Go to Brussels and you will go so far get only half an answer

The EU Emissions Trading Scheme (ETS) formally opened on 1 January 2005, and involves about 12,000 installations in the energy and energy-intensive industrial sectors, including power generation, oil refineries, coke ovens, steel manufacturing, and production facilities of cement, lime, glass and glass fibre, ceramics, and pulp and paper above a certain size. Together they are responsible for about 50% of EU carbon dioxide emissions.

There are three basic principles underlying the ETS. First, it is a cap-and-trade scheme, meaning that the number of emission allowances is fixed in absolute terms. Second, the emission allowances granted under the ETS should be consistent with countries’ overall greenhouse gas emission commitments under the Kyoto Protocol over the period 2008-12. Third, it should be consistent and link in with the Kyoto flexible mechanisms (Joint Implementation and the Clean Development Mechanism) for allowing countries to undertake emissions reductions abroad, which the European so-called Linking Directive agreed.

The first phase of the scheme runs from 2005-07, while phase 2 coincides with the Kyoto commitment period of 2008-12. Emission allowances are being allocated in EU member states on the basis of national allocation plans (NAPs), usually free of charge, although there is a small provision for auctioning allowances (a maximum of 5% in phase 1 and 10% in phase 2).

The key target unit for the ETS is the installation itself. At the end of each year eligible installations must possess emission allowances (EAs) corresponding to their audited emissions. Those with emissions excess to their allocation must purchase allowances from those with a surplus. Excess EAs may be banked at the end of each year (but not across phases). Failure to present enough EAs to cover emissions at the end of one year will incur a fine (€40/tCO2 in phase 1, €100/tCO2 in phase 2) and roll the emissions reduction commitment over to the next year.

National registries (NRs) keep an account of all emissions held and traded within EU member states; at EU level a community transaction log tracks all trades, including between countries; each member state has a competent authority (the Environment Agency and Scottish Environmental Protection Agency in Great Britain) to run the NR. Linkages with the Kyoto Protocol are intended to allow trades outside the EU, which should reduce allowance prices.

The price of emission allowances depends on a number of factors, including the initial allocation, international linkages outside the EU, economic growth, the treatment of new entrants, the relative prices of coal and gas, and the cost of abatement.

The number of factors, and the link to fuel prices, means that volatility in the allowance price is likely — and so it has proved. Typical early estimates of the price of emission allowances were €5-10/tCO2 over 2005-07, and €10-15/tCO2 from 2008-12. The price in April 2006 reached €30/tCO2 before crashing to €9/tCO2 towards the end of the same month. By June it was trading around €15-17/tCO2. The graph over the page shows the evolution of allowance prices over time, noting significant events in the development of the carbon market.

The ETS will result in both gains and losses for companies. Net gainers will be those firms which have low emissions relative to their initial allocation, low costs of abatement, an ability to pass on cost increases to their consumers and low exposure to the power generation sector. Net losers will display opposite characteristics.

Despite the fact that emission allowances have been allocated to installations free of charge, economists are generally agreed that, because they are part of the marginal cost of generation once the allowances have value, their cost would enter into companies’ pricing decisions and be passed on to consumers if possible.

There is now general agreement that this is happening to some extent in all sectors, but most particularly in power generation, with the sector being perceived as making substantial windfall profits — a recent report for the DTI put the figure at £800m per annum over phase 1 for the UK power sector.

It is not clear, and may never be, how much the price of emission allowances has affected electricity prices. However, the likely rise in electricity prices is the most significant indirect effect of the ETS on other sectors. Early estimates were that the price rises might be 4% for households and 10% for industry.

Despite this rise, other sectors in the ETS are likely to have increased profitability because of their ability to increase their prices to reflect the price of the allowances they have been given. In contrast, the aluminium sector, which is outside the ETS, is likely to experience reduced profitability because of the rise in electricity prices.

The ETS, and higher power prices, have raised concerns about the competitiveness of EU industry. In addition to costs, effects on competitiveness depend on exposure to competition from non-EU firms, and perhaps on differences in implementing the ETS within the EU. There is general agreement that the sector most vulnerable to non-EU competition as a result of the ETS is the aluminium sector. Intra-EU trade effects from the ETS are uncertain, but modelling suggests that they are likely to be small. The most sensitive sectors in the UK seem to be steel and cement, in terms of different decisions about allocation across countries, and steel, food, chemicals, and pulp and paper, in addition to aluminium, as a result of electricity price increases.

The implementation of the ETS has not been without its problems, including a legal spat between the UK government and the European Commission over the UK allocation plan (the UK won the legal battle but the Commission seems to have won the war by rejecting the UK attempt to revise its emissions allocation upwards).

Twelve months into the scheme, six national registries had still not opened, and because these involved new member states, which were expected to be net sellers of allowances, this resulted in allowance prices higher than they would otherwise have been. Both the implementation of the community transaction log and the transposition of the Linking Directive into national law are proving slow. It will not be possible to judge the overall effectiveness or success of the scheme until it is properly bedded down.

Most importantly, however, the situation post-2012, after phase 2, is still very unclear, which can do nothing but deter investments in carbon reduction that need carbon prices beyond that date in order to be viable.

For phase 2, it has been suggested by both the UK government and the European Commission that aviation should be brought into the ETS, but it has not been decided on what terms, and there is dispute over the likely impact of this on allowance prices — the key variable is whether the expected growth of aviation is reflected in its allocations, or the resulting increased number of emissions allowances has to be bought from other sectors.

In conclusion, it seems unlikely that even electricity price increases of 12% for households and 25% for industry by 2010 will have a major impact on their welfare or competitiveness, but this may not be the case for energy-intensive firms, especially those outside the ETS.

It is also not likely to be the case for fuel-poor households, especially when this impact is added to those of other measures — for example, in the UK, from the Renewables Obligation and the Energy Efficiency Commitment (although measures under the latter will also reduce some households’ fuel bills).

Concerns about intra-EU market distortions from the ETS could be removed by allowing a greater role for the auctioning of emission allowances in future phases. This would also remove the problem of windfall profits, but could exacerbate competitiveness concerns, and would certainly raise new questions about how to recycle auction revenues.

Of course, greater international buy-in for the need for emissions reductions, especially from the US, but also from major developing countries, would go far to alleviate concerns about extra-EU competitiveness and trade effects, and about the possible displacement of carbon emissions abroad.

The single most important determinant of the future success of the scheme is the generation of clarity about the status of the carbon market post-2012, but it is not clear how this can come about, given its dependence on slow-moving and uncertain international negotiations.

Finally, it is important to remember that the ETS only covers 50% of carbon emissions, and none yet from the transport and household sectors. A cost-effective carbon-abatement strategy will need to get emission reductions from these sectors as well.

Paul Ekins is Head of the Environment Group at the Policy Studies Institute, and Professor of Sustainable Development at the University of Westminster.