The EU Emissions Trading System and the Complexities of Incentivizing a Clean Energy Future

The European Union has been working diligently to promote the expansion of a low carbon economy. They have ratified the Kyoto Protocol, passed a relatively rigorous energy strategy for 2020, and created the largest Carbon Cap and Trade System in the World: the European Emissions Trading System (EU ETS).

To briefly explain how the EU ETS works, industries that are part of the trading scheme are given emissions allocations – or credits (the right to emit 1 ton of CO2 into the atmosphere). They must either reduce their emissions to the amount of credits allocated to them, or buy additional credits for every ton of CO2 over the allotted number of emissions allocations given to them. These emissions credits can be purchased on the EU ETS carbon market. Industries that reduce their emissions lower than the number of credits given to them will have a surplus of credits and can sell their extra emissions credits on the carbon market.

Each year, industries must hand over to the government the amount of emissions credits equal to the quantity of CO2 emissions they emitted within that year. The submission of credits to the government creates the necessity for some industries to buy emissions allocations if they have emitted more than they were allotted, and also gives the incentive for others to sell their surplus of credits if they have more allocations than they emitted. This supply and demand for credits creates the market for carbon.

The number of total emissions will always be at, or below, the “Cap” – the total number of credits in the system. The actual emitters will depend on each company’s decisions to either reduce their emissions or purchase additional credits from others. (Hence the name, Cap and Trade).

In the first two phases (2005 – 2012), most of the emissions credits were given by EU nation governments to industries without charge (with the exception of a few countries, like the UK and Germany which began to auction a portion of their allowances during phase 2). The third phase of the EU ETS began in January of this year and ends in 2020. In this phase, over 40% of total allocations will be auctioned. 100% of emissions allocations will be auctioned for the Power Generation Sector – creating a significant revenue stream for national governments.

The EU ETS and incentivizing Clean Energy Technology

The EU ETS was designed to be “technology neutral”, in that it does not favor one technology over another. One of the main goals of the system is to give a price to the environmental costs from emitting CO2 (contributing to climate change) that are not being paid by the emitting industries. The emission of CO2 by industries is a typical case of a negative externality: a cost resulting from one person’s activities which affects an otherwise uninvolved party. In other words, the one producing the “cost” is not paying the full price of that cost. In the case of CO2, without a carbon price, society is “paying” the costs of the additional carbon being emitted into the atmosphere by individual industries – as emitting CO2 into the atmosphere has traditionally been free for these companies.

The EU ETS puts a price on carbon emissions that companies must then factor into their cost of production. When the price of carbon is high, companies have a higher incentive to look into cleaner (or less carbon intensive) technologies. When the price is low, companies have less of an incentive to reduce their emissions, as the cost of emitting more CO2 is relatively low.

Unfortunately, currently the EU ETS has a large structural surplus of emissions (for several reasons), and therefore has a relatively low price for carbon. Therefore, the EU ETS is not properly incentivizing the investment in cleaner technologies; there is still need for the European Union to incentivize these technologies. To do this, the EU has created a programme within the EU ETS, called the NER300 Programe, which is meant to “boost the deployment of innovative low-carbon technologies and stimulate the creation of jobs in those technologies within the EU”.

NER300 Programme

As part of the EU ETS Directive (2009/29/EC), Article 10(a) 8 sets aside the funds raised from the auction of 300 million allowances in the New Entrants Reserve (NER) to be used to subsidize “commercial demonstration projects that aim at the environmentally safe capture and geological storage (CCS) of CO2 as well as demonstration projects of innovative renewable energy technologies, in the territory of the Union.” The New Entrants Reserve is a reserve of credits withheld in order to provide credits to possible new installations that may open during the current phase. According to the Directive, a maximum of 5 percent of the total quantity of allowances from 2013 to 2020 can be set aside for new entrants into the EU ETS.

The NER300 Programme assumes the role of choosing the clean energy programs that will receive the grants. In December 2012, 1.5 billion euros were raised from the auction of 200 million allowances earmarked for the NER300 Programme. The Programme awarded 1.2 billion Euros to 23 renewable energy projects under the first call for proposals. Regarding the grants, Climate Action Commissioner Connie Hedegaard stated:

This year Christmas has come early – today’s Decision is a major milestone in EU climate policy. The NER300 programme is in effect a ‘Robin Hood’ mechanism that makes polluters pay for large-scale demonstration of new low-carbon technologies. The €1.2 billion of grants – paid by the polluters – will leverage a further €2 billion of private investment in the 23 selected low-carbon demonstration projects. This will help the EU keep its frontrunner position on renewables and create jobs here and now, in the EU.

Programs and Policies like NER300 and the EU ETS are crucial to the success of renewable energy technologies; they are necessary in order to lock in clean energy technologies in the future.

“Locking In” Technologies?

“Lock in” is a phenomenon in which a certain technology is chosen over another; once this decision has been made, the chosen technology will be developed and implemented within society. After implementation of the chosen technology, society subsequently becomes locked in to that technology.

A simple example of this idea is demonstrated in the implementation of energy efficiency technologies when constructing a new building. If building owners do not take energy efficiency technology into account when designing the building, they will be locking themselves in to having a energy inefficient building once it is completed. Another example is the decision of whether or not to adopt Metro systems in certain cities.  Since Los Angeles did not invest well in developing a Metro in the early stages of development, Los Angelinos are  now “locked in” to using their vehicles to move around the city.

Regarding the “lock in” phenomenon:

It is not (always) because a particular technology is efficient that it is adopted, but (sometimes) because it is adopted that it will become efficient. (Arthur, 1989).

This idea is directly reflected in the current situation regarding renewable energies. Many countries are trying to incentivize the adoption of renewable energy technology at the moment, but not because it is cost efficient. In fact, renewable energy sources have historically been much more expensive to introduce into the electricity grid (although that is changing) and are not as reliable as conventional energy plants (the wind is not always blowing and the sun is not always shining). However, the act of investing in and adopting these technologies now will allow these technologies to become cost efficient, and therefore “locked in”, in the future.

Equally, “Lock In” can work in reverse:

Since our choices in the present directly impact the future path of technological advancement, technologies that have short-term advantages, yet long‐term disadvantages, can become “locked in” to society if we do not look at the long term effects of our decisions.

In the end, the European Union has taken tremendous strides in creating policies that help foster the innovation and implementation of cleaner technologies. Do they need to be improved? Yes. Currently, the European Union is working (with difficulty) on “fixing” the policy issues related to the structural surplus of emissions credits in the EU ETS.

If the EU ETS were able to send a credible long term signal to the market regarding the true social cost of CO2 emissions, companies would move towards cleaner technologies on their own, and complimentary policies like the subsidies from the NER300 Programme would not be necessary as an incentive to invest in clean energy.

However, in my opinion the NER300 Programme does serve its own purpose by helping stimulate development of new renewable energy technologies – “getting them off the ground” so that companies find an interest in investing in them.

Although there have been some bumps in the road, and some still to smooth out, when it comes to clean energy policy it is evident that the European Union is setting a strong example that the rest of the world should learn from and follow…  and soon.

Image credit: First image from Pixaby User Steppinstars, CC Licensed. Second Image from Flickr User Thinking Genuine. CC Licensed.

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