The measures of success

Europe’s Emissions Trading Scheme is attracting admiration, hostility, lawsuits and intense scrutiny. But is it actually going to work? Mark Nicholls asks how we should judge the scheme’s success

Less than six months after the launch of the EU’s pioneering Emissions Trading Scheme (ETS) is far too soon to consider the success – or otherwise – of this pioneering environmental market. Most of the estimated 5,000 companies covered by the scheme are just beginning to assess how they expect to comply with the carbon dioxide (CO₂) emissions targets that it sets.

Peter Vis, European Commission:“Don’t judge the scheme simply by prices and volumes.”

Nonetheless, the scheme has already ignited a fierce debate in Europe. On one side are those who fear that limiting CO₂ emissions from European companies will place them at a financial disadvantage to their overseas competitors. On the other, are those arguing that EU governments have failed to grasp the nettle, by setting the targets for industry so lax as to make a mockery of the principles underpinning the scheme.

Further afield, supporters of the Kyoto Protocol are willing the EU ETS on, hoping that it can demonstrate that emissions trading can help to meet the climate change agreement’s emissions reduction targets at low cost. Conversely, its opponents expect to see evidence that the countries of the EU, despite talking the talk on global warming, will ultimately balk at the cost of walking the walk.

So, as the scheme begins its first, ‘warm-up’, phase – which began on 1 January 2005 and runs to the end of 2007 – how do participants and observers assess its effectiveness?

According to the directive establishing the scheme, the EU ETS is designed “to contribute to fulfilling the [Kyoto] commitment of the European Community and its Member States more effectively … with the least possible diminution of economic development and employment”.

Such an objective sets, on the face of it, easily quantifiable metrics by which to judge the scheme’s effectiveness. In terms of cost, it seems likely that a ‘cap-and-trade’ scheme will deliver reductions at lower cost than equivalent measures, such as carbon taxes, says Vicki Arroyo, director of policy analysis at the Pew Center on Climate Change, a Virginia-based think-tank. “One thing to look at, retrospectively, is the cost overall to firms in the EU ETS compared to the costs of achieving similar reductions by other means.

“What we’ve found, historically, is that trading programmes are cheaper than ‘command-and-control’ methods, such as imposing technological or performance standards.”

However, according to many environmental groups, the scheme is already failing to deliver on its first metric – moving EU members toward their 2008–12 Kyoto emissions targets. “It is not clear whether the ETS will actually be a powerful tool to reduce emissions, or whether member states will continue to dilute it by developing weak NAPs,” says Oliver Rapf, senior policy officer in WWF’s Brussels office. “The first allocation round has been a mess. Governments across all member states have been bowing to industry pressure too much.”

These NAPs – the ‘national allocation plans’ that governments had to draw up, setting the 2005–07 emissions targets for all the installations covered by the scheme – are widely considered to have been generous.

Despite a requirement that they should put member states on a path towards meeting their various Kyoto targets, many will put little pressure on corporate emissions. Indeed, investment bank Dresdner Kleinwort Wasserstein estimates that, compared to a total allocation of more than 6 billion tonnes of CO₂ to industry over 2005–07, the scheme will be ‘short’ barely 40 million–65 million tonnes each year under ‘business-as-usual’ assumptions.

“You have to keep in mind the objectives of the EU ETS – to contribute to emission reductions, and in a cost-effective way,” agrees Frede Capellen, special advisor on environmental policy to Norwegian oil firm Statoil. “But we shouldn’t expect it to be 100% effective [in this regard] in the first period. It would be more appropriate to judge its effectiveness in 2012, than at the end of 2007.”

Indeed, many argue that it would be naďve to expect the scheme to deliver dramatic early reductions. What is more important, they say, is that it changes corporate thinking about CO₂ emissions and energy use. And evidence from companies affected by the scheme shows that, regardless of the size of their allowance allocation, the EU ETS has created a ‘cost of carbon’ that will now be factored into decision-making.

When BP introduced an internal emissions trading scheme in 1998, it found that simply imposing a cost of carbon was half the battle, explains Mark Proegler, head of the emissions markets group at the oil major. “Recognising that there’s a formal cost of carbon leads to the commercialisation of carbon,” he says. “It connects the technical people with the commercial people, and we found lots of low hanging fruit that was already viable.”

The European Commission endorses this view: “The success of the scheme lies in establishing incentives to change behaviour,” says Peter Vis, acting head of the Commission’s industrial emissions unit. “Don’t judge the scheme simply by prices and volumes, important though they are. This is about changing mindsets, and should be seen in a longer perspective than daily variations in price.”

But some within business warn of the danger of the ETS raising costs for carbon-intensive industries to such an extent that they are driven outside the EU, to jurisdictions where carbon emissions are uncapped.

“If you need a carbon price nearer €20-25/tonne to result in significant fuel switching, then it’s not yet clear that’s the sort of carbon price that industry can live with,” says Jeremy Nicholson, director of the UK’s Energy Intensive Users Group.

However, others are confident that the balance of supply and demand in the global carbon market means that such an eventuality is unlikely in the short term. “There’s a ‘sweet spot’ that needs to be hit, where the price is high enough to drive demonstrable progress to meet global warming goals, but in a way that’s economically efficient,” says Dirk Forrister, London-based managing director at environmental brokerage Natsource.

“The signs are that global demand is modest enough for the European example to work,” he adds. The 2001 withdrawal of the US from the Kyoto system reduced, at a stroke, a huge need for emissions allowances.

But demand for CO₂ allowances from companies in the EU ETS could be enough to support the Kyoto Protocol’s Clean Development Mechanism (CDM). “An important aspect of the EU market’s success is its ability to stimulate action globally,” says Forrister, “and it is critical to the success of the system that it links up with other markets around the world.”

The CDM is a cornerstone of the Protocol, promising to generate sustainable investment in developing countries, in exchange for emission reduction credits. While the mechanism has been slow to get off the ground, project developers hope the EU ETS will generate substantial demand as CDM credits can be used to offset companies’ domestic emissions.

Dirk Forrister, Natsource: “demand is modest enough for the ETS to work”

“In an operational sense, the two markets are still disconnected,” cautions Forrister, with price movements in EU Allowances thus far not reflected in prices of cheaper CDM credits. “That’s a reflection of the early stage we’re at. It will get better, as spot markets develop in both products.”

Supporters of the EU ETS are pushing for links to other markets, apart from the CDM. Norway is in advanced negotiations with the EU on linking its domestic scheme. And, although neither Canada nor Japan plan to set up domestic trading schemes before 2008, discussions are under way about linking them to the EU scheme. There is even pressure to try to link proposed regional GHG cap-and-trade schemes in the US – such as one planned by nine northeastern states – to the EU ETS.

“It would be good for liquidity if the EU ETS could be linked to other trading markets,” says BP’s Proegler. “The ultimate goal is a global trading system, and we should look at whether the EU ETS could provide that platform.”

The EU scheme also has an important role in showing that such a trading system can be successfully implemented. As the Pew Center’s Arroyo argues, “the example that the EU is setting is a really important one”.

“Europe started somewhat fearful of trading, but is now really leading,” she says. Indeed, it was the US government that insisted on including trading in the Kyoto Protocol, while the EU was at best ambivalent about such market mechanisms.

“A success factor for the system is that it forms a platform for policy development beyond 2012,” when the Protocol’s first reduction target period ends, says Statoil’s Capellen. “We need a robust system that delivers cost-effective reductions, that can deliver tougher environmental targets going forward without losing the support of the broad constituencies required,” including member state governments and the business community, as well as environmentalists.

Many in industry agree: whether the scheme leads to dramatic changes in short-term behaviour is a secondary concern. Of more importance are solid foundations on which more stringent reduction goals can be built.

“It’s about reducing emissions, but the amounts are really pretty small in the global context. It’s a first step,” says Joe Kruger, a visiting scholar with Resources for the Future, another US think-tank.

“In my view, too much attention is paid to exactly what the price is, or the number of tonnes included in the NAPs. People should take the longer view,” he says.

“Is the system working efficiently? Are prices at a level that maintains political support during the first phase? Are companies finding the right incentives to make reductions? Are they adapting to the new regulatory scheme, and starting to plan for the long term?”

Most would argue that it’s too soon to assess whether companies are factoring carbon emissions into their long-term planning. “It’s too early, and it’s been too much of a shock, for the scheme to be driving longer-term investment decisions already,” says Nick Campbell, Paris-based chairman of the climate change working group at Unice, the European employers’ federation. “Most companies are running around working out how to comply.”

But he argues that – at this point – the success of the scheme need not be measured in tonnes of carbon abated, but in the much more prosaic nuts and bolts of carbon management. “The real meat of the scheme is in getting companies to meet their emissions monitoring, reporting and verification [MRV] requirements.

“We’re going to have a very accurate idea of what emissions are in Europe. The EU ETS is going to result in world-class MRV systems – and that’s going to be seen as a major success,” he says.

However, Leo Birnbaum, a Dusseldorf-based partner at consultancy McKinsey, warns that the scheme, if not further developed, is in danger of failing to meet its longer-term goals. “You can’t design such a system, aimed at long-term behavioural change, on a five-year basis,” he says. “The system creates more uncertainty about future developments. And uncertainty is already a major problem, even at low carbon prices.”

McKinsey is undertaking a study for the Commission, with results due by the end of the year, to assess how the trading system is affecting sector competitiveness. This will feed into a review of the scheme, with the Commission expected to make recommendations on reforms to the EU ETS in mid-2006.

So the overall sense from industry is that the Commission has some breathing space before the scheme really needs to deliver. “If, by 2007,we have an instrument that’s workable, streamlined, with the various components in place to make the market function, and with the assumption that it will deliver in environmental terms in the Kyoto period, then that will be good enough,” says Capallen at Statoil. EF