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Core Elements of the EU ETS
with Jos Delbeke and Peter Vis
ANNIKA ZORN: Hello Jos, hello Peter, I’m Annika, we are working since some time together on this Course on Climate Governance, and today I wanted to ask you some questions. Both of you have been involved in the EU ETS since the very beginning. Where did the idea actually come from, Jos?
JOS DELBEKE: Well, the idea comes from economists, they have always been pleading to put a price on carbon and we tried to do that in the EU and we tried to do that at the beginning of the 90s in putting a tax on carbon and later on, apart from a carbon tax, we developed the whole thing of a carbon energy tax, but frankly, it did not succeed because we could not find the unanimity that is required in tax matters.
At the same time, the climate negotiators adopted the Kyoto Protocol and, as part of the negotiations under the Kyoto Protocol, the United States pushed in the so-called flexible mechanisms and emissions trading is a flexible mechanism that is embodied in the Kyoto Protocol, but there is one caveat. Economists see putting a price on carbon as a very cost-effective way of bringing down emissions. So, what we did in Europe was setting up a system, the ETS, where companies are the main drivers of the carbon market and not so much States, which was foreseen under the Kyoto Protocol.
So, we took the idea because the economists brought it on the table, not exactly like it was brought forward under the Kyoto Protocol, but we translated that through its true real meaning that is that companies competing on a market operate on a market and so the EU ETS was born, we changed from a tax to a cap-and-trade. We made a Reflection Paper and after the Reflection Paper we got the go ahead for making a proposal and so we started with real emissions trading, one of the first ones in the world as of 2005.
ANNIKA ZORN: So, you changed the system from one to the other, how long did it take you to recognize that one system wouldn’t bring the results you would wish for?
JOS DELBEKE: Well, it took us a couple of years to change the mindset in particular of the companies and the stakeholders because we were in a process towards a tax and then the tax failed and then we changed the system around, instead of acting on prices you act on quantities and it needed a lot of explanation that it is basically the same, but the approach is very different. So, it took us 2 to 5 years before we got the stakeholders agreeing to the whole new set-up, but then it went fairly fast because companies preferred an emissions trading system to a tax.
A tax is always a little bit controversial because it is money that is taken away from you and it goes somewhere and, even if we explained we would redistribute the revenues, it was very hard for people to believe that. While in emissions trading it is working as an incentive for companies to reduce emissions and it is in under a cap, so the NGOs liked the system because the environmental outcome has been guaranteed. It is guaranteed as part of the proposal that and the legislation you’re passing through. So we got the both sides.
Companies were not in favour of taxes and the Greens liked the guaranteed environmental outcome and that was a good match to change around the minds and to get started in 2005, three years before the Kyoto Protocol really entered into force and and we got ourselves the chance of having a pilot scheme of trying it all out because you need a little bit of institutional infrastructure before you can go ahead.
ANNIKA ZORN: So, we are today 28 Member States of the European Union and how many carbon prices are there? Are there 28 different carbon prices?
JOS DELBEKE: Ah, no, no, that’s a very important question because there is only one carbon price in Europe because the system of the ETS is fully harmonized, so there is only carbon price and that is also what economists always were advocating for, a uniform, a single carbon price and so in Europe, our system is completely harmonized. It doesn’t matter where your company is located, in Romania or in Scotland or in Italy or in the north of Finland, it is exactly the same treatment for the companies and they are subject to exactly the same price.
ANNIKA ZORN: And does anyone fix this carbon price, Peter?
PETER VIS: No, the carbon price is, the theoretical answer to your question is that it’s just a function, a balance between supply and demand of allowances. That’s the theoretical answer. In practice, there are three ways that trading takes place. One is that companies buy allowances in an auction and, of course, the carbon price is determined by what they are prepared to pay on that day for a carbon allowance. Another way of buying not in an auction is to go to an exchange where the exchange brings together buyers and sellers and they agree a price, the exchange if you like determines the price.
But if the auction price, if buying an allowance in an auction is more expensive, people will choose to go to the exchange and vice versa. So, in fact what will happen is the auction price and the exchange price will quickly align. A further way of trading is company-to-company trades. A big company that has a surplus of allowances can sell to a company that’s looking to buy allowances but, again, whoever is buying allowances will not pay more for that kind of transaction than they should pay to get them through an auction or through an exchange. So, these different ways of transacting allowances they lend towards an alignment of the price and in practice that is what happens.
Companies will always buy the allowances at the cheapest price they can and so the three mechanisms will tend to align themselves. Hence, the price fluctuates but it is markets’ forces that determine the price, not the regulators.
ANNIKA ZORN: So, we are really relying on the market here, fully relying on the market, how can we be sure that there is no cheating?
PETER VIS: Very good question. First of all, the first thing we had to do, even before the Emissions Trading System started, was agree monitoring and reporting protocols. We have got a harmonized method by which companies measure their emissions and report their emissions, they can’t do it their own way. There are proper methods that have to be employed and their report is a sort of declaration that then has to be audited by an independent verifier who checks, a third-party checks the accuracy of that report before it is submitted to government. So, that is a precondition for any market mechanism because if I can somehow misrepresent my emissions, I can avoid having to buy extra allowances.
So, there needs to be a harmonized strong methodology for, in effect, accounting for carbon in the same way, you know, with auditing functions by verifiers that give it integrity.
JOS DELBEKE: And if I may add, in fact, this is exactly the same system we have in the financial markets. So, companies are forced to make a financial report that is then checked by a third party and we have an additional particularity that is, if you would be cheating and it is being spotted, there is a penalty to be paid and the penalty is twofold. You have to buy into the market what you miss and on top of that you have to pay 100/tonne of carbon and if the price is 20, it is in your financial interest not to cheat and to prevent that you have to pay the penalty.
And that is the beauty of the penalty, it’s not the objective that the penalty is ever paid, it serves as a signal, buy on the market and do your accounts in a proper manner and then there is no penalty that needs to be paid.
ANNIKA ZORN: There is a strong incentive to incentive to play by the rules.
JOS DELBEKE: There is a strong incentive to play by the rules, indeed, yes.
PETER VIS: And I think the Emissions Trading Scheme was one of the first European instruments, European-wide instruments with a harmonized penalty rate that made it so, no CEO could go to their shareholders and say we’ve chosen to pay the penalty which is five times more than the market price for allowances. They would have to explain why, so in practice there has been a very high degree of compliance through the fact that there’s been a strong penalty in the case of non-compliance and there is a strong methodology for reporting and verification behind it.
ANNIKA ZORN: Peter, you mentioned before to me that indeed I was thinking it’s only certain market players who would participate in this trade, but you mentioned now that everybody can participate. So, how important is this that everything can participate in this market?
PETER VIS: When emissions trading was being designed, a decision had to be made as to who would be allowed to be engaged in this market mechanism. One option would have been just to say that those people with obligations under the Emissions Trading Scheme, those 11,000 companies, would be able to exchange with each other, but we decided deliberately to allow any entity or person who had a Registry account, an account open in the Registry, and anybody can open an account in the Registry, anyone could engage in the trading. Now, why did we do that?
Basically because by allowing more people to engage in trading increases the liquidity of the market, the efficiency of the market and it enables businesses to be able to not just transact with each other, but actually transact with people who are prepared to take more risk. Because businesses, if you are a power company and you are selling your electricity one year or two years in advance, they worry perhaps that the carbon charge for delivering that electricity might go up more than they wish.
So, what they want to do is to limit their risk and hedge themselves by engaging in a contract that fixes the price of carbon for that period of one year or two years, but they have to find some other financial institution, for example, who is willing to assume that risk. And that in practice is what is happening, some financial intermediaries hope to analyse the markets and to anticipate what the price will be in two years’ time and they are prepared to take that risk away from the companies. The companies generally do not speculate on carbon pricing.
Their business is running a power station, running a steel factory, doing a core business and the carbon market is something that they have to engage with, but they generally look to mitigate, to limit the risk that the carbon price would rise very suddenly. So, the fact that the market it is so big facilitates the hedging of this risk. There is, some people talk about speculation as being a bad thing, in practice, there are market intermediaries who assume risk and they hope to make a profit by doing that, but for companies the fact that it’s a liquid market with financial intermediaries enables them to limit the risks and I think that is a great advantage of everyone being allowed to trade.
And that’s quite apart from the fact that some NGOs wish to also engage in the carbon market, buy allowances in the market, either in an auction or through a market, and then cancel them. They are allowed to do that and indeed many of the offsetting schemes that exist have used carbon allowances from the EU market and they’ve cancelled them, that’s their way of saying we are preventing anybody making emissions using these allowances. So, in a way allowing everyone to engage lets everyone do what they think is best but it it also results in a more efficient market. That means it’s more cost-efficient, it means costs are lower than they would be if it was a much more constrained, limited market.
ANNIKA ZORN: We have very different players in this market, from the financial risk-taker, a typical power generator to an NGO or a private person would just decide I want to cancel
PETER VIS: You can have all of those people in the market. You know, it’s a specialized market, so you shouldn’t go into this blind, but it all serves to make this instrument more cost-efficient than it would ever be if it was just a case of the regulator imposing emission limits on all of these big installations like power stations irrespective of the cost. I think that’s what companies like about emissions trading, that’s why they prefer it to a tax, is that they have more options. They can either choose to reduce their own emissions or they can choose to buy surplus of allowances from someone else who has done their reductions and has more allowances than they need.
So, hopefully it’s a market mechanism that is of benefit to everyone.
ANNIKA ZORN: And Jos, you mentioned before, sorry if I’m asking, that this model has also been exported already, so there is other parts in the world who are interested in this European experience.
JOS DELBEKE: Indeed there are several markets already in existence. We have the Californians having their trading, we have the Canadians, New Zealand has it, Korea is setting it up, but the most important newcomer is China. China introduced, as a copy-paste a little bit of our EU ETS, seven try-out mechanisms, pilot schemes and they are now setting up a nationwide system. So, as of 2020 there is going to be a comprehensive system with eight sectors and they start with the power sector. So, it’s going to be quite massive because we know that fossil fuels are consumed massively in China, hence the importance that they do this.
Of course, there are going to be many Chinese elements and they have also a number of political pressures they have to deal with, very similar to what we experienced in the early stages, so we will have to give them the benefit of a bit of time, but that may work out fairly well. There is commitment from the highest levels, so the system is very determined to deliver.
Now, that is going to determine, in my view, very much whether we are going to suffer from trade impacts because the European Commission, who is responsible for international trade negotiations in the EU, has been rather reticent to go and use the trading instrument as an instrument to create a fair play because, if we have a carbon market and others do not have a carbon market, then there may be distortions of competition. Now, if many more like China are going to play under the Paris Agreement that distortion should disappear.
But let’s be real, that is not yet the case and in the short term there may be pressures coming from those who are not incorporating into the trade of industrial commodities, say steel or cement or chemicals, the carbon constraint is not incorporated into that. And that is why the European Commission opted, with support of the wide majority in Parliament and Council, that we should go for a system of free allocation, so industrial commodity producers get a lot of their allowances for free.
Not everything, they have to have a benchmark, they have to have state-of-the-art technology in place, but they get a fair amount of their allowances for free and that’s a transitionary measure, that’s waiting for others to follow the rule of the game to implement the Paris Agreement and hopefully that is going to be sufficient. But some are calling for border measures, which is really a protectionist kind of tariff at the border, which is easily said but not easily done because we will need cement and steel and chemicals for building the sustainable infrastructure that we need in the future.
So, the heart is to make these products in a way that is as low-carbon as possible, so you get to have a good incentive and if you are just saying our steel coming from country X or country Y is going to have a tariff at the border, is not good enough because every country will have very good steel producers, good in terms of low carbon and very bad, so you have to be able to distinguish between the good ones and the bad ones, like we do in Europe. That is why we have an emissions trading, you reward more the good ones compared to the bad ones and internationally it does exactly the same.
So, we have a refined system of free allocation. We are convincing others to follow on the same track and, as long as prices on the carbon market are what they are, I think the system is well-functioning. Of course, if prices would go through the roof and if others would not do anything, then we will see a very active trade debate and then we will have to look at the facts, to what extent that argument runs or doesn’t run, but let’s do it factual, and let’s do it evidence-based and let’s do it multilateral.
Let’s not jump to the gun like currently some countries like the United States are doing putting a tariff here, a tariff there, I mean this unilateralism is not something that is in line of the European tradition, so let’s do it in a very considerate way and in a very open rate way. And the Paris Agreement has so many players, 190-plus countries have signed the Paris Agreement, so let’s force them to implement what they said they would do and if there are remaining problems let’s address them but in an open and multilateral way, not unilaterally. I think that’s very important.
We are a main trading continent where European countries and companies are trading with all over the world, let’s not give any reason for others to see this as something that is bad. So, let’s nurture this free trade because it has brought us so much welfare.
The real important question is: is the things we are trading, are these things being produced in the low-carbon possible way? And that is the real question we should address.
ANNIKA ZORN: My daughter will be 42 when we should have zero emissions.
JOS DELBEKE: Yeah.
PETER VIS: Well, let’s hope we can do that for her.
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In this video, Jos, Peter and Annika talk about some of the elements of the EU ETS: where did the idea come from, who can participate in the market of EU allowances, and how to make sure this market functions and nobody is cheating?
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This article is from the online course:
Carbon Markets: Examining EU Policies for Transnational Climate Action
This article is from the free online
Carbon Markets: Examining EU Policies for Transnational Climate Action
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