Climate Finance: Regulatory and Funding Strategies for Climate Change and Global Development

Chapter 24 The EU ETS: Experience to Date and Lessons for the Future

Climate Finance 221 Chapter 24 The EU ETS Experience to Date and Lessons for the Future James Chapman Research Fellow, Center on Environmental and Land Use Law, NYU School of Law Key Points • The EU has learned valuable lessons about the effective structure and governance of carbon markets through its experience with Phases I and II of the EU ETS. The scheme has moved the EU towards expected full compliance with its Kyoto commitments. Plans for post-2012 provide for higher levels of auctioning, wider coverage of gases and industry, and a more centralized and harmonized scheme overall. • There has been some difficulty—especially recently—in creating a sufficiently high price on carbon to incentivize a significant shift towards a low-carbon economy, but a combination of a lower cap for Phase III that decreases annually after 2020 (promising longterm certainty) and other policy measures (such as subsidies and renewable energy standards) should promote such a shift. • In its 20:20:20 package for Copenhagen, the EU has committed to 20% cuts below 1990 levels regardless of the outcome of international negotiations. If a satisfactory agreement on multilateral limitations commitments can be reached, the figure rises to 30%, paving the way towards an OECD-wide carbon market by 2015 and a wider global carbon market after that, with the CDM continuing to play a role but in a reformed, refocused, and more limited way. 222 James Chapman • Even though the EU ETS provides the main source of demand for CERs, the CDM has fallen short in stimulating sufficient broadbase mitigation activity in developing countries. A stepping stone between the current state of affairs and assumption by major developing countries of a full cap-and-trade system is required. The EU has proposed adoption of sectoral crediting mechanisms to deliver both the necessary changes in actions and the requisite funding. The EU’s de facto control over significant private-sector financial flows to the developing world through the offset crediting features of the EU ETS will likely enable it to secure adoption of this approach. Experience to Date Operating from 2005 to 2007, Phase I had a cap of 2.4 billion allowances per year. This first period was highly effective in making boardrooms aware of carbon risks and opportunities and stimulating the search for abatement opportunities. Further, the infrastructure of a functional, liquid market was successfully created. Phase I did, however, encounter problems . Allocations were not based on verified emissions. Also, companies were able to achieve steep initial reductions by exploiting cheap abatement opportunities previously overlooked. The result was a deep drop in allowance prices. The European Union (EU) responded by placing a firewall between Phases I and II by not allowing banking, thereby protecting Phase II from a flood of cheap allowances. Currently the EU Emissions Trading System (EU ETS) is in Phase II (2008–12). The cap, significantly reduced from Phase I, is 2.08 billion allowances per year, 6.5% below verified emissions for 2005. The data received by the Commission indicate that there has been a sufficient drop in total EU emissions to make full compliance with Kyoto commitments appear likely. The use of certified emissions reductions (CER) and emission reduction units (ERU) offset credits from the Clean Development Mechanism (CDM) and Joint Implementation (JI) projects, authorized through the Linking Directive, has helped to lower compliance costs within the EU and generated significant levels of private investment in mitigation projects in a limited number of developing countries. The EU has placed a variety of both qualitative and quantitative limits on recognition of offset credits in order to protect the environmental integrity of the ETS from unsound credits or hot air credits, demonstrating the feasibility of both The EU ETS 223 kinds of regulation. Because the EU provides most of the demand for CERs, the EU regulations demonstrate the potential for recipient cap-andtrade systems to profoundly affect the norms and practices for generating offset credits. The functional extension of the EU ETS to the countries of the European Economic Area, the linkage of the EU ETS to the Kyoto offset credit mechanisms, and the related switching of central registries from the EU-based Community Independent Transaction Log to the UN-based International Transaction Log are promising indications of the prospects for future linking of carbon markets. One major lesson from both phases is that the initial allowance distribution process, based on grandfathered free allocation...