I. The European Union's Emission Trading Scheme

One way for countries to meet their Kyoto obligations is carbon trading. Allowable emissions levels are translated into commodities, such as credits or permits, which can then be bought and sold on a regional or global market for carbon dioxide. If a country or factory wants to exceed its emissions target, it can purchase additional emissions credits from another country or factory that is under the cap. In this way, emissions reductions are not only captured but also allocated in an efficient way.

The European Union established the first mandatory carbon trading market among its members when the Kyoto Protocol came into effect in 2005, the Emission Trading Scheme (ETS). It is based on the model described above. In the first phase running from 2005 to 2007, 12,000 factories representing about 40 percent of EU carbon emissions were integrated into a permit-based European market.

Phase two of the Emissions Trading Scheme began on January 1, 2008and is proposed to run until 2012. This phase witnesses the addition of other greenhouse gases and industries to the market and also incorporates permits from the Kyoto Protocol’s joint implementation and clean development mechanisms (CDM). The ETS is a bold experiment and “provide[s] a benchmark by which the world’s trade in carbon can be judged.” ¹

So far, the ETS has experienced a number of problems that are illustrative of the difficulties of implementing any carbon trading scheme. First, the number of credits initially dispersed to EU factories was overly generous. Before the market could open, government regulators had to guess how much pollution more than 13,000 factories were emitting. As it turns out, they guessed too high. When it became clear that the supply of credits exceeded the demand for them in May 2006, the price of the credits plummeted and the market collapsed. Though discouraging, this problem can eventually be addressed by adjusting the supply of permits.²

The second problem to emerge was grandfathering. Existing polluters in the EU were initially given free credits in compensation for the fact that their business practices would have to adjust to meet the requirements of the new system. Rather than using these EU issued emissions credits as they had been intended, many businesses sold them and used the proceeds to purchase cheaper credits from developing countries through the Kyoto Protocol’s Clean Development Mechanism. The price of the CDM permits was low because a market for them has not yet been established and because they are considered a high-risk investment. Businesses who exploited the system in this way were able to meet their emissions targets using the CDM permits but also make a profit from the sale of the free ETS credits. This loophole will need to be closed if the ETS is to develop credibility as a markets.3

Finally, the short timeframe of the initial phase of the ETS, which is slated to last only three years, discouraged aggressive investment by European companies in emissions reduction technology. Stable markets lend greater certainty to transactions in a variety of ways. But if the nature or ultimate fate of a market is itself a source of uncertainty, many potential gains can be lost. Since the ETS’ current time horizon is only three years and “the payback period for cleaner power-generating technology is at least five years, there is no
incentive for producers to invest in cleaner technologies."⁴

Observers understand that the ETS is still in its early stages and that plenty of time remains for the problems discussed above to be resolved. But it is also a powerful lesson about the difficulties of translating a good theory into practice.

1 Harvey, “Hot Air Balloons”; “EU Emissions Trading Scheme”
2 “Gaming Gases”
3 ibid.
4 ibid.