Under the 'cap and trade' principle, a maximum cap is set on the total amount of greenhouse gases that can be emitted by all participating installations. Installations must monitor and report their CO 2 emissions, ensuring they hand in enough allowances to the authorities to cover their emissions. If emission exceeds what is permitted by its allowances, an installation must purchase allowances from others. Conversely, if an installation has performed well at reducing its emissions, it can sell its leftover credits.
This allows the system to find the most cost-effective ways of reducing emissions without significant government intervention. The scheme has been divided into a number of "trading periods".
The second trading period ran from January until December , coinciding with the first commitment period of the Kyoto Protocol. The third trading period began in January and will span until December This target has been reached six years early as emissions in the ETS fell to mln tonnes in The EU ETS has seen a number of significant changes, with the first trading period described as a 'learning by doing' phase.
Overall, since its conception, the EU ETS has been characterized by relatively high levels of policy uncertainty. As a result, the scheme has resulted in a rather informal and tepid response by regulated organizations. The "Linking Directive" allows operators to use a certain amount of Kyoto certificates from flexible mechanism projects in order to cover their emissions. These Certified Emission Reductions CERs can be obtained by implementing emission reduction projects in developing countries, outside the EU, that have ratified or acceded to the Kyoto Protocol.
The implementation of Clean Development Projects is largely specified by the Marrakech Accords , a follow-on set of agreements by the Conference of the Parties to the Kyoto Protocol. The legislators of the EU ETS drew up the scheme independently but called on the experiences gained during the running of the voluntary UK Emissions Trading Scheme in the previous years,  and collaborated with other parties to ensure its units and mechanisms were compatible with the design agreed through the UNFCCC.
Those countries then allocate allowances to their industrial operators, and track and validate the actual emissions in accordance with the relevant assigned amount. They require the allowances to be retired after the end of each year. Like any other financial instrument , trading consists of matching buyers and sellers between members of the exchange and then settling by depositing a valid allowance in exchange for the agreed financial consideration.
Much like a stock market , companies and private individuals can trade through brokers who are listed on the exchange, and need not be regulated operators. When each change of ownership of an allowance is proposed, the national registry and the European Commission are informed in order for them to validate the transaction. However, the EU was not able to link trades from all its countries until because of its technical problems connecting to the UN systems.
The total number of permits issued either auctioned or allocated determines the supply for the allowances. The actual price is determined by the market. Too many allowances compared to demand will result in a low carbon price, and reduced emission abatement efforts.
The first and foremost criterion is that the proposed total quantity is in line with a Member State's Kyoto target. Of course, the Member State's plan can, and should, also take account of emission levels in other sectors not covered by the EU ETS, and address these within its own domestic policies. This approach has been criticized  as giving rise to windfall profits , being less efficient than auctioning, and providing too little incentive for innovative new competition to provide clean, renewable energy.
To address these problems, [ citation needed ] the European Commission proposed various changes in a January package, including the abolishment of NAPs from and auctioning a far greater share ca. From the start of Phase III January there will be a centralised allocation of permits, not National Allocation Plans, with a greater share of auctioning of permits. Allocation can act as a means of addressing concerns over loss of competitiveness , and possible "leakage" carbon leakage of emissions outside the EU.
Leakage is the effect of emissions increasing in countries or sectors that have weaker regulation of emissions than the regulation in another country or sector. Correcting for leakage by allocating permits acts as a temporary subsidy for affected industries, but does not fix the underlying problem. Border adjustments would be the economically efficient choice, where imports are taxed according to their carbon content.
Within a certain trading period, banking and borrowing is allowed. For example, a EUA can be used in banking or in borrowing. Interperiod borrowing is not allowed. However, the prior existence of the UK Emissions Trading Scheme meant that market participants were already in place and ready. In , carbon prices for the trial phase dropped to near zero for most of the year.
Meanwhile, prices for Phase II remained significantly higher throughout, reflecting the fact that allowances for the trial phase were set to expire by 31 December Verified emissions show a net increase over the first phase of the scheme. For the countries for which data was available, emissions increased by 1. Consequently, observers have accused national governments of abusing the system under industry pressure, and have urged for far stricter caps in the second phase — The second phase —12 expanded the scope of the scheme significantly.
Although this was a theoretical possibility in phase I, the over-allocation of permits combined with the inability to bank them for use in the second phase meant it was not taken up. The full activation process will include the migration of over 30, EU ETS accounts from national registries. Aviation emissions were to be included from The airline industry and other countries including China, India, Russia, and the United States reacted adversely to the inclusion of the aviation sector.
The EU insisted that the regulation should be applied equally to all carriers, and that it did not contravene international regulations. In the absence of a global agreement on airline emissions, the EU argued that it was forced to go ahead with its own scheme.
But only flights within the EEA are covered; international flights are not. Ultimately, the Commission intended that the third trading period should cover all greenhouse gases and all sectors, including aviation, maritime transport, and forestry. The annual Member State CO 2 yearly allowances in million tonnes are shown in the table:. Additional installations and emissions included in the second trading period are not included in this table but are given in the sources.
Prices for EU allowances for December delivery dropped 8. The market had been oversupplied with permits. In July , Thomson Reuters Point Carbon stated that it considered that without intervention to reduce the supply of allowances, the price of allowances would fall to four Euros. As well as more sectors and gases included in Phase III.
Also, millions of allowances set aside in the New Entrants Reserve NER to fund the deployment of innovative renewable energy technologies and carbon capture and storage through the NER programme,one of the world's largest funding programmes for innovative low-carbon energy demonstration projects. Phase IV will commence on 1 January and finish on 31 December The European Commission plans a full review of the Directive by Connie Hedegaard, the EU Commissioner for Climate Change, hoped "to link up the ETS with compatible systems around the world to form the backbone of a global carbon market" with Australia cited as an example.
Before the European Council summit on 20 March ,  the European Commission decided to propose a change in the functioning of the carbon market CO2 permits. The reserve would operate on predefined rules with no discretion for the Commission or Member States. The European Parliament and the European council informally agreed on an adapted version of this proposal, which sets the starting date of the MSR to so already in Phase III , puts the million backloaded allowances in the reserve and reduces the reaction time of the MSR to one year.
This adapted proposal has already passed the European parliament and is to be approved by the Council of ministers in September Emissions in the EU have been reduced at costs that are significantly lower than projected,  though transaction costs are related to economies of scale and can be significant for smaller installations.
It was suggested that if permits were auctioned, and the revenues used effectively, e. However, some governments and industry representatives lobby for their inclusion. The inclusion is currently opposed by NGOs as well as the EU commission itself, arguing that sinks are surrounded by too many scientific uncertainties over their permanence and that they have inferior long-term contribution to climate change compared to reducing emissions from industrial sources. A phishing scam is suspected to have enabled hackers to log into unsuspecting companies' carbon credit accounts and transfer the allowances to themselves, allowing them to then be sold.
The European Commission said it would "proceed to determine together with national authorities what minimum security measures need to be put in place before the suspension of a registry can be lifted".
Maria Kokkonen, EC spokeswoman for climate issues, said that national registries can be reopened once sufficient security measures have been enacted and member countries submit to the EC a report of their IT security protocol. The Czech registry said there are still legal and administrative hurdles to be overcome and Jiri Stastny, chairman of OTE AS, the Czech registry operator, said that until there is recourse for victims of such theft, and a system is in place to return allowances to their rightful owners, the Czech registry will remain closed.
Registry officials in Germany and Estonia have confirmed they have located , allowances stolen from the Czech registry, according to Mr. The security breaches raised fears among some traders that they might have unknowingly purchased stolen allowances which they might later have to forfeit.
In December a German court sentenced six people to jail terms of between three years and seven years and 10 months in a trial involving evasion of taxes on carbon permits. A French court sentenced five people to one to five years in jail, and to pay massive fines for evading tax through carbon trading.
Seinen also commented that the EU ETS needed to be supported by other policies for technology and renewable energy. According to CCC , p. Researchers Preston Teeter and Jorgen Sandberg have argued that it is largely the uncertainty behind the EU's scheme that has resulted in such a tepid and informal response by regulated organizations.
Their research has revealed a similar outcome in Australia, where organizations saw little incentive to innovate and even comply with cap and trade regulations. This drove the carbon price down to zero in CCC, , p. This problem naturally diminishes as the cap tightens. Over-allocation does not imply that no abatement occurred.
Even with over-allocation, there was theoretically a price on carbon except for installations that received hundreds of thousands of free allowances. For some installations, the price had a some effect on emitters' behavior. In September Thomson Reuters Point Carbon calculated that the first Kyoto Protocol commitment period had been oversupplied by about 13 billion tonnes According to Newbery , the price of EUAs was included in the final price of electricity.
Newbery wrote that "[there] is no case for repeating such a wilful misuse of the value of a common property resource that should be owned by the country". The price of emissions permits tripled in the first six months of Phase I, collapsed by half in a one-week period in , and declined to zero over the next twelve months.
Such movements and the implied volatility raise questions about the viability of this trading system to provide stable incentives to emitters. This criticism has face validity. In future phases, measures such as banking of allowances and price floors may be used to mitigate volatility. Nonetheless, producers and consumers in those markets respond rationally and effectively to price signals.
Newbery commented that the EU ETS was not delivering the stable carbon price necessary for long-term, low-carbon investment decisions. CERs and ERUs from nuclear facilities and from land use, land use change and forestry may not be used. The main theoretical advantage of allowing free trading of credits is that it allows mitigation to be done at least-cost CCC, , p. In terms of the UK's climate change policy, CCC , noted three arguments against too great a reliance on credits:.More...