The EU ETS: current problems and possible ways to move forward

1. The EU ETS: current problems and possible ways to move forward

2. Outline The EU ETS Present situation and current problems Possible ways to move forward

3. The EU ETS

4. EU Action Since 1991 Commission is taking action to reduce GHG emissions and improve energy efficiency Renewable energy Voluntary commitments (car makers) Taxation (energy products and electricity) In 2000 launch of European Climate Change Program (ECCP) to meet Kyoto Protocol goals of reducing emission levels during 2008 � 2012 to 8 percent below 1990 levels

5. Measures of the 1st phase of the ECCP Proposal for ratifying the Kyoto Protocol Proposal for establishing the EU ETS Regulating certain fluorinated gases Action Plan: linking EU ETS with CDM and JI

6. The EU ETS European Emission Trading System (EU ETS) is a part of the ECCP 1st January 2005 5000 operators 12.000 installations Sectors: energy, ferrous metals, minerals, pulp and paper Time periods: 2005 � 2007 (learning by doing phase (!)) 2008 � 2012 (Kyoto) 5 year periods

7. EU ETS peculiarities 15 Old MS: Burden sharing agreement 10 New MS: Kyoto commitments Malta and Cyprus: Very few installations No Kyoto commitments => bound by EU ETS, business as usual scenarios

9. Directive 2003/87/EC Obliges MS to: Identify operators Monitoring, Verification and Reporting Draw up a �National Allocation Plan� =>Allocate emission allowances - subject to: criteria listed in Annex III Legislative tool Directives are binding upon their result but leave choice of form and methods, Article 249 EC Treaty

10. Learning by doing (!) Commission wants legislative changes to take effect 2013 Review working group under ECCP II => legislative proposals in 2007 Review process considers post Kyoto period and international context

11. Present situation and Current problems

12. Present situation 21 Member States do have an electronic registry 99% of allowances (9000 installations) complied with Directive as of 30 April 2006 320 million allowances were traded 6.5 billion Euros Greenhouse gas emissions lower than expected Success or over allocation?

13. Problematic issues Price signals Linking EU ETS and �Kyoto� Design choices Scope New entrants Windfall profits Closure and transfer rules

14. Long run price signal Long run prices -> trigger behavior Sufficiently high prices Price stability Predictability

15. Price fluctuation is normal Allocation rules Compliance Supply and demand Emission cap Political developments Alternative supply sources

16. EAU price development

17. May 2006 unannounced pre-release of verified emissions data by several Member States Lower than expected actual level of emissions Current price below 10 cents Oversupply of perhaps 160 million tons CO2 Dim prospects for environmental effectiveness in the 1st trading period�

18. EAU futures

19. Scarcity in the 2nd phase Market seems to expect sufficient scarcity in phase 2 � despite linking Strong political massage at G8 meetings Downward corrections of 2008-2012 allocations demanded by Commission, ca. 9% 8 Member States have taken / consider taking legal action: Lithuania, Malta, Poland, Hungary, Czech Republic, Slovakia, Estonia and Latvia Preliminary question from a French Court to the ECJ => non-coverage of aluminum and plastics industries vs. principle of equal treatment

21. Linking EU ETS and �Kyoto� The Linking Directive (2004/101/EC) grants MS discretion to allow operators to use CERs (from CDMs, 1st period) and ERU (from JIs, as of 2008) for their EU ETS obligations Percentage is based on the allocation to each firm

22. Limits for usage of CERs and ERUs binding upon installations are expected to be wide For the second trading period they average around 11.5% 220 million tons of Kyoto Mechanisms can be imported annually Despite Commission�s reductions, supply surplus of 6% (2008-2012) if contrasted to actual demand in 2005

23. Supplementarity: Meaningful reduction domestically? Kyoto Protocol binding upon states If margins for EU ETS sectors are set widely => other sectors have a higher burden

24. Environmental soundness Allowing CDMs under EU ETS may give rise to leakage Additionally criterion Environmental integrity Credible baseline to quantify reductions Monitoring Verification Compliance Impact assessment + evaluation of projects done by host country (partly assessed by CDM Executive Board) Disincentives to promulgate environmentally stringent legislation?

25. Distortions of Competition If prices of CERs and ERUs are lower than EAUs and MS legislation differs -> distortions of competition Lower operating costs Windfall profits

26. Market price Unless demand during 2008-2012 lies at least 6% above the 2005 emissions EAU prices would be comparable to those of CERs and ERUs Price incentive sufficient to trigger environmentally friendly behavior? Yet: low cost burden on industry mitigates leakage

27. Design choices Directive Cap and trade system Scrutiny by the Commission Criteria Limitation of auctioning => free allocation mandatory (�grandfathering�) Ex post allocations

28. Scope of the Directive Definitions / criteria are vague => different interpretations of the legal text Different allocation methodologies => comparable installations are treated differently Distortions of competition, distortions between sectors, impacts on the Common Market, scope of covered industries

29. New entrants Directive obliges MS to include rules for new entrants in NAPs Commission�s guidance note Buying Auctioning Reserve + free allocation Commission�s position: Having new entrants pay satisfies equal treatment because new entrants do not incur stranded costs, and subsequently benefit from free allocation => cost burden limited

30. Not affording equal treatment can give rise to: Direct financial disadvantage Barriers to entry Higher consumer prices X-inefficiency

31. Equally authentic language versions of the Directive differ in clarity Obligation to take into account the need�(England) Necessity to keep allowances available� (Netherlands) Substantial differences in relative size of new entrance reserves Different strategies to deal with depletion of reserves Incumbent top performers can receive up to 10% more allowances while new entrants cannot

32. MS seek to attract new entrants Allocation for free makes environmentally friendly technology less attractive Need for scrutiny and harmonization

33. Windfall profits Overcompensating incumbents for stranded costs is seen as �unfair� Ability to generate windfall profits is unevenly distributed Dependent upon demand elasticities Competition on the market

34. Closure and transfer rules The European legislator did not regulate discontinuation of production and not address transfers from one plant to another MS enjoy discretion Distortions of competition Environmental incentives

35. Netherlands Scraping production or transfer => retaining of allowances for the whole period (2005 - 2007) Receiving allowances on different production statistics Operator may enjoy new entry benefits from another MS => comparative advantage vs. new entrants and incumbents

36. Germany Transfer => retaining of allowances for 1 year only if replacement installation in Germany Eligibility -> distortions of competition Free movement of companies (?)

37. Summary The EU ETS does not (yet?) provide a stable and sufficiently high market price that encourages environmentally friendly research and investment Over allocation Information asymmetry Sobering experience of 1st trading phase but price of 2nd period is strongly positive

38. Substantial amounts of CDMs and JIs Environmental effectiveness? Distortions of competition Sufficient cost incentive? Clear preference for free allocation Heterogeneous interpretation of the Directive Distortions of competition Differential treatment of new entrants Diverging Closure and transfer rules Windfall profits

39. Possible ways to move forward

40. Policy considerations

41. Grandfathering: Support of covered sectors MS are able to protect domestic interests Lack incentives for operators to reveal true valuations => information asymmetry Environmental effectiveness questionable if EAU price is low

42. Performance Standard Rate Credit and trade approach No Windfall profits No unequal treatment of new entrants No distortions from closure and transfer rules Emphasizes competition on the merits Credit and trade criticized as less efficient than cap and trade Relative targets more acceptable

43. PSR and EU ETS PSR must operate under cap-and-trade Long trading period reduces rent seeking costs Effective adjustments of benchmarks Ex post adjustments Emissions dependent upon production => no direct link between installation and EAU to be allocated at the start of the trading period => at odds under current ex post interpretation

44. PSR preferable to grandfathering Contingent upon Rent seeking costs Costs of negotiations Benchmark adjustment costs Benefits of exposed sectors vs. disadvantages of sheltered sectors?

45. PSR May mitigate / avoid some shortcomings of grandfathering May foster support of industry Political support? Rent seeking costs / operating costs? Information asymmetry remains

46. Only market based instruments can overcome information asymmetry Auctions gain more attention in the second trading period but remain limited to 10% under the present Directive Lack of political support Lack support of industry

47. Thank you for your kind attention!