At the end of their recent climate report, Lehman Brothers has one of the best brief discussions of the European Union Emissions Trading Scheme (EU ETS) that I have seen. Since the EU ETS is often viewed in this country as a failure, I thought I would reprint their somewhat different perspective in its entirety:

The EU ETS, which came into effect in January 2005, was constructed on the basic premise that setting emission caps and allowing them to be freely traded would enable companies to seek emission reductions wherever and however it was cheapest to do so. It is the world’s most ambitious cap-and-trade scheme to date, covering 25 countries, each with authority to issue emission allowances. The sectors included in Phase I (2005-07) are: power generation; ferrous metal production and processing; chemical processes; mineral industry; and pulp, paper and board. These account for approximately 45% of EU CO2 emissions. In its very first year of operation, the value of allowances issued across the EU reached more than €60bn.

Phase II (2008-12) expands the scope of the market to cover all greenhouse gases and adds further sectors, including aviation. And Norway, Iceland, Liechtenstein, and Switzerland will all join, even though they are not EU member states. Some economists have dubbed the EU ETS as “by far the most significant accomplishment in climate policy to date.”

Has the EU ETS achieved its mission?

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The EU ETS is sometimes said to have failed because the Phase I carbon price has fallen almost to zero. This situation arose because, at the outset, the European Commission had no reliable information about companies’ emissions, and was therefore obliged to use figures provided by installations themselves. In the spring of 2006, it became evident that in fact actual emissions were below the initial allowances. This led to some of the most volatile days in the market as prices fell close to zero.

This issue was addressed in the Phase II National Allocation Plan decisions: the Commission both significantly reduced the allocated volume of permits, and limited the use of external credits. As a result, the price of future emissions under Phase II (starting in January 2008) is far from zero: the current price is around €20/tCO2 (equivalent to €70 per tonne of carbon.)

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The EU ETS has thus succeeded, and fairly quickly, in imposing a price on carbon. In 2006, €22.4bn worth of allowances were traded — a substantial increase from the 2005 figure of €9.4bn. Furthermore, by opting for a market system, the EU has already succeeded in encouraging the private sector to invest in carbon-reduction projects. Significant capital has already been invested in emission-reducing projects in developing countries under the Clean Development Mechanism (CDM). Such projects generate emission credits that European companies can use to comply with the EU ETS via the Linking Directive.

The EU ETS’ basic market design has enabled companies, across the EU and across different sectors, to trade in a relatively transparent market where price movements reflect evolving perceptions about scarcity and abatement costs. Within a year of its introduction, most installations established trading relationships and, by the first surrendering date, there were few cases of non-compliance. This was reflected in the exponential increase in traded volume, as well as in the diversity of active participants. By end-July 2007, daily volume had increased to an average of 6.5m EU Allowances (EUAs). The CDM/JI market is now evolving similarly. This year saw the development of the secondary CER market, which attempts to standardize the CDM market and allow market participants to access the credit market without exposing themselves to the primary market.

What next?

Debate seems to be shifting from “Is a cap-and-trade scheme the best solution?” to “How should a global cap-and-trade scheme best be implemented?” From a market perspective, the continuation of the EU ETS into a third phase is a fact, and both private and corporate players are pre-positioning with regards to that next phase. It will probably not be long before the market place attempts to price this future scenario. Whatever the decision beyond 2012, we judge that the EU ETS provides a credible first framework from which governments are gaining significant experience.

This post was created for, a project of the Center for American Progress Action Fund.