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Emissions trading

As regulators around the world are becoming increasingly alert to the risks from climate change, companies in the industrial sectors will have to assess the impact that emissions trading regulations will have on them. Mandatory trading schemes such as the European Union’s Emission Trading Scheme (EU ETS) create compliance and financial risks for companies covered by the scheme. In the first in a series of articles on emissions trading, we look at the regulatory framework of national and multinational emissions trading schemes.

What is emissions trading?

Emissions trading arises from regulatory attempts to control pollution and to create economic incentives to reduce the emission of pollutants such as greenhouse gases.

Initiatives such as cap and trade schemes assign a cost to emissions by granting a limited number of emission allowances to designated industrial sectors and making these emission allowances a tradable commodity. They require that operators of industrial installations either keep emission levels within the limits of an assigned number of emission allowances, or purchase additional allowances to cover additional emissions, thus incurring the financial cost of emitting more greenhouse gases. Companies that reduce emissions, on the other hand, have the opportunity to benefit financially by selling any surplus allowances in the market.

Current regulations have focused on the reduction of CO2 emissions, resulting in the development of the carbon markets, where CO2 emission allowances and carbon credits are traded.

Global carbon markets accounted for trades worth €22.5 billion in 2006, corresponding to emission allowances for 1.6 billion tonnes of CO2. The majority of these transactions – 62% of the volume and 80% of the value – were traded in the EU ETS, the European Union Emission Trading Scheme. As such, the EU trading scheme, which became operational in 2005, created new assets and liabilities worth billions of euros and brought with it significant challenges for many European companies in five industrial sectors:

  1. Power and heat generation.

  2. Oil refineries.

  3. Metals.

  4. Pulp and paper.

  5. Energy intensive industries.

In order to understand the principles of the carbon market it is important to analyse the regulatory framework behind national and multinational emissions trading schemes. Although these schemes are operating independently they have been largely created in response to the Kyoto Protocol.

The Kyoto Protocol

The Kyoto Protocol is an amendment to an international treaty on global warming – the United Nations Framework Convention on Climate Change (UNFCCC). It prescribes mandatory emissions limitations for a number of signatory states in order to reduce greenhouse gas (GHG) emissions.

The Kyoto Protocol recognises that industrialised countries have been responsible for the majority of greenhouse gas emissions over the years and therefore distinguishes between industrialised countries that have agreed to reduce greenhouse gas emissions, the so-called Annex I countries, and countries in the developing world that have no obligations to reduce emissions. Several industrialised countries including the United States have not ratified the agreement.

Annex I countries are committed to reducing the aggregate emissions of six key greenhouse gases, of which CO2 is the most important, by a minimum of 5% relative to the 1990 emission levels. This reduction has to take place during the period from 2008 to 2012. The EU-15 states are committed to a collective 8% reduction, but have assigned different individual emission targets to the different EU member states. The Kyoto Protocol has been ratified by 163 countries which represent approximately 55% of global greenhouse gas emissions.

In order to reduce greenhouse gas emissions the Kyoto Protocol provides signatory states with three mechanisms:

  1. International Emissions Trading (IET)

    Under the Kyoto agreement each state is given a specified number of assigned amount units (AAUs) which corresponds to the level of gas emissions in tonnes of carbon dioxide that may be emitted during the commitment period. The Kyoto Protocol thereby effectively assigns an emissions cap to each participating country.

    After the commitment period, every country has to demonstrate its compliance with the UNFCCC by surrendering the number of AAUs that are equal to its actual emissions for the commitment period. This means that in order to comply, participating countries have several options. They can:

    • Meet the cap by reducing their own emissions to the cap level.

    • Emit more than the agreed cap and buy additional allowances.

    • Reduce emissions below the cap and sell (or bank) excess allowances.

    Countries are therefore not obliged to reduce their emissions at all. They have the option to emit more than their agreed cap. However, they will then have to buy additional AAUs equivalent to their surplus emissions under the ‘cap and trade’ system created by the Kyoto Protocol. Under this scheme AAUs can be purchased from countries that have reduced their gas emissions and, as a result, possess surplus allowances.

    Alternatively, they can be bought from individual carbon reducing projects that have generated carbon credits through one of the other two mechanisms introduced by the Kyoto Protocol: the clean development mechanism and joint implementation.

  2. The Clean Development Mechanism (CDM)

    In order to encourage developing countries to reduce GHG emissions, the Kyoto Protocol provides mechanisms for emission reducing projects. These projects, once approved under the UNCFFF by a CDM executive board, generate carbon credits which can be sold to industrialised countries, where they can be used for compliance with the Kyoto emission targets.

    The CDM covers CO2 reduction projects in countries that have no obligation to cut GHG emission under the Kyoto Protocol. It is designed to provide finance to projects which support sustainable development in these countries.

    Any GHG reduction achieved as a result of a CDM project will create carbon credits, known as certified emission reductions (CERs). CERs can be sold in international markets and used by companies or states to comply with carbon emission quotas assigned by the Kyoto Protocol. CDM projects range from increased energy efficiency and reduced industrial gas emissions to renewable energy. In order to qualify for the CDM, a project developer must demonstrate that emissions will be lower as a result of the project than they would be without the project. Once emission reductions have been independently verified, CERs will be issued.

  3. Joint Implementation (JI)

    JI follows similar principles to the CDM: one country invests in pollution abatement measures in another country (the host country) in return for credits which it may use in meeting its own pollution abatement targets. However, in contrast to the CDM, JI applies to GHG reducing projects in countries that have agreed emission reduction targets.

    Under JI, GHG reduction projects are implemented jointly between two or more Annex I countries. If a JI project reduces GHGs, the JI project will generate carbon credits known as emission reduction units (ERUs). As both partner countries have reduction obligations, the host country will convert a number of AAUs that it holds, equivalent to the emission reductions that are generated by the JI project, into ERUs. The ERUs are then transferred from the host country to the investor country. This means that JI projects do not result in additional emission rights, but merely transfer these rights from the host country to the investor country.

    ERUs may be issued to qualifying projects by the host country from 1st January 2008 and, provided certain conditions are met, they can be used for compliance purposes. The general idea behind both flexible mechanisms, JI and CDM, is that emission reductions are achieved where it is most cost-efficient. Currently most JI projects are carried out in Russia and other Eastern European countries.

The EU Emissions Trading Scheme (EU ETS)

While the emissions trading presented in the Kyoto agreement is designed with national governments in mind, most countries are free to launch their own emission trading schemes in order to meet emission targets. In practice most countries that have committed to emission reductions under the Kyoto agreement will delegate the responsibility of meeting emission targets to large national GHG emitters by assigning their emission allowances to individual industrial installations, for example refineries or power plants.

In response to its obligations under the Kyoto agreement the European Union introduced its own multinational trading scheme. The scheme is governed by the EU Emissions Trading Directive which has been transposed into national law in all EU member states.

The EU ETS covers companies from the five key industrial sectors mentioned earlier in the article. These include power and heat generation, oil refineries, metals, pulp and paper and energy intensive industries, which account for just under half of Europe’s CO2 emissions.

The scheme is a CO2 cap and trade scheme and covers over 12,000 installations in all 27 EU member states. It replicates the international emissions trading scheme of the Kyoto protocol on a corporate level and is based on the free transfer and trading of EU ETS allowances (EUAs). Each allowance effectively represents the right to emit one tonne of CO2 from an installation covered by the scheme.

Allowances are allocated to installations by national governments and their number is determined in a National Allocation Plan (NAP) which has to be approved by the EU Commission.

The role of National Allocation Plans in the EU ETS

The EU leaves it to the member states to decide how they want to reach their agreed national emission reduction targets. Emissions trading in key industries is only one of several possible methods to reduce GHG emissions. Reductions can, for example, also be achieved through measures affecting households and non-industrial companies in the services or transport industry. The National Allocation Plan (NAP) will therefore determine the extent to which emission targets have to be achieved through the trading of allowances in the EU ETS. The NAP will further determine how many allowances will be issued for each period in total and how many allowances each individual installation will receive.

The first National Allocation Plans covered a trading period from 2005 – 2007. New Allocation Plans will cover the second trading period from 2008 – 2012. This period coincides with the Kyoto Commitment period, during which all participating countries must achieve the emission cuts agreed in the Kyoto Protocol. For the time after 2012, additional five-year trading periods are envisaged by the EU.

Companies have to surrender a sufficient number of allowances each year, corresponding to their actual emission levels. Any shortfall of allowances has to be covered by the operator of the installation by either purchasing additional allowances or carbon credits created by CDM, or JI projects under the Kyoto Protocol.

The Linking Directive

The EU’s Linking Directive amends the Emissions Trading Directive and connects the EU ETS with the project-based mechanisms of the Kyoto Protocol (Clean Development Mechanism and Joint Implementation). Any carbon credits that have been generated by emission reductions (or limitations) in CDM or JI projects carried out in other countries can be imported by companies for trading and compliance in the EU ETS system.

While reductions from CDM projects have been potentially eligible to receive credits (CERs) since 2000 and can already be used in the EU ETS, credits from JI projects (ERUs) can be used from 2008. The credits will be recognised as equivalent to the EU ETS’s own emission allowances.

Why use emissions trading to achieve environmental objectives?

The general idea behind emissions trading is to assign a cost to CO2 emissions. The costs associated with EUAs are expected to create demand for innovative energy/carbon saving products, services and processes. The increased demand should, in turn, lead to more research and the development of new innovative technologies.

The main advantage of GHG emission trading, in contrast to other environmental instruments, is the ability to meet specific emission targets at minimum cost. An emissions trading system is more capable than any other instrument (eg taxes or penalties) of meeting specific environmental targets within a given timeframe. As the quantity of emission allowances is capped at the emission target, the level of actual emissions may not be higher than the number of allowances allocated to the installations covered by the trading system.

How does emissions trading work?

Various types of emissions trading schemes exist today. The most common scheme, also employed by the EU ETS, is the cap and trade method. Under the EU ETS, selected industries are assigned emission caps.

Companies are given emission allowances corresponding to their individual emissions cap. Any company that emits less than its assigned cap will be able to trade the surplus amount of allowances.

At the end of each year, every company covered by the scheme demonstrates compliance by surrendering the number of allowances that apply to the actual verified level of emissions.

If the verified emissions are higher than allocated, the shortfall has to be covered by the company by purchasing additional allowances from the market. The price of EUAs is completely unregulated and determined solely by market forces.

Issue of allowances

Allowances are assigned to individual installations according to the National Allocation Plan. In order to receive any emission allowances an installation will generally require an emissions permit, a licence to emit carbon dioxide, and will hold an account at the national registry, for emission allowances. Under EU ETS regulations each member state establishes a national registry which is connected to all other national registries as well as the Community Independent Transaction Log (CITL). Allowances are issued directly to the company’s account at the national registry.

Monitoring, reporting and verification of emissions

When applying for the emissions permit a company must submit a monitoring and reporting plan, which details how emissions will be measured and reported. Subject to regulatory approval the company will monitor and report the CO2 emissions on an annual basis. This annual emissions report must be independently verified by an accredited verifier. The verification statement and the emissions report must be submitted each year to the national regulator.

Surrendering allowances

Under the EU ETS scheme, each installation operator must surrender the number of EUAs that correspond to the actual emissions for the previous year, as determined by the company’s annual emissions report. The allowances are surrendered to the registry administrator through the company’s registry account. If insufficient allowances are surrendered within the given deadlines (for example, 30th April in the UK) the operator will be liable to a penalty of €40 per tonne of CO2. In addition any shortfall must be surrendered in the following year.

Trading of allowances

If a company believes that it will exceed its emissions cap and consequently has an insufficient number of EUAs to comply with the emission regulations at the end of the year, it has two options:

  1. Reduce carbon emissions.

  2. Purchase additional allowances (EUAs) or equivalent carbon credits (CERs or ERUs from 2008).

At the same time companies that have reduced carbon emissions, and as a result have excess allowances, have the option to sell these allowances.

Neither the Kyoto Protocol nor the EU Emissions Trading Directive has dictated how and where emission allowances and carbon credits can be traded. In both cases it has been left to the financial markets to develop solutions. The process of buying and selling allowances is very similar to the trading of shares. Currently market participants are able to trade EUAs and CERs, both over the counter or on one of several exchanges.

This means that allowances and carbon credits can be traded in the following ways:

  • Directly between two parties.

  • Through a broker who brings together buyers and sellers.

  • Through intermediaries (for example, banks and specialist traders).

  • Via an exchange (such as the European Climate Exchange).

EU ETS review

The EU ETS is currently under review by the European Commission. The scheme has come under criticism during the first trading phase. It has become apparent that National Allocation Plans over-allocated emission allowances to GHG emitters covered by the scheme. The lack of demand sent EUA prices crashing from €35 to less than €0.30 per ton of CO2, putting into question the environmental benefits of emissions trading.

While it is generally expected that NAPs have been more restrictive for phase 2 of EU ETS trading from 2008 – 2012, it is not entirely clear how much demand there will be for emission allowances. The EU ETS review will also consider expanding the scope of the scheme and will address the inclusion of other greenhouse gases (eg nitrous oxides or methane) as well as additional industries. The Commission aims to include the aviation industry in the scheme from 2011.