The EU as a frontrunner on greenhouse gas emissions trading: how did it happen and will the EU succeed?

Climate Policy 3 (2003) 3–18

Review

The EU as a frontrunner on greenhouse gas emissions trading: how did it happen and will the EU succeed? Atle C. Christiansen∗ , Jørgen Wettestad The Fridtjof Nansen Institute, Fridtjof Nansenvei 17, P.O. Box 326, N-1326 Lysaker, Norway Received 15 May 2002; received in revised form 18 July 2002; accepted 5 September 2002

Abstract The objective of this paper is first to provide empirical evidence of what can be seen as a rather remarkable change in EU’s position on the use of greenhouse gas (GHG) emissions trading (ET) in climate policy, from the role of a sceptic in the run-up to Kyoto towards more of a frontrunner. The paper argues that there is a synergistic and multilevel mix of explanatory factors for this “U-turn”, including developments at the international, EU, Member State, sub-national, and even down to the personal level. Second, the paper explores and discusses the philosophy behind the Commission’s proposal for a directive on GHG ET. Third, the paper examines the prospects for ‘success’ of a scheme for EU-wide ET using a multifaceted set of metrics. In brief, we argue that output success—the chances for having a directive adopted—hinges on the resolution of two key issues. First, whether the preliminary phase is to be mandatory or voluntary, and second, incompatibilities with domestic ET schemes. Outcome success—steering and cost-effectiveness—will in turn depend on factors like the coverage of the scheme and inclusion of project-based credits, while more long-term political implications hinges on the successful adoption and operation of the scheme. “The Proposal on emissions trading represents a major innovation for environmental policy in Europe. We are de facto creating a big new market, and we are determined to use market forces to achieve our climate objectives in the most cost-conscious way [. . . ]. The emissions trading system will be an important cornerstone in our strategy to reduce emissions in the most cost-effective way”. Environment Commissioner Margot Wallström. © 2003 Elsevier Science Ltd. All rights reserved. Keywords: Climate policy; Emissions trading; EU; Kyoto Protocol

Abbreviations: CDM, clean development mechanism; COP, Conference of Parties; EC, European community; EP, European Parliament; ET, emissions trading; ETS, emissions trading scheme; EU, European Union; FCCC, Framework Convention on Climate Change; GHG, greenhouse gas; GP, Green Paper; IPPC, integrated pollution prevention and control; JI, joint implementation; MS, Member State; NGO, non-governmental organisation; UK, United Kingdom; UN, United Nations; VA, voluntary agreement ∗ Corresponding author. Tel.: +47-67-11-19-00; fax: +47-67-11-19-10. E-mail address: [email protected] (A.C. Christiansen). 1469-3062/03/$ – see front matter © 2003 Elsevier Science Ltd. All rights reserved. PII: S 1 4 6 9 - 3 0 6 2 ( 0 2 ) 0 0 0 9 6 - 7

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1. Introduction1 The European Union (EU) is in many respects a key player in the global efforts to curb emissions of greenhouse gases (GHG). Firstly, the EU is one of the largest emitters in the world, being responsible for about 25% of GHG emissions in the group of Annex I countries.2 Secondly, the EU is generally recognised to have played an important strategic role in the climate negotiations under the United Nations (UN) Framework Convention on Climate Change (FCCC),3 a role that has become pivotal in the aftermath of the collapse at The Hague in 2000 and President Bush’s repudiation of the Kyoto Protocol in March 2001. Hence, the type of policies and measures adopted at the EU level are of importance not only for emissions abatement in its Member States (MS), but also for the evolution of the international climate regime. In the global climate policy discussions taking place in the 1990s, the USA stood forward as the main proponent of emissions trading (ET) and other flexibility mechanisms. In fact, the Kyoto Protocol and the so-called Kyoto mechanisms are by many seen as a US construct (e.g. Yamin, 1998; Grubb et al., 1999). The EU, on the other hand, has historically been rather sceptical to the use of flexibility mechanisms. However, in recent years, the EU position has changed quite dramatically. This process of change culminated in the European Commission’s proposal for a directive on ET launched on 23 October 2001, suggesting a mandatory cap-and-trade scheme for EU-wide ET from 2005. Hence, the rather paradoxical situation may arise that ET evolves as the key building block in EU climate policy, while the USA at present is aiming largely at voluntary measures in its climate strategy. Against this background, the aim of this paper is to address the following four questions: • How and why has the conspicuous “U-turn” in EU’s position come about? (Section 3) • Why is the Commission’s proposal for a directive designed the way it is, with regard to key design variables such as coverage and allocation method? (Section 4) • What could a final directive look like, following Readings in the European Parliament, debates in the Council of Ministers and a potential final round of conciliation? (Section 5) • What are the prospects for ‘success’ of an EU-wide trading system in the pre-Kyoto period 2005–2007 and beyond? (Section 5) Before addressing these questions, we first discuss briefly the multifaceted concept of ‘success’ in this context. 2. The multifaceted concept of ‘success’ The first and basic measure of success of an EU policy instrument is of course having it formally adopted as (in most cases) a directive. The continuing failure in adopting an EU-wide carbon tax provides a pertinent reminder that overcoming this hurdle should not be taken for granted. 1 This article has benefited from insights provided through a series of interviews conducted by the authors in Brussels and London in February and April 2002. 2 Emission data from 1998, available at UN FCCC online database, http://ghg.unfccc.int/. 3 See e.g. Grubb et al. (1999); Grubb and Yamin (2001) and Wettestad (2001).

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Second, the overarching goal of any climate change policy instrument is of course to bring down emissions. Hence, a key metric of success is the achievement of the desired or agreed emission reductions, which we refer to as the ‘steering effectiveness’. It is commonly conjectured that a well-functioning emission trading system could do this job with a higher degree of certainty than other instruments such as taxes. This owes to the fact that a ‘cap-and-trade’ scheme enables policymakers to fix emission quantities, while a tax may lead to a range of outputs due to uncertain abatement costs. The argument most often raised in favour of emission trading, however, is that it promises to reduce emissions at a lower cost compared to what can be achieved using other policy instruments. According to a body of economic literature and practical experiences from SO2 allowance trading under the US Clean Air Act Amendments of 1990, the benefits of ET owes largely to adding flexibility in terms of when and where emission reductions are to take place. Hence, emitters facing large abatement costs will in general prefer to buy additional allowances from the market if prices are lower than the costs of implementing in-house measures, while emitters with low abatement costs will have incentives to cut emissions beyond their targets and sell the surplus with a profit. As a third metric of success, we may thus use the achievement of envisaged cost savings, or ‘cost-effectiveness’. Finally, the success of EU-wide emissions trading could also be measured in terms of EU-internal and global political implications. Internally, the successful implementation of a pan-European ET scheme is likely to be perceived as a triumph for EU climate policymakers that could pave the way for wider use of trading schemes in EU (environmental) policy. Externally, a well-functioning and liquid trading system could show by example how to make the Kyoto mechanisms workable, and thus provide evidence of EU’s ability in demonstrating leadership in mitigating climate change. Overall, the metrics for success introduced above relates to what is often framed in political science as output (relevant policy), outcome (changes in the behaviour of those subject to the provisions of policy) and impact (tangible consequences affecting the physical problem at hand) (Easton, 1965).

3. EU climate policy and emissions trading: from fiend to frontrunner In the period leading up to the third Conference of Parties (COP-3) to the UN FCCC in Kyoto in 1997, the EU position on ET could briefly be described as ‘not very enthusiastic’.4 However, in recent years there has been a rather remarkable change, and the EU today stands forward as more of a frontrunner in the development of an international market place for ET. For instance, in June 1998 the former Environment Commissioner Ritt Bjerregaard stated that “we have to get involved in emissions trading [. . . ] we cannot let others dictate the rules” (International Environment Reporter, 24 June, p. 609). A Communication submitted on 19 May 1999 offered further evidence that the notion of ET was gaining ground in the EU policy debate (European Commission, 1999). Herein, the Commission indicated the possibility of a pilot phase for EU-wide emissions trading, and committed to submitting a Green Paper on emissions trading in 2000.5 The rather remarkable change in EU’s position culminated in the proposal for an EU-wide ET scheme in October 2001. How then, can we best explain this observed U-turn? 4 Authors’ interviews. For more comprehensive discussions on EU’s negotiating positions in general, and approaches to flexibility mechanisms in particular, see e.g. Yamin (1998); Skea (1998); Grubb and Yamin (2001), and Jacoby and Reiner (2001). 5 See p. 16 in the Communication; printed as a supplement to Europe Environment no. 546, 31 May 1999.

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3.1. Explaining the U-turn: a multilevel combination of factors There is clearly a synergistic and multilevel mix of factors that can help explaining the change in EU’s position, including developments at the international, EU, Member State, sub-national, and even down to the personal level. 3.1.1. The international level: slow progress in the Kyoto process and US repudiation In the aftermath of Kyoto, the focus of international policy debates was how one could make international emissions trading (IET) operational. Most parties, possibly with the exception of the USA, entered the debate with an aim of improving their understanding of what Kyoto in general, and IET in particular really meant. However, spurred by the slow progress in the international negotiations, increasing concerns were raised that a UN scheme for IET could in fact never materialise (Zapfel and Vainio, 2002). This, in combination with increasing uncertainties regarding US ratification, culminating in President Bush’s repudiation of the Kyoto Protocol, gradually turned EU’s attention to the need for designing instruments applicable to the EU level. For EU officials long burdened with tax deadlocks and limited success in formulating an overall climate strategy, this opened a window of opportunity for moving ET up on the European policy agenda. 3.1.2. The EU-level part I: learning from policy failures The Commission initially favoured an approach to mitigating GHG emissions based on common and coordinated policies and measures. An EU carbon/energy tax was thus proposed in the early 1990s as the cornerstone of EU climate policy (e.g. Wettestad, 2001). However, as a financial measure, a tax has to be adopted unanimously in the Council of Financial Ministers. Owing to strong opposition from industry and key Member States, it has so far proved impossible to achieve such a consensus. In fact, at the end of 2001, the Commission formally withdrew the original tax proposal, leaving only the Energy Products Tax Directive on the Council’s table. An increasing understanding has also emerged that other and traditional policy approaches have taken the EU as far as possible in terms of achieving emission reductions in a cost-effective manner. Hence, the lessons learned in formulating a common and coordinated climate change strategy at the EU level, most notably the poor experience with the carbon tax proposal, have served to reinforce the search for stronger and more suitable policy instruments. The process of learning more about ET as such within the EU institutions is also an important explanatory factor. Hence, up and until Kyoto, ET was largely a territory little explored by the EU, and knowledge was essentially limited to academic circles and business that followed debates in the USA.6 Post-Kyoto, however, work on ET was intensified within the Commission. A key factor in sustaining discussions at the time was the active involvement of experts from the USA, including actors with real-life experience in emissions trading, academics and environmental pressure groups (Zapfel and Vainio, 2002). The arguments put forth by proponents of flexibility mechanisms gradually convinced EU policymakers that ET was a useful idea. Evidence of learning is also evident at a more personal level. For instance, the head of the Climate Change Unit within the Commission, Jos Delbeke, was one of the key policy architects behind the carbon tax, which would have implied an increase in tax competence for Brussels. The failure in establishing sufficient support for the proposal made Delbeke very insistent on seeing a successful trading scheme 6

See e.g. Zapfel and Vainio (2002).

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adopted. Moreover, after Kyoto the Commission has also recruited economists having detailed knowledge and experience with emissions trading from the USA. Currently, the Commission views emissions trading as “one of the policy instruments that will impair competitiveness the least” (European Commission, 2001b, p. 2). 3.1.3. The EU-level part II: the role of the Council and European Parliament Even though the Commission is assigned the agenda-setting role of initiating new legislation, the prospects for adoption depend heavily upon the positions and coalitions of support in the European Council and the European Parliament (EP).7 Looking back, it would seem that the supportive attitude within these institutions has provided required legitimacy and encouraged the Commission in its efforts. For instance, at the Gothenburg European Council in June 2001, the heads of state and government reaffirmed their commitment to ratifying Kyoto. Moreover, the Environment Council meeting in Luxembourg 29 October 2001 concluded that “the Council is appreciative to the Commission for presenting a proposal for a framework Directive for an EU greenhouse gas emissions trading scheme”.8 Indications that a qualified majority in the Environment Council would be susceptible to adopting a trading scheme made its prospects seem much better than what was the case with the carbon tax. As regards the role of the EP, it is widely agreed that it has gained increasing influence in EU policyand decision-making over the last decade or so, having developed into a co-legislator with clout. In its 2000 resolution on the Green Paper, the EP stated that “a Community-wide scheme on GHG emissions trading could make a significant contribution to the fundamental objectives and core activities of the EC” (European Parliament, 2000, p. 7). This positive attitude has prevailed, as further elaborated in Section 5.1.3. 3.1.4. Member State level: prospects for market fragmentation and worrying emission trends The slow progress in the international climate negotiations post-Kyoto also triggered a change of focus from top–down (UN level) towards bottom–up approaches in the development of ET schemes (Zapfel and Vainio, 2002). Early discussions on a trading system for the Danish power sector (first draft of legislation in May 1998), the constitution of Parliamentary Commissions on ET in Norway (1998) and Sweden (1999), and the institution of the UK Emissions Trading Group in 1999 provided further impetus to this emerging ‘bottom-up’ approach. For the EU institutions, the possibility of dealing with a patchwork of incompatible national trading schemes was perceived as a threat to the overarching goals of harmonisation and protecting the internal market. Moreover, it was increasingly recognised that the debate was no longer about if ET would emerge, but rather where, when and how it will be implemented. Consequently, the Commission realised that it would have to move quickly in the development of a coordinated EU-wide scheme with common rules in order to ensure a level playing field and avoid market fragmentation. The need to reinforce the search for cost-effective climate policy instruments at the EU level was further emphasised by worrying trends in Member States’ GHG emissions. Hence, although the decline in GHG 7 For a comprehensive discussion of how the EU institutions share proposal and approval of policies, see e.g. Wallace and Wallace (2000). 8 Press release, 2378th Environment Council meeting, Luxembourg, 29 October 2001, Available at http://ue.eu.int/Newsroom/ (28 February 2002).

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Fig. 1. EU GHG and CO2 emissions for the period 1990–1999, projections for 2010 and Kyoto target (Source: European Commission, 2001c).

emissions over the period 1990–1999 is often taken as evidence that the EU is on track to achieving the Kyoto target, it is well known that the positive trend during the 1990s (see Fig. 1) owes largely to two specific and unique events. These include the switching from coal to natural gas in the UK power generation system (the ‘dash for gas’) and the reunification of Germany that led to economic restructuring and fuel switching in the former East German Länder. As shown in Fig. 2, the aggregated reductions in total CO2 emissions in the UK and Germany (204 Mt CO2 e) more than outweighed increasing emissions in the other Member States (150 Mt CO2 e). On present trends, it seems unlikely that emission reductions will continue at the same pace as that experienced in the 1990s. On the contrary, more than half of current Member States are headed towards

Fig. 2. Changes in CO2 emissions 1990–1999 within the EU, broken down to contributions from UK and Germany, remaining Member States (EU13), and EU15 (Source: Point Carbon, www.pointcarbon.com).

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substantially exceeding their agreed share of the EU’s total allowed emissions under the Kyoto Protocol (EEA, 2002). As illustrated in Fig. 1, the Commission projects that by 2010 total GHG emissions will have increased by 1% and CO2 emissions by 4% relative to the base year of 1990, compared to the Kyoto target of 8% reduction. Against these perspectives, emissions trading could prove instrumental for ensuring a cost-effective implementation of abatement policies across the EU. 3.1.5. The industry level: company initiatives and general support The change in focus from a top–down system towards bottom–up schemes was also reinforced by initiatives at the company level. More specifically, the establishment of an internal ET pilot scheme within BP in 1998 acted as a key driver in the policy debates. The BP scheme was implemented in September 1998 and extended to cover all 150 Business Units world wide as of January 2000. These groundbreaking moves were also mirrored by the implementation of a similar system in Shell. In a more general perspective, several observers highlight the general support for ET from a majority of business and industry groups across the EU. This is partly reflected in official responses from business and their Associations as well as in recordings from stakeholder consultation meetings between the Commission and industry.9 That said, there are clearly diverging views among different companies and sectors, and strong opposition from certain branches of industry serves to illustrate that the industry’s position is by far unified (more on this later). Let us then turn to the ET directive put forward in October 2001. 4. The Commission’s proposal: what’s in there and why? 4.1. Key features and design options On 23 October 2001, the Commission launched its proposal for a framework directive for GHG emissions trading within the European community (European Commission, 2001b). Some of the key elements in the proposal are: • Mandatory cap-and-trade scheme from 2005. • Reduction targets: The total quantity of allowances issued (‘cap’) would essentially be left to Member States (MS). However, it will be subject to verification of a national allocation plan to be transmitted to the Commission. • Compliance: The penalty for non-compliance was set at 50 or twice the market price for the pre-Kyoto period 2005–2007 and 100 from 2008 onwards. • Coverage: ‘Downstream’ system limited to CO2 only and large fixed-point sources, including electricity and heat generators with rated thermal input exceeding 20 MW; production and processing of ferrous metals; building materials (cement, glass, ceramics), and production of pulp and paper. • Allocation: Allowances are given to the emitters for free in the period 2005–2007, i.e. grandfathering. Decision on a common method for subsequent periods is to be made later. • Project-based mechanisms: Credits from Joint Implementation (JI) projects and the clean development mechanism (CDM) are not explicitly allowed in the period 2005–2007. However, a new directive on JI and CDM is being prepared. 9

See for instance European Commission (2001a, p. 1).

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• Links to countries outside EU: The proposal foresees the inclusion of the Accession Countries when they become EU members. Moreover, EU members may engage in trading with other Annex B countries through mutual recognition of allowances. Still, principles and methods to facilitate such linkages need to be developed. Let us then have a closer look at these points and why they have come about. 4.2. Why a mandatory system with the caps unspecified? In the Green Paper (GP) preceding the draft directive the Commission proposed two options in order to reflect that Member States (MS) may not be ready to participate in a pan-European trading scheme at the same time (European Commission, 2000). Under the “opt-in” option, MS would decide whether or not it wished to take part and which sectors that should be included. However, since this system could be administratively complex, an “opt-out” option was also proposed, in which case the Community decides which sectors to be included while MS could decide to opt-out, either completely, or for certain sectors. The opt-in and opt-out clauses were however removed in the very last phase before launching the draft Directive. A mandatory scheme was thus chosen mainly for competitiveness reasons and concerns over market distortions that could arise under a voluntary system.10 Moreover, it was felt that a voluntary could fail to include a sufficiently large number of emitters and thus restrict market efficiency and liquidity (e.g. Butzengeiger et al., 2001). The directive essentially leaves the setting of reduction targets to the Member States, subject to verification of a national allocation plan to be transmitted to the Commission. The proposal lists a set of criteria that these allocation plans must comply with, including inter alia provisions to avoid issuance of ‘excess’ allowances and that allocation shall be consistent with the technological potential for emission reductions and EU’s obligations under the Kyoto Protocol (European Commission, 2001b, p. 35). From a political perspective, the lack of specific targets owes largely to the understanding that the early inclusion of such targets would probably invoke controversies among Member States and delays in the political negotiations, as experienced during the process of working out the Burden Sharing Agreement. 4.3. Gas and sectoral coverage: why so ‘narrow’? Even though the Commission recognises that the cost-saving potential of EU-wide emission trading increases with increasing coverage, the Directive recommends a ‘downstream’ trading system starting with a limited number of sectors covered by the IPPC directive and CO2 only. The sectors listed above would comprise some 4000–5000 installations, covering about 52% of EU CO2 emissions in 1990, a share the Commission projects will be reduced to some 46% in 2010. The reason for starting with a limited trading system is the need to strike a “balance between simplicity, effectiveness, subsidiarity and transparency” (European Commission, 2001b, p. 5). For instance, the other five GHGs are excluded because of alleged difficulties related to monitoring, reporting and verification. The chemical sector was excluded for similar grounds, namely the high number of installations (about 34,000 plants), the limited contribution to EU total CO2 emissions (1%), and difficulties in measuring 10

Interviews with EU officials, February 2002.

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other GHGs. It also appears that the rationale for a ‘preliminary phase’ and a limited trading scheme is to get industry and governments more involved in ET, while the inclusion of sectors that are already covered by permitting licences (e.g. power plants under IPCC) is believed to ease the overall administrative burden. However, the Directive states that the Commission may make a proposal to expand gas and sectoral coverage by 31 December 2004. 4.4. Allocation of allowances: why common method and grandfathering? Conceptually, there are two basic methodologies for initial allocation of allowances. One option is some form of ‘grandfathering’, whereby allowances are distributed to companies on the basis of historical emissions or according to a certain performance standard (‘benchmarking’). The alternative is that the government requires companies to buy allowances, for instance at a fixed price or in an auction. The reason why the Commission proposed the use of grandfathering owes largely to the perception that the chances of getting a system in place by 2005 could be undermined by opposition from key Member States and lobby groups representing incumbents that would have to pay for allowances. Among the reasons for choosing a harmonised method rather than leaving the choice to the Member States’ discretion is the poor experience from auctioning of licenses for third generation cellular phone systems (Drexhage, 2001). However, the Commission has also committed itself to review the experience gained by June 2006 “with a view to ascertaining which harmonised method would be most appropriate in the future” (European Commission, 2001b, p. 11). 4.5. Compliance provisions: why ‘high’ penalties? The efficiency and political acceptability of any ET scheme is likely to depend strongly on its compliance provisions, meaning firstly that of establishing a set of common rules and principles for reporting, monitoring and verification of emission data. Secondly, it is often argued that any viable emissions trading scheme should have relatively high financial penalties for failure to comply, and that the enforcement should be credible and non-discretionary (Ellerman, 2000, p. 22). The experience from SO2 allowance trading in the US offers a key explanation for the inclusion of financial penalties, in showing that “sufficiently high penalties can prove critical to ensuring environmental and economic integrity” (e.g. Environmental Defense, 2000). The excellent compliance record of this scheme is also acknowledged in the draft Directive (European Commission, 2001b, p. 14). The NGO community has warmly welcomed the inclusion of a “strong clear compliance system”, arguing that without such a system “companies will not invest in emission cuts or seek to buy allowances” (Climate Network Europe, 2002, p. 1). 4.6. Project-based mechanisms: why are they not included? The draft Directive does not foresee the inclusion of credits from national or international project-based mechanisms for the pre-Kyoto period 2005–2007, such as the CDM and JI. A key reason for being somewhat precarious on this issue is concern over the environmental integrity of the rules and procedures for these mechanisms that are currently being worked out under the UN FCCC. This pertains partly to long-running concerns voiced by EU officials over the need to ensure that investments in CDM and JI projects actually produce real emission reductions. Moreover, the Commission felt that including the

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Kyoto mechanisms posed yet another issue to an already extensive list of hot topics. Perceptions were thus that opening discussions on the merits of such mechanisms could complicate negotiations and in turn jeopardize the chances of actually having a system in place in 2005. That said, the Commission intends to propose a Directive in which it aims to specify under which conditions such mechanisms are compatible with the proposed ET scheme (European Commission, 2001b, p. 8). 4.7. Links to countries outside the EU: why such an inclusiveness? Even though the aim of the Commission is to design a trading scheme for current Member States, the Directive includes an opportunity to “link up with domestic trading schemes established by particular countries” (European Commission, 2001b, p. 16). In principle, such linkages could encompass any Party to the Kyoto Protocol through a system of mutual recognition of domestic trading schemes, in which “the tradable unit [. . . ] will be recognised as counting towards domestic obligations” (ibid). Linking the ET scheme to other countries is important for economic as well as political reasons, most notably since the EU could be in a position to welcome up to ten new members before 2005. Trading in an enlarged “EU bubble” could in the first place reduce compliance costs, since abatement costs are believed to be much lower in the accession countries. Secondly, preparing the EU candidates for the set-up of an EU-wide ET scheme could prove beneficial for political purposes since new Member States are de facto required to enact and implement all EU legislation under the acquis communautaire, unless other provisions are made. Thirdly, the inclusion of other countries could improve overall efficiency by way of increasing the traded volumes and market liquidity. And finally, if the EU were to succeed in developing a workable trading scheme for its Member States and other Annex I countries, this could demonstrate that the EU is capable of leading the way in global efforts to curb GHG emissions.

5. Prospects for success: short- and long-term perspectives In Section 2, we outlined a set of metrics pertaining to the prospects for the success of an EU-wide GHG emissions trading scheme. In so doing, success was first operationalised as passing the hurdle of actually having a directive adopted, i.e. output success. In terms of outcome success, we introduced the notions of steering and cost-effectiveness. We also discussed success in terms of political implications, both internally and externally and in a short- and long-term perspective, respectively. 5.1. Passing the first hurdle: will the Commission’s proposal survive?11 The Commission’s proposal is currently subject to policy discussions within the EU’s policy-forming institutions and Member States. Although several and complex issues needs to be resolved, it appears as though the prospects for adoption of a ET scheme rests on the resolution of two controversial issues. First, a number of Member States seem to be in favour of a voluntary rather than a mandatory scheme for the preliminary phase. And second, possible incompatibilities between the proposed EU scheme and the UK ETS need to be resolved. 11

This section draws upon a series of interviews conducted in Brussels in February 2002, including talks with EU officials, political analysts and other stakeholders.

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5.1.1. Mandatory or voluntary? The perhaps most contentious issue in the Commission’s proposal is whether the scheme should be mandatory or voluntary for the preliminary phase 2005–2007. Regarding the positions of different stakeholders, part of industry is clearly in favour of a voluntary scheme. This view has been voiced on several occasions in the media, and is also reflected in the conclusions of the Working Group on flexible mechanisms under the European Climate Change Programme (ECCP, 2001, p. 11). Diverging views on this issue also surfaced when environment ministers in the Council first debated the Commission’s proposal in December 2001, even though there was seemingly a widespread consensus on the use of ET in EU climate policy.12 Hence, although the Commission presses for a mandatory scheme, there could be a blocking minority of Member States in favour of a voluntary approach.13 A critical task for the Commission is to overcome the vociferous opposition from German industry. Bearing in mind the difficulties involved in grouping together the views of different industries and companies, it appears as though opponents give weight to one of two dominating concerns, or a combination of these. First, a bureaucratic concern, according to which industry argue that they have already invested a lot of time and energy in working out voluntary agreements (VAs) on climate protection measures with the German government. In addition, the energy industry feels overloaded by regulatory pressures arising from new pieces of legislation in the areas of combined heat and power, renewables and the eco-taxes, for which the directive on ET is viewed as adding to the administrative burden. Second, there are economic concerns, framed by the industry in terms that they are already doing more than their share of EU-wide emission reductions, and that ET would require them to cut emissions beyond what is required under the VAs. 5.1.2. Compatibility with emerging trading systems at the Member State level The other key challenge for the Commission is to resolve potential incompatibilities between the proposed EU scheme and the UK ETS, which differ in several important respects. First, the UK ETS is essentially voluntary. Second, it includes more sectors (about 50) and all six GHGs. Third, it incorporates an incentive factor, and fourth it differs in the way it treats emissions from electricity production and consumption. Even though the Commission has cleared the UK ETS under EU guidelines on state-aid, there is an understanding that the UK scheme will have to be changed in accommodating the entry into force of an EU-wide scheme. In the eyes of the Commission, the need for convergence owes to the perception that competing schemes will create conflicting rules, high transaction costs and market distortions. 5.1.3. How much flexibility can the Commission accept? The task of foreseeing the outcome of the on-going political process is of course inherently prone to speculation. That said, a view held by informed observers is that the opposition from German industry can be muted if for instance the Commission was to reinstate the opt-out clause and/or allow for setting of caps on the basis of the industries’ voluntary agreements. The opt-out is most likely also a key in ensuring compatibility between the EU scheme and the UK ETS. However, the prospects of a voluntary approach will invoke opposition within the Commission for reasons of competitiveness and protection of 12 See summaries in International Environment Reporter, 2 January 2001, ‘Minority of states continue to block mandatory EU emissions trading scheme’, pp. 5–6; EU Energy, 20 December 2001, ‘Council split over emissions trading’, pp. 1–2. 13 A blocking minority consists of 26 votes out of a total of 87 votes in the Council. This minority could include Germany and the UK, which together hold 20 votes.

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the internal market. Still, there is a chance that such an approach could be accepted if Member States are able to convince the Commission that other and stronger policies and measures will be used for reducing emissions in sectors outside the trading scheme. Hence, in terms of output success, it would seem that making provisions for a voluntary scheme would improve the chances for having an ET scheme adopted. That said, and to the extent that industry may lack incentives for taking on ambitious reduction targets, a voluntary scheme could bring less emission reductions than a mandatory scheme. In addition to the above mentioned controversies, there are also diverging views among Member States and stakeholders on a number of other design options, such as the sector and gas coverage, the need for clearer and more consistent criteria for the National Allocation Plans, and inclusion of project-based credits. Taking all this into account, it seems apparent that the Directive will emerge in quite a different shape before a possible entry into force by 2005. According to an expert poll conducted by the company, Point Carbon, a majority of the experts expect that the proposal will be changed to include more sectors, more gases, opt-out provisions and to allow projects outside the EU to offset 2005–2007 emissions (Point Carbon, 2002). To the extent that cost savings increase with coverage and availability of low-cost reduction projects, such changes would increase cost-effectiveness. 5.2. The mid-term: what can the system deliver in the pre-Kyoto period? Economic analysis made on behalf of the Commission suggests that total annual cost savings for reaching the Kyoto target through an EU-wide ET scheme could accrue to some 3 billion Euro per annum compared to a situation where each MS reached its target unilaterally (Capros and Mantzos, 2000, p. 1). However, little has been said on the potential savings for the pre-Kyoto period. Moreover, uncertainties are considerable, and the cost reductions depend strongly on assumptions regarding the overall reduction target as well as the counterfactuals of cost-effective policy implementation and emission baselines. In the following, we discuss some of the key design variables and their potential impact on metrics such as political acceptability, environmental effectiveness, cost-effectiveness and market efficiency (liquidity). • Caps: The lack of concrete figures for reduction targets makes it difficult to foresee the environmental effectiveness of the trading scheme. Requiring MS to submit allocation plans without knowing the caps set by other countries could also open an avenue for undesirable political gaming. However, the condition that allocation plans should be reviewed by other MS and made public could facilitate co-ordination and ensure political expediency. To the extent that lack of clarity on caps exacerbates uncertainty regarding allowance prices, the need to hedge against the risk of high prices could encourage ‘conservative’ targets. This could negatively affect the liquidity of the market and limit early action in the period up until 2005. Conservative reduction targets could also bring promises of low compliance costs, which in turn may constrain the search for abatement opportunities outside the sectors included in the scheme. Hence, sending clear signals on caps could prove critical to output as well as outcome success. • Sectoral coverage: Even though aiming for a limited system makes sense in terms of administrative simplicity and the limited time available to prepare actors for start-up in 2005, limitations on gas and sectoral coverage could impair the effectiveness of the system in several ways. First, it could reduce cost-effectiveness. Second, it will not provide indications of abatement costs for sectors outside the system, which may prevent early action for outsiders. Hence, increased coverage could in general increase the chances of outcome success.

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• Allocation method: Neo-classical economic theory learns that under assumptions of perfect information and competition, the initial allocation of allowances does not affect environmental effectiveness, opportunity costs, or market prices. Even though these assumptions are unlikely to hold in practice, the choice of allocation method is among the most contentious political issue in the design of emissions trading schemes.14 Hence, agreement on an appropriate allocation method is critical for political expediency and the chances of having a system in place in 2005 (output success). • Linkages to other countries: Even though the directive foresees the inclusion of accession countries in Central and Eastern Europe and members of the European Economic Area, the key is really whether the trading system will be linked to large emitters like the USA, Canada and Australia, for at least two reasons. First, it will improve cost-effectiveness (outcome success) compared to a scenario with unilateral action. Second, it is likely to give more market players valuable experience in dealing with a policy instrument of which there is limited practical experience. • Project-based credits: Since project-based credits are not included, most market players could focus most of their attention on trading of emission allowances rather than searching for and investing in emission reduction projects. To the extent that this discourages investments in JI and CDM, it may be seen as running against the grain of the Kyoto Protocol. On the other hand, if such credits were to be included, it could not only enhance the cost-effectiveness (outcome success), but also provide incentives for early action for emission reductions outside the EU, particularly for countries and sectors with high abatement costs. 5.3. The long-term: convergence or fragmentation? Owing to prevailing uncertainties regarding the possible entry into force of the Kyoto Protocol, there is a risk that a ‘top–down’ scheme for international emissions trading under the Kyoto framework may not materialise. On the other hand, a ‘bottom–up’ development raises a risk of having in place a patchwork of domestic schemes that could create conflicting rules, high transaction costs and market distortions. In light of these observations, a successful EU scheme could prove instrumental in demonstrating the operability of ET, in terms of a liquid market with low transaction costs. Moreover, and owing to the US preference for market-based instruments, it could in principle provide an avenue for linking the Kyoto framework with US climate change strategies, and thus facilitate the process of convergence in a more long-term perspective. That said, uncertainties also prevail at the EU-level, for which the successful implementation of a pre-Kyoto scheme hinges on the outcome of on-going policy debates.

6. Concluding remarks This article provides empirical evidence of what we see as a rather remarkable change in EU’s position on the use of greenhouse gas emissions trading in climate policy. In contrast to the rather sceptical views voiced up to COP-3 in Kyoto, the EU has in the recent years stood forward as more of a frontrunner in the development of an international market place for ET, culminating in the proposal for an EU-wide ET scheme in October 2001. How then, can we best explain this observed U-turn? 14

For an overview of recent literature on the issue of allocation, see Woerdman (2000).

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This paper argues that there is a synergistic and multilevel mix of explanatory factors, including developments at the international, EU, Member State, sub-national, and even down to the personal level. At the international stage, slow progress in the Kyoto process and increasing uncertainty about US ratification opened up a political window of opportunity for moving ET up on the EU agenda. At the EU-level, the failure to get a carbon tax adopted fostered a group of disheartened officials dedicated to see other climate change instruments such as ET successfully adopted. The fact that domestic trading systems began to appear at the Member State level, and the perceived risk of having in place a patchwork of schemes with different rules and modalities, provided further impetus to the Commission’s efforts to develop and implement a harmonised EU trading scheme. Turning to the task of explaining the philosophy underlying the Commission’s proposal, several questions have been addressed in this paper. First, why did the Commission propose a mandatory system with unspecified caps? The mandatory part is clearly rooted in the Commission’s overarching goals of achieving harmonisation and avoiding market distortions. On the other hand, leaving the caps unspecified was considered crucial in retaining sufficient flexibility and thus support for the scheme at the Member State level. Second, why is the suggested gas and sectoral coverage relatively narrow? This must be seen in a feasibility perspective. Hence, in order for this rather ambitious project to fly, starting with a few sectors and CO2 only was seen as necessary to reduce complexity and ensure expediency in the policymaking process. Third, why opting for a common method of initial allocation and grandfathering? This is due to combination of poor experiences with auctioning in other areas of Community policymaking and basic feasibility concerns. Fourth, why the relatively high penalties for non-compliance? This is partly based on positive experiences within the US sulphur trading system. Fifth, why are project-based credits not included? This has again to do with feasibility and complexity concerns, and the need to avoid introducing additional elements that could trigger complex political negotiations and delays in implementation. Sixth, why are links to countries and systems outside of the EU so warmly welcomed? This should partly be seen as a signal that the EU sees its system in a more long-term, global perspective. With regard to the prospects ahead, there are at least two key questions. First, what kind of system, if any, is the EU likely to end up with? And second, how successful could it be in terms of bringing down emissions in a cost-effective manner? The chances for having a directive adopted hinges on the ability to strike the right balance between several, and to some extent conflicting concerns. In general, it will probably be necessary to make provisions for more flexibility, most notably since there could be a blocking minority against a mandatory system for the preliminary period 2005–2007. Flexibility could be added in the form of an “opt-out” clause, which in practice means opening up for transition periods. We also foresee the inclusion of more sectors and gases as a likely broadening of the system. Hence, the directive will most certainly emerge in a different shape compared to the Commission’s proposal. With regard to effectiveness, it seems safe to predict that EU-wide ET will reduce costs compared to a case where reductions were to be achieved unilaterally since abatement costs differ across countries and sectors. The contribution to emission reductions beyond the baseline for the pre-Kyoto period is however harder to predict, in that it depends strongly on the stringency of targets adopted at the MS level. Finally, in terms of political implications, a successful implementation of an EU-wide scheme could provide evidence of EU’s capabilities in acting as a frontrunner in the development of climate change strategies. At the international level, the role of the EU is critical since it at present seems unlikely that the US will re-enter the Kyoto process in the near-term. At the EU-level, having in place a common and coordinated scheme for ET could open up an avenue for wider use of market-based mechanisms

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in EU environmental policy. This could in turn be taken as evidence of EU’s ability in demonstrating leadership in the development and implementation of novel climate change abatement instruments, not only in words, but also in actions. Acknowledgements The authors thank colleagues at the Fridtjof Nansen Institute, notably Kristian Tangen and Jon Birger Skjærseth, Peter Zapfel at the European Commission, and two anonymous referees for valuable comments on previous draft versions. Financial support from the Norwegian Research Council, grant no. 145730/730, is also gratefully acknowledged. References Butzengeiger, S., Betz, R., Bode, S., 2001. Making GHG Emissions Trading Work—Crucial Issues in Designing National Emissions Trading Schemes. HWWA Discussion Paper No. 154, Hamburg. Available at http://www.hwwa.de/ Publikationen/Discussion Paper/2001/154.pdf. Capros, P., Mantzos, L., 2000. The Economic Effects of EU-Wide Industry-Level Emissions Trading to Reduce Greenhouse Gases. Results from the PRIMES Energy Systems Model. Available at http://europa.eu.int/comm/environment/enveco/ climate change/primes.pdf (5 March 2002). Climate Network Europe, 2002. Emissions Trading in the EU: Let’s See Some Targets. CNE Comments on Commission Emissions Trading Paper. Available at http://www.climnet.org/EUenergy/ET.html (5 March 2002). Drexhage, J., 2001. Establishing a Framework for Greenhouse Gas Emissions Trading Within the European Community: An Analysis of Some Salient Elements. Available at http://www.iisd.org/pdf/2002/climate detwgnote2001.pdf (2 February 2002). Easton, D., 1965. A Framework for Political Analysis. Prentice-Hall, Englewood Cliffs, NJ. ECCP (European Climate Change Programme), 2001. European Climate Change Programme—Report June 2001, European Commission: Brussels. Available at http://www.europa.eu.int/comm/environment/climat/eccp.htm (13 September 2001). EEA (European Environmental Agency), 2002. EU Reaches CO2 Stabilisation Target Despite Upturn in Greenhouse Gas Emissions. News Release 29 April 2002. Available at http://org.eea.eu.int (29 April 2002). Ellerman, A.D., 2000. Tradable Permits for Greenhouse Gas Emissions: A primer with Particular Reference to Europe. Report No. 69, November 2000. MIT Joint Program on the Science and Policy of Global Change, MA, USA. Environmental Defense, 2000. From Obstacle to Opportunity: How Acid Rain Emissions Trading is Delivering Clean Air, Environmental Defense. New York. European Commission, 1999. Commission Communication to the Council and the Parliament, Preparing for Implementation of the Kyoto Protocol. European Commission, COM(1999)230, Brussels. European Commission, 2000. Green Paper on Greenhouse Gas Emissions Trading Within the European Union. European Commission, COM(2000)87 Final, Brussels. European Commission, 2001a. Green Paper on Greenhouse Gas Emissions Trading Within the European Union. Summary of Submissions. Part 1. Non-Governmental Submissions. European Commission, 14 May 2001, Brussels. European Commission 2001b. Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for Greenhouse Gas Emissions Trading Within the European Community and Amending Council Directive 96/61/EC. European Commission, COM(2001)581, Brussels. European Commission 2001c. Third Communication from the European Community under the UN Framework Convention on Climate Change. European Commission, SEC(2001)2053, Brussels. Grubb, M., Vrolijk, C., Brack, D., 1999. The Kyoto Protocol. A Guide and Assessment. Royal Institute of International Affairs, London. Grubb, M., Yamin, F., 2001. Climatic collapse at The Hague: what happened, why, and where do we go from here? Int. Affairs 77 (2), 261–276. Jacoby, H.D., Reiner, J.D., 2001. Getting climate policy on track after The Hague. Int. Affairs 77 (2), 297–312.

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