The European Union Emission Trading System (EU ETS) is one of the key policies introduced by the European Union to promote emission-reductions in a cost-effective and economically efficient manner. The EU ETS was introduced in January 2005 as the largest greenhouse gas emission trading system worldwide that spans multiple countries and different sectors.
The system was initially set up as a means to help meet the EU’s GHG emission reduction targets under the Kyoto Protocol. The EU has firm goals to cut its overall GHG emissions by 8% of 1990 levels over the Kyoto commitment period (2008-2012) whereas the EU “Third Energy Package” includes a firm goal to reduce the overall GHG emissions of the Community by at least 20 % below 1990 levels by 2020.
The scheme is designed in phases (Trading Periods) with all EU members participating: “Phase I” was applied during the years 2005–2007, “Phase II” during the years 2008-2012 (coinciding with Kyoto commitment period) and “Phase III” during 2013-2020. All EU Member States have ratified the Kyoto Protocol and so Phase II of the EU ETS has been designed to support the Kyoto mechanisms. For each Phase, allocation of emission allowances to companies by Member States is carried out under a National Allocation Plan (NAP). The European Commission monitors this process to make sure that the NAPs fulfil the 11 criteria set out in Directive 2003/87/EC. The first criterion is that the total proposed emissions quantity of each member state has to be in line with its Kyoto targets.
The EU ETS is designed as a cap-and-trade scheme of direct emissions, based on an ex-ante allocation of allowances (in contrast to the Kyoto mechanisms that use a baseline-and-credit approach based on an ex-post verification of emissions). So under the EU ETS, NAPs are prepared by Member States and approved by the EU in advance of each trading period. Installations covered by the scheme are required to monitor and report their emissions. At the beginning of each year they are required to “surrender” allowances corresponding to the installation’s actual emissions for the previous year. They may any part of their allowance and have the option to buy more allowances from the market or sell any additional allowances they may have (which resulted from the reduction of their emissions below their allowance). They also have the option to borrow allowances from following years within the same Trading Period.
During Phase I of the EU ETS, most allowances were given to installations by Member States based on a “free allocation” approach. This has been criticized as being inefficient and providing little incentive for innovative competitive solutions to provide clean, renewable energy. To address these problems, the European Commission proposed various legislative changes under the Third Energy Package, including the abolishment of the national plans from 2013 and auctioning a greater share of emission permits. The measures were signed into law in April 2009 under the new, amending Directive 2009/29/EC. Consequently, from 2013 there will be a single EU-wide cap. Under this system, businesses will have to buy a higher share at auction as opposed to receiving emission allowances for free. From 2013, around 50% of total allowances will be auctioned and the goal is to reach full auctioning by 2027. However, there is an exception for some sectors which are energy intensive and their competitiveness is judged to be at risk. These sectors may continue to receive up to 100% of their allowances for free, provided they use state-of-the-art technology.
Allowances traded in the EU ETS are held electronically in account registries of the Member States. All of these registries are centrally controlled by an EU central administration. This administration checks each transaction for any irregularities through the Community Independent Transaction Log (CITL). The trading under EU ETS is carried out in Emission Unit Allowances (EUA) with one EUA giving the allowance (right) to emit one tonne CO2. So 1 EUA is equal to the credits set under the Kyoto mechanisms, enabling easier conjunction of the schemes.