Item a – Allowance allocations, verified emissions and net positions by member states

Item b – Allowance allocations, verified emissions and net positions by sector

Item c – Carbon and energy prices, 2005–8

Item d – EUA trading: transaction volumes by platform, 2005–8

Item e – Origin and destinations of surrendered allowances over the first

Introduction

In market-driven economies, giving parity of esteem to environmental endowments means introducing market prices for these assets that reflect their scarcity. Once the appropriate prices are in place, those who use these endowments have continuing and automatic incentives to use them parsimoniously and to find new and less expensive ways of doing so.

Thus, a critical issue in any cap-and-trade approach is whether this market price develops and whether participation in the market is broad enough to support the assumption of least-cost attainment of the environmental goal. These questions are particularly important when the facilities concerned are endowed with free allocations of allowances. In the case of free allocation, agents may not recognize the opportunity cost of using a freely allocated allowance to cover emissions and may simply consider their allocations as so many commands from the regulator to limit emissions to a specified level or to pay a required penalty. Facilities endowed with more allowances than their emissions would feel no need to abate and would simply surrender the required number of allowances and disregard the remainder. Facilities endowed with fewer allowances than needed to cover emissions would abate but only to the level of their allocation, or to the penalty price level, whichever would lead them to incur a lower marginal cost. In the absence of a market, this behaviour would be rational, but the marginal abatement cost (MAC) would vary and the environmental goal would not be achieved at least cost.

Introduction

In a context of which Nietzsche would have approved, the European Union Emissions Trading Scheme grew out of failure. He admonishes us:

The sapling that became EU ETS was a product of two failures. First, the European Commission failed in its initiative to introduce an effective EU-wide carbon energy tax in the 1990s. Second, the Commission fought unsuccessfully against the inclusion of trading as a flexible instrument in the Kyoto Protocol in 1997. This chapter explores how these apparent setbacks were followed by the successful creation of an EU-wide market in carbon dioxide.

Before delving into the political foundations of the EU ETS, some background knowledge will be useful. The first section of this chapter describes the political decision-making process within the European Union, in which power is shared between the Commission, the European Parliament and the Council of Ministers. The second section explores the academic and experiential platform that made the EU ETS possible, from the work of economists Coase, Dales, Crocker and Montgomery, to the American SO2 trading programme to intellectual development within Europe.

While conclusions ought not to be riddled with doubt, definitive judgements on the EU ETS seem out of place, given that the first trading period offers only three years of experience and observations. Policy is often formed on less, however, and the absurdity of certainty can apply to both sides of any proposition. Thus, we hope that the reader will share the discomfort, and appreciate the tentativeness, with which the following conclusions are proposed.

CO2 emissions are no longer free

The importance of this conclusion rests not in the price, which ranged from a few cents to more than €30, but in the changes in institutions and thinking that have characterized the trial period of the EU ETS. From being seen as a quixotic and, for some, dubious initiative, the EU ETS has become an accepted fact and centrepiece of European Union climate policy. More importantly, the fact that greenhouse gas emissions have a price has become embedded in the thinking and, more particularly, in the decision-making process for production and investment affecting the sources of more than a half of European CO2 emissions.

When emissions trading was first formally suggested by the European Commission in May 1999, the European Community comprised fifteen member states with a very diverse set of policies and inclinations regarding climate policy, not to mention attitudes towards the idea of mobilizing markets to address climate change.

This book focuses on the first period (2005–7) of the European Union Emissions Trading Scheme (EU ETS), known also as the ‘pilot’ or ‘trial’ period. The EU ETS is one of the most exciting and important initiatives ever taken to limit the greenhouse gas emissions that cause climate change. It will be an important influence on the development and implementation of trading schemes in the United States, Japan and elsewhere. As such, it can provide the cornerstone for an eventual global trading regime, which will be an important component of the set of policies that will be needed to address climate change.

The audience for this book are those in all walks of life who want to understand how the EU ETS came about, and (especially) how it functioned in its early life. It is written by economists, but for a general audience, defined as those who take more than a passing interest in how to address our planet's climate change challenge and who are neither technically nor temperamentally attuned to the economics literature. It will also be of value to those with an interest in understanding how the European Union can function effectively in developing and executing a climate policy that has global implications.

Ever since the profession of environmental economics came into being, the integration of the environment and the economy via markets has been a core objective, and the reason why many entered the field in the first place.

Introduction

At its launch in 2005 the EU ETS covered approximately 40 per cent of all European Union greenhouse gas emissions through caps on CO2 emissions from energy-intensive sectors in the then twenty-five member states. It did not limit non-CO2 emissions from the ETS sectors, nor did it regulate emissions from agriculture, housing, waste management or transportation. Nevertheless, the emissions initially covered by the ETS represented 11 per cent of emissions from developed nations and 4 per cent of emissions worldwide.

In order to enhance its environmental impact and its cost-effectiveness over time, the EU ETS was designed to be enlarged. The directive establishing the scheme included provisions to extend the programme's coverage by enabling member states to add further installations, economic sectors and non-CO2 gases (the opt-in). Additionally, the linking directive established a connection between the EU ETS and the Kyoto Protocol. This provision not only gave EU ETS participants permission to use Kyoto project credits for their compliance, but also outlined a framework by which the EU ETS could connect directly with cap-and-trade programmes in nations not covered by the scheme.

To date, the discussion of how the EU ETS might link with other nations has been largely normative. This chapter seeks to provide empirical evidence of how these links have been achieved in practice, and how the scope of the trading scheme was enlarged during the trial period.