Cap and Trade in Perspective: The European Version

Part III of a three-part series on cap-and-trade looking at the successes, failures and lessons the U.S. government can learn from three programs already in place.

The European Union’s Emissions Trading Scheme creates a common market for trading permits to emit carbon dioxide in 27 countries and puts a price on carbon emissions. But the 5-year-old program isn’t flawless, and critics question whether it’s powerful enough to meaningfully affect global climate change.

The EU ETS began with a trial phase in 2005 designed to prepare Europe for complying with the Kyoto Protocol. It covers emissions from more than 11,500 facilities across the EU, representing almost half the carbon emissions of the participating countries.

Last December, the European Commission approved the third phase of the program, which adds more greenhouse gases and calls for steeper cuts in emissions — 20% below 1990 levels by 2020. If other industrialized nations agree to steep greenhouse gas cuts at the United Nation’s Climate Change Conference in Copenhagen this December, the EU will increase that target to 30% below 1990 levels.

The EU’s efforts are of great interest to the U.S. Congress as it crafts a national, economy-wide climate program to cap emissions. From the EU's example, U.S. lawmakers are gaining insights into how to use offset credits, how to allocate permits, and how to select the best sources of emissions to include. Largely, the EU ETS has worked, says Janet Peace, a senior fellow at the Pew Center on Global Climate Change.

“There have been a few hiccups along the way, but in many respects the [EU’s] cap-and-trade system can be viewed as a success,” Peace says.

Among the successes cited in a May 2008 report prepared for Pew Climate by A. Dennis Ellerman and Paul Joskow of the Massachusetts Institute of Technology:

“A transparent and widely accepted price for tradable CO2 emission allowances emerged by January 1, 2005, a functioning market for allowances developed quickly and effortlessly without any prodding by the (European) Commission or member state governments, and the cap-and-trade infrastructure of market institutions, registries, monitoring, reporting and verification is in place, and a significant segment of European industry is incorporating the price of CO2 emissions in their daily production decisions.”

Many of the hiccups occurred in the ETS's test phase, and they were mostly addressed in the second trading period, which began in 2008 and runs through 2012. This is the first commitment period of the Kyoto Protocol, where emissions from the EU ETS are capped at 6.5% below 2005 levels.

One of the biggest initial problems from the European system was an over-allocation of emission allowances. Too many allowances were given out at first because the emissions cap was set before actual data on emissions had been collected. Officials at almost all facilities overestimated their emissions, says Peter Zaman, a partner at the law firm Clifford Chance in London.

When the actual data came in and it became clear the market had too many allowances in it — in other words, the supply far outstripped demand — prices for allowances plummeted.

The lesson for the U.S., says Davis:

“Don’t trust data information provided on a voluntary basis by utilities. Only trust actual data verified by a third party.”

Zaman believes the U.S. should follow the Europeans in testing the waters before implementing a full-blown cap-and-trade program.

“Nobody envisions having problems, but everybody does,” Zaman says.

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