As the average temperature of the world has been rising by approximately 1.4°F during the last century (about 1°F within the last thirty years), global warming grabbed the attention of researchers all over the world.1 They concluded that greenhouse gases like carbon dioxide are very likely to affect climate change.2
In the light of the severe consequences global warming could have, 192 countries participated in a conference in Kyoto and agreed to limit the emission of gases that are responsible for increasing temperatures around the globe.3
Motivated by the Kyoto Protocol, the European Union (EU) faced the challenges of global warming by launching the world's biggest emissions trading system in 2005:4 The European Union Emissions Transfer Scheme (EU ETS) limits emissions from approximately 11,000 power plants and factories in all 28 EU countries plus Norway, Iceland and Liechtenstein.5
About 45% of the total greenhouse gases emitted within the European Union are controlled by the EU ETS. Considering that 11% of the world's greenhouse gas emissions originate from the European Union, one should not be surprised, that we are talking about a large-scale program, which could affect future policies to combat global warming tremendously.6
II. How the EU ETS works
The EU ETS uses the “cap and trade” system:
Each participant is allocated a certain amount of allowances. One allowance gives the owner the right to emit one tonne of carbon dioxide.
The cap limits the number of allowances and therefore the total amount of greenhouse gases emitted by all the power plants and factories covered by the system.7 If a participant does not buy enough allowances to cover his emissions, he will be fined heavily.8 However, the members are free to trade the allowances within the EU ETS. The desired effect of reducing greenhouse gas emission is reached by lowering the cap over time.
Economically speaking, the EU introduced a scarce good (allowances) which is a nonsubstitutable factor of production of certain economic agents (participants in the EU ETS). By lowering the limit gradually, the “cap and trade” system generates an incentive to reduce greenhouse gas emissions, which can be achieved by introducing new technologies, producing more efficiently or reducing output.
Participants choosing not to reduce emissions are punished by the system because they would have to acquire allowances from emission-reducing members as the cap is being lowered over time.
In the first phase of the EU ETS, nearly 100% of the allowances were allocated freely to participants through national allocation plans (NAP), although it was allowed to auction up to 5% of all allowances.9 Between 2008 and 2012 (Phase 2) the three non-EU member countries joined and up to 10% of the allowances could have been auctioned, but again, almost none of the allowances were auctioned.10
In the third phase, which started in 2013, the European Commission wants to reduce the amount of free allowances and lean towards the auctioning system.11
III. Success of the EU ETS
As the European Union is pretty ambitious in terms of reducing its greenhouse gas 2 emissions (20% drop by 2020, 80% drop by 2050 compared to 1990 levels12 ), we want to inspect whether the EU ETS helped to reach these aims: In 2005 (first year of the EU ETS) the emissions were 3.4% lower than expected.13 This trend continues as the emission level of 2010 was about 8% lower than in 2005.14 According to the European Commission (EC), the EU greenhouse gas emissions in 2009 were 17% lower than in 1990, despite a 40% increase in GDP and a 12% rise in manufacturing output.15
The EC also states, that the reduction of emissions was achieved inexpensively (equivalent to 0.01 % of the EU GDP), which would underline the economic efficiency of the EU ETS.16
The same source states that the benefits for the upcoming years (with lower cap) are likely to be much greater:
The EU could save up to €20 billion of fuel costs annually from 2016 to 2020.
Furthermore, the value of health benefits due to better air quality would be equivalent to €3 billion to €8 billion until 2020.17
The expansion of the EU ETS by the airline industry (2012) and the Australian emissions market (planned 2015) show, that the EU ETS is considered to be an effective system to reduce greenhouse gas emissions and may even operate globally one day.18 19
IV. Remaining Issues
Despite the fact, that the EU ETS helps to reduce greenhouse gas emissions, the EU ETS is still developing as there were and there still are some downsides, which affect the efficiency of the scheme.
Especially in Phase 1, the EU ETS suffered from overallocation:
Starting in 2005 with a price of €5 per emitted tonne of carbon dioxide, prices went up rapidly and peaked at €30 within a few months.20 However, the aggregate emissions were lower than the allocation in each of the first 3 years of the EU ETS.
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- The University of Texas at Austin – College of Liberal Arts
- VWL Economics Environmental Economics Umweltökonomie EU Europäische Union European Union Emissions Trading System EU ETS emissions market Emissionsmarkt efficiency Effizienz Zukunft Austin Freiburg cap and trade price volatility Preisvolatilität Over-allocation Überallokation Ressourcen VAT fraud Mehrwertsteuer Cyber Crime Zertifikate Treibhausgas greenhouse gas Kyoto