from them; that many projects would have gone ahead in any case; and that the scheme creates incentives to exaggerate estimates of “business as usual” emissions, in order to win greater credits from subsequent reductions. Campaigners, such as Friends of the Earth (FOE), also make a moral case against offsets, arguing the EU should be reducing its own emissions rather than exporting the problem abroad. As Sarah-Jayne Clifton, climate campaigner at FOE and author of several reports on carbon trading, puts it, the CDM gives “rich countries an escape hatch from their carbon reduction commitments.”

Meanwhile, the credibility of the EU ETS has also been hit by a series of criminal incidents. In the first three months of 2011, thieves stole an estimated 50 million euros ($73 million) of allowances from registries in Eastern Europe, hacking into computers and transferring the credits to the open market. The most elaborate attack, in the Czech Republic — involving a bomb scare to clear the registry building — precipitated the closure of a several registries while officials reviewed security arrangements.

The European Commission, which manages the scheme on behalf of member states, says it is working to improve the integrity of the EU ETS to ensure such episodes do not recur. But for critics of the scheme, security issues are secondary to the more pressing concern of over-allocation in the next phase.

To tighten up on allowances, the European Commission has suggested reducing the number of future emissions permits or creating a new target of cutting emissions 30 percent below 1990 levels by 2020. These ideas come on top of previously announced changes for the next phase, including to auction — rather than give away — 60 percent of allowances, and to include new sectors, such as aviation, in the trading scheme.

EU governments are likely to decide on these proposals by the end of the year, according to European Commission climate spokesperson Isaac Valero-Ladron. “The whole idea is to keep companies investing in low-carbon efficiency and green technologies rather than buy allowances and emit the same,” he says.

Some climate campaigners want legally binding emissions cuts and carbon taxes.

The idea of a higher cap is being resisted by some governments and by industries covered by the EU ETS. Henry Derwent, president of the International Emissions Trading Association, which represents EU ETS participants, argues that because emissions have fallen in the last few years the system is working, recession or not. And, indeed, some researchers believe the EU is on course to hit its targets. Bloomberg New Energy Finance forecasts that, based on current trends, emissions will peak in 2015, before falling sharply in second half of the decade, as the effect of the new phase kicks in.

Assessing the effectiveness of the EU ETS is complicated, in large part because it is hard to distinguish the impact of the emissions trading scheme from other policies or market signals, such as the recession. Several studies have tried to understand the effect at the company level. Researchers at Thomson Reuters Point Carbon recently surveyed 287 organizations to ask how managers were responding to the EU ETS. Fifty-nine percent said it had caused emissions reductions in the company’s operations, while 44 percent said long-term carbon prices were “decisive factors” for investment in their industries.

Critics are far from convinced by such data, though, arguing that the scheme is a “dangerous distraction” from other initiatives. “The focus on the ETS has crowded out alternative mechanisms, such as regulations or taxes,” says FOE’s Sarah-Jayne Clifton.

Friends of the Earth wants EU member states to introduce legally binding emissions cuts for all sectors, mandatory energy savings and renewable energy targets, and carbon taxes. Taxes, it says, would provide a more reliable price signal than the EU ETS, where prices have fluctuated dramatically in the last few years. Currrently trading at about 17 euros per ton, prices have risen above 30 euros, but fell to near zero in 2007.

‘Scrapping it would take a long time, and there’s no guarantee we would have something better,’ says one expert.

But the wider question surrounding the EU ETS is whether it can keep expanding while other parts of the world fail to develop their own carbon abatement mechanisms. Policymakers face the danger of “carbon leakage,” where firms will choose to operate outside the EU, should it set caps too stringently. “There are limits how far you go in Europe if the rest of the world does not follow,” says Stig Schjolset, senior analyst at Thomson Reuters Point Carbon. “Before something happens in the U.S. and the developing countries, it will be difficult to make the European system more stringent and more effective.”

When the EU ETS was conceived, the EU envisaged countries around the world setting up their own systems, and thus creating a level playing field. Adoption of carbon trading, however, has been patchy. The Obama Adminstration failed to get its cap-and-trade measure passed in Congress last year, and South Korea and Japan recently delayed plans for their own ETSs. On the other hand, China is planning trial ETSs in several cities and provinces, and a group of states in the northeastern U.S. has established a cap-and-trade system.

Despite such moves, a growing number of academics argue that Kyoto-era solutions such as carbon trading have had their day. Gwyn Prins, a professor at the London School of Economics, says the idea of raising the cost of carbon as a way of stimulating development of cleaner technologies is wrongheaded for two reasons. One, there is no guarantee higher prices will lead to the required innovations. And, two, voters, and therefore politicians, are likely to resist measures that increase energy prices.

Steve Rayner, a professor at Oxford University, adds, “I think we have been over-enamored of the economists’ argument that if we get the right price, the problem will fix itself. The notion that we can force up the price of carbon-based fuels and thus facilitate a move away from them is not taking adequate account to the political resistance from rising energy costs.”

Prins and Rayner are members of the Hartwell Group, an informal band of academics who argue that Kyoto has “failed to produce any discernable real world reductions in greenhouse gases.” Instead, the group — which includes representatives from Europe, the U.S. and Japan — recommends carbon taxes, with proceeds going to renewable energy research. The group also proposes increasing aid to developing nations to moderate the impact of global warming.

Others say it is too early to make a judgement about the EU ETS’s long-term effectiveness, and that moving to other measures such as carbon taxes is not politically feasible. Michael Buick, at Sandbag, says it is better to reform the current system than throw it out.

“If you are looking for a serious achievable policy, this is the best one we’ve got,” says Buick. “It took years to get it up and running, and that in itself is a good reason for using it. Scrapping it would take a long time, and there’s no guarantee we would have something better. Probably, given the current climate, it would be worse.”