The European Union Emission Trading Scheme

The members of the European Union (EU) agreed to jointly fulfil their commitments to reduce greenhouse gas emissions caused by human activity under the Kyoto Protocol. On 13 October 2003, the European Parliament and Council published a directive establishing a scheme for greenhouse gas emission trading between the member states and the EU Emission Trading Scheme (ETS) was launched on 1 January 2005. It is the largest cap and trade scheme in the world. The second stage (or trading period) of this scheme commenced on 1 January 2008. The second trading period under the ETS coincides with the five-year period—known as the 'first commitment period'—in which the EU and member states must meet their targets for limiting or reducing emissions of greenhouse gases under the Kyoto Protocol on climate change. A third stage will commence from 2012.

The overall aim of the EU ETS is to reduce greenhouse gas emissions in an economically efficient manner. Currently, the scheme has the following features:

The first trading period of the EU Emission Trading Scheme had as its overall objective the creation of the critical mass for a liquid and well-functioning carbon market. The first trading period was always intended to be a 'learning by doing' phase for all the parties involved. The first trading period led to the following:

• A European CO2 market was firmly established.
• There was an over-supply of permits compared to actual emissions.
• A volatile emissions permit price in 2005–06 and a ridiculously low permit price in 2007.
• A small reduction in emissions during 2005 and 2006, but a small rise in emissions during 2007.
• Emissions reductions from unexpected sources, such as using hard black coal in previously brown coal fired power stations.
• Emissions trading became a firm part of European industry and business planning.
• There was minimal impact on industrial competitiveness during the first trading period. However, this was over a time of buoyant economic conditions and with a limited application of emissions trading.
• Some sectors made windfall profits during the first trading period.

There are a number of lessons for the design of an Australian ETS from the experience of the EU ETS during its first trading period, such as:

• The EU ETS further entrenched cap and trade schemes as the preferred way to control emissions.
• The scarcity of emissions permits in such schemes must be maintained.
• There is no substitute for accurate verifiable emissions data for the efficient operation of such schemes.
• Emission permits must be allocated on a consistent basis, preferably by a central administrator or by a market based mechanism such as auctioning.
• Unused emission permits must be able to be 'banked' for later use.
• The best may be the enemy of the good. The EU ETS was still able to achieve a reduction in emissions, even with a comparatively low emissions price and many economic sectors not covered by the scheme. This suggests that an ETS need not be perfectly designed to produce worthwhile outcomes and to gather relevant experience in operating such a scheme.

Further reading:

A. Denny Ellerman and P. Joskow, The European Union's Emissions Trading System in Perspective, Pew Centre on Climate Change, May 2008.

L. Nielson, The European Emissions Trading System—Lessons for Australia, Research paper, no. 3, 2007–08, Parliamentary Library, Canberra, 20 August 2008.