The European Union EmissionsTrading System Ten Years andCountingA. Denny Ellerman*, Claudio Marcantoniniy, andAleksandar ZaklanzIntroductionThe European Union EU Emissions Trading System ETS is the world’s largest cap-and-tradeprogram and arguably the most important market-based application of economic principles tothe climate problem. From its inception, the EU ETS has drawn attention and been the subjectof vigorous debate in the public arena. In fact, in 2007, it was the topic of the symposium in theinaugural issue of this journal. The articles in that symposium discussed the unusuallydecentralized nature of the EU ETS Kruger, Oates, and Pizer 2007 and provided an initialassessment of its perance during its first two years Convery and Redmond 2007; Ellermanand Buchner 2007. In 2015, the EU ETS started its eleventh year, having completed its secondphase 2008–2012 and begun its third phase 2013–2020 under an EU-wide cap on emissionsthat is declining indefinitely at an annual rate of 1.74 percent.The objective of this journal’s second symposium on the EU ETS is to review and uate theliterature on the EU ETS as of 2014, to draw some conclusions about the perance of theEU ETS, and to suggest a research agenda to address unresolved issues. In this introductoryarticle, we provide an overview of the EU ETS to serve as background for the topics discussed inthe other two articles. In the first article, Hintermann, Peterson, and Rickels 2016 examinemarket and price behavior in the EU ETS. The second article, by Martin, Muuˆls, and Wagner2016, addresses the effect of the EU ETS on the behavior of regulated firms with respect toabatement, competitiveness, and innovation.The remainder of this article consists of three sections. The first section describes the historyand structure of the EU ETS. The second section reviews the perance of the EU ETS over itsfirst ten years, focusing on emissions, allowance prices, and the use of offsets.1The final section* European University Institute and Massachusetts Institute of Technology; e-mail ellermanmit.edu.y European University Institute; e-mail Claudio.MarcantoniniEUI.eu.z DIW Berlin; e-mail azaklandiw.de.1Offsets are emission reductions accomplished outside of the system that can be used to substitute for reductionsthat would otherwise occur within the system. In the EU ETS, the only offsets allowed are those certified under89Review of Environmental Economics and Policy, volume 10, issue 1, Winter 2016, pp. 89–107doi10.1093/reep/rev014Advance Access published on December 3, 2015C223 The Author 2015. Published by Oxford University Press on behalf of the Association of Environmental and ResourceEconomists. All rights reserved. For Permissions, please email Downloaded from https// by University of Bologna user on 19 February 2019discusses the continuing debate about the design of the EU ETS and the recently adopted andproposed changes to that design.History and Structure of the EU ETSThe EU ETS is a classic cap-and-trade system.2As of 2014, the EU ETS covered approximately13,500 stationary installations in the electric utility and major industrial sectors and all domesticairline emissions in the EU’s twenty-eight member states, plus three members of the closelyassociated European Economic Area Norway, Iceland, and Liechtenstein. Approximately twobilliontonsofcarbondioxideCO2 and some other greenhouse gases GHGs are includedin the system, together accounting for about 4 percent of global GHG emissions in 2014 Olivieret al. 2014. Aside from its sheer size in terms of geographic scope, number of included sources,and value of allowances, another distinguishing feature of the EU ETS is its implementationthrough a multinational framework, namely the EU, rather than through the action of a singlestate or national government, as assumed in most theory and as has been the case for most othercap-and-trade systems.3We turn now to the process by which this multinational system wasadopted.Legislative DevelopmentThe first clear signal that the EU might implement an emissions trading system was in 2000,when the European Commission issued the Green Paper on Greenhouse Gas Emissions TradingwithintheEuropeanUnion European Commission 2000. This paper discussed whether the EUshould implement an EU-wide cap-and-trade system to limit GHG emissions initially CO2tocomplement other policies and measures, chiefly concerning energy efficiency and renewableenergy, implemented primarily at the member-state level. Such a cap-and-trade system was alsoviewed as a means to ensure achievement of the targets to which the EU and its member stateshad committed in the Kyoto Protocol KP. The green paper laid out the essential features ofthe system that would become the EU ETS a trial period to run from 2005 through 2007,followed by full implementation over the 5-year period corresponding to the FirstCommitment Period of the KP 2008–2012. Following extensive debate, the ETS Directivewas unanimously adopted by the European Council of Member States in October 2003 OJEUthe Kyoto Protocol through the Clean Development Mechanism Certified Emission Certifications [CERs] andJoint Implementation Emission Reduction Units [ERUs].2In a cap-and-trade system, a constraining quantitative limit is placed on the aggregate emissions of a specifiedset of plants, and trading of implied emission reductions is allowed among these plants in order to minimizecost. Such trading is conducted through the sale and purchase of allowances, which are issued in an amountequal to the aggregate cap. Regulated plants are required to surrender an amount of allowances equal to theiremissions. Allowances can be acquired either through free allocation or by purchasing through auctions or fromothers through trading.3When the EU ETS was created, the main example of cap-and-trade was the U.S. Sulfur Dioxide TradingProgram, which was implemented as a federal program. Other smaller cap-and-trade systems existed at thesubnational level in the United States and in some European nations, but all were smaller and under a singlejurisdiction. Since the creation of the EU ETS, other multijurisdictional cap-and-trade systems have beencreated, including the Regional Greenhouse Gas Initiative in the Northeastern United States and the linkedsystem of California and Quebec.90 A. D. Ellerman et al.Downloaded from https// by University of Bologna user on 19 February 20192003. And, as initially proposed in the green paper, the EU ETS went into effect on January 1,2005, 15 months later.In October 2004, the ETS Directive was amended by the Linking Directive OJEU 2004,which allowed the owners of affected facilities to substitute a yet-to-be-specified number ofoffsets i.e., credits from the KP’s Clean Development Mechanism [CDM] and JointImplementation [JI] to fulfill their obligation to EU allowances EUAs equal totheir annual emissions.In keeping with the spirit of an initial trial period,theETSDirectivecalledfortheEuropeanCommission to review the first years of experience and to propose appropriate changes to theETS. This review led to the adoption of significant revisions to the EU ETS in late 2008 OJEU2009b, which would govern the system from 2013 on. The most important changes in thisAmended Directive were the following. adoption of a single EU-wide cap declining at 1.74 percent per annum;. adoption of auctioning as the basic allocation principle, to be fully applied to the electricutility sector in 2013 and to be phased in by 2027 for the remaining industrial sectors;. continued free allocation for industrial facilities according to centrally determined bench-marks during the transition to full auctioning; and. changes in offset provisions that further limited their use while expanding the scope forlinking with GHG cap-and-trade systems that might develop in other parts of the world.4The significance of the single EU-wide cap can only be appreciated by recognizing the consid-erable decentralization of cap-setting and allocation of allowances that existed under the initialETS Directive.Evolution from a Highly Decentralized Structure to an EU-Wide CapIn its early years, the EU ETS can be best understood as a system for the mandatory linking oftwenty-five member-state systems, each of which set its own cap and determined the distribu-tion of allowances to affected facilities, subject to a 90-day review by the European Commission.More specifically, each member state developed a National Allocation Plan NAP statingthe total number of allowances to be created and how they would be allocated to affectedinstallations in the member state. These NAPs would go into effect unless the commissionrejected the NAP because it failed to comply with certain criteria in the ETS Directive. In effect,the EU-wide cap was the sum of the member-state caps, and it would not be known definitivelyuntil the last NAP had been reviewed and not rejected.54Among other notable changes were the inclusion of the chemical and aluminum sectors beginning in 2013. Aseparate Aviation Directive OJEU 2009 further expanded the scope of the ETS to include aviation emissionsstarting in 2012. Inclusion of emissions over non-EU airspace for flights originating in the EU and terminatingelsewhere and vice versa proved to be controversial internationally and led to later amendment to limitincluded emissions to those over EU airspace. In addition, the global system being developed by theInternational Civil Aviation Organization to take effect in 2020 is expected to supersede the EU ETS withrespect to these emissions.5The commission was empowered to reject NAPs only if they did not meet the criteria for cap-setting andallocation agreed by the member states in the ETS Directive. Nonrejection constituted implicit approval, but inthe multinational context of the EU, it is considered beyond the capacity of the commission, a mere secretariat,to “approve” the actions of a sovereign state. This may be a distinction without a difference, but it wasimportant in terms of respecting national sensibilities.The European Union Emissions Trading System Ten Years and Counting 91Downloaded from https// by University of Bologna user on 19 February 2019The NAP process proved to be long, laborious, and unrewarding for all concerned. In boththe 2005–2007 and 2008–2012 periods, the commission rejected many NAP submissions, andseveral member states subsequently challenged these rulings before the European Court of FirstInstance.6It was not until 18 months into phase I that the last NAP cleared the commission’sreview. The second NAP cycle started at this time, 18 months before the start of 2008, butmember states were often late in ting, and the final NAP to clear review without beingrejected did so 1 month before the start of phase II. A year later, the member states agreedunanimously to abandon the NAP process and instead to adopt a system-wide cap to take effectin 2013. The single cap required a new set of principles for distributing allowances, which weexplain next.Auctioning and Centralized Allocation RulesThe two greatest criticisms of the first phase were the “windfall profits” from free allocation andthe alleged competitive distortions resulting from different member-state rules for allocation.Despite strong arguments in the European Parliament for significant auctioning of allowances,the directive finally agreed upon in 2003 required that at least 95 percent of allowances beallocated freely in the first phase and 90 percent in the second phase. In effect, decentralized freeallocation was the political price for ensuring the participation of all member states in thismultinational trading system.7Auctioning addressed both criticisms of the NAP process in onefell swoop. That is, windfall profits would be eliminated, as would the possibility of competitivedistortions within the single EU market. However, auctioning would be phased in, which meantthat EU-wide, sector-specific standards would have to be developed to avoid distortions fromthe remaining free allocation.The timing by which auctioning would be introduced and free allocation phased out variedaccording to sector, perceived loss of competitiveness in international non-EU trade, andwhen the member state joined the EU. For example, free allocation ended abruptly in 2013 forthe electric utility sector, which accounts for about 50 percent of EU ETS emissions Trotignonand Delbosc 2008, p. 23 and was deemed not to face any competitive threat internationally.Some exceptions were allowed for coal-dependent new member states in Eastern Europe, whichhave more time to phase out free allocation, provided that they make investments in themodernization of the electricity sector.The nonelectric industrial sectors, which face varying levels of non-EU competitive pressures,were allowed a more gradual phase out of free allocation beginning in 2013. Allocations toaffected facilities were to follow EU-wide sector standardscalled benchmarksto be de-veloped during phase II. For these industrial facilities, free allocation would start at 80 percentof the full benchmark in 2013, be reduced to 30 percent by 2020, and then phased out com-pletely by 2027. In addition, if certain sectors continue to face competitive threats internation-ally, they will receive free allocations at the full benchmark level so long as the threat isdetermined to exist. The development of these sector-specific, EU-wide standards for freeallocation was no small achievement.6See Ellerman, Convery, and de Perthuis 2010, pp. 42–60, for the details of these rejections and legal challenges.7For a detailed discussion of the debate leading up to the adoption of the EU ETS, see chapter 5 of Skjaerseth andWettestad 2008.92 A. D. Ellerman et al.Downloaded from https// by University of Bologna user on 19 February 2019BenchmarkingPerhaps no concept had been more advocated and less practiced during the NAP process for thefirst and second trading periods than benchmarking Ellerman, Buchner, and Carraro 2007.The basic problem was the lack of agreement on a suitable benchmark, which, when combinedwith the rushed conditions under which the NAPs were developed, made it inevitable that thebasis for allocation would be historical emissions. The Amended Directive resolved this issue byrequiring the EU-wide benchmarks to be the average emission rate per unit of output for thoseinstallations in each ETS sector constituting the 10 percent with the lowest CO2emission ratesin 2005. Although defining sectors was a challenge, benchmarks were established for some fiftysectors before the end of phase II. Finally, these be