The biggest environmental meeting in history opened in Copenhagen this week, with more than 15,000 delegates from over 192 countries converging on Denmark’s picturesque capital with the daunting task of agreeing a global strategy to combat climate change.  Much of the debate in the lead-up to the event has centered on the proposed use of a cap-and-trade system to reduce carbon emissions.

Many cap-and-trade proponents have pointed to Europe, where the world’s largest multi-national, multi-sector greenhouse gas (GHG) emissions trading system, the EU Emissions Trading Scheme (EU ETS), has been running since January 2005.  The EU ETS is not without its critics, however, and many have suggested the scheme has yet to deliver positive results.

This week, we speak to Dr. Ralf Wagner, manager of forward analysis for E.ON Energy Trading and one of the company’s resident carbon market experts, to learn more about the current state of the EU ETS and ask whether or not it is actually achieving what it was set out to do.

RW: In 1997, 55 countries representing more than half of the world’s GHG emissions signed the Kyoto Protocol, which set emissions caps for every country that took part in the agreement.  European Union member states agreed to share the burden of meeting their Kyoto targets, which amounted to an 8% cut in emissions on 1990 levels for the first Kyoto commitment period of 2008-2012. The EU ETS was established as the primary mechanism to ensure the required emissions reductions are made.  In 2005, the EU launched the first phase of the ETS as a pilot. The second phase of the EU ETS is now aligned with the first Kyoto commitment period.

RW: Simply put, it’s the world's first international carbon trading system.  Every energy-intensive installation in Europe, such as a power station, oil refinery, or steel plant, is allocated carbon permits by EU member states, based upon the amount of carbon that each installation and each country is allowed to emit. Each installation owner, who must present a allowance for each unit of carbon that they emit, can then buy or sell these allowances on the open market. 

Over time, the amount of carbon that each installation is allowed to emit is reduced and fewer allowances are allocated. Reducing the supply of carbon allowances available to the market in each phase should create scarcity and help to increase the value of each allowance. This is important, because if you have a higher carbon price, there is less incentive for companies to run carbon-intensive plant and more incentive to invest in cleaner technology. 

It’s also important to note that the EU doesn’t foresee an end to the EU ETS. Therefore, there will be further phases which will be linked to each other by allowances which can be banked from one phase to the next.

RW: I would disagree.  It’s is true that the EU ETS is a politically constructed market, and in this way it is different from other commodities.  But it’s also true that the carbon market is now reacting to market fundamentals and behaving as we’d expect, given the current economic conditions.  The recession means that energy-intensive industries across Europe are producing less and emitting less carbon.  As a result, the demand for carbon emission certificates has dipped and the price has responded accordingly. 

From a trading perspective, it’s a positive sign that carbon is functioning as a commodity and, though not closely correlated to other commodities, still reacting to the same market fundamentals. As the recession eases and industrial production begins to increase, the demand for carbon emission certificates will also increase and we would expect to see the carbon price respond accordingly.

EUA prices respond to economic development. In autumn 2008 industry players started to sell their lengh.

RW: Yes.  Sometimes it’s easy to get fixated on the carbon price, but that can be misleading.  The fact is, no matter what the carbon price, the EU ETS sets a cap on emissions from the outset of each phase, ensuring that emissions are reduced.  The penalties for non-compliance are severe: €100 for each ton emitted without an allowance, and an obligation to return the relevant number of allowances in the next compliance year.

RW: To really achieve meaningful emissions reductions globally, we need to create a level playing field with a single global cap-and-trade carbon market.  You could start by linking up all existing trading mechanisms, such as the EU ETS.  The two principal objectives should be to facilitate a global price setting mechanism for carbon and encourage the most efficient low carbon technologies.

Ralf recently discussed the EU ETS at the NARUC/NCEP Climate Change Conference in Houston. His paper "The impact of the EU Emissions Trading Scheme on power: the price to be paid for CO2 abatement" is available for download in the menu to the right.