European Union Emission Trading Scheme - Mechanisms

Mechanisms

The first phase of EU ETS was created to operate apart from international climate change treaties such as the pre-existing United Nations Framework Convention on Climate Change (UNFCCC, 1992) or the Kyoto Protocol that was subsequently (1997) established under it. When the Kyoto Protocol came into force on 16 February 2005, Phase I of the EU ETS had already become operational. The EU later agreed to incorporate Kyoto flexible mechanism certificates as compliance tools within the EU ETS. The "Linking Directive" allows operators to use a certain amount of Kyoto certificates from flexible mechanism projects in order to cover their emissions.

The Kyoto flexible mechanisms are:

• Joint Implementation projects (JI) defined by Article 6 of the Kyoto Protocol, which produce Emission Reduction Units (ERUs). One ERU represents the successful emissions reduction equivalent to one tonne of carbon dioxide equivalent (tCO₂e).
• the Clean Development Mechanism (CDM) defined by Article 12, which produces Certified Emission Reductions (CERs). One CER represents the successful emissions reduction equivalent to one tonne of carbon dioxide equivalent (tCO₂e).
• International Emissions Trading (IET) defined by Article 17.

IET is relevant as the reductions achieved through CDM projects are a compliance tool for EU ETS operators. These Certified Emission Reductions (CERs) can be obtained by implementing emission reduction projects in developing countries, outside the EU, that have ratified (or acceded to) the Kyoto Protocol. The implementation of Clean Development Projects is largely specified by the Marrakech Accords, a follow-on set of agreements by the Conference of the Parties to the Kyoto Protocol. The legislators of the EU ETS drew up the scheme independently but called on the experiences gained during the running of the voluntary UK Emissions Trading Scheme in the previous years, and collaborated with other parties to ensure its units and mechanisms were compatible with the design agreed through the UNFCCC.

Under the EU ETS, the governments of the EU Member States agree on national emission caps which have to be approved by the EU commission. Those countries then allocate allowances to their industrial operators, and track and validate the actual emissions in accordance with the relevant assigned amount. They require the allowances to be retired after the end of each year.

The operators within the ETS may reassign or trade their allowances by several means:

• privately, moving allowances between operators within a company and across national borders
• over the counter, using a broker to privately match buyers and sellers
• trading on the spot market of one of Europe's climate exchanges.

Like any other financial instrument, trading consists of matching buyers and sellers between members of the exchange and then settling by depositing a valid allowance in exchange for the agreed financial consideration. Much like a stock market, companies and private individuals can trade through brokers who are listed on the exchange, and need not be regulated operators.

When each change of ownership of an allowance is proposed, the national registry and the European Commission are informed in order for them to validate the transaction. During Phase II of the EU ETS, the UNFCCC also validates the allowance and any change that alters the distribution within each national allocation plan.

Like the Kyoto trading scheme, EU ETS allows a regulated operator to use carbon credits in the form of Emission Reduction Units (ERU) to comply with its obligations. A Kyoto Certified Emission Reduction unit (CER), produced by a carbon project that has been certified by the UNFCCC's Clean Development Mechanism Executive Board, or Emission Reduction Unit (ERU) certified by the Joint Implementation project's host country or by the Joint Implementation Supervisory Committee, are accepted by the EU as equivalent.

Thus one EU Allowance Unit of one tonne of CO₂, or "EUA", was designed to be identical ("fungible") with the equivalent "Assigned Amount Unit" (AAU) of CO₂ defined under Kyoto. Hence, because of the EU's decision to accept Kyoto-CERs as equivalent to EU-EUA's, it is possible to trade EUA's and UNFCCC-validated CERs on a one-to-one basis within the same system. (However, the EU was not able to link trades from all its countries until 2008-9 because of its technical problems connecting to the UN systems.)

During Phase II of the EU ETS, the operators within each Member State must surrender their allowances for inspection by the EU before they can be "retired" by the UNFCCC.