Cap and Trade in Perspective: The European Version

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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.

Peace at the Pew Center disagrees. The U.S. already has experience with emission trading programs from the U.S. Acid Rain Program, the NOx Budget Trading Program, and the Regional Greenhouse Gas Initiative. Also, the Clean Air Act Amendments of 1990, which established the Acid Rain Program, require electricity generators to report CO2 emissions, so data on emissions already exists.

The EU ETS also shows the workings of a large scale cap-and-trade program in action. In the second phase, the EU program covers oil refineries, and power plants as well as iron, steel, cement and pulp, paper and board factories. The U.S. envisions including many of these industries in a national plan.

Also, the EU has successfully used banking of emission allowances for future use, which helps to support the price of emission allowances. Allowances in the trial phase couldn’t be banked for future phases, which contribute to the price drop in that period.

One much-publicized aspect of the EU ETS was the free allocation of allowances in the first two phases of the program. Critics charged those free allowances led to windfall profits for power companies. A power company profits from free allowances by accounting for its market value as if the allowance had been sold, a concept known in economics as the “opportunity cost.”

The situation in Europe, though, was clouded by several factors that make it difficult to say power companies profited from free allowances, according to the Pew Climate report on the EU ETS. At the time, wholesale and retail electricity markets were being deregulated across Europe, but to varying degrees, so the effect on retail electricity prices from free allowances also varied across the continent, the authors said.

Another factor clouding the picture was the price of fuel. Natural gas and coal prices rose in the first half of 2005, pushing electricity prices higher. Data in the Pew Climate report shows how the rise in fuel prices correlated more closely with the rise in electricity prices than the cost of carbon did.

While the EU ETS has had notable successes, some critics say the program as it exists now isn’t stringent enough to bring about the reductions in emissions needed to forestall climate change.

One environmental group in the UK is calling on the European Commission to increase caps on emissions, charging that current levels won’t do enough to turn the tide against climate change. The group, Sandbag, says the current cap should be tightened immediately to realize a 30% reduction in 2005 levels by 2020, and tightened further to achieve a 40% reduction, depending on the deal reached in Copenhagen with other developed countries.

“We think it has huge potential, but you really do have to have tight caps,” says Anna Pearson, co-author of ETS S.O.S: Why the Flagship ‘EU Emissions Trading Policy’ Needs Rescuing.

Sandbag finds two key problems with the current scheme: too many permits were issued to industrial companies, and the system is without a mechanism to handle a drop in demand for permits.

According to the report, industries are awash in surplus permits, in part because of an over-allocation to the sector, and in part because industrial output has slowed, leading to fewer emissions. Sandbag estimates industries could profit by more than $8.25 billion from the surplus, or they could bank their surplus permits for use in the future, depressing carbon prices.

Instead of the “polluter always pays,” Pearson says. “What’s happening now in some cases, the polluter is actually being paid.”

The recession is slowing industrial output, and therefore emissions, meaning companies will need to buy fewer permits, leading to a surplus in the system. According to Sandbag, the EU ETS doesn’t address falling demand, but it does address increasing demand by allowing companies to buy credits in offset projects outside the EU. The level of offset credits is capped, but Sandbag asserts the limit is still higher than the demand.

Unlike industrial companies, power companies have had to make more significant cuts in emissions, they are meeting their obligations by buying permits from industry or they are buying offset credits, which can cost much less, Pearson says.

In the EU ETS, a Certified Emission Reduction credit is equal to an allowance permit, so the value in terms of emissions reductions is the same regardless of the price. The American Clean Energy and Security Act (ACES), which passed the House in late June, would also allow for an offset credit to equal an emission permit until 2018. Then, one permit would be equal to 1.25 offset credits, which should help keep the cost of offsets more in line with the cost of emission permits.

“It’s important you have a strong price, otherwise countries won’t make the necessary changes,” Pearson says.


(For Part I of the series, see Cap and Trade in Perspective: Stopping Acid Rain. For Part II of the series, see Cap and Trade in Perspective: Carbon Trading in the Northeast.)

See also:

Climate Bill Wins Enough Votes to Pass, But at What Cost?

Memo to Obama: Make Carbon Cap Simple and Unsinkable

Greenpeace Says ‘No’ to Climate Bill: ACES Is Too Weak

Senate Urged to Protect Clean Air Act from Climate Bill

Letter to Pelosi: 20 Environmental Groups Call for Stronger Climate Bill