The Implementation of the European Trading Scheme (EU-ETS) in German SMEs and its Implication on Environmental-Innovation-Activities

Bachelor Thesis, 2014

43 Pages, Grade: 2,0


Table of content

I. Index of abbreviations

II. List of figures

1. Introduction

2. Methodology

3.1 Theoretical background: Implementation and development of the EU-ETS
3.1.1 Phase
3.1.2 Phase
3.1.3 Phase
3.2 Political asymmetry and carbon leakage

4. Status quo of the EU-ETS

5. SMEs in the German economy
5.1 Adaption of the EU-ETS within German SMEs
5.2 Environmental-innovation-activities
5.2.1 Short-term impacts of eco-innovation-activities
5.2.2 Long-term impacts of eco-innovation-activities

6. Porter hypothesis
6.1 Porter hypothesis within the EU-ETS
6.2 Criticism on Porters’ hypothesis

7. Further research

8. Conclusion

Appendix A

Appendix B

III. Bibliography

Index of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1: Efficiency enhancing effect of emissions trading

Figure 2: Traded future contracts of EUAs at the ICE, London

Figure 3: Annual Total Volume and Settlement Price at the ICE, London

Figure 4: Short-term impacts on eco-innovations

Figure 5: Europe’s handicap - Industrial energy prices in Euro cents per kWh

Figure 6: Conceptual relationship between sustainable manufacturing and eco-innovation


The implementation of the European Trading Scheme (EU-ETS) regulatory in 2005 is the consequence of the rising emission of greenhouse-gases (GHG). Currently, Europe emits about 3.74 billion tonnes pollution per year, which is high but - looking from a global angle - nevertheless below the US’ and China’s level of emissions. The reason for the increased pol­lution is the growth of demand and consequently productivity that has compound over time but needs to be stopped. The EU-ETS is Europe’s instrument to achieve the Global Tempera­ture Target, whose goal is to decrease the overall temperature by two-degrees Celsius and thereby to reduce the negative externalities for the society and in the long run for the world. Furthermore the aim of the EU-ETS is to stop the growth of emissions of greenhouse gases and to declare binding targets for 2020 in order to reduce emissions by 20 per cent compared to the level of 2005 (see Gurria, 2010, p.11). The implementation of the regulatory has marked a turning point in the European policy because it was the first time that a market- based approach of tradable permits got implemented in a cross-national way. It is the biggest implementation of a cap-and-trade scheme and the engine of the European climate policy.

The German industrial landscape is shaped by small and medium-sized enterprises (SMEs)[1] that account for approximately 99.7 per cent of all enterprises in Germany (see Bli- esner et al., 2010, p.13). Hence, around half of the German companies who need to participate in the EU-ETS are SMEs. The European Commission stated in their Enterprise and Industry Fact Sheet released in 2013 that “German SMEs continue to be more innovative and interna­tionally orientated than most of their EU partners”. As SMEs are important for German econ­omy and are innovative orientated it is especially important to investigate how they are im­plementing the above-described EU-ETS.

With the help of the linkage between these two key aspects - the innovative SMEs in the German economy and the implementation of the EU-ETS - this thesis investigates how German SMEs implement the EU-ETS in their value chain and in how far they - as a conse­quence of the EU-ETS regulatory - are developing innovations regarding pollution reducing measures. The market itself does not provide incentives to develop and to implement pollu­tion reducing technologies and that is why the EU-ETS regulatory is needed in order to create a synergy between environment and innovation. Consequently, the government has to attract

SMEs to develop environmentally related innovations (eco-innovations) which reduce harm­ful externalities. Eco-innovations are defined as “the production, application or use of a prod­uct, service, production process or management system new to the firm adopting or develop­ing it, and which implies a reduction in environmental impact and resource use throughout its life-cycle” (Mazzanti et al., 2014, p.2). As this thesis focuses on the economic impact of eco­innovation, GHG emissions encompass a wide range of pollution caused by facilities.

The aim of the thesis is to investigate the implementation of the EU-ETS in German SMEs and its implication on environmental-innovation-activities. The investigation can be split into two central research questions: Firstly, do eco-innovation-activities in SMEs benefit from the EU-ETS? Secondly, does the EU-ETS have an impact on long-term effects of eco­innovations within the SME? In particular long-term effects are of interest due to the past financial and economical crisis. Hence, economists and politicians agree:

“(...) that a paradigm change in modern capitalism is needed, from short-term profit maximization to a long-term value-creating and value-maintaining strategy. (...) The goals are to minimize the firm’s negative effects on the natural environment and socie­ty without compromising profits. (...) They [long-term value creating without com­promising profits] are compatible in the long run. They are different sides of the same coin, with innovation being the missing link between them.” (see Marcus et al., 2011, p.81)

In order to answer the research questions the first part of this paper descriptively outlines the implementation and development of the EU-ETS in correspondence to eco-innovation and subsequently constitutes the current economical implications. Hereby, the findings will be applied on the SMEs in the German economy. Furthermore, the investigation of the EU-ETS within the SMEs will be expounded by researching short-term versus long-term impacts. Ad­ditionally, the findings will be analysed with the help of the strong version of the Porter hy­pothesis that explores the effects of environmental regulatory on the economy and of the af­fected companies and furthermore investigates the double dividend of an increase in labour demand within the economy (see Goodstein and Polasky, 2014, p.43). Finally, the thesis high­lights where further research efforts have to be applied in order to gain an outlook regarding the future regulatory.

Methodologically, this thesis draws upon already existing academic literature and existing empirical data, which has been published over the past years due to the Kyoto-Protocol and the implementation of the EU-ETS. Studies from the “Mannheimer Innovationspanel” the “Centre for European economic research”, the “European Commission” and the “German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety” in particular provide holistic insights. Furthermore this thesis deals with the findings from the “CO2 Ba­rometer” which is published by the “Kreditanstalt für Wiederaufbau” (KfW) and the “Centre for European Research” (ZBW) which is analysing the situation of German companies regu­lated by the EU-ETS on an annual basis since 2009 and provides therefore detailed infor­mation about the development of the implementation. Besides the above-mentioned empirical examples, the case study “Climate Innovation - The Case of the Central German Chemical Industry” by the “Halle Institute for Economic Research” from April 2012 provides additional insights and its findings are used as a base of this thesis. Researcher Ehrenfeld made use of an open interview and gained qualitative data in order to investigate the current practice. At the beginning of September 2011 twenty-two interviews were conducted, which compromises fifteen SMEs and is limited to the energy intense Chemical Industry. The study was mainly conducted in East Germany where the lion’s share of the industry is located. The qualitative interview comprised thirty-two questions in total. The central questions were about climate relevant innovations within the companies, expectations and achievements of the innovation introduced, the potential of future innovations plus the expected importance of the EU-ETS and the arising cost pressure for enterprises. This study offers a detailed investigation of the organizational process and the implementation of the EU-ETS and is therefore useful in order to answer the central research questions of this thesis. Furthermore, the Chemical Industry is one of the largest industrial energy consumers and is always challenged to improve resource efficiency due to high competition from the Asian countries and is therefore an especially interesting case study. Nevertheless, it is important to note that this empirical case study is only used in order to comment the findings from the academic literature and to answer the question whether there is a mismatch between theory and actual practice. One disadvantage that should be noted as well is that the results are solely from the Chemical Industry and hence quantitative (statistical) generalisations cannot be made (see Ehrenfeld, 2012, p.1 ff.). з. eu-ets

The roots of the EU-ETS can be found in the Kyoto Protocol of the UN Framework Conven­tion on Climate Change (UNFCC) in 1997. The Kyoto Protocol adopted an international cli­mate protection agreement between the 39 leading industrial countries to reduce GHG (for example carbon dioxide) by five per cent in 2012 compared to the level of 1990. On a Euro­pean level an agreement was stipulated to reduce the GHG by eight per cent by 2012 com­pared to level of 1990 (see The EU Emissions Trading System, 2013, p.1 ff.). The European Commission finally introduced the EU-ETS in 2005. The idea of the EU-ETS is to reduce emissions at minimal economic costs and to create monetary incentives in order to further promote energy and carbon-efficient technologies.

The EU-ETS is a marked-based instrument and its function is based on a “cap-and- trade” basis. At the beginning of each trading period an overall emission budget for all indus­tries is given (“cap”). The specified amount is separated into tradable emission allowances (EUA) (“trade”), which allows emitting one tonne emission. In the long run this cap-and- trade-system gives companies the flexibility to adjust their emissions and adapt to new tech­nological conditions. Emission allowances (EUAs) is the “currency” of the EU-ETS and be­cause of the limitation and shifts in demand, prices are underlying volatility. Unlike taxation, which sets the price for emissions and enables the market to determine the optimal rate of pollution, the cap-and-trade-system sets an overall quantity of pollution and allows the market to determine a price. Putting value on each tonne of emission the EU-ETS has put climate change on the companies’ task-list. Lower costs for emission-savings compared to the market price of EUAs lead to investments in environmentally friendly technologies. As a result of early action towards eco-friendly technologies, companies can realize the surplus of allow­ances on the market, which explains monetary incentives. On the contrary, higher costs for emission-savings than the market price, results in an increasing demand for allowances. Hence, a rising price tendency makes investments in environmentally friendly-innovations more profitable. In consequence, this mechanism leads to a cost-efficient reduction in emis­sions (see Hertz and Lo, 2010, p.2).

Industries who need to participate in the EU-ETS due to their high emissions are pro­ducer of electricity / heat and additionally carbon dioxide intense facilities like the Chemical Industry, Steel Industry etc. (see Grüning et al., 2014, p.13). All decisions regarding the over­all EU-ETS regulatory are finalized on European level in order to prevent competitive distor- tion (see The EU Emissions Trading System, 2013, p.1 ff.). 28 European countries plus Ice­land, Liechtenstein and Norway have to participate in the EU-ETS in order to create an ho­mogenous European standard. Since 2012 the aviation industry, flights to and from the EU- ETS Countries, is part of the regulation as well. In total, around 45 per cent of Europe’s emis­sions is covered by the EU-ETS (see The EU Emissions Trading System, 2013, p.1 ff.) which highlights its importance.

3.1 Theoretical background: Implementation and development of the EU-ETS

In order to describe current phenomena[2] of the regulatory implementation of the EU-ETS, the theory of the synergies between natural capital as input goods for production and consump­tion and its effects on the social welfare has to be applied. Natural resources such as air and water are input factors that the nature provides for production and consumption. An overex­ploitation of these resources results in pollution, which is known as a negative externality. Therefore, negative externalities can be understood as external costs for people who are not involved in the polluting product or process (see Goodstein and Polasky, 2014, p.32). Assum­ing the neoclassical school of economics theory[3] full competition leads to a market pricing in supply and demand, which implicates the shortage of the good - respectively the factor of production causes market clearance. Whereas an overexploitation of the good environment shows no reaction on the market - the market mechanism fails. Therefore, environmental is­sues can also be understood as allocation problems (see Betz, 2003, p.16). From the economi­cal point of view, the market for natural inputs, which are goods such as air and water, are underpriced because of no existing legal ownership and due to the lack of limitation or regula­tion. Hence, businesses use them freely (see Goodstein and Polasky, 2014, p.33). In the case of the EU-ETS the system forces polluting industries to compensate the damages and to re­duce the GHG emission that they have imposed. The approach “internalizing the externali­ties” raises the production costs on the firm and therefore leads to a price for natural inputs. To sum it up, if all pollution industries pull their full social costs[4] of production, the price for pollution will be higher and hence the overall emissions will be lower. In the case of the the­sis, the American Environmental Economists Goodstein and Polasky claim that “(...) believ­ing that as resources become scarce, prices will rise, and human innovation will find high- quality substitutes, lowering prices once again. Neoclassical economists also tend to view nature as highly resilient; pressure on ecosystems will lead to steady, predictable degradation, but no surprises” (Goodstein and Polasky, 2014, p.144).

The following notion with the visual support of figure 1 demonstrates the impact of ra­tional emission trading. Simply speaking, the EUAs a factor of production which gives the firm the allowance to exert a harmful effect on the society. The EU-ETS gives a trading cen­tre and enables the market to value the harmful effects. Thereby EUAs can result to their highest value when a high demand occurs. A low price occurs whenever there is an exceed­ingly small demand towards EUAs on the market.

illustration not visible in this excerpt

Figure 1 : Efficiency enhancing effect of emission trading (see Brunner et al., 2008, p.5)

In this case firm A with marginal abatement costs (MAC) curve A and firm B with a relative­ly steeper MAC curve B are facing the dotted horizontal line P which implicates a cap in emission allowances. Without a market for EUAs both firms have to reduce emissions until they comply with their individual abatement obligation. This example shows that firm A faces relatively lower cost compared to firm B for a given quantity. With emission trading, firms are subject to the market and firm A increases the abatement until the marginal abatement costs converge at price P and firm B decreases the abatement until the marginal abatement costs converge at price P. The blue triangle illustrates the efficiency gain of firm A due to the increased abatement and selling the freed up allowances to firm B. The efficiency gain of firm

B is illustrated by the red triangle which demonstrates the amount of saved abatement cost net of the money paid to A (see Brunner et al., 2008, p.4 ff.).

Besides this theoretical sight, Ehrenfeld furthermore states in his case study about the Chemical Industry that next to the regulation of emissions, “gaining a competitive edge is claimed to be the most important driver in the environmental innovation literature” (Ehren­feld, 2012, p.3). In order to reduce emissions and to support environmentally friendly tech­nologies in the long run, it is necessary to implement the system carefully and anticipatory. Therefore, emission trading gives each member state the option to distribute allowances freely and thereby create a consensus. Free allowances in the beginning of the implementation and a transparent tradable price make the legislation easier. From the political point of view an agreement on limits is more executable than on prices (see Towards a Global Carbon Market, p.10) because taxes affect directly the companies cost of productivity whereas limits affect them indirectly.

The implementation of the EU-ETS is divided into Phase I (2005 - 2007), Phase II (2008 - 2012) and the current Phase III (2013 - 2020); Phase I and II demanded a mandatory National Allocation Plan (NAP) from each member state. The legislative basis for the imple­mentation of the EU-ETS (2003/87/EG) became effective of the 25th October 2003. The NAP required seven mandatory criteria which had to be published: (1) Kyoto commitments, (2) Assessments of emission’s development, (3) Potential to reduce emissions, (4) Consistency with other legislation, (5) Non-discrimination between companies or sectors, (6) Involvement of the public and (7) list of installations (see Guidance paper from the European Commission to assist Member states in the preparing the implementation of the Europe 2020 strategy, 2010, p.2 ff.). The structure of the German NAP consists of: “A Macroplan which defines the national emissions budget and determines the total quantity of allowances to be allocated and a microplan for the intended allocation of allowances to operators of individual installations; the microplan also sets out the volume of emission allowances to be set aside the new entrant reserve” (National Allocation Plan for the Federal Republic of Germany, 2004, p.6)

3.1.1 Phase I

The first phase (2005 - 2007) is known as a “learning-by-doing”-phase and was particularly used to form institutional and internal-office infrastructures (see Versteigerungen von Emis­sionsberechtigungen in Deutschland, 2012, p.8). In order to gain advantages from the EU- ETS the policy has to secure cost efficiency and the inherent flexibility of emission trading by supervising transaction costs and establishing an effective incentive structure of emission re­duction. The German government freely distributed 100 per cent of the EUA. The emission budget for GHG was appointed by the macroplan to 861 million tonnes per year. It is divided into 505 million tonnes for the energy and industry sector and 356 million tonnes for other sectors (not covered by the EU-ETS) like households, commerce etc. and based on historical data from the year 2000 - 2002, with a compliance factor[5] of 0.9755 and a reserve of nine million tonnes (three million per year) for new entrants (see National Allocation Plan for the Federal Republic of Germany, 2004, p.44 f.). Grandfathering is a method which makes use of historical data in order to generate an overall benchmark for industries concerned. Grandfa­thering was the approach to estimate the needs for existing installations. Nevertheless, observ­ing the method of grandfathering shows weaknesses in terms of economic efficiency. All al­lowances are allocated by the same procedure for all existing installations multiplied with the same compliance factor except for small emitters (less than 25.000 tonnes GHG per year) because there a compliance factor of one is applied in order to avoid competitive disad­vantages. Hence, companies have an incentive to overestimate their emissions despite the same output (see Barzantny et al, 2004, p.127 ff). Thereby, grandfathering grants higher al­lowances to installations, which have not shown efforts towards emissions reduction in the past. Industrial branches and companies that conform to efficient contemporary standards as a result of active climate protection measures and climate-friendly technologies are disadvan­taged and not honoured appropriately (see National Allocation Plan for the Federal Republic of Germany, 2004, p.22 ff.). Furthermore, grandfathering offers fewer innovation- inducements and amounts to subsidizing investments and thus increases the total costs of achieving climate targets. In short, early actions actually punished future-oriented strategies (see Wegner, 2004, p.131) and as a consequence, the market struggled with a price slump and an oversupply of EUA in the first phase (see Versteigerung von Emissionsberechtigungen in Deutschland, 2012, p.8).

Around 1.850 German facilities attended to the regulatory, which controlled around 499 million tonnes of emissions per year. In order to encourage companies to follow the re­striction and to enter the market for EUA banking from the first phase into the second phase was discussed on both ecological as well as economical points of view. From the ecological point of view EUA banking would increase green technology[6] implementation due to its in­crease in value. From the economical point of view the German NAP stated that banking:

“(...) encourages early reductions in emissions and the innovative effects these can trigger. It offers operators greater flexibility in scheduling their measures and will re­duce volatility in the price of allowances towards the end of a trading period.” (Na­tional Allocation Plan for the Federal Republic of Germany, 2004, p.43)

However, EUA banking contains also risks in line with emission reductions and the Kyoto targets. The possible prohibition of EUA banking by other member states triggers the difficul­ty to achieve the mentioned targets due to the missing harmonisation. Therefore, the German government prohibits EUA banking from the first into the second phase (see National Alloca­tion Plan for the Federal Republic of Germany, 2004, p.44).

3.1.2 Phase II

Around 800 German companies that include 1.665 facilities participated in the second phase (2008 - 2012) of the EU-ETS. Approximately half of the companies are SMEs. In order to get a notion of the emission dimension, a statistical evaluation shows that small enterprises with less than 50 employees emit on average 17.000 tonnes of GHG per year. Medium sized enter­prises (50-249 employees) emit on average 198.000 tonnes per year although some SMEs emit more than one million tonnes of GHGs per year (see Hertz and Lo, 2010, p.3). In this period, the European Commission changed the terms of allocation towards a more harmo­nised regulation. Moreover, a reduction in allowances by 6,5 per cent was decided and each member state had to dispose up to ten per cent of the EUAs by auctioning. That is why 40 million EUAs out of 452 million EUAs were auctioned in Germany during this phase (see Versteigerung der Emissionsberechtigungen, 2012 p.13 f.). Furthermore, the second phase had the fundamental problem of oversupply due to insufficient allocation due to grandfather­ing of allowances in the first phase. Geo-ecologist and economist Karoline Rogge et al. argue in their article that auctioning all allowances would have prevented most distributional prob­lems and effects.


[1] SMEs are defined in this thesis according to the definition from the "Deutsche Emissionshandelsstelle”. SMEs are enterprises with fewer than 250 employees and an annual turnover less than 50 million Euros.

[2] Current phenomena: EUA price generates incentives for eco-innovation

[3] Adam Smith's „invisible hand“ leads to an optimal allocation of the good

[4] Social costs are negative effects due to the polluting industries which effects non-participants

[5] The compliance factor: „The Macroplan defines the emissions budget for the Microplan. This is determined by the ratio of total CO2 emissions in the reference period 2000-2002 from all installations subject to emissions trading to the emissions budget for the energy and industry sector in the period 2005-2007 (...) When determining the compliance factor, the total of all special allocations and the requirement for the new entrant reserve are also taken into account” (National Allocation Plan Germany, 2004, p.44 f.)

[6] Green technology can be understand as environmental friendly technology

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The Implementation of the European Trading Scheme (EU-ETS) in German SMEs and its Implication on Environmental-Innovation-Activities
University of Hamburg
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EU-ETS, CO2, KMU, SMEs, Umweltökonomik, VWL, Innovationsökonomik, Porter, Emissionen, Innovation, Innovationen
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Jes Hennig (Author), 2014, The Implementation of the European Trading Scheme (EU-ETS) in German SMEs and its Implication on Environmental-Innovation-Activities, Munich, GRIN Verlag,


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