1

Innovation Management

THE EU EMISSIONS TRADING

Coordinating Professor Villy Sogaard

Project submitted by…..190558

University of Southern Denmark

Delivered on the 14th of June 2010

Introduction

Global warming has gradually become one of the most urgent issues to be dealt with. Around the
world, states have started acknowledging the fact that actions must be taken against the increasing
level of pollution, but at the same time, other issues, such as poverty or hunger must not be set
aside.
Treating with the level of emissions needs a thorough comprehension of the development of the
human society. Economical and social issues have to be taken into account in order to develop a
proper strategy to implement policies that can alleviate emission levels. Therefore scientists have
started looking for innovative solutions to slow down and eventually stop global warming. Amongst
such solutions, technological progress and policy making constitute most impactful factors.
Recent research and development work has shown tremendous potential to substitute existing
technology with systems much more efficient and beneficial for the environment. Wind turbines,
solar panels or biomass plants have started slowly but surely replacing traditional fuelled power
plants, as well biofuels are being developed to switch automobiles from fossil fuels.
On the other hand policy making has a more wide reach in dealing with pollution. Different
programs have been implemented on a local, regional, national or even international level with of
course different results. This paper deals with the current policies implemented by the European
Union in order to curb the level of emission of its member states.
We will review the phases of the EU ETS (Emissions Trading Scheme), potential threats and future
conditions, taking into consideration the level of innovation involved and the reasons for needing
such a process. The results of the paper show that the EU ETS can be a solution for dealing with
pollution as well as benefit developing countries.
Method
In the following parts of this paper, we will go through the two existing phases of the EU ETS
implementation, the characteristics, the issues, debates between states and industries and the much
needed innovation which can alleviate the tension between the above mentioned parties, as well as
the changes that will appear in phase three of the program. In addition we will briefly present the
Clean Air Act, as it is the foundation of the EU ETS.
Cases
Clean Air Act (Acid Rain Program)
Title IV of the 1990 Clean Air Act established the basis of the allowance market for emissions in
the US. The Acid Rain Program (as it is known today) was set in motion in order to reduce the
levels of SO2 by 50% compared to 1980s levels. The program was implemented in two Phases,
starting with 1st Jan 1995 to 31st Dec 1999 (Phase I) and Phase II from 1st Jan 2000.
Within the 1st Phase the initial procedures and systems were implemented in order to have an
accurate overview of the national levels. 261 units along the US were required to cut sulphur
dioxide emissions rates. Each unit was identified and its emissions quantified following a delegation
of emission allowances.
 3

Phase I had as part of the program a clause stating that the owner of any unit that would reduce
emissions below the applicable emissions limit would be granted emissions allowances which could
be handled as wanted by the owner (e.g. relocated to another unit, sold or kept).
Phase II had more enforcing clauses, stating that all fossil-fired units over 75 MWe had to limit
emissions of SO2 to only 1,2 lbs/mmBtu by 1st Jan 2000. Beyond that date, each ton of SO2 emitted
was punished by a 2000 $ fine, the equivalent of a new emissions allowance. The way of
distributing the permits depended on calculations of historical Btu usage for each unit. Free
allocation was used also known as grandfathering.
Regarding the price, the US Energy Department estimated in 1991 an installed retrofit price per ton
of SO2 of around 665 – 736 $, which was achieved in 2005 for the first time. The Acid Rain
Program was considered a success, having an innovative approach to the SO2 emissions, and later
other substances such as mercury or nitrous oxide.
EU ETS
The EU ETS was established to curve the growing levels of CO2 emissions in Europe; it used the
framework of the Acid Rain Program. It was initiated in 2005 and it was set to cover 45% of the
total CO2 emissions in the EU, a total of 11,500 units. The implementation of the EU ETS followed
intensive consultations between the European Commission and stakeholders, which by the end
came to a consensus to apply the policy. The EU settled on a cap-and-trade model, considered to be
the most efficient and effective scheme available. Basically cap-and-trade keeps transaction costs
low by allocating unambiguous property rights and ensures environmental effectiveness as
emissions are capped.
The EU ETS was planned to take place in two phases, first between 2005-2007 (more of a test
drive, to try and limit the amount of uncertainty threatening the survival of the strategy) and second
from 2008 to 2012, after which depending on the results, further programmes will be implemented.
With the first two phases the EU required the acceptance of the industries targeted, thus it had to
make two very important compromises. Firstly, the method of allocating the allowances was
grandfathering, which meant that for Phase I, 95% of the allowances were given for free and 90% in
Phase II. This compromise had a very solid reason, which was that the EU had to “buy” the
business sector, in order to have the programme taking off. The firms thought highly of the idea of
receiving free allowances which could partly help offset higher production costs, due to the
additional revenues deriving from the allocation.
Secondly, the EU decided to leave the allocation process in the hands of member states. This meant
that member states could deal at their own liking with the situation in their own state, allowances
being allocated not only on effective achievements, but as well on political reasons, plus the
industry in each state did not appreciate the idea of being regulated at an EU level.
Analysis
Phase I of the EU ETS came as mentioned before, as a test drive, to try and see the impact on
sectors where it was applied, and if it showed potential for diminishing the emission levels. But the
outcome of the first period showed flaws, discrepancies between the expected results and reality.
This was a sign that improvement was needed. Overall the main reason was that the programme
was implemented without deeper analysis of uncertainty. The member state governments were not
 4

given enough time to cope with the necessary actions. Issues such as national member state
registries, National Allocation Plans (NAPs) delayed the proper implementation. Other issues were
encountered; monitoring, reporting and verification represented initial impediments.
The situation was uncertain due to lack of information regarding the existing levels of emissions.
This lead to a functioning of the market based on expectations, rather than accurate data.
In addition a lethal combination proved to be adopting modest cuts, close to actual emissions and
inflated projections which lead to “surplus” allowances of almost 5% of total annual allowances.
These projections were the main reason for the steep drop in allowance prices, which after an
increase to approx 30 € t/CO2, dropped to or even less than 1 € t/CO2. These are repercussions
from member state allocations without proper data.
The dialogue between member state governments and industries, proved to be extremely complex
for the first, meaning that the industries pressured the governments to ensure enough allowances
were allocated in comparison to other states. Benchmarking could have prevented this issue, and
delivered a more efficient way of allocating allowances. Still some countries have used
benchmarking for allocation to new entrants or for installations in general and/or fixed energy
efficiency rates, however member states used different metrics, leading to a lack of harmonization
across the EU. Having a standard to base benchmark on could have alleviated the process.
As an innovative clause, the EU ETS introduced the provisions for new entrants, which have not
been used or taken into consideration by previous emissions trading schemes. Such provisions
emerged as means to preserve pre-policy investment incentives.
Regarding investment, the EU ETS has been viewed as a discouragement to invest in low-carbon
technologies in the long-term. Current allocation periods provide certainty only for short spans of
time (three or five years), which cannot be associated with investment cycles. This makes planning
future investments difficult for the industry.
There is another issue surrounded by uncertainty, regarding largely oligopolistic national or
regional power markets, which could be manipulated into allowing a coal power generator to be a
marginal producer as often as possible and therefore increase the price effect of CO2 for the power
price. In extent to this, oligopolistic markets could hinder investments in low carbon technologies,
being driven by cost issues, therefore keeping the available high carbon ones into the market.
Phase II
The second phase of the EU ETS brought much needed improvements, in the allocation department,
planning of NAPs, use of benchmarking or even auctioning, which has doubled since the first part
of the program, even if still at a low level. Auctioning continues to be concentrated into the power
sector, being justified by member states because of lack of non-EU competition for power. There is
a close connection between the cap and auctioning, due to the direct influence of a reduction of the
first to the second. NAPs 2 are far more stringent than NAPs 1, mostly because the EC imposed
significant reductions. As well allocations have been set at a lower level than the previous period
(9%). This has lead to a lessening of the differences between the trading and non-trading sectors,
making sure that the overall target will be met in a cost-effective way.
 5

Conclusion/Discussion
The EU ETS has proved to be an innovative solution to tackle the CO2 emissions issue in Europe,
in order to achieve the goals stated in the Kyoto Protocol. Even with the obvious setbacks, the
programme shows great potential, and with the necessary modifications can be implemented on a
long-term basis, thus limiting the amount of uncertainty available.
The programme was initiated in a short time span, policy makers choosing a rationalist approach,
knowing that this initial phase will be the foundation on which a more capable strategy will be built.
The goal of the EU ETS first Phase was to set the parameters, rules and gameplay, thus sketching a
framework which remained to be improved in the future.
Phase II as well as the following, face a change in strategy, from a ‘rationalist’ way of thinking to
an ‘incrementalist’. Policy makers focus on the actions and reactions of member states and
industries, and the influence, the relationships, between these two parties, have on the market, on
the allowance price fluctuations, and levels of emissions. Each Phase will be adjusted accordingly
to the previous Phase’s results. Thus, for Phase III, the EU wants more consistency among member
states, a harmonization in terms of allocation. New entrants will be given more attention, therefore
there have been negotiations to create new entrants reserve, ensuring that investments will still
happen. Another important issue is the allocation methodology, member states, considering
cooperation to develop benchmarking and output factor or activity rates. On the same issue of
allocation, there have been voices stating that they will make more use of auctioning, which has
happened with some countries, such as Germany or the UK, but mainly to earn experience on how
to recycle auctioning revenues or avoid market dominance. In the future stages of the EU ETS, it is
very likely that a threshold will be set in order to avoid pressure from industries on member states,
not to auction more than other states where competitors are located.
The greatest problem with the EU ETS will continue to be uncertainty, which will affect the policy
makers, member states and firms. The EU can afford more than the firms to ‘play’ with the
programmes, until the most effective version will be acquired. Still by leaving the data gathering to
member states, will not fasten the process, auditing, verification, monitoring, registry maintenance
are issues that need clarification and a more centralized system, in order to give correct, accurate
information regarding each participant in the market. Knowledge will lead in time to predictability,
efficient caps could be set ahead, thus lowering the level of uncertainty each firm has to deal with,
helping them to strategize the future, plan investment cycles, even substituting high-carbon
technologies with low-carbon ones. A European Agency that would have the above mentioned
duties, and a representative body in each member state, would help with centralizing the data.
In designing the framework for the EU ETS, incremental innovation has been essential. Starting
with the existing example provided by the Acid Rain Programme in the US, the EU has begun
working and testing the strategy, adding new clauses that ensure both environmental and cost
effectiveness. The EU ETS still qualifies as ‘work in progress’, still the path has been set, and the
progress is happening, estimates give 2020 as the year when the best results will be achieved.
 6

References

Christian Egenhofer – “The Making of the EU Emissions Trading Scheme: Status, Prospects and
Implications for Business”, 2007 – European Management Journal, Vol. 25,
No. 6, pp 453-463