In 1997 dozens of countries worldwide signed the Kyoto Protocol, which set the first binding targets for reducing global greenhouse gas (GHG) emissions. It also created incentives for how these targets could be reached. Although the United States was initially among the strongest advocates of international emissions trading, it was the European Union that actually first put such a system in place.
Approved in 2003, the European Union Emissions Trading Scheme (ETS) is the largest market of its kind. It encompasses over 11,000 industrial facilities in the energy and manufacturing sectors: from power stations and steel mills to car factories and chemical plants. Europe’s aviation sector has been in the ETS since 2012. In total, the ETS covers about 45 percent of European GHG emissions and thus about 5 percent of global emissions.
Flying with no regrets
Simple in theory
Global warming needs to be tackled globally. Consequently, it doesn’t matter where GHG emissions are cut as long as the global total declines. The principle of emissions trading is to reduce emissions where it’s most cost-effective.
The ETS obliges large energy, industrial, and aviation companies to have an emissions allowance for every metric ton of GHG they emit. The number of allowances is limited. This creates a market in which the price of allowances is determined by supply and demand. This market sends companies a price signal: at the current allowance price, does it make more sense for them to invest in climate-friendlier technology (and thus reduce their future need for allowances) or to simply keep buying allowances from other companies.
Limiting the number of allowances in circulation sets a cap on maximum total GHG emissions of companies covered by the ETS. Gradually reducing this number ought to be a fairly straightforward way of gradually decarbonizing Europe’s energy, industrial, and aviation sectors.
Thornier in practice
EU policymakers don’t want the ETS’s additional costs to place European industry at a disadvantage in global competition. Consequently, companies that compete globally receive a large proportion of their allowances at no cost.
When the ETS was first launched in 2005, all allowances were free. A company's allotment was based on its prior-year GHG emissions. In the wake of the 2008-09 economic crisis, many companies scaled back their production and thus emitted less carbon. But there was no corresponding reduction in the number of allowances issued. This created a glut in the allowance market, which led to a steep price decline.
In addition, companies were able to acquire allowances by financing climate-friendly projects in developing and emerging countries. Not all of this funding ultimately went toward the intended project, and calculating the precise climate impact of that which did proved difficult. In any case, it soon became apparent that this scheme made it easy for companies to obtain carbon allowances for little money.
All of these factors resulted in the price of one metric ton of carbon falling to below €3 in 2013. Allowances this cheap would never encourage European companies to invest in climate-friendlier technology.
Reboot in 2013
Policymakers responded with three important changes that took effect in 2013. First, the EU itself began issuing the allowances instead of the member states. It also set the maximum GHG emissions of companies covered by the ETS at 2.08 billion metric tons. This figure was to be reduced by 1.7 percent annually through year-end 2020 and by 2.2 percent annually thereafter.
Second, an increasing proportion of allowances is auctioned instead of being issued at no cost. In fact, electricity producers have had to buy all their allowances in the secondary market since 2013. Third, the schemes to offset GHG emissions in developing and emerging countries were severely restricted and, in some cases, abolished. Since 2013, the EU has taken several additional steps to reduce the number of allowances in circulation.
Since year-end 2018, carbon prices have stayed between €20 and €30 per metric ton. Carbon therefore accounts for a big share of the cost of fossil-fueled power generation. At these prices, the ETS is serving its intended purpose: it’s encouraging companies to convert to green energy, sustainable production methods, and innovation.
The ETS is now making an important contribution toward the achievement of Europe’s climate targets. By 2030, the EU’s GHG emissions are supposed to decline by 40 percent relative to 1990. Companies in the ETS will do most of the work: they’ll reduce their emissions by 43 percent. Other sectors, including households, will only reduce theirs by 30 percent.
Setting the bar higher
At the end of 2019 the European Commission decided 40 percent wasn’t enough. Its Green Deal proposes cutting the EU’s carbon emissions by 50 or even 55 percent by 2030. The ETS’s current reduction trajectory isn’t steep enough to enable Europe to meet these new, more ambitious targets. Transport, agriculture, and households will therefore have to do their part. Some form of emissions trading may make sense for them too. Currently under discussion is the inclusion of large cargo ships in the ETS.
Despite its many advantages, the ETS is just one of a suite of mechanisms to help tackle climate change. Another is a carbon tax, which 15 EU countries have already introduced (with Germany likely to follow shortly). And of course everyone in the EU has a responsibility to conserve energy and thus shrink their carbon footprint. In short, effective climate protection requires teamwork.