The EU emissions trade system

1 Introduction

The EU ETS is an ambitious project to meet the EU’s commitment to the Kyoto Protocol to reduce its greenhouse gas emissions. The aviation industry is set to enter the ETS regime on the 1st of January 2012. It is necessary to include this industry, so other industries ’t have to shoulder the entire Kyoto burden. The projected cost is significant but not disproportional. Airlines operating modern fuel efficient fleets are advantaged. The international nature of aviation and the apparent disadvantage of international carriers have provoked debates on the legality of the scheme. The short and long term impact on the strategic goals affects mainly investment in fuel efficient technologies and investment in the Clean Development Mechanism. Overall the industry is expected to notice minor demand fluctuations and invest more in emission abatement technologies.

2 The EU and the Climate

Climate change has become in recent years a subject of heated political debate. At the G8 summits of 2007 and 2009 and the G20, 2009, climate change was a top priority (European Commission, 2003 , Massai, 2011). In all instances the participants were unable to agree on a common agenda, let alone sensible emission cuts. One could even say that no major political encounter takes place without discussing climate policy (Faure and Peeters, 2008).

Regardless of the setbacks in the geopolitical arena, the EU has been a leader in climate change policies since the 90’s. The EU voiced vociferously its concern over the destruction of the ozone layer (Hansjürgens, 2005), negotiated the Climate Change Convention in 1991 (Massai, 2011) and played a key role in the enactment of the Kyoto-Protocol, 1997 (Massai, 2011). Further evidence of the EU’s commitment to prevent climate change is the pledge to the Kyoto Protocol to reduce its greenhouse gas emission (GHG) by 20% by 2020, compared with 1990 levels (Massai, 2011).

These achievements are impressive, considering that the EU is not a sovereign state, but a bloc of diverse countries. As a result the EU has arguably become the global champion for climate policy. To be credible however, it needs to prove its integrity and lead by example. A Project that aims to do just that is the EUETS. It is a unique large scale pilot project, which its proponents hope, will become the basis for international emissions trade, thus bringing the Kyoto emissions allowance system to the next level (Tuerk, 2009).

3 The EU Emissions Trade System (EUETS)

In order to meet this ambitious target the emissions trade system (ETS) has been devised as a way to gradually and effectively reduce the EU’s carbon footprint and change the economy through its incentive system (European Commission, 2003).

The EUETS is a so called “cap and trade” model where a cap is set on the maximal output of emissions cause negative externalities, as opposed to “command and control” where either a fixed allowance is granted or emissions are taxed at source. Early research on cost benefit by Tietenberg (1985), suggests a 90% reduction in administration costs using ETS and a study commissioned by the EU commission, certifies 30% (Hansjürgens, 2005).

Under the ETS framework these rights to emit are traded as certificates on a specialised market (i.e. initially allocated, in the future auctioned). At the end of the year a company must hold enough certificates to cover its emission over the year; otherwise the company is fined and required to buy the missing certificates (Faure and Peeters, 2008). The hope is that market forces will allocate these rights efficiently and that the economy as a whole will benefit. More precisely industries with a high marginal cost of emissions reduction (compared with the market value of certificates), will purchase certificates on the market, conversely industries with lower marginal emissions reduction costs will reduce emissions and sell their certificates on the market (Hansjürgens, 2005).

An emission trade system on a supranational level such as the EUETS has never been tested. Administration, enforcement and viability of the system have yet to be established. The gradual implementation however seems sensible, since the EU itself was created one step at a time.

The system is implemented in three phases: 2005- 2007, is the pilot period and intended to develop the necessary structures and gain experience. In this period only CO2certificates for selected industries are traded (11,000 installations and 30% of EU CO2Emissions) (Perdan and Azapagic, 2011). From 2008 onwards nitrous oxide certificates will be capped. In the final stage from 2013 to 2020 more greenhouse gases will be capped and more industries are required to purchase certificates. Among the most prominent and visible industries is the aviation industry.

4 Aviation in the EU ETS

In accordance with the EU ETS directives, starting from 2012 the aviation industry will need to purchase CO2certificates to cover its emissions. Lobbying, persuasion and lawsuits have not changed the EU’s intentions (The Economist, 2011b , The Economist, 2011a). This will affect the industry’s competitiveness, customer relations, strategic targets and economic development (Scheelhaase and Grimme, 2007).

Under the ETS all airlines (European and international) landing and departing from EU airports are required to surrender CO2 certificates for their emissions or be denied landing, take off or have their aircrafts impounded (Anger and Koehler, 2010). Furthermore an EU-wide CO2 cap is set to stabilise emissions levels, countries are allotted an allowance and are responsible for the administration.

In the first phase a predetermined number of certificates will be allocated and gradually phased out to be replaced by auctioning. However due to legal complications these allowances are not compatible with the Kyoto allowances. As a consequence airlines allowed to buy certificates, but only sales to other airlines are permissible.

5 The Necessity to include aviation

International aviation, according to Grimme and Scheelhase (2007) is responsible for 2.5% to 3% of anthropogenic CO2 emissions, but has hitherto escaped

1% to 5% of recently introduced taxes, such as the UK Air Passenger Duty and the German Air Passenger Tax and is overall only a fraction of a percentage of total revenue.

Reuters (2011) points out differences in free allocation of certificates between airlines (see Figure 7-1). formal emissions regulation.

Projections made by Bows et al. (2005), shows that carbon EU emission targets are not achievable if the aviation industry continues to grow and operate outside the EU ETS. The implication of not including aircrafts in the scheme is that other industries need to cut more and faster than is possible to stay competitive. The inevitable conclusion is that the global competitiveness of other industries will suffer if aviation is not held accountable for its emissions.

Further analysis done by Grimme (2007) on the impact of ETS on future profitability suggests, that no substantial losses are expected in the short to medium term.

6 Demand for air travel

According to Anger (2010) the increasing variable costs of emission certificates will reduce profit margins if the additional cost is not passed on to consumers. The extent to which consumers are willing to accept higher prices is subject to the price elasticity of demand (Zhang and Wei, 2010). It stands to reason that demand for air travel is not perfectly elastic, since substitutes are not readily available (i.e. fast, reliable and international) and according to Bloomberg (2011) due to the vast geographic market, the reduction in demand will be lower than the increase in price. In any case demand should slightly decrease, in the short term. This on the other hand will force airlines to reduce emissions in the long run (Anger and Koehler, 2010). Studies by Ernst and Young (2007) and Boon (2007) agree that prices will increase adjusted for inflation. On the basis of different assumptions such as price and method of allocation (i.e. auctioning or grandfathering) both studies present different figures, Boon’s being substantially higher than Ernst and Young’s estimates.

The overall conclusion is: ETS will increase ticket prices, reduce demand to match supply in the short term and slow but not stop industry growth in the long term. The increase in supply is explained as a result of new CO2 reduction technologies and their cost benefit. This however is only speculative.

7 Cost to the industry

Reuters Point Carbon (2011), an energy and environmental intelligence unit of Reuters, reckons that the industry will need to buy 88 million allowances beyond the free allocation of 176 million certificates in 2012. The additional purchase will amount to 1.1 billion EUR at current carbon market prices.

Research by Bloomberg New Energy Finance (2011), an intelligence unit of Bloomberg, agrees that the EU ETS is an additional cost, but represents only

illustration not visible in this excerpt

Figure 7-1: Allocation of CO2 certificates as a

percentage of predicted 2012 requirements (source (Thomson Reuters Point Carbon, 2011)

Scheduled and large long haul carriers are given comparatively more certificates than smaller flag carriers as a proportion of predicted usage.

This means that compliance costs are not spread evenly across the industry and on average EEA carriers are better served than their international counterparts. This asymmetric distribution could be regarded as anticompetitive as argued by the USA (see Part 9). However Andreas Arvanitakis points out that “long- haul carriers and those airlines with more efficient aircraft and higher load factors tend to receive more than the average. (Thomson Reuters Point Carbon, 2011)”.

Peter Hind reasons that 1.1 billion in additional costs are comparatively little considering rising fuel prices and although substantial for the industry as a whole, are not major costs for carbon efficient carriers. Carriers with obsolete fleets in need of substantial upgrade investments will suffer more (Thomson Reuters Point Carbon, 2011).

As argued by Grimme (2007) and Boon (2007) this situation will increase prices and decrease profitability, but will in the long run improve industry wide fuel and carbon efficiency.

Since carriers are allowed to buy but not sell certificates under the Kyoto regime, allowances could be increased through alternative mechanisms such as Certified Emission Reductions (CER), generated by the Clean Development Mechanism (CDM) by up to 15% of free allocations. This is reckoned to reduce the overall cost to airlines (Thomson Reuters Point Carbon, 2011).