EU Directive on Emission Allowances Trading (Proposal)

Rutger de Witt Wijnen

Introduction
Only a few things can be as frustrating as writing an article on greenhouse gas emissions trading these days. There are new developments almost on a daily basis. By the time you have finished your draft article, not to mention at the time of publication, you will discover to your dismay that some conclusions or predictions are already history. The only consistency in the area of greenhouse gas emissions trading over the last few years has come from Washington, D.C.: a consistent and deafening silence. Keeping this caveat in mind, I will give a brief update on the status of the proposal for a directive establishing the framework for an EU-wide system of greenhouse gas emission allowance trading (the EU Directive), highlighting some key issues in the implementation process. See http://register.consilium.eu.int/pdf/en/02/st15/st15792en02.pdf.

Relevance for U.S. Companies
The EU Directive is not only relevant for European companies, but also for U.S. companies. First, for U.S. companies with operations in Europe which fall under the scope of the EU Directive, the Directive will impact the way such operations do business. It may also have an impact on their consolidated annual accounts, which will have to take into consideration potential liabilities and positions in Allowances (as defined below). Secondly, the EU Directive will be relevant for U.S. companies considering acquiring a business in Europe. Compliance with the EU Directive will become an important part of the due diligence process in affected industries.

The EU Directive
For an excellent summary of the EU Directive, I refer to the contribution by Mary Anne Sullivan and Jacqueline Mailly in the ABA Section of Environment, Energy, and Resources’ Climate Change and Sustainable Development Committee Newsletter of January 2002. With the risk of some repetition, I will first identify a few highlights of the EU Directive in the context of important topics that are currently being debated.

The system under the EU Directive will apply to coke ovens, mineral oil refineries, combustion installations with a rated thermal input exceeding 20MW (except hazardous or municipal waste installations), production and processing of ferrous metals, the mineral industry and production of paper, board and pulp from timber. Certain threshold values apply. (For installations producing pig iron or steel: 2.5 tons/hour; for production of cement clinker in rotary kilns: 500 tons/day or lime in rotary kilns or in other furnaces 50 tons/day; for the manufacture of glass and glass fiber: a melting capacity of 20 tons/day; for the manufacture of ceramic products by firing: 75 tons/day, and/or with a kiln capacity exceeding 4 m3 and with a setting density per kiln exceeding 300 kg/m3; and for production of paper and board: 20 tons/day.)

Initially, only these installations and activties will be covered by the EU Directive. Member States may apply to the EU Commission to exclude certain installations and activities until Dec. 31, 2007. However, Member States may, subject to approval by the EU Commission, apply emissions allowance trading to installations carrying out the activities listed above below the capacity limits referred to in Annex I of the EU Directive. Also, as from 2008 Member States may apply emission allowance trading to activities, installations and greenhouse gasses which are not listed in Annex I to the EU Directive, subject to the approval of the EU Commission.

The EU Directive is limited to the emission of carbon dioxide, but is likely to be extended to other greenhouse gases in the future. It is unclear when such extension would occur. There are indications that the European Parliament will propose an amendment to that effect so that other greenhouse gases may already be covered in the initial compliance period which runs from 2005 to 2008.

Under the EU Directive, Member States are obligated to establish absolute limits on the emissions of carbon dioxide gases from the installations covered (Installations). Operators of Installations have to obtain a greenhouse gas emissions permit and need emission allowances. Allowances will be allocated by the respective Member States according to a national allocation plan. The EU Commission shall ultimately by Dec. 31, 2003, develop guidelines on the implementation of the criteria for the national allocation plans, which are annexed to the EU Directive.

Main Features of the EU Directive
Allowance

The EU Directive defines an allowance as “the allowance to emit one tonne of carbon dioxide equivalent during a specified period” (Allowance). This definition closely resembles the definitions of the various units under the Kyoto Protocol so as to facilitate a link between the two schemes. Allowances will be allocated to operators of Installations pursuant to a national allocation plan.

Trading of Allowances

Allowances can be transferred (a) between persons within the European Community and, (b) between persons within the European Community and persons in countries listed in Annex B to the Kyoto Protocol which have ratified the protocol, provided, however, that such Annex B countries have entered into an agreement with the Community on the mutual recognition of their allowance trading schemes. Any person may hold Allowances. Under the EU Directive it seems to be irrelevant whether or not the Kyoto Protocol enters into force, as long as it has been ratified by the relevant Annex B country. Although this provision appears to be primarily aimed at linking the EU and the Kyoto community, it also opens the door to fungibility of Allowances with allowances under certain national trading schemes, such as in Canada.

Cancellation of Allowances

Each year the operator of an Installation has to surrender a number of Allowances equal to the total emissions from such Installation during the preceding year. These Allowances are subsequently cancelled. Allowances will also be cancelled at any time at the request of the person holding them. This provision allows third parties, such as environmental groups, to remove Allowances from the market thereby limiting the total permitted output of greenhouse gasses.

Validity of Allowances

Allowances shall be valid for the relevant compliance period. The first compliance period runs from 2005 until 2008. Thereafter, each five-year period shall be a compliance period. Any excess Allowances, i.e., any Allowances not surrendered to offset emissions from an Installation in a compliance period, will be replaced by Allowances valid for the new compliance period. This provision allows banking of Allowances.

Registries/Transaction Log

Each Member State shall establish a registry containing separate accounts to record the Allowances held by each person. The registries shall be accessible to the public. Member States may, but are not obliged to, maintain their registries in a consolidated system. The Commission will adopt a regulation for a standardized system of registries in the form of standardized electronic databases, containing common data elements to track the issue, holding, transfer and cancellation of Allowances. This regulation is also to ensure that there are no transfers incompatible with obligations under the Kyoto Protocol.

A Central Administrator will maintain an independent transaction log. Each transaction in national registries shall be automatically checked to ensure that there are no irregularities. If irregularities come up, the Central Administrator shall inform the relevant Member State(s) who shall not register the transaction.

Linking

It is the intent that links will be made to other emission trading schemes, such as Emissions Trading under the Kyoto Protocol. First of all, through agreements concluded with third countries listed in Annex B to the Kyoto Protocol. Secondly by recognizing emission credits from project-based mechanisms in accordance with a directive which is to enter into force simultaneously with the EU Directive, i.e. 2005. This directive will be primarily focussed on recognizing credits derived from Joint Implementation (JI) and Clean Development Mechanism (CDM) projects.

Timeframe
The first step towards adoption was taken by the political agreement on the EU Directive in the European Council on Dec. 9, 2002. As the next step, the proposal for the EU Directive needs to be approved by the European Parliament. The Parliament is expected to vote in July/September of this year. If no amendments are made by the European Parliament, the EU Directive will be adopted by the end of this summer. However, if amendments are adopted by the European Parliament, which is currently considered likely to occur, the proposal will go back to the European Council. Should the Council not approve of the amendments, a Conciliation Committee will be established with the mission to approve of a joint text within six weeks. In this scenario the adoption of the EU Directive by the end of this year looks more probable.

Once the EU Directive is final and has entered into force, the actual implementation process will begin as a directive is an instruction to the EU Member States to implement legislation in their respective jurisdictions. The EU Directive itself does not establish a trading scheme; it only provides a framework for the Member States to be filled in with national legislation.

The EU Directive does provide a timeframe for implementation: Member States are to bring into force the laws, regulations and administrative provisions necessary to comply with the EU Directive by Dec. 31, 2003 at the latest. This date may be problematic, if the EU Directive is not adopted ultimately by the end of the summer so this date may change during the current adoption process. Irrespective of what the final date will be, it is clear that the EU Directive will provide for an ambitious time frame as the prohibition to operate a facility covered by the EU Directive without a permit takes effect on Jan. 1, 2005. Also, Allowances will be allocated for the first period of three years which begins on Jan. 1, 2005.

Important Topics
Even though the EU Directive is still before the European Parliament, intense debates are currently taking place regarding various implementation issues.

Kyoto and EU Registries?

There is an important, but quite technical, debate going on whether the registries to be established pursuant to the Kyoto Protocol may be the same as the registries to be established pursuant to the EU Directive. It would go too far to describe this debate in detail in this contribution, but it is important to note that the issue of registries is a typical example of how important and complicated the details of establishing successful cross-border emissions trading schemes will be. Without doubt, the correct registration of ownership and transfer of Allowances and the Kyoto units will be key to the success of both schemes.

Compliance with the Kyoto Protocol

The foregoing expectation is consistent with the instruction in the EU Directive that a regulation by the Commission will have to address compliance with obligations under the Kyoto Protocol. This requirement might lead to unforeseen consequences which may not be compatible with the intent to create normal market conditions. For instance, each party included in Annex I to the UN Framework Convention on Climate Change (Annex I Party), which includes each EU Member States, is obliged to keep a commitment period reserve in its national registry which should not drop below 90 percent of such party’s assigned amount. If a legal entity with an account in Member Country A wants to transfer an amount of Allowances to an account in another jurisdiction as a result of which the commitment period reserve of A would drop below 90 percent of its assigned amounts, this transfer is incompatible with A’s obligations under the Kyoto Protocol. Consequently, the Central Administrator will inform the EU registry in country A that the transfer cannot be made. Neither seller, nor buyer in this trade of Allowances will be amused.

Laundering CDM and JI and Credits

Credits resulting from CDM or JI projects, Certified Emisisons Reductions (CERs) and Emissions Reductions Units (ERUs) respectively, have limitations on their bankability, because CERs and ERUs held in a national (Kyoto) register may be carried over to a subsequent commitment period in each case up to a maximum of 2.5 percent of the assigned amount of the relevant Annex I Party. Allowances do not have these limitations. The EU trading scheme should not become the laundry machine for soon-to-be-expiring CERs and ERUs. Therefore, the modalities to be adopted by the EU Parliament and the Council regarding the recognition of emission credits from project-based mechanisms will undoubtedly include some form of limitation on such recognition.

Old and New Europe

Recently some so-called EU accession countries, which will join the EU within the next few years, have expressed concerns on the implications of the EU Directive on their national industries. By the time these accession countries become EU Member States, the EU Directive will most likely have become effective and will, therefore, also apply to the new EU entrants. I expect there will be some further debate if and to what extent the application of the EU Directive can be delayed or watered down for an interim period for the accession countries.

Concluding Remarks
Although the EU Directive has not yet entered into force, the first future trade of Allowances has already taken place. Shell Trading, based in London, and Nuon, a Dutch energy company, announced on February 27 of this year the completion of the first ever future trade of Allowances to be allocated under the EU Emissions Trading Scheme. More trades are to be expected in the near future well before the EU Directive and the national implementation laws will have entered into force. The International Emissions Trading Association (www.ieta.org) has taken the initiative to draft standard agreements for trading under the EU Trading Scheme. The first draft, an Allowances Emission Trading Master Agreement, is expected to be published within the next few months. There appears to be an appetite in the European market to commence trading. Experience gained in this market will undoubtedly be of great help to the legislators in the various EU Member States in working out the devilish details of quite a complex and novel way of curbing greenhouse gas emissions, because there is little doubt in my mind that the EU Directive will – eventually – enter into force.

Rutger de Witt Wijnen is a partner in the New York office of the Dutch law firm De Brauw Blackstone Westbroek (www.debrauw.com). He thanks his colleague Sija van Mourik for her valuable suggestions.