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EcoLogic Insight - EU ETS

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EcoLogic Consultancy Understanding the EU-ETS EcoLogic Insights series EcoLogic Insights series Understanding the EU-ETS
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EcoLogic Consultancy 

Understanding the EU-ETS EcoLogic Insights series

EcoLogic Insights series

Understanding the EU-ETS

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European Union’s Emissions Trading System (EU ETS) 

Author : Shailesh Telang, EcoLogic Consultancy

Overview

The European Union Emission Trading System (EU-ETS) is the largest emissions

trading scheme in the world and also a first cap and trade system1 of CO2 started in

2005. Formerly the tradable emission allowances were first used under the United

States’ Acid Rain Program, the world’s first cap and trade program. The program, which

began in 1995, addresses Sulphur dioxide emissions from utilities. The success of this

program helped paved the way for the development of cap and trade programs

addressing green house gas emissions, the most notable of which are the European

Union’s Emissions Trading Scheme (ETS). Under the EU-ETS, large emitters of carbon

dioxide within the European Union must monitor and annually report their

CO2 emissions. EU-ETS was enacted before the Kyoto Protocol became legally binding

in international and EU law and it would have become operational even if the Kyoto

Protocol had not entered into force in February 2005. Although it is inspired by the

Kyoto Protocol but it is independent of it.

How does it operate?

The ETS system is divided into trading periods or phases. Allocation of Cap is done by

fixing the trading period. The cap for the first period (2005-07) was determined in mid-

2005 (Pilot or Trial phase). Cap for second trading period (2008-12) was not finalized

until late 2007 and the period after 2012, the European Council has declared that the

EU’s greenhouse gas (GHG) emissions will be at least 20 percent lower than the 1990

level by 2020.

Emission allowances: An emissions allowance is an authorization to emit a fixed amount 

of a pollutant. It is a term commonly used to describe a unit of greenhouse gasemissions (GHG) covered under an emissions trading, or “cap and trade” program. An

emissions allowance is sometimes also referred to as a permit. An allowance is a fully

1 In a cap and trade system a central authority sets a limit, or a cap, on the overall amount of pollutants

that are allowed to emit in one certain area and allocates permits representing the right to emit a specific

amount of pollutants to companies. Companies then can trade permits on a created market. Over time, the

limit or the cap becomes stricter, allowing less and less pollutions, until the final reduction goal is met.  

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Understanding the EU-ETS EcoLogic Insights series

marketable commodity that may be bought, sold, or traded for use by entities covered

by the program. Currently under EU-ETS, each member state decides how many

allowances to allocate per trading period based upon criteria established by the

European Commission. The member states draw up national allocation plans (NAPs),which the Commission must adopt. The countries, through their NAPs, set the overall

emission caps, establish a set number of allowances, and distribute those allowances to

the regulated installations within their countries. 

The EU ETS is a classic cap-and-trade system. However, it also contains some significant 

design differences from those reflected in cap-and-trade systems for other emissions

that have been implemented in the U.S. The common features are that 

1.  An absolute quantity limit (or cap) on CO2 emissions has been placed on some

12,000 emitting facilities located in the European Union,

2.  Tradable allowances have been distributed to these facilities (typically for free) in an

amount equal to the cap, and

3.  These facilities must measure and report their CO2 emissions and subsequently

surrender an allowance for every ton of CO2 they emit during annual compliance

periods. The primary differences from U.S. experience with cap-and-trade

mechanisms relate to how the cap is set, the process for allocating emission

allowances, banking and borrowing provisions, the monitoring, reporting, and

verification procedures, and the linking or off-system provisions.

Cap setting process

There was no initially determined overall limit. No there are separate decisions

concerning the total number of European Union Allowances (EUAs) that each member

state could distribute to affected installations within its jurisdiction. Each member state

proposed a quantity of EUAs, but that quantity was subject to review and approval by

the European Commission according to procedures and criteria specified in the EU

Emissions Trading Directive.

The main change in EU ETS is that it is a cap within a cap from 2008 on. The Kyoto

Protocol, as modified for the European Union (EU15) by the Burden Sharing Agreement 

(BSA) imposes an economy-wide cap on all greenhouse gas emissions (The EU-ETS

includes only CO2 emissions). The sectors (power sector, specified industrial sectors

and all combustion facilities with a thermal input of greater than 20 MW regardless of 

the sector in which they are found including commercial and institutional

establishments) included under the EU ETS comprise about half of EU CO2 emissions

and about 40 percent of the GHG emissions covered by the Kyoto Protocol. GHG

emissions from sources not included in the EU ETS.

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Incorporation of Kyoto Mechanism in EU-ETS

An important but less noticed complement to the Emissions Trading Directive is the

Linking Directive, which was formally adopted in November 2004. Up to a certain limit,

it allows affected installations to comply by submitting qualifying credits for emission

reductions accomplished outside of the European Union. The only credits allowed are

those created through the provisions of the Kyoto Protocol relating to the Clean

Development Mechanism (CDM) or Joint Implementation (JI) and known respectively as

Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs). Even so,

credits generated by certain CDM activities cannot be used for compliance in the EU

ETS, namely, those associated with nuclear power and from CO2 sinks. Interestingly,

however, credits generated by non-CO2 GHG emission reduction projects outside the EU

are acceptable.

When the Kyoto Protocol came into force on 16 February 2005, the EU ETS had already

become operational. Only later, the EU decided to accept Kyoto flexible mechanism

certificates as compliance tools within the EU ETS. The "Linking Directive" allow

operators to use a certain amount of Kyoto certificates from flexible mechanism (CDM,

JI & IET2) projects in order to cover their emissions.

How does trading occur?

Notable feature of the EU ETS is that effectively there is no restriction on banking or

borrowing of allowances within any given multi-year trading period. Allowances are

issued annually but they are valid for covering emissions in any year within the trading

period. Moreover, each year’s issuance of allowances occurs at the end of February, two

months before allowances must be surrendered for the preceding year. As a

consequence, installations can cover shortages in any given year by allowances issued

for the next year. This arrangement effectively allows year-ahead borrowing within the

trading period. 

The Linking Directive allows affected installations to buy KP units but the limit on CER

and ERU use in EU-ETS is 10% only (A. Denny Ellerman & Paul L. Joskow). This limit is

specified in each member state’s National Allocation Plan (NAP) and it varies among

member states and, in some cases, even by sectors within a member state.

2 International emission trading scheme: IET allows trading of Kyoto units (credits generating from CDM

and JI) between the Annex 1 parties (Mostly European countries). IET is relevant as the reductions

achieved through CDM projects are a compliance tool for EU ETS operators.

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Trading analysis: Use of credits or allowances from outside the system for compliance,

that is, the use of anything other than the system’s own allowances.   In the case of the

EU- ETS, the primary sources of such offsets are the project credits created under the

Kyoto Mechanism i.e. CDM & JI and known as Certified Emission Reductions (CERs) &Emission Reduction Unit (ERU). The Linking Directive, enacted soon after the Emissions

Trading Directive, opened the door to the use of CERs and Joint Implementation credits

created by a similar process under the Kyoto Protocol.

In searching of low cost mitigation options: EU ETS will exploit lower cost mitigation

options wherever they are located. Since there is no necessary relationship between

individual country emissions caps and the geographic distribution of low-cost 

mitigation opportunities, mechanisms must be found to facilitate the ability of countries

with relatively high-cost mitigation options to exploit relatively low-cost mitigation

opportunities in other countries.

Post 2008-12: The EU also agreed to three additional important system changes. They

agreed to extend the trading period to eight years, tighten the emissions cap so that 

21% reductions (Climate Lab Website) would occur by 2020. This creates immense

opportunities in the carbon market for developing countries to implement mitigation

plans and to facilitate the industrial nations.

References

1.  A. Denny Ellerman & Paul L. Joskow., Massachusetts Institute of Technology ., ‘The

European Union’s Emissions Trading System in perspective’ .

2.  European Commission official EU ETS website, Accessed on 2 August 2010

http://ec.europa.eu/environment/climat/emission/index_en.htm

3.  Climate Lab Website, Accessed on 2 August 2010

http://climatelab.org/European_Union_Emissions_Trading_System

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 About Us

EcoLogic Consultancy came into existence with the purpose of “To help our clients inunderstanding, establishing sound Environment Management Systems, and pursuing

sustainable business solutions through our various services to abate direct and indirect 

mpact on ecological balance.” 

We have expertise in the areas of carbon accounting and management, energy

management systems, voluntary/compliance carbon markets, environment 

management and sustainability and carbon branding.

To know more about EcoLogic, please visit  http://www.ecologicconsultancy.in 

To schedule a meeting and discussion with us, do reach us on

Kedar - +91-9665407848 – [email protected] 

Indrajeet - +91-9028788430 – [email protected] 

Shailesh - +91-9890887670 – [email protected] 


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