New Zealand Journal of Environmental Law

The European Commission used the results of the ECCP to develop an overall EU climate strategy in order to achieve the commitments made under the Kyoto Protocol.⁴⁶ In addition, “the Commission analysed whether emissions trading at the level of installations might be an appropriate national policy to meet the EU’s Kyoto targets”.⁴⁷

In March 2000 the Green Paper on greenhouse gas emissions trading within the European Union which initiated a public consultation process was published.⁴⁸ In this Green Paper the European Commission discussed the issue of GHG emissions trading within the European Union. It is built on previous Commission communications and discusses the implementation of a GHG emissions trading scheme, prior to the start of emissions trading under the Kyoto Protocol, within the EU as an integral and major part of the EU implementation strategy to achieve the obligations under the Kyoto Protocol.⁴⁹

This Green Paper discusses several basic questions related to emissions trading in the EU and assesses possible mechanisms to answer them.⁵⁰ A main element of the Green Paper is to install a limited emissions trading scheme within the EU by 2005.⁵¹ The main idea behind it is the chance for the EU to assess the possibilities of an emissions trading scheme through a “learning-by- doing” approach prior to the start of emissions trading under the Kyoto Protocol in 2008⁵² because the experiences which could be gained by it were expected to give the European Union a certain familiarity and practice with the issue of emissions trading.⁵³ The Green Paper had an informative role in explaining the basics of emissions trading and also an analytical role in making “a strong case for Community involvement in future developments in this area”.⁵⁴ The key to fulfilling the obligations of the Kyoto Protocol through emissions trading was seen in the parallel use of several mechanisms in several energy sectors.⁵⁵

The prior emissions trading scheme for the EU is limited to the GHG carbon dioxide, because it constitutes “approximately 80 per cent of the

46. Ibid.
47. Ibid.
48. Ibid.
49. European Commission, Green Paper on greenhouse gas emissions trading within the European Union (8.3.2000), COM (2000) 87 final, 7 & 10.

50 Ibid, at 20–23.

51. Ibid, at 10.
52. Ibid.

53 Ibid, at 10 & 20–23.

54. European Union, Press Releases, Climate Change — Commission launches European Climate Change Programme and advocates twin-track approach for reducing emissions (2007), at <http://europa.eu/rapid/pressReleasesAction.do?reference=IP/ 00/232 & format=HTML & aged=0 & language=EN & guiLanguage=en> (access date 15.09.2007).
55. Ibid.

Community’s greenhouse gas emissions and it is the easiest one of all other GHGs to accurately monitor”.⁵⁶ The EU Green Paper led to the “Proposal for a framework Directive for greenhouse gas emissions trading within the European Community” in 2001, which started a formal legislation process on the member state level as well as on the European Community bodies level.⁵⁷

The result was the amendment of the proposal for a Directive of the European Parliament and of the Council establishing a scheme for GHG emission allowance trading within the Community COM (2001) 581 and the amendment of the Council Directive 96/61/EC, which laid the foundation for the EU ETS.⁵⁸

• 2.1.3 Directive 2003/87/EC and amending Directive 2004/101/EC

The EU ETS is legally based on the Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 and entered into force on 25 October 2003.⁵⁹ This Directive establishes a scheme for GHG emission allowance trading within the Community amending the Council Directive 96/61/ EC.⁶⁰ The subject matter of the Directive 2003/87/EC which is stated in Article 1 is “to promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner”.⁶¹

Therefore, emissions trading is based on a cap-and-trade system, which allows the participants to reduce GHG emissions wherever the abatement costs are the lowest, instead of a command-and-control approach of governments through laws and taxes to reach the Kyoto Protocol GHG reduction targets. A market-based approach is seen as more efficient and successful, because this solution to achieve GHG reduction targets is based on market rules such as supply and demand, which helps to keep costs at a low level instead of imposing mandatory obligations, laws, or taxes.⁶²

Directive 2003/87/EC provides the rules for the trade with GHG emission permits and also the rules for the National Allocation Plans for them.⁶³ GHG emission permits — also called “allowances” — means the entitlement to

56. European Commission, Green Paper on greenhouse gas emissions trading, supra note 49, at 10–11.
57. Butzenberger, Michaelowa & Bode, Europe — a Pioneer in Greenhouse Gas Emissions Trading, supra note 45, at 220 & 221.
58. Ibid.
59. Directive 2003/87/EC.
60. Ibid.
61. Ibid, Article 1.
62. Barbara Buchner & Michela Catenacci, Institute for International and European Environmental Policy, “Governance and Environmental Policy Integration in Europe”, Ecologic (2007) 14.
63. Directive 2003/87/EC, Articles 4 & 9.

emit an equivalent of a tonne of carbon dioxide during a specified period of time.⁶⁴ Guidelines for monitoring and reporting of emissions as well as a strong compliance framework are included in Directive 2003/87/EC.⁶⁵ Article 25 enables the system of the EU ETS to link it with other schemes under the Kyoto Protocol to ensure successful emissions trading worldwide.⁶⁶

Directive 2004/101/EC of the European Parliament and of the Council of 27 October 2004 amending Directive 2003/87/EC establishes a scheme for GHG emission allowance trading within the Community, in respect of the Kyoto Protocol’s project-based mechanisms.⁶⁷ This amending Directive recognises the flexible mechanisms of the Kyoto Protocol — the clean development mechanism (“CDM”)⁶⁸ and joint implementation (“JI”)⁶⁹ — as measures to be used under the EU ETS to achieve the GHG emission reduction targets under the Kyoto Protocol. Thus, credits from CDM and JI are seen as equivalent to EU emission allowances, except those from land use, land use change, and forestry activities.⁷⁰ The credits from JI are called “emission reduction units” (“ERUs”) while the credits of the CDM are called “certified emission reductions” (“CERs”).⁷¹ The use of CERs is allowed from 2005 on, while the use of ERUs will start in 2008.⁷² Directive 2004/101/EC ensures also, that these CERs and ERUs are not being counted twice where they also result from activities of reducing or limiting GHG emissions under Directive 2003/87/EC.⁷³ As a result, the compliance costs for achieving the GHG emission reductions should be lower than before. Directive 2004/101/EC, which is also called the “linking- Directive”, because it links the Kyoto Protocol mechanisms JI and CDM to the

64. Ibid, Article 3a.
65. Ibid, Articles 14, 16 & 21.
66. Ibid, Article 25.
67. Directive 2004/101/EC.
68. The CDM is laid down in Article 12 of the Kyoto Protocol. It comprehends the cooperation between industrialised countries and developing countries in relation to the fight against climate change. In comparison to the developing countries, which do not have binding GHG reduction targets, the industrialised countries have legally binding GHG reduction targets and thus CDM gives them the possibility to carry out environmental projects to reduce GHG emissions in non-Annex I countries (developing countries) and be credited the net emission reductions. This is known as certified emissions reductions (“CERs”).
69. JI is laid down in Article 6 of the Kyoto Protocol. In a JI endeavour an Annex I party invests in an environmental project in the territory of another Annex I country to reduce GHG emissions and is credited the net emission reduction for it. Therefore, according to Article 3.10 and Article 3.11 of the Kyoto Protocol, the total emission allowance of Annex I countries with a commitment inscribed in Annex B of the Kyoto Protocol stays unchanged. JI is a project-based system with the requirement that projects have to be additional to those projects which would otherwise occur in the receiver country.
70. Ibid, Article 11a (3b). 71 Ibid, Article 3m & n.
72. Clause 5 of Directive 2004/101/EC.
73. Clause 10 of Directive 2004/101/EC.

EU ETS, entered into force on 13 November 2004, just in time for the start of the EU ETS on 1 January 2005.⁷⁴

• 2.1.4 EU instruments

Since the establishment of the UNFCCC and its Kyoto Protocol, the European Commission and the European Council as well as the European Parliament agreed to declare the fight against climate change a political priority of the European Union.⁷⁵ Therefore, the EU has accepted a global leadership role in climate change discussion through its economic and political effort to reduce GHG emissions, even though its internal structure did not provide the necessary instruments or resources to deal with this issue in such a role.⁷⁶ The EU is not a state and therefore it does not have a government.⁷⁷ Thus, the European Parliament alone does not represent the will of the people of the 27 member states.⁷⁸ Even though the EC Treaty enables the EU to act within certain limits, there is no provision in the EC Treaty which deals with the issue of climate change.⁷⁹ The member states have the competence for energy policy while the EU is able to “to take measures in the area of energy”.⁸⁰ This situation makes it difficult for the EU to deal with a complex problem like the fight against climate change.

However, the EU with its “supranational character” has the competence to regulate many issues and is even able to replace the sovereign power of the member states.⁸¹ The Kyoto Protocol covers areas of “mixed competence”, which means that the EU and its member states have competence in this field.⁸² As a result, the EU is a party to the Kyoto Protocol as well as the member states.⁸³

The EU is represented by its several instruments: the European Council, the European Commission, and the European Parliament. The EU Council consists of the respective Ministers of the member states and has the power to adopt legislation, often together with the European Parliament, that has a direct

74. Buchner & Catenacci, Governance and Environmental Policy Integration in Europe, supra note 62, at 12.
75. Marjan Peeters & Kurt Deketelaere, EU CLimate Change Policy: The Challenge of New Regulatory Initiatives (2006) 205. This environmental policy was also supported by the Prodi Commission (1999–2004) and the Barosso Commission (2004–2009).
76. Ibid.
77. Ibid, at 280.
78. Ibid.
79. Peeters & Deketelaere, EU CLimate Change Policy, supra note 75, at 280. 80 Ibid.

81 Oberthür & Ott, The Kyoto Protocol, supra note 27, at 142. 82 Ibid.

83 Ibid.

effect on the member states.⁸⁴ For example, “Regulations” of the EU Council create rights and duties for the member states immediately, meaning they are enforceable by any law court in the member states.⁸⁵

In comparison, “Directives” have to be implemented by the member states before they become national law.⁸⁶ In the event a member state does not comply with the European legislation, there is a strong judicial system and the European Court of Justice is able to impose high financial penalties in such a case.⁸⁷ Directive 2003/87/EC of the European Parliament and of the Council (dated 13 October 2003) established a scheme for GHG emission allowance trading within the Community amending Council Directive 96/61/EC.⁸⁸ This binding legislation was proposed by the European Commission and approved by the EU member states and the European Parliament and established the EU ETS.⁸⁹

• 2.1.5 Phases of the EU ETS

The EU ETS is being introduced in two phases including periodic reviews and opportunities for expansion to other gases and sectors.⁹⁰ It is divided into two emissions trading periods — the first one commenced in 2005 and the second one will take place from 2008 to 2012, which corresponds with the first commitment period of the Kyoto Protocol.⁹¹

While the Kyoto Protocol covers a basket of six greenhouse gases (carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulphur hexafluoride), the first phase of the EU ETS only covers the greenhouse gas CO₂, while in the second phase the other five gases will be added to the scheme.⁹² In the first phase of the emissions trading scheme for the EU, the scope of GHGs is limited to the GHG carbon dioxide, because it constitutes “approximately 80 per cent of the Community’s greenhouse gas emissions and it is the easiest of all the GHGs to accurately monitor”.⁹³ Of course, the first phase of the EU ETS is also regarded as a “warming-up” period, which is seen as an opportunity to develop some experience with emissions trading and to help gain knowledge about how to build up a successful emissions trading

84. Ibid.
85. Ibid.
86. Ibid.
87. Ibid.
88. European Commission, EU Action against Climate Change, supra note 41, at 8. 89 Ibid.
90. Ibid, at 9.
91. Ibid.
92. Ibid.
93. European Commission, Green Paper on greenhouse gas emissions trading, supra note 49, at 10–11.

scheme.⁹⁴ In the second phase of the EU ETS from 2008 to 2012 the scheme may be amended in terms of expanding the categories of activities subject to the Directive, particularly aluminium and transport, and an expansion to other GHGs may potentially be added.⁹⁵

• 2.1.6 Involved industries of the EU ETS

Concerning the limitation of the scope of GHGs to carbon dioxide during the first phase of the EU ETS from 2005 to 2007, the EU ETS involves, in its initial period, only large emitters in the power and heat generation industry in selected energy-intensive sectors.⁹⁶ Annex I of Directive 2003/87/EC lists all industries and activities that are covered by the EU ETS, such as: electricity and heat production plants greater than 20 MW of capacity; mineral oil refineries; basic metal production including coke ovens and rolling mills; cement and lime production; glass and glass fibres; ceramics including roofing tiles, bricks, tiles, stoneware, and porcelain; and pulp and paper.⁹⁷ Even though the first phase of the EU ETS has a limited scope, there are approximately 11,500 individual installations in the 25 member states of the EU which are covered by it.⁹⁸ Overall, the EU ETS covers about 45 per cent of the EU’s total carbon dioxide emissions or “about 30 per cent of its overall GHG emissions”.⁹⁹

• 2.1.7 Cap-and-trade system of the EU ETS

The EU system for emissions trading is based on a cap-and-trade concept, which is a system where the right to emit GHGs is tradable amongst the participants. The “currency” of this system is a so-called European Union Allowance (“EUA”), which is the right to emit one tonne of carbon dioxide under the EU ETS.¹⁰⁰ Under the EU ETS as well as under the Kyoto Protocol, GHG emissions are quantified according to tonnes of carbon dioxide equivalent (CO₂e).¹⁰¹ One

94. European Commission, EU Action against Climate Change, supra note 16, at 9. 95 Clause 15 of Directive 2003/87/EC.
96. European Commission, EU Action against Climate Change, supra note 16, at 9; Directive 2003/87/EC, Annex I.
97. Ibid.
98. Ibid; Directive 2003/87/EC of the European Parliament and of the Council, Article 3(e). “Installation means a stationary technical unit where one or more activities listed in Annex I are carried out and any other directly associated activities which have a technical connection with the activities carried out on that site and which could have an effect on emissions and pollution.”
99. European Commission, EU Action against Climate Change, supra note 16, at 9.
100. European Commission: Environment, Emission Trading Scheme, supra note 13, at 11 (access date 21.09.2007).
101. UNFCCC, The mechanisms under the Kyoto Protocol, The Clean Development Mechanism,

tonne of CO₂e means “one metric tonne of carbon dioxide or an amount of any other greenhouse gas listed in Annex II with an equivalent global-warming potential”.¹⁰² The EU ETS imposes caps on the amount of European Union Allowances to reduce GHG emissions within the EU member states.¹⁰³ Thus, the European Commission allocates the maximum level of emissions to control the final amount of air pollution through GHG emissions, while each EU member state has to propose how many EUAs to allocate for a certain period of time and how these EUAs will be distributed within this country amongst the installations which are listed in Annex I of Directive 2003/87/EC.¹⁰⁴ Therefore, each EU member state has the responsibility for developing its own National Allocation Plan for the EUAs.¹⁰⁵ Even though only installations are covered by the scheme by receiving EUAs, anyone else, such as individuals, institutions, non-governmental organisations and so on, can buy and sell in the emissions trading market as well as companies.¹⁰⁶

The flexibility of the emissions trading market gives emitters the opportunity to choose how they want to achieve their GHG reduction targets. In order to comply with the caps, emitters, who have emitted less than they were allowed to, are able to sell their excess EUAs into the emissions trading market to those emitters who have not been able to meet their GHG reduction targets.¹⁰⁷ In addition, emitters can invest in technologies to reduce their GHG emissions.¹⁰⁸ For example, a company that exceeded their individual limit is allowed to buy unused EUAs from companies that have taken successful steps to reduce their GHG emissions.

The allocation of EUAs will be almost free of charge. Article 10 of Directive 2003/87/EC states that in the first phase of the EU ETS from 2005 to 2007, “Member States shall allocate at least 95% of the allowances free of charge”¹⁰⁹ and for the second phase of the EU ETS from 2008 to 2012, “Member States shall allocate at least 90% of the allowances free of charge”.¹¹⁰

Joint Implementation and Emissions Trading, Eligibility requirements (2007), at <http:// unfccc.int/kyoto_protocol/mechanisms/items/1673.php> (access date 22.09.2007); European Commission: Environment, Emission Trading Scheme, supra note 13, at 11 (access date 22.09.2007).

102. Directive 2003/87/EC, Article 3(j).
103. European Commission: Environment, Emission Trading Scheme, supra note 13, at 11 (access date 22.09.2007).
104. Michela Catenacci, EPIGOV, Governance and Environmental Policy Integration in Europe: What can we learn from the EU Emission Trading Scheme? (2007) 5.
105. See supra 2.1.1.
106. Ibid; Directive 2003/87/EC, Article 12(3g).
107. European Commission: Environment, Emission Trading Scheme, supra note 13, at 11 (access date 25.09.2007).
108. Ibid.
109. Directive 2003/87/EC, Article 10.
110. Ibid.

The National Allocation Plans for the EUAs have to be approved by the European Commission,¹¹¹ which has to review the NAPs from each participating EU member state to assess whether or not they meet the allocation criteria.¹¹² How to meet the criteria of the NAPs is outlined in Annex III of Directive 2003/87/EC.¹¹³ Most important is that a NAP includes the GHG emission reduction target under the Kyoto Protocol, taking into account the national energy policies that should be consistent with the national climate change programme.¹¹⁴ In addition, the allocated quantities of allowances should be consistent with the actual and projected progress of the country to achieve its GHG reduction targets.¹¹⁵ Furthermore, the consistency with other legislation, non-discrimination between companies or sectors, and an outline including information about the technology which is going to be used to fulfil the GHG emission reductions must be included.¹¹⁶ New entrants to the EU ETS, early action taken by some of the emitters, the involvement of the public, a list of installations, and possible competition from outside the European Union must also be taken into account.¹¹⁷

In order to support the EU member states in applying Annex III for the NAPs, the European Commission has issued a special guidance called “Commission Communication COM (2003) 830 of 7 January 2004 on guidance to assist member states in the implementation of the criteria listed in Annex III to Directive 2003/87/EC establishing a scheme for GHG emission allowance trading within the Community and amending Council Directive 96/61/EC.¹¹⁸ This guidance also provides support for the interpretation of Article 29 of Directive 2003/87/EC, which deals with the issue of “force majeure”.¹¹⁹

In a case of force majeure the “Member States may apply to the Commission for certain installations to be issued with additional allowances”.¹²⁰ This is an exception to the rule that EU member states make their allocation decisions before a trading period starts to avoid uncertainty in the allowance market.¹²¹ European Commission Communication COM (2003) 830 determines the

111. Directive 2003/87/EC, Article 10.
112. Ibid, Article 9. 113 Ibid, Annex III. 114 Ibid, Annex III, 1.
115. Ibid, Annex III, 3.
116. Ibid.
117. Ibid; European Commission Communication COM (2003) 830 of 7 January 2004 on guidance to assist Member States in the implementation of the criteria listed in Annex III to Directive 2003/87/EC establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, 3.
118. European Commission Communication COM (2003) 830, supra note 117.
119. Ibid, at 23.
120. Directive 2003/87/EC, Article 29.
121. European Commission Communication COM (2003) 830, supra note 117, at 23.

circumstances under which force majeure is demonstrated including exceptional and unforeseeable situations such as “natural disasters, war, threats of war, terrorist acts, revolution, riot, sabotage or acts of vandalism”.¹²² The European Commission assesses the NAPs of the EU member states according to these provisions as well as “EU rules on State aid and competition” including the “power to require changes or even to reject a plan altogether”.¹²³

• 2.1.8 Operational rules: pooling and banking

The legal basis of the EU ETS does allow companies and other participants in the market to trade emissions allowances directly with each other or indirectly through, for example, brokers, exchange, or other opportunities like “pooling”.¹²⁴ Participants in the EU ETS are allowed to form an emissions trading pool under Article 28 of Directive 2003/87/EC.¹²⁵ Operators who want to create a pool have to nominate a trustee who will be responsible for trading allowances on behalf of all members of the pool.¹²⁶ This trustee is subject to “penalties applicable for breaches of requirements to surrender sufficient allowances to cover the total emissions from installations in the pool”.¹²⁷ Furthermore, the member state that wants to allow a pool has to apply for it to the European Commission, which has the power to “reject an application that does not fulfil the requirements” of Directive 2003/87/EC.¹²⁸

Besides creating a pool, the participants of the EU ETS also have the possibility of using the instrument of “banking”, which means to transfer unused allowances from the first to the second trading period.¹²⁹ This “carry-over” is only possible if it does not lead to an allocation beyond the total allocation approved by the European Commission for the second trading period.¹³⁰ Thus, every banked allowance “must be deducted from the total quantity issued for the second trading period”.¹³¹ Furthermore, banking has to comply with EU state aid rules, which basically means that banking must be a result of real GHG emission reductions to be compatible with them.¹³² The EU member states have

122. Ibid.
123. European Commission, EU Action against Climate Change, supra note 16, at 13. 124 Ibid, at 16.
     125. Directive 2003/87/EC, Article 28.
     126. Ibid, Article 28(3).
     127. Ibid, Article 28(4).
     128. Ibid, Article 28(5).
     129. Joseph A Kruger & William A Pizer, “Greenhouse Gas Trading in Europe: The New Grand Policy Experiment”, Environment (2004) 5.
     130. IHS Germany, Emissionshandel — Banking (2007), at <http://germany.ihs.com/news/eu- de-emissions-trading-11-06.htm?wbc_purpose=Basi> (access date 27.09.2007).
     131. Ibid.
     132. Ibid.

to decide whether or not they allow “banking” between the two phases of the EU ETS, while they must allow “banking” from the second phase (2008–2012) on to any following phase.¹³³ Even though “banking” is allowed by the EU ETS, most of the EU member states banned this transfer of unused allowances to the second phase of the EU ETS.¹³⁴ While EUAs cannot be banked into phase two of the EU ETS, the CDM credits which are called Certified Emission Reduction Units (“CERs”) can be transferred.¹³⁵ All but two EU member states — France and Hungary — restricted the banking of allowances between the two phases of the EU ETS.¹³⁶ The reason for that is the concern that “any EUA banked from 2005–2007 adds one unit more to the burden of the Kyoto Party’s otherwise fixed assigned amount”.¹³⁷

• 2.1.9 Compliance

Directive 2003/87/EC provides a strong framework to ensure compliance under the EU ETS. Article 16 of the Directive determines penalties for those installations that emitted more carbon dioxide than they were allowed to through their allocated emission allowances.¹³⁸ In the first phase of the EU ETS, the penalty fine for each excess tonne emitted is 40 and in the second phase of the EU ETS, which conforms to the first emission trading period under the Kyoto Protocol, the fine is 100 per tonne of excess GHGs.¹³⁹ Furthermore, companies will have to surrender a compensating amount of allowances in the following year.¹⁴⁰ The EU member states have to implement additional administrative and criminal penalties for infringements of the EU ETS on a national level which have to be in accordance with the general guidance from the EU Directive.¹⁴¹ The names of operators who have not been in compliance with the EU ETS will be published by the member states.¹⁴²

133. Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5.
134. Joachim Schleich, Karl-Martin Ehrhart, Christian Hoppe & Stefan Seifert, “Banning Banking in EU Emissions Trading? ”, Energy Policy (2006), Vol 34, 112.
135. Miles Austin, “The Business of Carbon Trading”, Renewable Energy Focus (2007) 61; James Allen & Anthony White, Carbon Trading (2005), at <http://findarticles.com/p/ articles/mi_qa3650/is_200509/ai_n15351002/pg_4> (access date 28.09.2007).
136. OECD/IEA, Act Locally, Trade Globally (2005) 79.
137. Ibid.
138. Directive 2003/87/EC, Article 16.
139. Ibid, Article 16(3) & (4).
140. Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5. 141 Ibid.

142 Directive 2003/87/EC, Article 16(2).

• 2.1.10 Monitoring, reporting, and verification

Article 14 of Directive 2003/87/EC addresses the European Commission to elaborate guidelines for the monitoring and reporting of GHG emissions under the EU ETS.¹⁴³ Furthermore, Article 14(2) states that member states “shall ensure that emissions are monitored in accordance with the guidelines” adopted by the European Commission.¹⁴⁴ Therefore, a guideline for these issues was adopted by the Commission at the beginning of 2004, which is called “Commission Decision 2004/156/EC of 29 January 2004 establishing guidelines for the monitoring and reporting of greenhouse gas emissions pursuant to Directive 2003/87/EC of the European Parliament and of the Council”.¹⁴⁵

Every installation under the EU ETS must obtain a permit “to set out the GHG emissions monitoring and reporting requirements for the installation”,¹⁴⁶ which is not the same as an allowance which is the “currency” as a tradable unit of the EU ETS. After each calendar year the installation must report their GHG emissions.¹⁴⁷ These reports have to be checked by an independent “verifier”, who assesses the report on the basis of the criteria set out in Commission Decision 2004/156/EC which is legally binding.¹⁴⁸ In the event a verifier finds an emission report unsatisfactory the operator of the installation will not be allowed to sell allowances until “a revised report is approved by the verifier”.¹⁴⁹

• 2.1.11 Linking of the EU ETS with other schemes

Directive 2003/87/EC provides the possibility to link with other schemes in Article 25, which states explicitly that the EU ETS can only be linked to schemes of parties that have ratified the Kyoto Protocol.¹⁵⁰ In such a case, the allowances of the other country listed in Annex B of the Kyoto Protocol will be recognised in the EU system on the basis of a bilateral agreement between the other country and the European Union.¹⁵¹ However, due to a policy adopted by the EU Commission and the EU Parliament, a linkage with emissions trading systems of parties that have not ratified the Kyoto Protocol is possible — “as

143. Ibid, Article 14(1).
144. Ibid, Article 14(2).
145. European Commission Decision 2004/156/EC of 29 January 2004 establishing guidelines for the monitoring and reporting of greenhouse gas emissions pursuant to Directive 2003/87/EC of the European Parliament and of the Council.
146. European Commission, EU Action against Climate Change, supra note 16, at 15. 147 Ibid.
     148. Ibid.
149. Ibid; European Commission Decision 2004/156/EC of 29 January 2004, Annex I, 2(s). 150 Directive 2003/87/EC, Article 25(1).

151 Ibid; Joseph Kruger & William A Pizer, The EU Emissions Trading Directive (2004) 9.

long as they have mandatory caps on emissions”.¹⁵² Possible candidates for linkage are, for example, Norway, Iceland, and Switzerland. Non-European countries have also been mentioned as possible linking schemes candidates, such as Japan, Canada, or even nine northeastern US states.¹⁵³ However, the linkage of the EU ETS with other emissions trading schemes raises many problems that have to be resolved such as different GHG emission reduction targets and price caps.¹⁵⁴

• 2.1.12 Transaction registries

Article 19 of Directive 2003/87/EC regulates the issue of registering the trade with GHG emission allowances.¹⁵⁵ The tradable allowances under the EU ETS are not printed but held in accounts in electronic registries which are established by the EU member states.¹⁵⁶ It is a “standardized and secured system of registries in the form of standardized electronic databases containing common data elements to track the issue, holding, transfer and cancellation of allowances” providing also public access, which was set up by legislation of the European Commission.¹⁵⁷ JI and CDM projects are also included in this legislation.¹⁵⁸ At the European Community level the system of registries is overseen by a central administrator who, through an independent transaction log (“ITL”), checks transactions for any irregularities.¹⁵⁹ In the event irregularities are detected the affected transaction cannot be completed until they are remedied.¹⁶⁰ “The EU registries system is being integrated with the international registries system used under the Kyoto Protocol.”¹⁶¹

• 2.1.13 Scope of the EU ETS

The EU ETS is functioning very well so far with a high compliance rate of some 8,980 installations which fulfilled their obligations with regard to reporting their 2005 emissions during the first compliance cycle till 30 April 2006.¹⁶² “These

152. Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5.
153. Directive 2003/87/EC, Article 25; Kruger & Pizer, The EU Emissions Trading Directive, supra note 151, at 9; European Commission, EU Action against Climate Change, supra note 16, at 22.
154. Ibid.
155. Directive 2003/87/EC, Article 19.
156. European Commission, EU Action against Climate Change, supra note 16, at 15–16. 157 Directive 2003/87/EC, Article 19(3).

158 European Commission, EU Action against Climate Change, supra note 16, at 15–16. 159 Ibid.

160. Ibid.
161. Ibid.
162. European Commission Communication COM (2006) 676 final of 13 November 2006,

installations account for more than 99% of allowances allocated to installations in the 21 Member States with functioning electronic registries on 30 April 2006.”¹⁶³

The EU ETS allowance market already developed ahead of the start of the scheme with the first forward transactions having been contracted in 2003. In 2005, more than 320 million allowances worth more than 6.5 billion were reported as having been traded over-the-counter, at exchanges or bilaterally. As regards 2006, by May a trading volume of over 300 million allowances had been reported and the monthly trading volume in May had approached 100 million allowances. Transactions under the EU ETS dominate the global carbon market, accounting for over 80% of the monetary value and over 60% of the total volume of carbon trades.¹⁶⁴

2.2 Similarities and Differences of the EU ETS and the Kyoto Protocol

In order to assess whether or not the EU ETS can serve as a model for the IET of the Kyoto Protocol, it is necessary to compare the two emissions trading schemes with each other. Even though the EU ETS is a self-contained emissions trading system, it was created to achieve the GHG emission reduction targets which the EU has committed to under the Kyoto Protocol. Therefore the EU ETS has interactions with the IET system under the Kyoto Protocol. The two emissions trading systems of the EU ETS and the IET under the Kyoto Protocol have much in common, but there are also some important differences, as set out below.

• The greenhouse gases that are targeted for emission reductions are the same ones in the second phase of the EU ETS and the first phase of the IET under the Kyoto Protocol from 2008 to 2012, and comprise the greenhouse gases CO₂, CH₄, N₂O, HFCs, PFCs, and SF₆.¹⁶⁵ While the EU ETS has two phases, the first one from 2005 to 2007 (which comprised only the GHG CO₂) and the second one from 2008 to 2012, the Kyoto Protocol has its first phase from 2008 to 2012, while it is uncertain how the next phases of the Kyoto Protocol will develop after this period of time. There are still negotiations going on about this issue.

Communication from the Commission to the Council, the European Parliament, the European Economic and Social Committee and the Committee of the Regions / Building a global carbon market — Report pursuant to Article 30 of Directive 2003/87/EC, 3–4.

163. Ibid, at 4–5.
164. Ibid.
165. Kyoto Protocol, Annex A.

• The Kyoto Protocol also distinguishes on the basis of the principle of “common but differentiated responsibilities” (“CBDR”) between industrialised and developing countries.¹⁶⁶ According to this principle, there is a common responsibility of all countries for global warming, but some countries are more responsible than others for it, due to the fact that the industrialised countries have a historical, and thus higher, responsibility for the pollution of the atmosphere by their emission of GHGs during the last century. Therefore it would be unfair if developing countries had to limit their economic growth through reducing GHGs when wealthy developed countries are most responsible for the present concentration of GHGs in the atmosphere and the future consequences. The principle of CBDR was first outlined in the UNFCCC in Article 3.1 of the Convention and was reaffirmed by the Kyoto Protocol in Article

10.¹⁶⁷ Therefore the industrialised countries have the legally binding GHG emission reduction target of “at least 5 per cent below 1990 levels in the commitment period 2008 to 2012” in comparison to developing countries, which have no legally binding GHG emission reduction targets at all.¹⁶⁸ The EU ETS has made a similar approach to CBDR with their burden sharing agreement. However, the burden sharing agreement is made between industrialised countries, but it takes the different economic and social circumstances of the several parties into account and gives every participating country an appropriate GHG emission reduction target accordingly.

• The EU ETS involves 27 member states of the EU which have as a group the common GHG emission reduction target of 8 per cent in the Kyoto Protocol while the internal reallocation ranges from the maximum GHG emission reduction of 28 per cent in Luxembourg to an increase in GHG emissions in Portugal of 27 per cent.¹⁶⁹ Whether or not the EU will expand is not an issue for the overall GHG reduction target of 8 per cent for the EU as a whole. In comparison, the Kyoto Protocol has been ratified by 175 parties to date, including 36 countries and the EEC having

166. Ibid, Article 10.
167. UNFCCC, Article 3.1; Kyoto Protocol, Article 10.
168. Kyoto Protocol, Article 3.1.
169. Deutsche Bundesregierung, Wie ist die Lastenverteilung in der EU?, supra note 28 (access date 10.09.2007).

individual GHG emission reduction targets, while “these add up to a total cut in greenhouse-gas emissions of at least 5% from 1990 levels in the commitment period 2008–2012”.¹⁷⁰ New entrants to the Kyoto Protocol are always welcome and Annex B can be extended through amendments, such as the proposal for an amendment made by Belarus in 2005.¹⁷¹

• The Kyoto Protocol and the EU ETS do not prevent participating governments from devolving parts of their assigned amounts and EUAs to private parties. However, responsibility to achieve the GHG emission reduction target under the Kyoto Protocol still remains with the countries and not the enterprises. The included sectors differ in both systems, because the first phase of the EU ETS excludes some industrial sectors like transport, while the Kyoto Protocol also includes transport.¹⁷²
• Furthermore, the Kyoto Protocol allows the use of CERs, ERUs, AAUs (“assigned amount units”) and RMUs (“removal units”) in the IET for the participating countries to achieve their GHG emission reduction targets under the Protocol. The linking Directive 2004/101/EC which recognises the flexible mechanisms of the Kyoto Protocol — JI and CDM

— also allows parties to the EU ETS to use credits from CDM and JI as equivalent to EU emission allowances, except those from land use, land use change, and forestry activities.¹⁷³ The use of CERs is allowed from 2005 on, while the allowed use of ERUs will start in 2008 in the first phase of the IET of the Kyoto Protocol.¹⁷⁴ A further difference is the allowed use of RMUs under the Kyoto Protocol, arising from land use, land use change, and forestry activities undertaken in Annex B countries, which are not allowed under the EU ETS.

• The EU ETS does allow companies and other participants in the market to trade emissions allowances directly with each other or indirectly through, for example, brokers, exchange, or other opportunities like “banking” or “pooling”.¹⁷⁵ The EU member states have to decide whether or not they allow “banking” between the two phases of the EU ETS, while they must allow “banking” from the second phase (2008–2012) on to any following phase.¹⁷⁶ However, most of the EU member states

170. UNFCCC, Kyoto Protocol, at <http://unfccc.int/kyoto_protocol/items/2830.php> (access date 16.10.2007).
171. Botschaft der Republik Belarus in der BRD, Belarus ist dem Kyoto Protocol beigetreten, Pressemitteilung Nr 54, at <http://www.belarus-botschaft.de/de/presse54_2005_de.htm> (access date 14.10.2007).
172. Kyoto Protocol, Annex A.
173. Directive 2004/101/EC, Article 11a (3b).
174. Clause 5 of the preamble of Directive 2004/101/EC.
175. European Commission, EU Action against Climate Change, supra note 16, at 16. 176 Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5.

banned the use of banking to the second phase of the EU ETS.¹⁷⁷ While European Union Allowances (EUAs) cannot be banked into phase two of the EU ETS, the CDM credits which are called Certified Emission Reduction Units (CERs) can be transferred.¹⁷⁸ In comparison, the Kyoto Protocol allows the “carry-over” of any ERUs, CERs and AAUs which are “at least equivalent to its anthropogenic carbon dioxide equivalent emissions of the greenhouse gases, and from the sources, listed in Annex A to the Kyoto Protocol”.¹⁷⁹ The “carry-over” of the IET under the Kyoto Protocol is the same procedure as the “banking” under the EU ETS, and also both schemes do not allow the banking of RMUs to the subsequent period.

• In order to achieve compliance under the EU ETS and the IET of the Kyoto Protocol, there is a strong framework for this issue provided in both emissions trading systems. In the first phase of the EU ETS, the penalty fine for each excess tonne emitted is 40 and in the second phase of the EU ETS, which conforms to the first emission trading period under the Kyoto Protocol, the fine is 100 per tonne of excess GHGs.¹⁸⁰ In addition, companies will have to surrender a compensating amount of allowances in the following year.¹⁸¹ Furthermore, the EU member states have to implement additional administrative and criminal penalties for infringements of the EU ETS on a national level.¹⁸² Compliance under the Kyoto Protocol is outlined in its Article 18 and defined in the Marrakesh Accords.¹⁸³ The branches which are established under the Marrakesh Accords have the aim to provide assistance and advice to the parties as well as to promote compliance by determining and enforcing the consequences of non-compliance.¹⁸⁴ In the event of non-compliance by a party, there are several measures that can be taken by the enforcement branch, “taking into account the cause, type, degree and frequency of the non-compliance of that Party”.¹⁸⁵ Both emissions trading systems are designed to ensure transparency of accounting by parties and therefore

177. Schleich, Ehrhart, Hoppe & Seifert, “Banning Banking in EU Emissions Trading?”, supra note 134, at 112.
178. Miles Austin, “The Business of Carbon Trading”, supra note 135, at 61; Allen & White,

Carbon Trading, supra note 135.

179. Marrakesh Accords, J4, Annex, F, Carry-Over, 106–7. 180 Directive 2003/87/EC, Article 16(3) & (4).

181 Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5. 182 Ibid.

183. Kyoto Protocol, Article 18.
184. UNFCCC, Kyoto Protocol — Compliance — Introduction, at <http://unfccc.int/kyoto_ protocol/compliance/introduction/items/3024.php> (access date 3.10.2007).
185. Marrakesh Accords, Procedures and mechanisms relating to compliance under the Kyoto Protocol, Annex, XV, 1, at 139.

also to support the credibility of the carbon market. While the Kyoto Protocol follows the principle of promoting and enforcing compliance through assistance and advice for its parties, the EU ETS imposes high monetary penalties on excess tonnes emitted by its parties. Nevertheless, both systems of compliance are well structured and provide strong systems of compliance for multilateral environmental agreements, which is a very important issue for the success of the emissions trading systems.

• Harmonised GHG emissions monitoring, reporting, and verification requirements were set under the EU ETS.¹⁸⁶ In comparison, the Kyoto Protocol also established a system to ensure that GHG emission reductions claimed by the parties are authentic and that they are satisfactory to the individual GHG emission reduction targets each Annex I country is committed to. Any suspicion that parties are cheating on emission reductions would lead to an undermining of the integrity of the Kyoto Protocol and it would also affect the parties’ confidence and trust in the system. Therefore, the Kyoto Protocol and the Marrakesh Accords include a set of monitoring procedures to avoid any mistakes in calculating emissions data or accounting for transactions in relation to the three flexible mechanisms of the Kyoto Protocol — JI, CDM, and IET

— and activities referring to LULUCF (“land use, land use change and forestry”).¹⁸⁷ The Kyoto Protocol addresses the issues of reporting and review of information by Annex I parties as well as the issues of national systems and methodologies for the preparation of GHG inventories.¹⁸⁸ Both emissions trading systems show effective measures to avoid any error in calculating GHG emission reduction data. This is important to ensure the reliability of the GHG emission reduction data and therefore provides the possibility of a proper assessment of compliance by the parties.

• The EU ETS can be linked to other emissions trading schemes of countries which have ratified the Kyoto Protocol.¹⁸⁹ In such a case, the allowances of the other country listed in Annex B of the Kyoto Protocol will be recognised in the EU system on the basis of a bilateral agreement between the other country and the European Union.¹⁹⁰ However, due to a policy adopted by the EU Commission and the EU Parliament, a

186. European Commission, EU Action against Climate Change, supra note 16, at 15.
187. UNFCCC, National Reports — Accounting, Reporting and Review under the Kyoto Protocol, at <http://unfccc.int/national_reports/accounting_reporting_and_review_under_ the_kyoto_protocol/items/1029.php?plus=j> (access date 6.10.2007).
188. Ibid.
189. Directive 2003/87/EC, Article 25(1).
190. Ibid; Kruger & Pizer, The EU Emissions Trading Directive, supra note 151, at 9.

linkage with emissions trading systems of parties that have not ratified the Kyoto Protocol is possible — “as long as they have mandatory caps on emissions”.¹⁹¹ The European Commission implemented its own transaction log called the Community Independent Transaction Log (“CITL”), which started its work at the beginning of the first phase of the EU ETS in 2005.¹⁹² When the IET under the Kyoto Protocol starts in 2008, the EU registries have to switch their connections from the CITL to the ITL.¹⁹³

• There are several registry systems implemented under the IET of the Kyoto Protocol. Participating countries have to establish national registries to ensure accurate, transparent, and efficient exchange of data between national registries, the clean development mechanism registry, and an independent transaction log.¹⁹⁴ The ITL verifies the validity of transactions of Kyoto units. The transaction registries under the EU ETS operate in similar ways. Every participating country has to set up its own national registry.¹⁹⁵ JI and CDM projects are also included in this legislation.¹⁹⁶ At the European Community level, the system of registries is overseen by a central administrator who, through an ITL, checks transactions for any irregularities.¹⁹⁷ In the event irregularities are detected, the affected transaction cannot be completed until they are remedied.¹⁹⁸ “The EU registries system is being integrated with the international registries system used under the Kyoto Protocol.”¹⁹⁹
• The scope of the EU ETS comprised by 2005 more than 320 million allowances worth more than 6.5 billion. The scope of the IET under the Kyoto Protocol, measured by the suggested demand by the industrial signatories, is expected to be around 840 million tonnes of CO₂ in the year 2010.²⁰⁰

2.3 The Strengths and Weaknesses of the EU ETS

The EU ETS began operating its first phase on 1 January 2005. Therefore, after two years of running the system, it is possible to assess what the strengths and

191. Kruger & Pizer, “Greenhouse Gas Trading in Europe”, supra note 129, at 5. 192 Ibid.
193. Ibid.
194. Marrakesh Accords, J4, Annex, II, Registry Requirements — National Registries, 107.
195. EUROPA: Environment, Kyoto Protocol, at <http://ec.europa.eu/environment/ets/ registrySearch.do> (access date 20.10.2007).
196. European Commission, EU Action against Climate Change, supra note 16, at 15–16. 197 Ibid
198. Ibid.
199. Ibid.
200. OECD/IEA, Act Locally, Trade Globally, supra note 136, at 33.

weaknesses of the EU ETS are. The EU ETS is, in terms of its size and scope, the first emissions trading market of its kind and thus it was faced with many challenges. Despite economic and social differences, all 27 member nations adopted the scheme. This impressive outcome shows that the EU ETS set the right incentives to attract the participating nations to join the scheme.

• 2.3.1 Multi-level governance

A major challenge was the multi-level governance approach, which created a more decentralised structure of decision-making that leaves much of the authority for important key decisions, such as the allocation of EUAs, to the 27 member nations. The EU ETS is an example of multi-level governance, “where different modes of governance are applied at different levels”²⁰¹ and “where the different modes of governance interact among them and affect each other”.²⁰² The “old mode” of governance is used at the EU level, achieved through the strong leadership role of the European Commission which imposes regulations and administrative decisions on the EU member nations.²⁰³ The member nations have the power to make key decisions in interaction with private actors, which are affected by their legislation and who play an important role in implementing the emissions trading system. Thus, the “new mode” of governance is used at the national level, where the private actors have to decide how to use the market instruments provided by the EU ETS.²⁰⁴

• 2.3.2 European Union allowances

A new class of assets was built by the EU ETS — the European Union allowances. Therefore, the pollution of the atmosphere now costs money for the industries involved, so that parties cannot continue to pollute any more without thinking of the costs involved. This is an important step forward in tackling global warming.

• 2.3.3 Cap-and-trade system

The cap-and-trade system approach of the EU ETS is a better solution than the command-and-control approach of governments, because it is a market-based approach, which allows more cost-efficiency than, for example, CO₂ taxes. The market functions freely, without a “price cap”, which sets the right signal

201. Barbara Buchner, Michela Catenacci & Fondazione Mattei, Governance and Environmental Policy Integration in Europe (2007) 18.
202. Ibid, at 3.
203. Ibid, at 18.
204. Ibid.

for companies to invest in cleaner technology to meet their GHG emission reduction targets. Companies can have the flexibility to choose how to meet their targets instead of having to follow given carbon taxes.²⁰⁵ A command- and-control approach is not as efficient as a market-based approach, because it cannot react flexibly enough to market changes and has the tendency to over- or under-regulate the system, which leads to economic inefficiency. Furthermore, the cap-and-trade system is not as cost-intensive as bureaucratic legislation in relation to the administration of the system.²⁰⁶ Another advantage of using a cap-and-trade system is that the level of emissions can be determined prior to the start of the system, which is not possible with instruments such as carbon taxes.

• 2.3.4 Differing national approaches of the member states

The decision-making authority in several fields of the member nations led to differing national approaches. Different rules for monitoring, reporting, and verification procedures as well as the elaboration and implementation of the NAPs raised several difficulties.²⁰⁷ In particular, the allocation methodology differed considerably from member nation to member nation — for example, the choice of allocation methods, such as emission-based or production-based allocation, the base year periods, treatment of new entrants, and how reduction potential and clean technology are considered.²⁰⁸ Thus, the consequence is a different treatment of stakeholders, such as differing given allocations to one and the same installation (for example a power plant), depending on the jurisdiction of its member nation.²⁰⁹ Such a different treatment, depending on the location of the installation within the EU, can lead to market distortion and unfair competition amongst the participants which affects the integrity of the EU ETS.

• 2.3.5 Allocation and auctioning

The EU ETS participants are allowed to auction up to 5 per cent of their allowance total in the first phase of the EU ETS and up to 10 per cent in the second phase. The rest of the allowances have been allocated free. This created windfall profits for utilities — for example, in the power sector — because the

205. Buchner, Catenacci & Mattei, Governance and Environmental Policy Integration, supra note 201, at 8.
206. Franz Josef Schafhausen, National Implementation in Germany — Regulators evaluation of the EU ETS (2007) 2.

207 COM (2006) 676 final, 8.

208 Lars Zetterberg et al (eds), Analysis of National Allocation Plans for the EU ETS (2004) 4. 209 See supra 2.1.1.

cost of carbon was passed through to power prices, even though the allowances were allocated free.²¹⁰ Another negative aspect was that free allocation penalised early action by companies.

In addition, the allocation of allowances was too generous, which affected the stringency of the scheme and the price of EUAs.²¹¹ There are many reasons for this considerable surplus of allowances — for example, the ability of companies to cut GHG emissions back more quickly and more cheaply than expected. But also, the allocation process itself was questionable, because the allocation of allowances was based on projections and historic emissions data of the companies, whereby the data were determined by the companies themselves and therefore often insufficient.²¹² This oversupply of EUAs weakens the effectiveness of the scheme, because prices for EUAs fall and the reduction of GHGs is not as high as it should be and therefore, also from an environmental point of view, the EUAs become valueless. Overall, there is a need for more certainty and predictability about allocation methodologies, and the “problem of windfall profits, caused by the calculation of opportunity-costs, has to be solved”.²¹³

Furthermore, there was little space left for the option of auctioning EUAs, and even though some member nations suggested using this option, only four of them (Denmark, Hungary, Lithuania, and Ireland) implemented it.²¹⁴ The strong opposition of companies and strict deadlines for implementation might have been reasons for this.²¹⁵ “For the EU ETS as a whole, with an average annual allocation of almost 2.2 billion EUAs, slightly less than three million EUAs — or 0.13 per cent — are designated for auctioning”.²¹⁶ Therefore, the auctioning option was not used in an appropriate way and member states who wished to auction a higher amount of EUAs were not able to.

• 2.3.6 New entrant and closure provisions

The new entrant and closure rules had to be determined by the member nations of the EU ETS in their NAPs. Thus, there were differing rules implemented within the EU ETS according to the jurisdiction of each country. Two novel

210 COM (2006) 676 final, 4–5.

211. Buchner, Catenacci & Mattei, Governance and Environmental Policy Integration, supra note 201, at 17.
212. Denny Ellerman & Barbara Buchner, “The European Union Trading Scheme: Origins, Allocation and early results”, Review of Environmental Economics and Policy (2007), Vol 1, no 1, 69–70 & 72.
213. Franz Josef Schafhausen, National Implementation in Germany, supra note 206, at 32. 214 Ellerman & Buchner, “The European Union Trading Scheme”, supra note 212, at 73. 215 Ibid.

216 Ibid.

features were created which provide that new entrants will get allowances free and facilities which close have to give back unused allowances, even though they were granted to them.²¹⁷ The allocation of free allowances to new entrants compensates the new entrants for most of the carbon costs involved.²¹⁸ Therefore, a situation is created in which the conditions for an investment are similar to the conditions prior to the start of the EU ETS. The closure rule mentioned above ensures that unused allowances flow back into the system and avoid “providing an incentive for shutting down and relocating existing production facilities”.²¹⁹ These rules are understandable from an equity point of view, because the new entrant rule avoids disadvantages for new entrants and the closure rule protects employees.²²⁰ However, these rules can also have distorting effects on the system, because they can create excess capacity of allowances and raise inefficiency with distorting effects for investments.²²¹

• 2.3.7 Sectors

The EU ETS covers six key industrial sectors, which are “electricity and heat production plants greater than 20MW capacity, oil refineries, coke ovens, metal ore and steel installation, cement kilns, glass manufacturing, ceramics manufacturing, and paper, bulb and board mills”.²²² However, sectors with high GHG emissions like transport are excluded. For example, international aviation contributes about 3.5 per cent to global warming according to a report of the IPCC.²²³ It is suggested, that up till 2010, the contribution of aviation to global warming could be higher than the overall contribution to the greenhouse effect by countries like Germany.²²⁴ Thus, there is a serious need to include more sectors in the scheme.

• 2.3.8 Coverage of installations

The coverage of installations was not appropriate, because relatively small installations were included in the scheme, even though their emissions were not very high and other alternative policy measures might have been sufficient to address the issue of reducing GHGs.²²⁵ The participants of the EU ETS

217. Ibid, at 75.
218. Ibid.
219. Ibid.
220. Ibid.
221. Ibid.
222. Buchner, Catenacci & Mattei, Governance and Environmental Policy Integration, supra note 201, at 16–17.
223. Martin Carnes & Odette Deuber, Emissions trading in international civil aviation (2004) 9. 224 Ibid.

225 COM (2006) 676 final, 8.

interpreted the term “combustion installation” in different ways, so the outcome in the member nations needs to be clarified in the next trading period.²²⁶

• 2.3.9 Duration of the EU ETS

The EU ETS operates in two phases. Whereas the first phase from 2005 to 2007 was meant as a “warming-up phase” for the commitment period under the Kyoto Protocol, the second phase of the EU ETS coincides with the first phase of the Kyoto Protocol from 2008 to 2012. The EU ETS is independent from the IET under the Kyoto Protocol, and even in the event the IET ceases to operate, the EU ETS will still continue to do so.²²⁷ The system was created for an unlimited duration. This independent, long-term approach adds integrity and certainty to the scheme and gives potential investors confidence in the reliability of the system.

• 2.3.10 Compliance and enforcement

The monitoring, reporting, and verification procedures set up in the EU ETS built the necessary legal framework to ensure compliance of the member nations. The EU ETS involves a strong system of monitoring and sanctions with stringent penalties, which are indispensable to ensure the proper functioning and supervision of the emissions trading market.²²⁸ To harmonise the procedures, the European Commission is considering laying them down in a Regulation for the member nations.²²⁹

• 2.3.11 Registries

All installations which are included in the EU ETS are connected to one of the 27 national registries of the member nations, and thereby also connected to the Community Independent Transaction Log, by which an internal communication is provided. This system of registries ensures compliance and enables companies to trade within the EU ETS. Even though the implementation of registries was delayed in many countries, which was preventing market access for many installations, the electronic registries are all in full operation now.²³⁰

226. Ibid.
227. Ibid, at 5–6.
228. Buchner, Catenacci & Mattei, Governance and Environmental Policy Integration, supra note 201, at 20.

229 COM (2006) 676 final, 9.

230 Ibid, at 3–4.

• 2.3.12 Linking with other schemes

Article 25 of Directive 2003/87/EC states the possibility of linking the EU ETS with other schemes of parties that have ratified the Kyoto Protocol.²³¹ Linking with schemes of other countries will be considered for the following phases. Possible linking candidates are Japan, Canada, and several states of the USA, as well as European countries like Norway, Switzerland, and Iceland.²³² Therefore, it is necessary to implement a system to recognise the GHG emission allowances of each system to ensure the functioning of the emissions trading market. Also, different GHG reduction targets and price caps will have to be considered as a problem that needs to be solved.²³³ Furthermore, there is the openness of the EU ETS for the acceptance and use of external credits of the flexible mechanisms of CDM and JI under the Kyoto Protocol, to allow more flexibility for complying with the environmental commitments under the Protocol.²³⁴ Project-based GHG reductions in key developing countries like India, Brazil, or China are possible through CDM, which is a win-win situation for all participants, because the participants of the EU ETS reduce their costs in GHG emission reduction and the developing countries gain assistance in improving their environment and economies through the transfer of technology.

But although there are benefits for the parties involved, there also exists a wide range of possible problems. Arguments against the CDM are, for example, that “transaction costs are larger than the difference in abatement costs, CDM would interfere with national sovereignty, developing countries lack the technical expertise to negotiate complex CDMs and would be exploited, the CDM may distort host countries’ development priorities, investors would choose the most lucrative projects — so the developing countries are left only with high cost options for the future and long-term commitments may foreclose future development opportunities, such as increased agricultural output”.²³⁵ Overall, the concerns are based on the weak bargaining position of developing countries.²³⁶ However, in spite of the disadvantages of CDM, it does offer some benefits such as the opportunity to assist developing countries, technology transfer, and reduction of GHG abatement costs. In addition, CDM projects as well as JI projects have to be supplemental to domestic action. Therefore,

231. Directive 2003/87/EC, Article 25(1).
232. Ibid; Kruger & Pizer, The EU Emissions Trading Directive, supra note 151, at 9; European Commission, EU Action against Climate Change, supra note 16, at 22.
233. Ibid.
234. This was achieved by Directive 2004/101/EC.
235. Larry Karp, “The Clean Development Mechanism and its Controversies”, Journal of Economic Dynamics and Control (2004), Vol 28, no 8, 11–14.
236. Ibid.

both flexible mechanisms are still a good choice for the EU member nations to achieve their GHG emission reduction targets.

2.4 The EU ETS as a Model for Worldwide Emissions Trading?

The EU ETS is the world’s first large-scale CO₂ emissions trading scheme with the aim of reducing CO₂ emissions in a cost-effective way without harming the economy of the countries involved. The EU ETS is motivated by the Kyoto Protocol, but is also independent of it.

While the EU ETS was created to fulfil the obligations for GHG emission reductions under the Kyoto Protocol in the first commitment period of the Protocol from 2008 to 2012, the first phase of the EU ETS from 2005 to 2007 is independent of the IET under the Protocol having started in 2008. Its implementation is based on EU law and even in the event the IET under the Kyoto Protocol ceases to continue to operate in the future, the EU ETS is still expected to continue. Besides some teething problems at the beginning of the emissions trading scheme in 2005, such as delayed national allocation plans and delayed implementation of electronic registries, the EU ETS can be seen as a successful outcome.²³⁷

The first phase of the EU ETS from 2005 to 2007 has already shown how successfully this emissions trading scheme was implemented, because the EU ETS comprised, by 2005, more than 320 million allowances worth more than 6.5 billion.²³⁸ “The transactions under the EU ETS dominate the global market, accounting for over 80% of the monetary value and over 60% of the total volume of carbon trades.”²³⁹ The European Commission stated in a report that “the EU ETS is already a key driver of international carbon trading and provides a solid foundation for a global carbon market”.²⁴⁰ The EU ETS has a multinational scope and therefore a multijurisdictional political structure, and its “learning-by-doing” approach in its first phase could teach others the lessons that can be learned from the experience already gained. Thus, the EU ETS can build a cornerstone in environmental policy in a worldwide CO₂ market in which “over 160 countries, representing over 90% of the global population, can engage in the emerging carbon market either through emissions trading schemes or through the Kyoto Protocol’s flexible mechanisms”.²⁴¹ The emissions trading scheme itself is set up and functions very well from an economic perspective.

237. The European Commission raised infringement proceedings against Austria, the Czech Republic, Denmark, Hungary, Italy, and Spain, for failure to submit their proposed NAPs.
238. European Commission, EU Action against Climate Change, supra note 16, at 15–16.
239. Point Carbon, Outlook for 2006. Mid-year update/ Carbon Market Analyst (August 2006). 240 European Commission, Building a global carbon market — Report pursuant to Article 30

of Directive 2003/87/EC (November 2006) 3.

241 Ibid.

Another question is, how environmentally effective has the EU ETS already been in reducing CO₂? In 2005, “1829.5 million tonnes of emissions allowances were allocated by the member states, while the participants only emitted 1785.3 million tonnes”.²⁴² This is due to the overallocation of allowances within the EU ETS. As a result, there were no efficient CO₂ reductions in 2005 (and it is questionable that there was sufficient CO₂ emission reduction in the first phase of the EU ETS at all) and therefore this does not encourage companies to invest in low-carbon technologies.²⁴³ However, it has to be kept in mind that this first phase of the EU ETS was meant to be a “warming-up phase”, in order to learn from mistakes.

As a result of the experiences gained from this first phase, the EU ETS has to be reformed, and many issues, especially allocation procedures, have to be harmonised. Assessments and reviews of the first phase will help to fix the current problems, so that the EU ETS can be more efficient in reducing GHGs. Overall, much can be learned from the EU ETS, and therefore it can serve as a model for the IET under the Kyoto Protocol.

2.5 Future Perspective — After 2012, What’s Next?

Both emissions trading systems — the EU ETS and the IET under the Kyoto Protocol — have set up provisions for running the systems till 2012. Thus, the question is: what will happen after 2012?

• 2.5.1 EU ETS

The EU ETS was set up for an unlimited duration, so it will continue in the future. To solve all the current problems of the EU ETS, the European Commission started a review process of the situation, to gain knowledge of what could have been done better, to be able to implement changes in the third trading period in 2013.²⁴⁴ According to the European Commission, this review process should be driven by environmental efficiency as well as by economic considerations.²⁴⁵ Therefore the consultations with stakeholders will be intensified to achieve a better evaluation.²⁴⁶ Important issues to be dealt with in the review process are “the scope of the Directive, further harmonization and predictability, robust compliance and enforcement and links to third countries”.²⁴⁷

242 Tim Gibbs & Simon Retallack, Trading up: Reforming the EU ETS (2006) 11. 243 Ibid.

244 COM (2006) 676 final, 6.

245. Ibid, at 7.
246. Ibid.
247. Ibid.

There are many procedures that need to be harmonised under the EU ETS, such as allocation methods, monitoring, reporting and verification methods, new entrant and closure rules, and definitions of terms like “combustion installations”. The participation and cost-effectiveness of small installations have to be assessed, and thereby a solution has to be found to handle this issue in a different way — for example, by an opting-out possibility.²⁴⁸ Furthermore, other sectors and gases will be added to the scheme — for example, N₂O from the production of ammonia and CH₄ from coal mines.²⁴⁹ The EU ETS will be extended to other sectors like transport, such as aviation, in 2011, and another issue will be the inclusion of households.²⁵⁰ The amount of EUAs to be auctioned is unspecified after 2012, whereby the role of auctioning is expected to be greater than 10 per cent.²⁵¹

Another future option is the linking of the EU ETS to other schemes. In the current situation, the EU ETS cannot acquire AAUs (under the IET of the Kyoto Protocol) to use them in its effort to comply with its GHG emission reduction targets. Even though there is the possibility of using the credits of JI and CDM (through Directive 2004/101/EC), this is only allowed as a supplement to domestic actions and therefore the EU ETS is isolated from IET under the Kyoto Protocol. The result of this isolation could be that the price of EUAs would be higher than the price for AAUs, which would affect the European industry in a negative way in international competition.²⁵² Thus, there are considerations to link the EU ETS with other emissions trading schemes at a regional or national level in other countries. Possible candidates are, for example, Canada (with the GERT scheme),²⁵³ Norway (which has a similar emissions trading scheme to that of the EU ETS),²⁵⁴ Switzerland (which introduced a CO₂ law in May 2000),²⁵⁵ Japan (which has a voluntary emissions trading scheme established in 2000),²⁵⁶ Australia (which has state and territory emissions trading schemes),²⁵⁷ and a number of domestic emissions trading systems in the USA (for example, the Chicago Climate Exchange).²⁵⁸ Overall, there are several issues that have to be improved in the EU ETS. However, it is a very successful emissions trading

248. Ibid, at 12.
249. Ibid, at 8.
250. Buchner, Catenacci & Mattei, Governance and Environmental Policy Integration, supra note 201, at 17.
251. Ellerman & Buchner, “The European Union Trading Scheme”, supra note 212, at 73. 252 OECD/IEA, Act Locally, Trade Globally, supra note 136, at 98.
     253. GERT is the greenhouse gas emissions reduction trading programme of Canada.
     254. Norway’s system covers emissions from 51 installations in the energy production and the process industries: mineral oil refining and the production and processing of iron and steel.
255. OECD/IEA, Act Locally, Trade Globally, supra note 136, at 103. 256 Ibid, at 105.

257 Ibid, at 110.

258 Ibid, at 98–117.

scheme, which will be even more successful after thoughtful reviewing and adaptation to challenging and changing circumstances in the present and the future.

• 2.5.2 Kyoto Protocol

The IET under the Kyoto Protocol has just started in 2008, and therefore it is not possible to conduct a review of it yet. However, there are many expectations and concerns in relation to the future of the IET under the Kyoto Protocol. Its scope is far larger than the EU ETS and it includes far more countries worldwide as well. Therefore, it is expected that the market for Kyoto emission allowances will be larger than that for the EU ETS. The World Energy Outlook (“WEO”) suggests a demand by the industrial signatories for “some 840 million tonnes of CO₂ in the year 2010”.²⁵⁹ The procedures and structures of the IET under the Kyoto Protocol are similar to the ones under the EU ETS. Thus, the IET system should be able to ensure an accurate monitoring, reporting, and verification system as well as an efficient system of compliance and enforcement.

However, how successful the IET will be depends on many factors, such as the liquidity of the market and how stable prices of AAUs will be. This remains to be seen. Environmental effectiveness and economic efficiency could be raised by key developing economies like India, Brazil, or China accepting legally binding GHG emission reduction targets under the Kyoto Protocol. The last Climate Change Conference in Bali in 2007 developed the so-called “Bali Roadmap” to create a secure climate future. As a positive result of this conference, Australia ratified the Kyoto Protocol. A new negotiation process was launched, designed to tackle climate change, with the aim of completing this in 2009.

3. CONCLUSION

Global warming is a problem that requires action sooner rather than later. Past and future anthropogenic GHG emissions will remain in the atmosphere for many centuries and will continue to contribute to global warming. Thus, there is a need for an international effort to greatly reduce GHG emissions. It would be irresponsible not to consider all possibilities to minimise climate change.

Global warming is a serious threat for today’s world, and emissions trading schemes, such as the EU ETS, could be the solution to this worldwide problem. Even though there were some initial problems in the setting up of the EU ETS such as delayed NAPs, the final implementation of its rules and procedures in

259 OECD/IEA, Act Locally, Trade Globally, supra note 136, at 33.

the member nations was successful. Today, the EU ETS is functioning very well, with clear exchanges of EUAs, a transparent and traceable carbon price, and a strong monitoring, reporting, and verification system, which ensures a proper accounting of GHG emissions. The reduction of CO₂ emissions and the improvement in energy efficiency through low-carbon technologies are now embedded in business strategies.

It has been shown that the market-based approach of the cap-and- trade-system of the EU ETS is more efficient than a command-and-control approach. The system of the EU ETS has been economically efficient, but the environmental effectiveness needs to be greatly improved on the following phases. The environmental ineffectiveness is due to the starting problems of the scheme and an overallocation of allowances. Thus, the first phase, which was seen as a “warming-up phase”, has been successful in showing the problems that should now be solved for the following phases.

Overall, the EU ETS is a huge success and the first emissions trading market of its kind, from many perspectives, worldwide. Therefore, it can serve as a model for the IET under the Kyoto Protocol and also for other emissions trading schemes in other countries to tackle the problem of global warming.