EU Emissions Trading Off to Shaky Start

Published July 1, 2005

British Prime Minister Tony Blair, during a June 7 meeting with President George W. Bush, pushed hard for the U.S. leader to support the Kyoto Protocol. Blair’s lobbying pleased environmental activists back home but masked very troubling developments for European adherents to Kyoto. The European Union is having a very difficult time complying with the treaty.

The June 9 Financial Times reported in the wake of the Blair-Bush meeting, “the UK itself is likely to miss the targets set by Mr. Blair for the reduction of greenhouse gas emissions.” That forecast is especially ominous given that the UK’s burden was substantially lightened by grandfathering in emission reductions that preceded Kyoto and had no connection to the treaty.

Observed the Times, “the greatest reduction in emissions has already been achieved, by the switch that happened in the 1990s from using coal to generate electricity to using gas instead.”

The United Kingdom is not alone in having trouble complying with Kyoto. Reports the Competitive Enterprise Institute’s Iain Murray, “The EU is almost certain to miss its collective targets for the first Kyoto period. While the EU as a whole is committed to an 8 percent reduction in emissions (on 1990 levels), the EU itself admits that policies currently in place (other policies are unlikely to be adopted) will lead to a reduction of only 1 percent in 2010. The implications of this are huge.”

Broad Outline

The Kyoto Protocol became effective on February 16, 2005, 90 days after Russia ratified the treaty. It took signatories who emitted at least 55 percent of the world’s greenhouse gases in 1990 to bring the treaty into force. Russia’s 17.4 percent pushed the protocol over that mark.

Work on the emission trading scheme has been proceeding in parallel with the ratification process. A three-tiered structure has been created. At the bottom are 12,000 or so corporate entities. Above them are the member states, which must design the national trading system and approve the initial allocations of the allowances. At the top is the European Commission, which reviews and approves (or rejects) the national allocation plans. The commission also will ensure compliance with the reductions agreed to in the Kyoto Protocol and settle disputes among the member states.

There will be two phases in the emissions trading scheme. The first will last from 2005 to 2007 and the second will occur from 2008 to 2012. Member states can allow banking in these two phases. However, the member states have thus far not allowed banked credits to be carried over from the first phase to the second. That sends a counterproductive message to firms that are prepared to reduce emissions early. It also puts in doubt the expected cost savings from emissions trading.

By contrast, the allowances under Title IV of the Clean Air Act Amendments of 1990 do not expire unless used. Thus, the allowances can be banked for use at some future time, like during an oil shock.

International Trading Difficult

Trading of emission allowances by companies even in different EU member states will be complicated given the variations in national allocation plans. To help the process, each EU member state is slated to have its own greenhouse gas registry. The EU also will have a centralized trading registry.

According to David Hayes at Latham & Watkins, “There are substantial uncertainties surrounding the EU ETS [emission trading scheme]. As a preliminary matter, the three-step process required to develop a NAP [national allocation plan] has been a complex and difficult process. As a result, many MSs [member states] were late sending the NAPs to the European Commission, and the Commission in turn has been delayed in approving NAPs.”

Cross-border trading by companies involving nuclear power and carbon sequestration will not be allowed. Only member states will be allowed to buy and sell allowances from nuclear power and carbon sequestration. That will put a damper on the prices received by installations (individual corporate entities) selling allowances, because private companies will be excluded from the list of buyers.

This may be a partial payback for the refusal of developing countries such as China and India to take on Kyoto reductions. However, it also will reduce a major source of low-cost emission reductions.

An important omission from the emission trading scheme is the transportation sector. How this will be handled in the future is an important unsettled question.

Success Unlikely

The recent rejection votes on the very complex constitution for the European Union suggests trouble for the similarly complex EU emissions scheme. Moreover, there are enough clouds on the emissions trading horizon for existing systems to put the success of the EU scheme in further doubt.

That leaves one clear alternative for operators of emission installations. Companies and member states can simply reduce emissions and use the trading scheme merely as an emergency measure in case of an energy crisis. That is what is happening with sulfur dioxide allowance trading in the United States. At present, the prices for the modest amount of trading that currently goes on track the price of natural gas, which is the marginal, peak-load fuel for producing electric power.

The sulfur dioxide allowance price in the United States is currently at $730 per ton, up from $300 in 2003. That is similar to the rise of natural gas prices during the same period and significantly different from the price of low-sulfur coal from the Powder River Basin in Wyoming, which has remained steady at $6 per ton throughout the 1990s to the present. The implication is that potential traders do not trust the reliability of the trading systems enough to justify long-term investment in earning allowances. The allowances seem to be useful only for extraordinarily high peak-load emergencies.

The basic theoretical model of emissions trading has run up against the reality of markets. If the rules are not likely to remain stable, emission sources will take protective measures. That means the EU trading scheme will not experience substantial trading across firms beyond simple averaging within firms. The small amount of trading across emission installations will take the form of hedging for emergency periods. Thus, the touted cost savings will not be realized … with dire consequences for economic growth in the European Union.

James L. Johnston ([email protected]) is an energy economist and director of The Heartland Institute. This report is based on a more complete document available online at