Carbon Trading in the European Community

Mary Anne Sullivan and Jacqueline Mailly

In the week leading up to the Marrakech negotiations over the final shape of the Kyoto Protocol, the European Union (EU) strongly reaffirmed its commitment to the Kyoto Protocol. Acting through the European Commission (Commission), it took three steps: issued a draft decision calling for Member States to ratify the Protocol by June 2002; identified additional measures to implement Kyoto that it will propose over the next 24 months; and, most importantly, formally proposed legislation to establish a carbon trading program within the EU.

The trading program is vitally important because the EU has collectively committed to an eight-percent greenhouse gas emissions reduction, and trading is a critical tool for business to mitigate the cost of achieving that reduction. Given the overall leadership role the EU has played in the Kyoto Protocol, the Commission proposal is also likely to substantially influence the shape of other greenhouse gas trading programs, even before final legislative action in the European Parliament and Council.

Proposed Directive on Carbon Trading

Scope
The newly proposed Directive sets forth the basic requirements for greenhouse gas emissions trading within the EU. It is designed to minimize both the costs and impacts on competition arising from achieving compliance with the Kyoto Protocol and to work in harmony with existing environmental regulations. The Commission notes in particular the intent to preserve the trend toward liberalization of electricity markets in the EU.

For now, carbon dioxide is the only greenhouse gas covered by the Directive. Within specified size or output limits, ten types of installations in several different industrial sectors are covered, including:

• most power plants with a thermal rating exceeding 20 megawatts
• oil refineries
• coke ovens, iron and steel mills and metal sintering facilities
• cement, glass and ceramic manufacturing facilities of certain sizes and types
• pulp and paper mills.

The Commission notes that it intends to propose expansion of the trading program by the end of 2004 to include additional greenhouse gases and other types of facilities. Waste incinerators, small power plants and a wide array of chemical plants are the likely next targets. The goal in this first phase, however, is to limit coverage to manageable numbers (between 4,000 and 5,000 facilities) and types of facilities so that compliance can be readily monitored, while still reaching a significant portion of greenhouse gas emissions. The Commission estimates that, with its current scope, the Directive covers approximately 38 percent of total projected 2010 greenhouse gas emissions in Member States.

Permits and Allowances
The basic tools of the trading program are permits and allowances. Every covered installation must receive a permit specifying the level of emissions allowed, as well as the monitoring, reporting and verification requirements to which the installation is subject. The Directive further provides that permits should be updated by the relevant national authority as necessary to reflect changes in the operation of a covered installation. Permitted installations will receive each year the emissions allowances authorized by the permit. At the end of each year of a compliance period, the person holding the permit must surrender for cancellation allowances sufficient to cover the actual carbon dioxide emissions from the installation. If an installation anticipates emissions in excess of its allowances, it must acquire additional allowances from a party that has more than it needs or face penalties. If emissions are lower than permitted, it can trade the allowances away or bank them for the future.

The number of allowances issued to a given installation is plainly critical in determining whether operational changes or allowance purchases will be necessary to comply with carbon dioxide emissions requirements. The Directive anticipates that, over time, the number of allowances issued will generally decline in order to achieve emissions reductions. Under the proposal, a Member State has some discretion in determining what allowances it issues. However, it is required to establish a national plan for allocating allowances "based on objective and transparent criteria." The proposed Directive sets common requirements for national allocation plans, including, among other things:

• consistency with progress towards the emissions reduction target to which the Member State has committed;
• consistency with technological potential to reduce emissions so that allowances are not issued for emissions that can be reduced at little or no cost;
• provisions for allowances for new entrants to the market; and
• an opportunity for the public to comment on the plan.

The proposal calls for national plans to be submitted to the Commission for review by March 31, 2004. The plans will be evaluated for consistency with the common criteria, including whether they afford an installation in a Member State an unfair competitive advantage, by disproportionately freeing it of emissions reduction obligations.

Trading
Recognizing that markets serving other pollutant trading programs have evolved without substantial government involvement, the Directive says remarkably little about the actual trading process. To provide the necessary transparency, any party who holds allowances must register on an electronic national registry. (There are no restrictions on who can hold allowances.) To facilitate the transfer of emissions-reduction obligations among Member States, trades carried out under the Directive must be reported on the national registries, which will be linked and standardized. Thus, for example, if a power plant in the United Kingdom sells allowances to a coke oven in Italy, the parties will report the trade, with the result that the emissions-reduction obligation will rise for the UK and decrease for Italy by the number of allowances traded. An EU central administrator will independently review the trading and cancellation of allowances, alerting Member States to any apparent irregularities.

Penalties for Non-Compliance
A point of contention within the Commission has been how steep the penalties should be for installations that do not have sufficient allowances to cover their emissions. The Directive proposes to require a financial penalty of 100 Euros per ton or twice the average market price for allowances during a designated reference period, whichever is higher. Member States are to determine for themselves penalties for other violations.

Phased Implementation
Binding limits take effect in 2008. However, the Directive provides for a preliminary trading phase from 2005 to 2007. For that period, a potentially less rigorous set of requirements applies. Allowances must be issued without charge. Whether they will be auctioned or issued without charge for the period beginning 2008 remains to be determined. Penalties may also be lighter in the preliminary phase. Finally, the decision whether to permit allowances from the test phase to be "banked" for future periods is left to Member States. During subsequent binding periods, the Directive would require that unused allowances be given carryover credit.

Relationship with Other Trading Plans
This Directive governs only trades within the EU. It provides for countries seeking admission to the EU to participate once admitted. It also provides that the EU may enter into separate agreements with non-EU countries for the mutual recognition of trading schemes. An accompanying explanatory note emphasizes that such agreements will depend on whether there are adequate monitoring, reporting and verification programs in place so that the carbon allowances that would be recognized under such agreements are demonstrably related to actual emissions reductions. Reaching such agreements, particularly with Eastern European countries that have already reduced carbon dioxide emissions substantially since 1990, has the potential to greatly expand the availability and reduce the cost of carbon allowances.

This carbon trading system does not recognize credits based on Joint Implementation or Clean Development Mechanism emissions offset-projects. The Commission promises a future Directive addressing this issue. Again, the cost of achieving Kyoto compliance can be considerably reduced if these additional mechanisms can be used.

Closing Note
The proposed Carbon Trading Directive represents a significant step by the EU toward Kyoto Protocol implementation. In many respects, the proposal is quite prescriptive, but in some respects, consistent with the EU principal of subsidiarity, it leaves discretion to Member States. Considerable legislative and regulatory actions remain to be taken to put this program in place.

Mary Anne Sullivan is a partner in the Washington office of Hogan & Hartson. Jacqueline Mailly is a European Regulatory Affairs Advisor in the Brussels office of Hogan & Hartson.