The 21st Century climate challenge

Cap-and-trade—lessons from theEU Emission Trading SchemeClimate change realpolitik presents a powerfulcase for cap-and-trade. Whatever the theoreticaland practical merits of carbon taxation, thepolitical momentum behind cap-and-trade isgathering pace. The next few years are likely towitness the emergence of mandatory emissionscontrols in the United States with an expansionof institutionalized carbon trading. Morebroadly, there is a prospect that the post-2012Kyoto framework will witness a process ofintegration between carbon markets in thedeveloped world, with strengthened carbonfinancing links to developing countries. Noneof this precludes an expanded role for carbontaxation. However, cap-and-trade programmesare emerging as the primary vehicle for marketbasedmitigation—and it is vital that they areimplemented to achieve the central objectiveof avoiding dangerous climate change. Theseare important lessons to be learnt from theEuropean Union.The EU Emission Trading Scheme—a bigscheme with a short historyThe EU ETS is by far the world’s largestcap-and-trade scheme. For the European Unionit represents a landmark contribution to climatechange mitigation. To its critics, the EU ETSis a design-flawed confirmation of all that iswrong with cap-and-trade schemes. Reality ismore prosaic.The first phase of the EU ETS ran from 2005to 2007. Phase II will run for a 5-year period tothe end of 2012. 43 Writing off an experimenton the scale of the EU ETS before the end of itspilot phase might be considered a case-study inpremature judgement. However, the scheme hasundoubtedly suffered from a number of flaws indesign and implementation.The origins of the EU ETS can be traced tothe ‘flexibility mechanisms’ introduced underthe Kyoto Protocol. 44 Through these mechanisms,the Protocol aimed to create a mechanismfor achieving emission reductions at lower cost.The EU ETS operates through the allocationand trading of greenhouse gas emission permits.The permits are allocated to member states anddistributed to identified emitters, which in turnhave the flexibility to buy additional allowancesor to sell surplus allowances. In the first phaseof the EU ETS, 95 percent of allowances had tobe distributed free of charge, severely restrictingthe scope for auctioning.Other Kyoto flexibility mechanisms havebeen linked to the EU ETS. The Clean DevelopmentMechanism (CDM) is an example. Thisallows countries with a Kyoto target to investin projects that abate emissions in developingcountries. The rules governing the generation ofmitigation credits through the CDM are basedon the twin principles of ‘supplementarity’ and‘additionality’. The former requires that domesticaction on mitigation should be the primary sourceof emission reductions (though there are no quantitativeguidelines); the latter requires evidencethat the abatement would not have occurred inthe absence of the CDM investment. Between theend of 2004 and 2007, there were 771 registeredprojects with a declared reduction commitmentof 162.5 Mt CO 2e. Just four countries—Brazil,China, India and Mexico—accounted for threequartersof all projects, with sub-Saharan Africarepresenting less than 2 percent. 45Rapid institutional development is oneof the positive lessons to emerge from the EUETS. During the first phase, the scheme coveredaround one-half of the European Union’s totalgreenhouse gas emissions, spanning 25 countriesand over 10,000 installations in a wide rangeof sectors (including power, metals, mineralsand paper). It has spawned a large market. In2006, transactions involving 1.1 billion tonnesof CO 2e worth €18.7 billion (US$24.4 billion)took place in a global carbon market worth €23billion (US$30 billion). 46Three systematic problemsThe EU ETS provides an institutional structurethat has the potential to play a key role in anambitious European Union climate changemitigation strategy. That potential has yet to berealized, however. During the first phase, threesystemic problems emerged:• Overallocation of permits, creating thewrong price signals. In the initial stages ofRapid institutionaldevelopment is one ofthe positive lessons toemerge from the EU ETS3Avoiding dangerous climate change: strategies for mitigationHUMAN DEVELOPMENT REPORT 2007/2008 129