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.

Introduction

The launch of period 1 of the EU ETS in January 2005 coincided with a particularly turbulent period in Europe's electricity markets. Two directives of the European Commission, Directive 2003/54/EC (internal electricity market) and Directive 2005/89/EC (security of electricity supply), advanced the objective of complete liberalization of electricity and gas markets in the European Union. In parallel, Europe experienced an intense process of industrial concentration, with a de facto transnational oligopoly emerging around EDF, E.ON, Enel-Endesa, RWE and GDF Suez. Coupled with the intrinsic short-term inelasticity of electricity demand, the absence of storage and electricity's importance as an essential good for households and industry, the establishment of wholesale markets outside national regulatory oversight and the movement towards concentration have repeatedly given rise to suspicions of the abuse of market power. To top it off, western and central Europe experienced severe cold snaps, in the winters of both 2004/5 and 2005/6, which, in conjunction with low hydro-power levels, led to dramatic high price spikes during the first phase of the EU ETS.

There is objectively a close connection between electricity and carbon markets, and this annex explores it. The introductory remarks above should, however, draw attention to the fact that electricity prices had plenty of reason to be both unusually high and volatile during period 1, in particular during the crucial period stretching from the beginning of 2005 until spring 2006, quite independently of the newly introduced EU ETS. In addition, the European electricity market is not yet fully unified due to the saturation of certain physical interconnections at peak times and different regulatory regimes for retail prices in several EU countries.

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.

Pricing Carbon is the result of a multinational research collaboration primarily between researchers (leader in brackets) at the Mission Climat of the Caisse des Dépôts and the University Paris-Dauphine in Paris (Christian de Perthuis), University College Dublin (UCD) (Frank Convery) and the Massachusetts Institute of Technology (MIT) (Denny Ellerman) but also involving researchers from the International Energy Agency (IEA) (Richard Baron and Barbara Buchner), the Öko-Institut in Berlin (Felix Matthes) and the University Paris-Dauphine (Jan Horst Keppler).

The project has been motivated by the belief that the European Union's Emissions Trading Scheme is a significant public policy experiment that should be subjected to a comprehensive and rigorous ex post evaluation. It is the world's first cap-and-trade programme for greenhouse gases, by far the largest environmental market in the world and the possible prototype for a global climate policy regime that would be based on emissions trading.

As an ex post exercise, the research reported in this book is resolutely backward-looking and focused mostly on the first three years that constituted the trial period of the EU ETS. The tone of the book is more descriptive or positive than normative. The objective is to describe, analyse, and understand what has transpired and not to prescribe what should be, or should have been. The normative preferences of the authors may intrude here and there, but the intent has been to keep these judgements to a minimum and to let every reader draw his or her own conclusions about the European experience during the trial period.

Introduction

A unique feature of cap-and-trade systems

Cap-and-trade systems operate through the creation and distribution of tradable rights to emit, usually called allowances, to installations. Since a constraining cap creates a scarcity rent, these allowances have value, and there are many claimants for them, not least the owners of installations required to surrender allowances equal to their emissions. The distribution of these rights, usually for free, is what is called allocation, and it is the unique feature of cap-and-trade systems.

Allocation is often portrayed as contentious and sordid, but it should be remembered that similar rights, rents and value are created by any system that effectively constrains emissions. An emissions tax is relatively straightforward. It creates a fixed price on emissions, instead of a fixed quantity limit, and the right to emit is acquired by paying the tax. The government is typically the recipient of the tax revenues, although cases exist in which the revenues are returned to emitters, such as the NOx (nitrogen oxides) tax in Sweden (Millock and Sterner 2004). ‘Command-and-control’ approaches are more common and less transparent, but they create the same rights and rents. Firms acquire implicit rights to emit by meeting the prescribed regulatory standard, or whatever derogations may be granted. The value created by the constraint is conveyed to facilities meeting the new standard through the increase in the price of output due to the new regulatory requirement, which often places more demanding standards on new entrants.

Introduction

The objective of a cap-and-trade system is often expressed as reducing emissions by a given amount, but no cap-and-trade system can guarantee any given reduction. All that is assured is that the cap, the absolute limit on emissions over some relevant period of time, will be observed. The actual reduction of emissions, or abatement, will depend on what emissions would otherwise have been, given all the conditions prevailing at that time except the price on emissions, or what is called counterfactual emissions. For instance, if economic growth is stronger (or weaker) than expected, counterfactual emissions would be higher (or lower) than expected, and the reduction in emissions required in order to stay within the cap would be commensurately greater (or smaller). What is assured by the cap is that the level of emissions will be limited regardless of all the other conditions that may obtain. Instead, it is the price and the quantity of abatement that will vary.

Abatement is a matter of particular interest in the EU ETS because emissions during the trial period were significantly lower than the cap. This slack condition is frequently referred to as over-allocation, which implies that the cap was set too high, often with the further implication that there was no abatement. This slack condition is an ex post condition, however, and, in the EU ETS, a significant CO2 price prevailed for almost two years until the slack condition became widely recognized.

Introduction

The impact of the EU ETS on competitiveness is an issue that emerged months ahead of the launch of the scheme in 2005. Following the conclusion of the first trading period, the debate is as heated as ever – all the more so because rhetoric continues to supersede evidence. Various proposals for border adjustments and other trade measures have now emerged in official debates, and the global economic slowdown is unlikely to make them go away.

The purpose of this chapter is to clarify the primary issues in the competitiveness debate and to share the evidence to date about the impact that the EU ETS has had on the competitiveness of industry. The discussion addresses the impacts observed during the first three years of the EU ETS, and is thus an examination of how the competitiveness of EU installations evolved over the short term.

Competitiveness is a notion that is most useful when applied at a relatively microeconomic level. Krugman, in his article ‘Competitiveness: a dangerous obsession’ (Krugman 1994), warns against the view that nations, like companies, compete against each other, and that their economic problems are attributable to a failure to compete in global markets. Krugman's advice is all the more relevant for an analysis of the EU ETS, whose effects are felt almost exclusively by a subset of economic activities. How, then, does one define competitiveness at the microeconomic level?

Introduction

No concept is more debated before the adoption of an environmental programme, and less discussed afterwards, than cost. Typically, a number of ex ante analyses of cost can be found, albeit of varying quality, but few or no ex post evaluations. Part of the problem is that cost can be defined in a number of different ways and from a variety of perspectives. This chapter starts with a discussion of the varying concepts of cost as typically found in analyses, including the important economic distinction between costs and transfers. The next section discusses the several published ex ante studies that have presented some aspects of cost for the first period of the EU ETS. The following section takes an ex post perspective and offers several estimates of what the cost of the EU ETS during the trial period might reasonably have been. The next section addresses an aspect of cost that is often overlooked: transaction costs. These are not the direct costs that are occasioned in reducing emissions but the more indirect costs that are incurred in preparing for and participating in the programme. In this instance, the results of a survey of the transaction costs incurred by Irish installations included in the EU ETS are reported. The final section concludes.

Defining cost

A first important distinction is that between costs and transfers. Strictly speaking, costs reflect resources – labour, capital, energy, etc. – that are devoted to producing a good or service and, thereby, are not available for other uses.