Climate Change Regulation in The EU

01 October 2007

Owen Lomas and Jennifer Wallace, Allen & Overy LLP

The International Context

The EU’s approach to climate change has not developed in a vacuum, but rather in the context of significant international agreements in the field, particularly the United Nations Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol. The Kyoto Protocol supplements the UNFCCC by setting legally binding targets for cutting or limiting greenhouse gas emissions for developed country signatories (the Annex B Parties). 

Overall, the Annex B Parties agreed that during the ‘commitment period’ 2008-2012 they would reduce their emissions of six gases by 5.2 per cent compared to 1990 levels. For many countries, that in fact requires a much greater percentage reduction, since their emissions have increased since 1990. 

Two of the world’s fastest growing economies, India and China, have no binding targets under the Kyoto Protocol. This has always been one of the chief objections of the US to the Kyoto Protocol, and is certain to be the source of considerable controversy in the international negotiations over a successor to Kyoto. Developing countries, not unnaturally, assert their right to economic development as unfettered as that of the West. Others point to statistics about the rapid building of power stations in China and to the use of coal in China and India as factors that could quickly wipe out emissions reductions hard won elsewhere.

All 27 EU member states have rati- fied the Kyoto Protocol, and the European Community itself is also a signatory. As is permitted under the UNFCCC, the 15 countries that were member states of the EU before 2004 have agreed to meet a joint target of an 8 per cent reduction in greenhouse gas (GHG) emissions. The EU ‘bubble’, as it is known, allows the EU’s target to be redistributed between member states to reflect their national circumstances. The UK agreed, as part of this arrangement, to reduce its emissions by 12.5 per cent. Germany and Denmark, for example, have targets of 21 per cent reduction each, while Ireland’s target is to limit any increase in emissions to 12 per cent. 

The Flexible Mechanisms 

One notable feature of the Kyoto Protocol is that it establishes a number of ‘flexible mechanisms’ designed to help Annex B countries meet their commitments to reduce emissions in a cost-efficient way. The flexible mechanisms recognise the fact that GHG emissions from one part of the world affect not only that part, but contribute to an effect that has consequences for the whole globe. Since the precise source of the emissions is ultimately irrelevant, it makes sense for reductions in emissions to be made where it is easiest and cheapest to do so. 

International emissions trading allows Annex B countries to buy and sell, among themselves, the right to emit GHGs in the form of a carbon credit. They can also acquire carbon credits by participating in and contributing to projects to reduce or avoid emissions in other Annex B countries (known as joint implementation). Under the Clean Development Mechanism (CDM) similar projects in developing countries (which do not have emissions targets of their own) can also earn credits representing rights to emit. These credits are also intended to act as an incentive for the transfer of efficient, low carbon technology from developed world economies to the developing world. Parties to the Kyoto protocol can also authorise private entities to participate in the flexible mechanisms, driving a private sector market. 

A Successor To Kyoto 

The market in carbon credits depends, ultimately, on absolute emission reduction commitments. At present, the Kyoto Protocol imposes obligations only up to 31 December 2012. Climate change regulation after that date will be shaped to a significant degree by the outcome of negotiations on a successor treaty. The parties to the UNFCCC meet in Bali in December to discuss this, and it is also the subject of conferences, preliminary intergovernmental summits and, doubtless, of considerable less formal discussion. 

The EU Picture

The EU has set ambitious targets to reduce GHG emissions. The Council of the European Union has endorsed a proposal by the Commission for the objective of a reduction in GHG emissions from developed countries in the order of 30 per cent by 2020 compared to 1990, provided that other developed countries commit themselves to comparable targets and that countries such as China and India agree to play their part. Even if there is no international agreement, the EU is committed to achieve at least a 20 per cent reduction of GHG emissions by 2020 compared to 1990. 

The EU ETS

The main focus of attention in recent years has been the EU Emissions Trading Scheme (the EU ETS). This is a means of devolving member states’ obligations to reduce emissions of carbon dioxide from a national level to the level of individual power stations, factories, etc. It is a ‘cap-and-trade’ scheme, the broad concept of which will be familiar to those with experience of SO2 and NOx emissions trading in the United States. 

The EU ETS allocates, to installations in certain sectors of the economy, a fixed number of emissions allowances in each ‘phase’ of the scheme (Phase I runs from 2005 to 2007, Phase II from 2008 to 2012). The allowances exist only in electronic form and are recorded in national registries. An installation must be able to surrender to its regulator one allowance for each tonne of carbon dioxide it emits, for each year of the scheme. If it has surplus allowances it may sell them to other installations. If it has a shortfall, it may take steps to reduce its emissions or it may purchase allowances from other installations. 

Currently, most allowances are allocated free of charge, although there is provision in the relevant European legislation for a limited proportion of allowances to be auctioned to end users. Some commentators have called for more, if not all, allowances to be auctioned, to create a market price for carbon emission rights less influenced by government allocations of allowances. It would also help to avoid the windfall profits that some participants have made from selling their free allowances. A system based entirely on auctioning would, however, create a significant obstacle to compliance for some of the smaller, less commercially sophisticated participants in the EU ETS. 

Installations may also buy and use credits from joint implementation and CDM project, within certain limits on the number of credits and types of projects. This has made participants in the EU ETS a significant market for this type of credit, although at the time of writing the absence of the necessary software systems means that the first CDM credits have yet to be delivered to registry accounts in the EU. 

Lessons from the First Phase of the EU ETS

The first phase of the EU ETS is now drawing to an end. The European Commission has pointed to this as a successful ‘introductory’ period, in which infrastructure and procedures for the verification of emissions and the successful trading of allowances has been established. It is inescapable, however, that the first phase has seen an overall over-allocation of allowances by member states. The scheme requires scarcity if there is to be an appreciable ‘cost’ of carbon emissions and therefore an incentive to reduce them.

The over supply of allowances meant that, at the time of writing in August 2007 (and for several months before that), the market price for an allowance was less than €0.50. It did, however, take some time for this to become apparent, and since some industrial sectors and installations were ‘short’ of allowances, the market has not been stagnant. During 2005 for example, allowances for more than 260 million tonnes of CO2 were traded. 

Phase II of the EU ETS promises to be more stringent. The European Commission has required a number of member states to tighten their national allocation plans for Phase II, in which the details of the number of allowances allocated to each installation are set out. Each plan is supposed to fulfil certain criteria, including that of assisting the relevant member state to meet its Kyoto commitments. The Commission scrutinises the plans for compliance with these criteria and, this time, has required cuts in overall allocations and other specific changes. 

A mark of how strict this scrutiny has been is that a number of member states, including Slovakia, Lithuania, Latvia, Poland, Hungary, the Czech Republic and Estonia, have all decided to bring legal challenges to the Commission’s decisions on their national allocation plans. 

The Evolution of the EU ETS

The European Commission has been conducting a review of the EU ETS, intending to make improvements in light of lessons learned from the operation of the scheme so far. The European Commission is expected to issue a legislative proposal sometime towards the end of 2007 to make revisions to the EU ETS that will take effect in 2013 when the scheme begins its third phase. 

Currently, the EU ETS covers only one of the six Kyoto gases, carbon dioxide. It does not apply to emissions from transport, which, as an example, accounted for around 24 per cent of GHG emissions in the UK in 2002. 

The review will consider whether to expand the EU ETS to cover other sectors and gases such as N2O from the production of ammonia and CH4 from coal mines. It will also consider how to link the scheme to existing and future domestic schemes, such as the emissions trading schemes in the northeastern US states and California as well as by Australian states. 

The Commission has already put forward a proposal for the inclusion of aviation in the EU ETS. Under the current proposal, the scheme would cover intra-EU flights from 2011 and all flights either arriving at or departing from the EU from 2012. “Aircraft operators” performing “aviation activities” would be able to buy and sell aviation sector carbon allowances and could buy additional allowances from other sectors already covered by the EU ETS or from joint implementation and CDM projects. Some details are still uncertain, and the scheme that finally becomes law may look rather different, given the current heated debate that the proposal has sparked.

Road transport remains difficult to tackle though the EU ETS. Any attempt to include millions of individual vehicle-owners in the scheme would be a very ambitious undertaking. At present, it seems most likely that emissions from this source will be addressed by other means, such as legislation on fuel quality, the use of biofuels, and fuel efficiency and emissions standards for new vehicles. 

Carbon Capture and Storage 

The Commission is also considering the recognition of carbon capture and storage (CCS) under the EU ETS, and is expected to give further details in a specific communication on CCS in the autumn of 2007. 

Many hopes have been pinned on CCS. The Stern Review, for example, estimates that it has the potential to contribute 20 per cent of global carbon dioxide mitigation by 2050. The technology involves capturing carbon dioxide emissions arising from the combustion of fossil fuels (as in power generation), or from the preparation of fossil fuels (as in natural-gas processing), and storing it underground in deep saline formations or depleted oil and gas fields. The processes involved in CCS are not novel, but have yet to be demonstrated together at scale. The EU and some member state governments, such as that of the UK, have policies in place to encourage and facilitate demonstration and trial projects. However, slow progress has frustrated some industrial players. 

Some legal barriers to CCS posed by international conventions have already been addressed through the amendment to the 1996 London Protocol on dumping of waste at sea in November 2006 and the adoption of amendments to the OSPAR convention in June 2007, to allow the storage of carbon dioxide in geological formations under the seabed. 

The Future of Climate Change Regulation 

There is no space here to examine every policy and measure in this crowded field. EU legislation on renewable energy, energy-ef- ficient products and energy efficiency in buildings, for example, also aims to contribute to a reduction in emissions. The nuclear debate has gained a new urgency in the context of the need for low- or no-carbon energy sources. In the current political climate it seems certain that, whatever the precise outcome of the international negotiations on a post-2012 climate change treaty, the regulatory environment will be shaped by efforts to avoid dangerous climate change.

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