What difficulties arise in the design and implementation of market based

solutions to curb greenhouse gas emissions and mitigate climate change? To

what extent does the EU Emissions Trading Scheme provide a credible
solution in this regard?
With increasing pressure from the international community calling for the implementation of
policy measures designed to limit greenhouse gas emissions and prevent climate change, policy
makers have turned towards market based systems in an attempt to address the often divergent
interests of environmental protection and economic policy.
EU directive 2003/83/EU, introduced to aid EU member states in reaching their Kyoto Protocol
commitments, set out the legal framework for creating a cap and trade scheme within the EU and
general rules for setting up the EU Emissions Trading Scheme (EU ETS); the largest
multi-national greenhouse gas emissions trading scheme in the world.
Market based solutions, like the EU ETS, are seen as the preferred method, from a firms
standpoint, to curbing greenhouse emissions as any distortion of the market is limited through the
use of the free markets inherent allocation and cost efficiency. Yet for all the advantages of
market based approaches, over more traditional taxes and regulation, there are several difficulties
that arise in the design and implementation of market based schemes. This essay shall detail the
difficulties faced by policy makers in the allocation of allowances, the verification of emissions,
and the scarcity of allowances; while providing evidence of how the EU ETS moved to provide a
credible solution to these challenges.
1.1 Allocation Difficulties
When approaching the allocation of allowances to industry operators, governing bodies must
evaluate the associated benefits between allocating allowances freely to industry operators, known
as grandfathering, or allocating through sealed bid auctions.
The economic reasoning behind the free allocation of allowances is as a means of easing industry
operators into the emissions scheme and to limit the impact to the international competitiveness
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of domestic firms, as immediately requiring firms to bear the cost of pollution is deemed
uncompetitive. However, by allocating them freely, firms see the allowances as windfall profits
and pass the opportunity cost of allowances onto the consumer.
The alternative to this method is the allocation of allowances through auctions: auctions are
deemed more open, transparent, harmonised and non-discriminatory. This method puts into
practice the idea that the polluters should pay and when compared to the free allocation of
allowances, where there is little incentive to actually reduce emissions, auctioning permits has
more direct incentive for firms to invest in low carbon methods and to abate emissions.
It must be determined then, whether the short term benefits to competitiveness and general
simplicity of freely allocating allowances is outweighed by the equity and greater long term
effectiveness of auctioning allowances to industry operators.
1.2 Measurement, Reporting and Verification
Designing and establishing a market based emissions scheme requires vast amounts of data. To
manage all the data, an emissions registry must be created whose primary task is to operate a
database for collecting, verifying, and tracking emissions data from emitters. (International
Emissions Trading Association, no date). Industry operators must submit reports on their
emissions and emission offsets to these registries, where they are verified by independent bodies.
To provide a deterrent to these operators to not provide inaccurate reports, or to not acquire
enough allowances to account for their emissions, there must be a penalty system in place
whereby the cost of providing an invalid report and exceeding their allowed emissions limit is
greater than any potential gains.
International emissions market schemes pose a problem for these registries: as operators are
usually allowed to mitigate any increases in their own emissions by investing in foreign emission
offsets, domestic registries are tasked with pooling information from numerous foreign markets.
And as such, there must be international co-operation between emissions registries creating
significant barriers to the successful implementation of a market based emissions scheme.

1.3 Price and Scarcity

The basic model of supply and demand dictates that if supply of a good exceeds demand (for said
good) then the equilibrium market price will fall; and if demand exceeds supply the market price
will rise. When implementing market based emissions schemes, like a cap and trade system,
policymakers must take undue care in deciding the number of allowances that should be made
available to the market.
An oversupply of allowances to the market, as shown in Diagram 1 of Fig. 1, will lead to a lack of
scarcity, reducing the equilibrium market price. This lower market price actively reduces the
incentive of industry operators to reduce their emissions: the gains from reducing emissions (and
selling any excess allowances) are not greater than the cost of investing in emission reduction
methods and abating emissions.
Fig. 1

Under supplying the market, as shown in Diagram 2 of Fig. 1, leads to increased scarcity and an
increased market price. A higher market price for allowances will effectively price out smaller
firms who cannot compete financially with larger operators when purchasing allowances.
Internationally, this can stifle economic growth of developing nations as their domestic firms fail

to acquire enough allowances to allow for the purchase of more emissions heavy capital necessary
to stimulate economic growth.
2.1 EU ETS
Acting as one of the EU's central policy instruments to meet their emission cap at the least cost
society, the intended aim of the EU ETS (as with all emissions trading schemes) is to provide a
cost efficient method of emissions reduction, such that firms in the EU facing high abatement
costs must buy additional allowances while those with low abatement costs will have incentive to
reduce emissions beyond their legal target and to sell excess allowances. Under the ETS, EU
member states each agree on national emission caps which, if approved by the EU commission,
grants them the ability allocate allowances to industry operators, with an obligation to ensure
independent verification of emissions reports from industry operators and to issue fair penalties
for violation of national law adopted pursuant to EU directive 2003/83/EU. The operators within
their respective markets are then free to trade/reassign their allowances through various channels:
(1) Private trade, whereby allowances are moved intra-firm between operators. (2) Allowances are
traded through a broker who privately matches buyers and sellers. (3) Traded on the spot market
of one of Europes climate exchanges.
The scheme is divided into a number of periods: Phase 1, a trial period, ran from early 2005 to the
end of 2007. The second trading period, Phase 2, ran from early 2008 to the end of 2012 and
coincided with the first Kyoto Protocol commitment trading period of an 8% reduction in CO2
emissions between 2008-2012 from 1990 levels. . Phase 3 will run from early 2013 until the end of
2020 with stated emissions caps for 2020 being 21% lower than greenhouse emissions compared
to 2005.
2.2 Allocation
The allocation of allowances is a principal factor in the effective implementation of an emissions
trading scheme. Phase I of the ETS required member states to allocate at least 95% of allowances
free of charge while Phase II reduced this number to 90%. This approach to the allocation of
allowances gave rise to numerous issues.
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Allocating allowances free of charge is the more favoured approach to allocation from an industry
standpoint but, it doesnt succeed in providing a credible incentive to actually reduce emissions.
This approach puts firms that were required to purchase their allowances at a competitive
disadvantage to those who were allocated allowances for free; which violates the key reason
behind using a market based approach, limited market distortion.
The directive gave member states discretion in whether to base the allocation of these free
allowances on historical emissions or performance benchmarks; with most member states
choosing to allocate allowances based on historical emissions for the sake of limiting the burden
on industry. Member states are also allowed to determine their allocation based on both present
and projected emissions, which can result in over zealous allocations by member states to industry
operators. The key problems with this approach being that it tends to reward the greatest
emitters and penalise firms who have already taken action to reduce emissions prior to enactment
of the scheme. It diminishes the incentive of firms facing low abatement costs to reduce emissions
and erodes the carbon spot price.
Another issue with this method of allocation under the ETS is that member states, under Article
87 of the EC Treaty, should not discriminate between firms and industries in any form
whatsoever which distorts or threatens to distort competition (Article 87, EC Treaty). Aimed to
prevent market distortion, this Article created difficulties for member states at a national level
since main competitors for domestic industries may operate in other member state markets so the
allocation of allowances free of charge would provide competitive advantage for domestic firms,
breaching Article 87, consequently requiring monitoring by the European Commission.
Phase III worked to gradually move from allocating allowances freely towards allocation through
auction as auctioning is the most transparent method of allocating allowances and puts into
practice the principle that the polluter should pay (EU Commission, 2013). From 2013 the
number of allowances allocated free of charge shrunk below 60% (of total allowances allocated),
with this share falling progressively in the following years. Eighty-eight per cent of the allowances
to be auctioned were allocated to member states based on ETS measured emissions in 2005; ten
per cent were allocated to the poorest member states, to alleviate the impact on industrial growth
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of cap and trade systems, and two per cent were awarded to member states that successfully
reduced emissions by 20% in 2005 from the Kyoto base period.
The initial free provision of allowances lends itself to the suggestion that the EU ETS failed to
provide a credible solution to the issue surrounding the evaluation of the short term economic
benefits of grandfathering and the long term environmental benefits of allocation through
auction. Introduction of allowance auctions during Phase III suggests policy makers for the EU
ETS did attempt to amend earlier failures of the scheme.
2.3 Monitoring, Reporting and Verification
The EU ETS moved to solve the issue of verifying emissions by creating conditions that must be
met by all industry operators in accordance with an EU Commission guideline. All monitoring
and reporting of emissions must be carried out annually, with the report being subject to
independent review and if deemed unsatisfactory the operator is blocked from trading allowances
until an acceptable report is submitted. If an operator fails to acquire an adequate number of
allowances they are obliged to pay 40 per tonne of CO2 for excess emissions in the following
year, with this penalty increasing in successive trading periods.
The Commission guideline created a tiered system of monitoring; the higher the tier
(corresponding with an increasing level of emissions) the greater the level of accuracy required.
The cost of monitoring is factored for within the guideline, whereby the monitoring installation
should provide the highest achievable accuracy at a cost deemed in-excessive. Even with this
factored into the guideline, it still leads to comparatively high costs of monitory installations for
smaller firms than larger ones.
2.4 EU ETS Carbon Price
As illustrated in section 1.3 emissions trading schemes suffer from high information requirements
with regards to issuing the correct number of permits to markets: issuing too few permits can
result in excessively high permit prices, effectively pricing smaller firms out of the market and
limiting their growth, while issuing too many will result in low prices which reduces the firms

incentive to cut back emissions. The ETS is not exempt from this, suffering from consistently low
market prices due to a lack of scarcity of allowances.
Phase I, known as the trial phase, commenced on January 1st 2005 but national registries, tasked
with holding, trading and confiscating permits (for compliance purposes), were unable to settle
transactions for several months. After the registries were able to accommodate transactions, the
price of allowances increased promisingly up to a peak level of close to 30 in April 2006. In late
April, however, the price of EU allowances dropped 54% following the release of reports by
numerous member states that their verified emissions were lower than the number of allocated
allowances.
Fig. 2

(Neilson, 2009)
In May 2006, the market price of allowances fell under 10/tonne following a European
Commission report confirming that CO2 emissions were in fact 4% lower than the amount of
allowances allocated. As this period ran as a getting used to period, allowances for this trial
period were set to expire by 31st December 2007 thus creating a unique issue whereby permits
would be deemed worthless by the end of the trading period; resulting in no incentive for firms to

actually bank any excess permits, leading to a higher market supply than had been hoped for and
a negative impact on the market equilibrium price of permits and by late 2007 the carbon market
price had fallen to effectively zero.
It was also recorded that emissions during Phase 1 actually increased by 1.9% (European
Commission, 2008), reflecting the fact that there was little incentive for firms to reduce emissions
whilst the spot price of allowances existed well below the 30/tonne price level which, by general
consensus, is the allowance price needed to drive large scale investment in low carbon methods.
Allowance prices during Phase II did little better, not aided by reduced output from emission
intensive sectors during the 2007-08 recession and lower expectations of future fossil fuel prices.
Fig. 3

(Ares, 2014)
Achieving a respectful average of 21/tonne in 2008 the price fell to an average of 13/tonne in the
first half of 2009, as reported in the Committee on Climate Changes 2009 report (CCC, 2009),
following a marked fall in output by CO2 intensive
industries as a result of the financial crisis. This

report highlighted that allowance prices were only being maintained throughout 2009 due to the

ability (and need) of industry operators to bank allowances for Phase III, where tougher caps
would be implemented.
Allowance prices were consistently below 10 from late 2011 to the end of Phase II, leading to
numerous critiques from financial commentators on the oversupply of allowances to the market
and that without intervention to reduce the supply of allowances, the price of allowances would
fall to four Euros (Reuters, 2012) and by the end of Phase II the market price of allowances had
fallen to just 6.76. It was estimated that by the end of 2012, the ETS had been oversupplied by
about 2 billion allowances (Carbon Market Watch, 2015).
Such volatile movements in the market price of allowances raises questions about the schemes
ability to provide a credible and stable incentive to polluters. Granted, volatility is an inherent
feature of commodity markets but the price movements of allowances did not provide a stable
platform necessary for long term investment in low carbon methods. Introducing a price floor and
ceiling to the carbon market would move to limit this volatility but there does also appear to be an
apparent reluctance of policymakers to introduce a price floor to the allowance market limits,
which does bring into question just how credible they believe the scheme to be. For either the
policy makers believe the EU ETS market price to always exist above a price floor, then putting a
price floor in place would not be a problem, or they believe the price could fall below the floor,
bringing into question as to the credibility of the scheme as a whole.
The ETS did fail during Phase I & II to provide a solution with regards to low allowance prices
and as such, failed to provide sufficient incentive to member states and their respective industry
operators to reduce emissions at all during Phase I and any emission reductions during Phase II
have regularly been attributed to reduced output from EU firms as a result of the 2007-08
recession.
Conclusion
Market based approaches to curbing emissions are generally held to be the most efficient method
of providing economic incentive for firms to engage in emissions abatement but, as illustrated
earlier there are significant difficulties with the allocation and pricing of allowances.
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From the above it may be suggested that the EU ETS failed to address many of the pre-existing
challenges facing the implementation of market based emission schemes and as such, fails to
provide a credible solution to the policy limitations: the consistently low carbon price illustrates
key failures by policymakers to successfully offer the correct number of allowances to effectively
incentivise emissions abatement and this low carbon price also highlights the EU ETS failure to
promote large scale investment in carbon reduction methods and if any investments were
undertaken, they were likely limited to small-scale efficiency savings.
The EU ETS, however, has been successful in bringing attention to climate change, which is a key
prerequisite for long term investment and has likely acted to deter investments into carbon
intensive projects. It has lead to a growth in the amount of research and literature surrounding
emissions markets and a number of important lessons for the design of future emissions trading
schemes are being drawn from the schemes successes and failures.
Bibliography
Ares, A. (2014) Carbon Price Floor. Available at:
http://researchbriefings.parliament.uk/ResearchBriefing/Summary/SN05927 (Accessed: 6 December 2015).
Carbon Market Watch (2015)

. Available at:

http://carbonmarketwatch.org/category/eu-climate-policy/eu-ets/ (Accessed: 2 December 2015)

Committee on Climate Change (2009)

The Stationery Office.

European Commissions (2008)

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http://europa.eu/rapid/press-release_IP-08-787_en.htm?locale=en
European Commission (2013)

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http://ec.europa.eu/clima/publications/docs/factsheet_ets_en.pdf
International Emissions Trading Association (no date)

Available at:

http://www.ieta.org/index.php%3Foption%3Dcom_content%26view%3Darticle%26catid%3D54:3-minute-briefin
g%26id%3D205:cap-%26-trade-basics (Accessed: 3 December 2015).
Nielson, L. (2009)

Available:

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http://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/BN/0910/E
missionsTrading (Accessed: 2 December 2015)
Reuters (2012)

. Available:

http://financial.thomsonreuters.com/en/resources/articles/point-carbon.html
(Accessed: 2 December 2015)

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