Tuesday, July 26, 2011

Overallocation and Reform in the EU ETS

There are some who say that the European Union Emissions Trading Scheme (EU ETS) is a big failure and others who say it is a great success.  I am not going to pronounce judgment today.  I’d just like to suggest that the EU ETS is a good example of a cap-and-trade program that has been able respond to overallocation and other problems through ongoing reform.

The EU ETS, initiated in 2005, regulates about 11,500 stationary sources in 27 European countries.  It covers about half of all CO2 emissions in the region.  The EU ETS’s first phase covered the years 2005 through 2007.  By 2006, it became clear that there was an oversupply of EU ETS allowances market, and allowance prices collapsed.  The second phase of the program, which spans 2008 to 2012, is designed to ensure that Europe meets its Kyoto Protocol emissions reduction commitment.  Tighter caps were imposed for this phase of the program, but due to the economic recession in these years, it appears that there is still an oversupply of allowances.  Allowance prices haven’t collapsed, in part because allowances can be banked for the third phase of the program, covering the years 2013 to 2020.  In the third phase, more stringent emissions caps are being imposed that are aimed at reducing the emissions of the regulated entities to 21% below 2005 emissions by 2020. 

The almost 7 years of the EU ETS have been a case study in cap-and-trade tinkering.  Notably, the first phase is often referred to as the “pilot phase.”  The EU apparently recognized that it could not set up a cap-and-trade system that would work for the long term at one fell swoop.  Unlike the Acid Rain Program and RGGI (see my posts on overallocation in these programs here and here), the EU ETS had reform opportunities built into the program, and the EU has used them to progressively tighten caps as well as add new types of regulated sources and increase the number of allowances auctioned.  One of the major lessons to be taken from the EU ETS is that cap-and-trade programs should be designed to enable reforms in the cap and other important features based on the performance of the program. 

- Lesley McAllister


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