by Jenay Randall
Emissions trading is a market-based environmental policy instrument used to promote sustainable growth. The EU’s Emissions Trading System (ETS) is the prototype for global existing and emerging cap-and-trade schemes.
The “cap-and-trade” version (the most common) of the system works by setting a “cap” on greenhouse gas (GHG) emissions and then incentivizing polluters to reduce their emissions by allowing them to essentially “trade” the excess carbon “allowance” they did not surrender. Larger emitters buy allowances from smaller emitters .
While it is beyond the scope of this article to evaluate the implementation of these schemes, it will compare and contrast the EU ETS with that of 4 countries: China, South Korea, Switzerland and the UK, plus one region (California).
The EU: Pioneers of ETS
Before comparing the different existing and emerging schemes globally, it is crucial to briefly describe the first and largest system for reducing greenhouse gasses (GHG)– The European Union’s Emissions Trading System.
Its main features are:
- Sectoral Coverage: The EU ETS covers energy-intensive industries, power stations and domestic civil aviation.
- Allowances: Through this market mechanism, companies are incentivized to emit less than the emissions cap because they can sell carbon permits (allowances) to companies that pollute more .
- Allocation: Allocation refers to the distribution of emission allowances to polluters. Allowances are either auctioned or given for free to protect against carbon leakage (businesses transferring production to other countries with laxer emission constraints).
Emissions Coverage by ETS
Emissions trading systems tend to cover energy-intensive industries and the power sector as those tend to emit the most carbon.
In the EU, the system covers 41% of GHG emissions.
Most recently, China launched their piloted ETS scheme that regulates around 2,200 companies from the power sector, accounting for approximately 40% of total carbon emissions .
Korea’s impressive ETS (K-ETS) is one of the largest carbon markets after the EU and covers almost 700 of the greatest polluters, contributing to about 75% of their total emissions .
The system is mandatory for larger, energy-intensive operations in Switzerland but voluntary for smaller ones. They also linked with the EU ETS and their reach expanded to civil aviation and power plants .
Similarly, the UK now has its own ETS separate from the EU ETS, which covers energy-intensive industries, the power sector and aviation, accounting for approximately one-third of all GHG emissions .
Lastly, California’s cap-and-trade ETS covers around 80% of the state’s emissions, with the highest overall emissions coming from the transportation and industrial sectors .
Allowances and Auctioning
While ETS aims to make it cheaper for polluters to meet emission reductions targets, external economic and political variables can result in unstable allowance prices and, therefore, de-incentivize green investment. For this reason, a mechanism is necessary to regulate carbon pricing .
In the case of EU-ETS, policymakers introduced The Market Stability Reserve (MSR), which increased allowance prices in the short term. In the EU ETS, the price went from 8 euros in 2018 to 60 euros in 2020, in part due to MSR .
The current price is approximately 85 euros .
In terms of how these allowances can be traded, there are two methods: free allocation and auctioning. Free allocation refers to when allowances are given away and auctioning refers to when they are sold. Most ETS employ a mixture of the two, except South Korea, which relies almost 100% on free allocation.
In reducing GHG emissions, auctioning is the preferred method because it is the most transparent way of ‘making the polluter pay’ .
In the EU-ETS, 57% of allowances will be auctioned in the next ten years, and 88% were proportionally distributed to the EU Member States, 10% to lower-income EU Member States and 2% distributed among nine Member States that reduced 2005 emissions by 20% .
California ETS has implemented both free allocation and auctioning, while in the UK ETS, it is auction-dominant. Allowance prices in the UK are currently 78 euros. The Swiss and EU ETS have in common the use of benchmark-based free allocation .
A benchmark is based on the average GHG emissions of the best performing 10% installations. A priori, installations that meet the benchmark will receive all necessary allowances, and those that don’t will be obliged to either reduce their emissions or buy more allowances .
China’s ETS also uses benchmarking (a type of free allocation) as the primary allocation method but with lower requirements.
It is clear ETS schemes are a relatively valuable market mechanism to reduce GHG emissions to some extent, as the number of these schemes continues to expand. It is also essential for schemes to be adapted to the local context to be effective.
There remains much progress to be made in international carbon markets, as policymakers are now discussing the opportunities for national ETS to “link”, as in the case of EU ETS and that of Switzerland. However, if national ETS is still emerging and developing, a globally integrated carbon market appears to be a distant goal.
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