The EU’s Emissions Trading Scheme as a Climate Protection Instrument. How it Works and How to Improve it

Term Paper, 2021

14 Pages, Grade: 1,0


Table of Contents

Table of abbreviations

Table of figures

1 Preface and Approach

2 Emissions Trading in General

3 The Current System in the EU

4 Evaluation

5 Tangible Problems and Possible Improvements

6 Conclusion


Table of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of figures

Fig. 1 ICAP ETS Allowance Price Chart

Fig. 2: Average price per CO2e

1 Preface and Approach

"It is unequivocal that human influence has warmed the atmosphere, ocean and land. Widespread and rapid changes in the atmosphere, ocean, cryosphere and biosphere have occurred."1 This quote is part of the sixth climate assessment report, which was produced by a collaboration of more than 100 scientists worldwide.2 It shows the importance of addressing climate change and is one reason this paper will concern itself with emissions trading schemes. First of all, emissions trading in general will be examined. Next, the European Union's implementation of such schemes will be investigated more closely.

2 Emissions Trading in General

Simply put, emissions trading is a governmental instrument or framework to reduce pollutant emissions. While such trading has seen popularity in recent years, the broad concept has been around for quite some time. In 1968, Canadian economist John Dales argued that a government should issue a certain number of pollution rights certificates and offer them for sale, while at the same time enacting a law mandating anyone discharging a certain amount of waste in a given year to own one or more pollution rights for the whole year.3 He further argued that this framework would benefit by having the price determined by competition between buyers and sellers of rights rather than a person or authority.4 The fundamental idea behind emissions trading has remained the same to this day. At the end of the 1960s, the United States of America were the first to experiment with governmental trading schemes.5,6,7 During the Carter administration, the US Environmental Protection Agency (EPA) continued to expand these pollution control mechanisms, notably using them to reduce and ultimately stop the use of leaded petrol in the 1980s.8 Emissions trading schemes continued to be popular in the US and were used by the following administrations. When climate change, global warming, and their connection to carbon emissions became apparent, trading systems to reduce carbon emissions were put forth. In 1988, the Project 88 Initiative recommended creating a global carbon trading system to manage greenhouse gas (GHG) emissions.9 Other economists also advocated this as the best possible approach.10,11 It was argued that such a market would be the most practical and feasible method to reduce GHG emissions12 while also having the highest chance of success.13 Since then, many such markets have been implemented. Among them are California's cap-and-trade programme, created in 2013 and covering 85% of the state's greenhouse gas emissions,14 and New Zealand's "Climate Change Response (Emissions Trading) Amendment Act", passed in 2008.15 Most recently, China launched its national emissions trading scheme in 2021, setting in motion one of the world’s biggest carbon markets.16

3 The Current System in the EU

The European Union's Emissions Trading Scheme, launched in 2005, is the Union's main effort to combat climate change. Additionally, it was the first ETS put in place by a governmental body.17 It applies to 27 countries within the EU and the European Economic Area-European Free Trade Association (EEA-EFTA), covering approximately 40% of emissions.18 For a long time, the EU ETS was the most significant trading scheme, but this title has recently been taken over by China’s ETS, moving Europe’s scheme to the second position.19,20 The Greenhouse Gases covered by the ETS are carbon dioxide (CO2), nitrous oxide (N2O), and perfluorinated compounds (PFCs). To measure these GHGs, the term "carbon dioxide equivalent" (CO2e) is used. This includes the emissions mentioned above and helps to calculate the total climate change impact.21 The price is therefore measured as price, in this case, euros, per tonne of CO2e. Each year the market is given a cap or a total of allowances in circulation (TNAC), which indicates the maximum amount of GHGs or CO2e which may be emitted and therefore traded. This is usually measured in megatonnes of carbon dioxide equivalent (MtCO2e).22

Abbildung in dieser Leseprobe nicht enthalten

Fig. 1 ICAP ETS Allowance Price Chart23

Open trading started in 2008. At this point, the price was at approximately 20 € per CO2e. In the following years, the price fell to its lowest point at 2.68 € per CO2e. Currently (30.09.2021), the price has reached its highest value yet, which at 64.32 € per CO2e is at least 20 € more expensive than any of the other programmes. The average value of the EU ETS is 14.51 € per CO2e. putting the EU trading scheme in third place regarding pricing.

Abbildung in dieser Leseprobe nicht enthalten

Fig. 2: Average price per CO2e24

The Union’s scheme is divided into four different phases.

Phase One was active from 2005 until 2007 and was seen as a test phase. Emissions from industry, power stations, and other combustion installations were included.25 Many of the certificates were distributed for free by EU member states. Additionally, the market cap was set relatively high (2,096 MtCO2e) in comparison to the later phases, which led to a small impact overall.26

Phase Two followed and was active from 2008 until 2012. In addition to the previous emissions, the aviation sector was added at the end of this phase. Additionally, some countries added N2O to the covered emissions. Iceland, Liechtenstein, and Norway joined the EU ETS at this point in the program.27 The market cap, now at 2,049 MtCO2e, was reduced slightly. However, due to many licences still being allocated for free, prices remained low in this period.28

Phase Three lasted eight years, from 2012 to 2020, during which time the covered emissions were extended to include more production facilities. For the first time in the Union’s trading scheme, the market cap was repeatedly lowered throughout this Phase. It started at 2,084 MtCO2e and was reduced linearly by 1.74%, leading to a cap of 1,816 MtCO2e in 2020. Additionally, most allowances in this phase were not distributed for free but auctioned off.29 This led to the previously discussed rise in pricing, particularly at the end of this phase. This timeframe also saw the implementation of the Market Stability Reserve (MSR), which commenced in late 2019.30 The MSR’s purpose is to lessen supply-demand imbalances within the EU carbon market and stabilise the EU ETS. The way it works is relatively simple: Every year, if TNAC exceeds 833 million, 12% (24% after 2023) of the allowances are moved from the total number of allowances in circulation to the Market Stability Reserve. If TNAC is lower than 400 million, 100 million allowances are moved from MSR back to the open market through auctions.31

Phase Four will be the most prolonged yet, spanning over 9 years from 2021 until 2030. In this phase, the emissions cap will again decline linearly at a rate of 2.2% and a starting value of 1,572 MtCO2e. The current intention is that the cap will continue to decline at the same rate even after 2030. There is no minimum value that might end the decline other than zero. It should be noted that, due to Brexit, emissions from UK entities were removed from the EU ETS in 2021.32 Nevertheless, the low starting cap, the steep rate of decline, and the sparing use of free allowances led to the highest price the EU ETS has yet seen. If Phase Four remains unchanged, the emissions cap will reach 1,260.74 MtCO2e in 2030, and the zero value will be reached in 2066.

In addition to reducing GHG emissions, the Union’s scheme also generates revenue. In November 2021, the total collected revenue was measured at 69.7 billion Euros. Member States are required to use at least 50% of this revenue for climate- and energy-related purposes.33 In 2021, Phase Four also saw the establishment of two European funds to support low-carbon investments. The Innovation Fund supports innovative breakthrough technologies, and will be funded in part by selling at least 450 million allowances throughout Phase Four.34 It is set to continue until 2030, giving out flexible funding up to one billion euros in total to large-scale clean-technology projects. Potential projects may receive funding for up to 60% of costs connected to low-carbon innovations and are evaluated by an independent external commission.35 The Modernisation Fund prioritises the generation and use of electricity from renewable sources, modernising energy systems, and improving energy efficiency (fossil fuel installations are exempt), energy storage, and modernisation of energy networks, especially in the lower-income member states. It is also meant to support a socially just transition to a low-carbon economy. At least 70% of the Modernisation Fund resources are to be spent on these priority investments; other investments are possible, but an extensive assessment will then be necessary.36 2% of the total revenue in Phase Four will be used to accumulate capital for the Modernisation Fund.37

4 Evaluation

Overall, the EU ETS has shown success and potential in its first 17 years of its existence. GHG emissions covered by the ETS have decreased approximately 43% in total38 since the scheme was introduced in 2005.39 In November 2020, the European Commission reported positive results.40 According to the Commission, "In 2019, [GHG] emissions from EU ETS-covered installations marked a historical fall of 9.1% compared to 2018."41 However, the report also highlights that aviation emissions, while not as high as in previous years, have continued rising rather than falling. In 2019, included aviation emissions were 1% higher compared to 2018. Overall the total rise of these emissions was 27.5% from 2013, when they were first added, until 2019.42 The 2021 report paints a different picture. In 2020, the covered GHG emissions decreased dramatically by 63%,43 this, however, can be attributed to the effects of the COVID-19 pandemic and is not likely to continue. Additionally, 2020 also saw another record decrease in overall covered GHG emissions at 11.4%.44 While some of those reductions must undoubtedly also be attributed to the effects of the pandemic, it is unclear how much of it was due to the Union’s scheme. As previously discussed, the CO2e price has seen a more or less steady rise since approximately 2018, which can be attributed to the introduction of the MSR and the changes in Phases Three and Four. Higher prices generally increase the positive environmental impact, but the economic impact must also be considered. This is one of the reasons why the commission started the MSR, which in theory should be able to absorb drastic changes in pricing. The two funds previously discussed also showed a promising start in 2020. The European Commission calculated a funding pool of at least 20 billion euros for Phase 4 (2020-2030). In October 2020, 15 large-scale projects had received a total of 4 million euros of Project Development Assistance funding, with a total of 1 billion euros available for future funding and other large-scale projects. In addition, 32 small-scale projects were selected to receive a total of 118 million euros.45 Meanwhile, the Modernisation Fund is set to pool approximately 25 billion in Phase 4. As of October 2021, funding of 304 million has been confirmed for six multiannual schemes.46 This could be a vital step towards a low-carbon or carbon-neutral Europe, but unfortunately, the projects and funds are in too early a stage to evaluate the long term impact. With the exit of Great Britain from the EU, the EU ETS membership has been reduced to 27 states and selected power stations in Northern Ireland.47 The link between the Swiss and European ETS in early 2020 looks like a promising start in enlarging the scheme.48 Nevertheless, the short run time of the combined programme offers little data and is hard to evaluate in more detail. As mentioned before, the European ETS does not cover all GHG emissions. In fact, as of October 2021, only 36% of the EU's emissions are covered. This proportion is even less than in 2012, when approximately half of emissions were covered.49 Additionally, in 2020 a total of 753 CO2e certificates, approximately 40% of the overall market cap of 1.8 billion CO2e allowances, were given out for free.50 This was done partly to avoid carbon leakage, that is, to stop companies and activities from moving outside of EU territory, leading to higher emissions. The European Commission also argues that "electricity production was not eligible for free allowances, and the free allocation to industry was based on performance benchmarks to strengthen the incentives to reduce GHG emissions and increase innovation."51 However, this still means that of the mere 36% of emissions covered by the ETS, certificates covering 40% were given out for free, resulting in a total of only 14.4% of emissions being paid for. Furthermore, the so-called indirect carbon cost compensation allows EU ETS member states to grant state aid to compensate some electro-intensive industries for carbon costs arising from indirect emissions. This is done to help companies cope with price changes brought on by the ETS. The total indirect cost compensation paid out by the member states in 2020 for costs incurred in 2019 amounted to approximately EUR 1.4 million.52 Considering the revenue in 2020 reached 19 billion euro,53 this can be disregarded.


1 Masson-Delmotte et al. 2021, p. 5

2 Cf. Masson-Delmotte et al. 2021, p. 1

3 Dales 1968, p. 801

4 Dales 1968, p. 801

5 Cf. Burton et al. 1968, p. 227 et seq.

6 Cf. Burton et al. 1969, p. 48 et seq.

7 Cf. Burton et al. 1969, p. 227 et seq.

8 Cf. Gorman et al. 2002, p. 304

9 Cf. Stavins 1988, p. 19 et seq.

10 Cf. Swisher 1989, p. 466

11 Cf. Victor 1991, p. 213

12 Cf. Victor 1991, p. 214

13 Cf. Grubb 1989, p. 70 et seq.

14 Cf. Hsia-Kiung et al. 2014, p. 1

15 Cf. New Zealand, Ministry for the Environment, 2008

16 Cf. ICAP, China National ETS 2021, p. 1

17 Cf. Kossoy et al. 2012, p. 40

18 Cf. ICAP, EU ETS 2021, p. 1

19 Cf. ICAP, EU ETS 2021, p. 1

20 Cf. ICAP, China National ETS 2021, p. 1

21 Cf. ICAP, EU ETS 2021, p. 2

22 Cf. EU Directive 2008/101/EC, 2008

23 Cf. ICAP, ETS-prices, 2021

24 Cf. ICAP, ETS-prices, 2021

25 Cf. ICAP, EU ETS 2021, p. 2

26 Cf. ICAP, EU ETS 2021, p. 3

27 Cf. ICAP, EU ETS 2021, p. 2

28 Cf. ICAP, EU ETS 2021, p. 3

29 Cf. ICAP, EU ETS 2021, p. 2

30 Cf. ICAP, EU ETS 2021, p. 6

31 Cf. EU Commission, TNAC publication, 2020, p.1 et seq.

32 Cf. ICAP, EU-ETS 2021, p. 3

33 Cf. ICAP, EU-ETS 2021, p. 7

34 Cf. ICAP, EU-ETS 2021, p. 7

35 Cf. EU Commission, EU-ETS Report, 2020, p. 22 et seq.

36 Cf. EU Commission, EU-ETS Report, 2020, p. 23

37 Cf. ICAP, EU-ETS 2021, p. 7

38 To October 2021

39 Cf. EU Commission, EU-ETS Report, 2021, p. 42

40 Cf. EU Commission, EU-ETS Report, 2020, p. 41

41 EU Commission, EU-ETS Report, 2020, p. 41

42 EU Commission, EU-ETS Report, 2020, p. 41

43 EU Commission, EU-ETS Report, 2021, p. 43

44 EU Commission, EU-ETS Report, 2021, p. 42 et seq.

45 EU Commission, EU-ETS Report, 2021, p. 19

46 EU Commission, EU-ETS Report, 2021, p. 19 et seq.

47 EU Commission, EU-ETS Report, 2021, p. 4

48 EU Commission, EU-ETS Report, 2021, p. 36 et seq.

49 EU Commission, EU-ETS Report, 2021, p. 4 et seq.

50 EU Commission, EU-ETS Report, 2021, p. 10 et seq.

51 EU Commission, EU-ETS Report, 2021, p. 10

52 Cf. EU Commission, EU-ETS Report, 2021, p. 20 et seq.

53 Cf. EU Commission, EU-ETS Report, 2021, p. 14

Excerpt out of 14 pages


The EU’s Emissions Trading Scheme as a Climate Protection Instrument. How it Works and How to Improve it
Baden-Wuerttemberg Cooperative State University (DHBW)
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ISBN (Book)
The EU’s emissions trading scheme as a climate protection instrument, emissions trading scheme, emission trading, Europe, EU, Climate, climate protection instrument, emissions trading scheme as a climate protection instrument, climate change, Emissionshandelssystem, Emissionshandel, EU Emissionshandel, CO2, Klimawandel, Klima
Quote paper
Lukas Melhus (Author), 2021, The EU’s Emissions Trading Scheme as a Climate Protection Instrument. How it Works and How to Improve it, Munich, GRIN Verlag,


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