1. The EU CO2 Emissions Trading Scheme
Denny Ellerman
Center for Energy and Environmental Policy Research
Massachusetts Institute of Technology
New Directions in Regulation Seminar
JFK School, Harvard University
October 22, 2007
Massachusetts Institute of Technology
Center for Energy and Environmental Policy Research

2. Topics Market Development 2005-06 Results: Over-allocation?
Allocation choices
Broader Implications

3. The EU ETS 27-state multinational CO2 trading system
Classic cap-and-trade covering large sources
About 45% of EU CO2 emissions
Hybrid implementation of Kyoto Protocol
Trading and non-trading sectors
Decentralized cap within a cap with CDM linkage
trial period, second period, and post 2012 periods

4. The EUA Market Mostly futures trading in front contract
Also, spot but 10-15% of total volume
OTC market initially, but exchanges developed quickly and account for 30-40% of volume
US allowance markets all OTC
An EUA is a downloaded AAU, but non-EU AAUs are not acceptable; CERs/ERUs are.
Also any linked systems: probably Norway

6. EUA Prices Jan 2005 - Present

7. Three Prominent Features
Higher than expected initial prices
Energy price relations
Adverse weather
Institutional features
Sharp adjustment upon revelation of lower than expected emissions
All prior information was speculative
Similar response in US SO2 program
End-of-period price separation

8. Temporal Trading: An Important Pricing Feature
Unrestricted intra-period banking and borrowing, but none between trial and subsequent periods
Explains 1st and 2nd period price separation in 2007
Inter-period banking expected from on

9. Temporal Restriction Does Affect Prices

10. Linked to a Complicated International Market
Non-ETS Sectors ETS Sectors
(Gov’t responsibility) (Private Responsibility)
(AAUs remain as such) (AAUs converted to EUAs)
EU Kyoto AAUs
Kyoto Parties with Surplus AAUs
(Russia, E Europe)
Kyoto Parties in Deficit
(Japan, Canada, NZ)
Non-Annex I Kyoto Parties
(China, India, Brazil, etc.)
CERs
Subject to
supplementarity limits

11. Topics Market Development 2005-06 Results: Over-allocation?
Allocation choices
Broader Implications

16. EU ETS: Over-allocation
Not an issue until first data release
Muddled concept; conflated with being long
With inter-period banking constraint, sure to be either long or short
Concept also used to imply no abatement; data are showing abatement
Inherently difficult problem of ensuring shortage with ambition is modest; ex post rarely coincides with ex ante

17. Topics Market Development 2005-06 Results: Over-allocation?
Allocation choices
Broader Implications

18. Allocation in the EU ETS
Delegation to member states to decide total and distribution with  95% grandfathered
Member state decisions subject to review by the European Commission
In practice, limited to the proposed totals, and
No ex post adjustment or quota management
Huge data problems at installation level
Extended discussion between industry and government on data and allocation principles

19. What Choices were Made? Allocations based on recent emissions
Benchmarking proved infeasible
Shortage allocated to the power sector
More abatement possibilities & no competitive problems
Very little auctioning (4 MSs & 0.13% of total)
New entrant and closure provisions
Potentially distorting effects but ubiquitous

20. Principles or Politics?
Near universal disapproval of grandfathering, yet always chosen
Is there more than just politics & lobbying?
Unacknowledged social norms?
Lockean prior use and squatter rights
EU variant: production conveys the right
A convergence of fairness and expediency?
Allowances permit Coasian separation of efficiency and equity
Assign rights to mitigate financial impact of the change in prices and rules

21. NAP2 Differences More auctioning: 11 MS’s,  3% of total
Some increase in benchmarking, but still little
Substantially lower caps
Based on aggregate 2005 Verified emissions
All East European MS’ suing in ECJ
Wide variation among MSs (-19% in Denmark to +33% in Lithuania (relative to 2005 emissions)
Updating at micro level only in East Europe

22. Evolution of Auctioning in the EU ETS
Member State
Percent of Cap Auctioned
Denmark
5.0% 0%
Hungary
2.5%
4.3%
Lithuania
1.5%
2.9%
Ireland
0.75%
0.5%
Austria
1.2%
Belgium
0.3%
Germany
8.8%
Italy
5.8%
Luxembourg
4.8%
Netherlands
Poland
0.9% UK
7.0%
EU Total
0.13%
 3.1%

23. % Relation to 2005 Emissions
NAP2 ( ) vs. NAP1 ( )
% Relation to
1st Period Total
% Relation to 2005 Emissions
EU 15
- 11.4%
- 6.1%
EU10
- 12.8%
+ 5.5%
EU25
- 11.7%
- 3.9%

25. Topics Market Development 2005-06 Results: Over-allocation?
Allocation choices
Broader Implications

26. The Next Steps for the ETS
The East European challenge in NAP2
Expanding the scope: Aviation proposed
The ETS (post-2012) Review: Dec 07
An EU-set cap? -20% from 1990
Much higher auctioning share?
More harmonized allocations?
Maintaining a credible price
Overlapping mandates (i.e., renewables)
International market linkage (CERs, greened AAUs)

27. The EU ETS as Prototype
A multinational trading system with a uniform price on carbon throughout the EU
The east/west parallel to the global north/south divide
Differing criteria for EU15 and Accession-10
Differing responsibilities for non-covered emissions
What made all 25 join up?
The European idea?
Or the benefits of the club?

28. The Geopolitical Importance of the EU ETS
The Fact on the Ground
The Pioneering Example
Learning experience for those who follow
The subtle influence on the American debate
The €20/tonne incentive and the CDM
Attracting interest from those outside
Influencing Chinese and Indian preferences

29. The Challenges Ahead Continuing the EU ETS and keeping it open
Avoiding trans-Atlantic acrimony in global environmental diplomacy
First step is linking EU and US systems
Developing combination of community and interest that will attract others (as in the EU)
Finding a multinational institution to coor-dinate and negotiate accession/membership