1. ETS – How does it work? Dr Marzena Chodor, Clima East Key Expert Moscow, 08.04.2014

2. Contents: Cap and trade system: main elements Cap and trade system: how does it work and why does it work? EU ETS: history Legal framework Scope of the EU ETS ETS: main elements in 2005-2012 Carbon market in 2005-2012 Main lessons from 2005-2012 EU climate policy goals until 2020 EU approach from 2013 Aviation in emissions trading ETS 2013 – 2020. Main features Lessons from target setting – creating the market

3. Cap and trade system: main elements A cap on annual emissions/ a cap on annual allocation (of emission allowances) Identified participants –registered (eg. through permits) –obliged to comply with rules Allowances distributed or acquired (auction, market) –tradeable –transferable freely/with constraints –bankable/not bankable –1 allowance equals one tonne of CO2 MRV

4. Cap and trade system: how does it work? Regulator determines allowed emissions level (the cap), and creates and distributes allowances corresponding to the cap Allowances are put in circulation Scarcity gives allowances value Carbon market develops – Price signal guides companies by how much to reduce emissions – Regulator enforces rules and levies sanctions, if needed

5. Cap and trade system: why does it work? The emissions allowance is an asset with immediate value Some companies find it easier and less expensive to reduce their emissions below their required limits than other More efficient companies, which release less carbon dioxide equivalent than their limit set in a given year/period, can sell their surplus allowances to companies that cannot reduce their emissions or want to increase production Cap and trade systems reward the most efficient companies and provide incentive to increase carbon efficiency over time The prices of allowances are visible signals of current cost of carbon dioxide reductions

6. EU ETS: history The EU ETS started in January 2005 First EU ETS phase (trial) 2005 -2007 Second EU ETS phase 2008-2012 Third EU ETS phase 2013 – 2020 (and beyond) GHGs included: –Carbon dioxide (2005-2012) –N2O, PFC (from 2013) Coverage: about 11 thousand installations Around 45% of EU GHG emissions 28 EU Member States and 3 EEA-EFTA states

7. EU ETS: legal framework Directive 2003/81/EC (adopting emissions trading) Directive 2004/101/EC (linking directive) Directive 2008/101/EC (including aviation activities in ETS) Directive 2009/29/EC (ETS review – part of the climate and energy package) Current key implementing provisions: –Commission Regulation No 389/2013 establishing a Union Registry Forthcoming: –Draft Regulation on determining international credit entitlements

8. Scope of the ETS: activities Combustion installations above 20 MW Oil refineries Ferrous metals production above 2,5t/hr Cement production Glass production above 20 t/d Ceramics production above 75 t/day Pulp and paper production above 20 t/d International aviation (flights from and to the EU airports) - entry into force in 2012 –A retroactive suspension applied to intercontinental flights (stop the clock in April 2013) PFCs from alluminium production and N2O emissions from chemical plants included from 2013

9. ETS 2005-2012 Applicable since January 2005 Environmental outcome determined – puts a cap on emissions from 10,000 energy-intensive installations across EU (25, later 27, and 30 countries, around 2 billion tonnes/ yr) Covering around half of EU’s total CO 2 emissions Companies can choose: To emit allocated emission rights (allowances) or To reduce emissions below allocation and sell or bank To emit more than allocation and buy Cost-effective emissions reductions to the level of the cap, because investments take place where cheapest

10. ETS design Simple “downstream” cap-and-trade system for major emitting industries that is part of a comprehensive policy – the largest cap-and-trade scheme ever implemented Monitoring rules for direct emissions, independent verification Robust penalties to ensure compliance (€100 + shortfall) Electronic registry system to record holdings of allowances Market development driven by the private sector

11. ETS 2005-2012 Member States initially responsible for setting the cap on national level and distribution of allowances through NAPs (National Allocation Plans) NAPs approved by the European Commission – assessment of national allocation plans against agreed common criteria: – consistency with actual and projected emissions, consistency with potential to reduce emissions, not more allowances than needed, on track for reduction commitments, not unfairly discriminating –transparency, comments by the public 25 (in phase II 27) registries National authorities overseeing compliance only on average 5% allowances auctioned, the remainder distributed free of charge Dominant allocation methodology - grandfathering

12. Allocation In the period 2005-2012 the task of each Member State Main challenges in the inception phase: – Identifying covered installations – Gathering and processing of relevant data – Fixing the national cap and deciding on the path to the Kyoto target – Elaborating allocation rules at sector and installation level – Elaborating new entrants and closure rules – Overcoming know-how gaps in authorities and among stakeholders – Organizing public consultation and securing political acceptability – Tight time schedule

13. Compliance Member State competence, harmonized elements: – no permit, no operation – blocking transfers if no verified emission report by 31 March – name & Shame if not surrendered sufficient allowances – €40 penalty and compensate shortfall for insufficient surrendering

14. Links to the Kyoto Protocol mechanisms Art 30 ETS Directive: “emission credits from the project-based mechanisms will be recognised for their use in this scheme subject to provisions adopted by Parliament and Council on a proposal from the Commission” Directive 2004/101/EC (linking directive) Clean Development Mechanism (CDM) from 2005, Joint Implementation (JI) from 2008 Supplementarity: from 2008, use limited to % of allocation of allowances to each installation Harmonised EU-wide exclusion of nuclear energy projects and temporary forestry credits, national decisions on other types of credits Double-counting guidelines – Commission Decision C(2006)5362 Large hydro: MSs to make sure that relevant international criteria and guidelines will be respected during the development phase

15. Carbon market prices in 2005-2012 Source Point Carbon ETS cut emissions by 2 % to 5% in Phase1 1 ETS emissions down 13.7% 2007 - 2009 2 1 assessment by Ellerman et al, ‘Pricing Carbon 2010 2 verified emissions data, European Commission

16. Main lessons from 2005-2012: EU ETS developed into the largest carbon market in the world Carbon market infrastructure operational: MRV, institutional capacity in EU Member States, electronic registries Strong, harmonised provisions to ensure compliance (€40/tonne) Liquid carbon market and reflective carbon pricing :However:  Member States’ NAPs not based on verified emissions + litigation  Reductions projected by MS proved insufficient in terms of scarcity, which led to a price crash Long term - a market-based signal for low carbon investments

17. EU (unconditional) climate policy goals until 2020: 20% reduction in EU greenhouse gas emissions from 1990 levels; 20% increase in the share of EU energy consumption produced from renewable resources 20% improvement in the EU's energy efficiency implemented through a package of binding legislation entering into force from 2013 Climate and Energy Package adopted in 2008 contains directives to be implemented by MS (ETS, RES, CCS) and Effort Sharing Decision

18. Carbon capture and storage Directive CO2&cars Renewable Energy Directive Fuel Quality Directive -20% / -30% wrt 1990 levels by 2020 technology specific & product policies cross-sectoral targets & instruments large industrial installations & aviation “small emitters” EU ETS Effort Sharing Decision Instruments of EU emission reductions from 2013

19. GHG reduction target: -20% compared to 1990 -14% compared to 2005 EU ETS -21% compared to 2005 Non-ETS sector -10% compared to 2005 27 national targets, from -20% to +20% EU approach

20. Aviation in emissions trading - rationale Contributes to climate change through emissions of carbon dioxide, nitrogen oxides and cirrus effects Taxation not blocked by 1944 Chicago Convention, but various bilateral air service agreements historically foresee exemption from general fuel taxation 1992 UNFCCC requires States to take measures to reduce emissions Under Kyoto Protocol, States were asked to make progress working in international forum: International Civil Aviation Organisation (ICAO) International emissions from aviation not part of States’ Kyoto commitments for emission reductions

21. Aviation in emissions trading - rationale Overall EU objective: limit global warming to 2° C above pre-industrial level to avoid dangerous climate change All sectors should contribute to emission reductions Early industry preference for open emissions trading above taxes and charges and technical regulation more disagreement than agreement in ICAO discussions on any market-based action

22. Projections of aviation emissions growth Source: EC 2020 63% to 88% increase 2050 290% to 667% increase

23. Aviation in emissions trading - design All flights to and from EU airports Small aircraft and certain flights excluded Equivalent action on aviation emissions taken by other countries recognised Total quantity of allowances equivalent to 97% of average annual emissions 2004-6 From 2013, total quantity of allowances equivalent to 95% of average annual emissions 2004-6 Allocation based on commonly-agreed benchmark (T/km) combined with harmonised level of auctioning –15% auctioning from 2012 until 2020 All auction revenues should be used for addressing climate change and to adapt to its effects

24. ETS 2013-2020 Directive 2009/29/EC amending Directive 2003/81/EC One single EU –wide cap (limit) set on the total GHG emitted by installations included in the EU ETS –EU ETS cap set at 2,084,301,856 allowances in 2013 –Decreasing by 1.74% anually –Reduction continued beyond 2020 (revised no later than 2025) –Aiming at -21% reduction against 2005 levels Harmonised allocation - main allocation method: auctioning –The proportion increasing annually –At least 48 % in ETS phase III The remaining allowances allocated free of charge to industry threatened by carbon leakage, based on benchmarking Strengthened MRV Increased scope (new GHG, new activities)

25. ETS 2013-2020 – broader scope: New sectors –Aluminium –Basic chemical production New gases: –PFCs from aluminium –nitrous oxide from certain chemicals Broad interpretation of “combustion”, Annex I listing only activities Combined effect: approx. 6 - 7% increase of scope compared to current trading period Confirmation that all sectors should contribute to emission reduction commitments –Aviation –Maritime transport: future action foreseen

26. ETS 2013-2020 – strengthened MRV: Monitoring and Reporting Regulation Replaced earlier guidelines Verification and Accreditation Regulation – New EU-wide rules replacing regulation on MS level Harmonised €100 penalty for non-compliance – requirement to surrender allowances remains Single Union registry –MS responsible for operations on MS level

27. ETS 2013-2020 – allocation principles: Harmonised allocation rules to ensure a level playing field across the EU: –No distortion of competition –Fully equal treatment within sectors across EU Auctioning as the general rule, with transitional free allocation up to 2020 In terms of allocation rules, three categories of operators: –No free allocations (i.e. full auctioning) –Partial free allocation (no carbon leakage) –Up to 100% free allocation (carbon leakage – based on benchmarks)

28. ETS 2013-2020 – auctioning: Basic long-term principle for allocation: – Eliminates ‘windfall’ profits – Simplest and most transparent allocation system – Level playing field for new entrants and incumbents Auctioning on the basis of harmonised rules: – Transparency and non-discrimination – Full access for SMEs Full auctioning for sectors able to pass on costs: – Power sector, except CHP and district heating (except agreed derogations) Revenues to accrue to Member States, with 50% used to address climate change and its effects

29. ETS 2013-2020 – auctioning: Auctioning Regulation agreed unanimously by Member States and adopted (12 November 2010, with later amendments) MS determine use of revenues, but at least 50% should be used for climate related purposes MSs shall inform on use of revenues through the reports under GHG monitoring Decision 280/2004/EC 88% of auction rights distributed according to MS’ share in verified emissions in 2005 or average of period from 2005 – 07 (whichever is the highest) 10% for purpose of solidarity and growth (Annex IIa) 2% “Kyoto bonus”: at least 20% below Kyoto base year emission levels

30. ETS 2013-2020 – transitional free allocation Transitional free allocation to industry – quantities determined in accordance with Community-wide rules – Annual reductions of free quantity To result in full auctioning by 2020 for “normal” industry (no carbon leakage) Community-wide rules - benchmarking, for free allocation – determined taking into account most efficient techniques, substitutes, alternative production processes, etc. Levels of allocation under rules reducing over time in line with reduction pathway No free allocation for electricity production (as a rule, except transtional measures in some MS) installations in sectors exposed to a significant risk of carbon leakage can receive up to 100% free allocation of the quantity of allowances determined under the general Community-wide rules

31. ETS 2013-2020 – transitional option of free allocation for electricity producers 10 Member States qualify – New EU12 except SI, SK, maximum 14% of EU power generation For existing installations only Conditional upon national plan to modernise energy infrastructure, clean technologies, diversification of energy mix – Taking into account the need to limit as far as possible directly linked prices rises – Monitoring and enforcement provisions. – Annual reporting (to the European Commission) Total amount in 2013 maximised at 70% of 2005-2007 verified emissions, gradual decrease to zero in 2020 – For the amount corresponding to gross final national consumption of the MS Individual allocation based on 2005-2007 verified emissions/benchmark – Option of non-transferable allowances – Commission guidance

32. ETS 2013-2020 – use of JI and CDM credits Use of CDM should not exceed 50% of reduction below 2005 over period 2008-2020 for existing operators and not exceed 50% of reductions below 2005 over period 2013-2020 for new sectors and aviation –Existing operators receive no less than 11% of 2008-2012 allocation –Least endowed operators receive additional access up to a certain % –New entrants and new sectors receive access to no less than 4.5% of verified emissions –Aviation receives no less than 1.5% of actual emissions Exact percentages determined through a regulation

33. Lessons from target setting – creating the market Markets do not function properly without demand Demand means scarcity Scarcity depends on – Getting baseline data – monitoring and reporting – Capping emissions below demand (taking into account accuracy) Accuracy depends on MRV and Scope Keep systems simple – Cover installations/ gases at the outset where sufficiently accurate monitoring is feasible, extend later in line with technical progress – No need to re-invent the wheel – Use verified data as basis for any free allocation – EU ETS development and recent review show EU’s practical experience

34. More information: http://ec.europa.eu/clima/policies/brief/eu/index_en.htm http://ec.europa.eu/clima/policies/ets/documentation_en.htm#Im plementation Or contact us on: Info@climaeast.eu