The European Union leads the world in sensible policies to reduce dangerous planetary-wide pollution.

Carbon dioxide emission reduction via a cap and trade system.

The EU Emission Trading System—Today-- is far larger than either of the US programs. It covers 11,000 installations while the US sulfur dioxide program covers only 3,000, and the value of the allowances is about $80 billion as opposed to $4 billion.

Five lessons emerged from an MIT study of the process:

  1. the notion that the carbon price would wreck the overall economy is clearly disproved for the European system, "
  2. “permitting ‘banking and borrowing’ will make a cap-and-trade system work more efficiently.”
  3.  “having accurate data & good communications both to ensure a smooth-running market and to achieve the desired reduction in emissions, " is critical.
  4. allocating emissions allowances is going to be contentious—and yet cap-and-trade is still the most politically feasible approach to controlling carbon emissions.… the EU method of allocating free allowances to polluting facilities, is criticized but effective for participants.
  5.  main message for policy makers is that everything does not have to be perfectly in place to start up.

Perhaps most striking, the EU ETS operates internationally. Allowances are traded by facilities in 27 independent nations that form a loose federal union and differ widely in per capita income, market experience, institutional background, and other features.

As the EU moves into the second phase of its ETS, what are some of the lessons to be learned?

First, the European experience shows that the economic effects—in a macro economic

sense—have not been large. "No one talks about under-performance in Europe since 2005 because of the carbon price," Ellerman said. "Changes have occurred in certain industries, but the notion that the carbon price would wreck the overall economy is clearly disproved for the European system, which for a long time had a high price compared to what was expected." Even though reducing emissions was not the primary focus of the three-year trial, carbon reductions were in fact achieved, with minimal macroeconomic impact.

A second lesson is that permitting "banking and borrowing" will make a cap-and-trade system work more efficiently. Within the three-year period of the EU ETS, facilities can bank (save some of this year's allowance for use next year) or borrow (use some of next year's allowances now and not have them available next year). During the first three years, many facilities took advantage of the opportunity to trade across time. But they always produced the necessary allowances within the required time period. Concerns that facilities would postpone their obligations indefinitely have proved unwarranted. "We've seen no abuses of borrowing within the system at all," said Ellerman.

A third lesson is the importance of having accurate data & good communications both to ensure a smooth-running market and to achieve the desired reduction in emissions. When the EU system was established, data on actual emissions—installation by installation—were not available, so facilities received allowances based on their estimated emissions. As a result, no one was quite sure how restrictive the cap would turn out to be. That uncertainty pushed up prices—until April 2006, when the first verified emissions reports came in. Actual emissions were far lower than expected, allowances were plentiful, and the carbon price fell by half within a week (see the figure). Communication of information among the market participants has improved, and prices for allowances bought ahead for use in 2008 have been far less erratic.

A fourth lesson is that the process of allocating emissions allowances is going to be contentious—and yet cap-and-trade is still the most politically feasible approach to controlling carbon emissions. Some people have argued that the EU method of allocating free allowances to polluting facilities is morally wrong. But an emissions-control policy is more likely to succeed if those most affected—the current polluters—are given some assets along with the liabilities they are being asked to assume. "Part of the genius of these cap-and-trade systems is that you're saying, ‘Look, we're going to make a deal. You're now going to have to submit a permit for every ton of emissions you make, but we're going to give you most of the permits that you'll need—and if you're able to reduce your emissions, you'll have permits to sell,'" said Ellerman.

Perhaps the main message for policy makers is that everything does not have to be perfectly in place to start up. When the EU ETS began, the overall EU cap had not been finally determined, registries for trading emissions were not established everywhere, and many available allowances—especially from Eastern Europe—could not come onto the market. The volatility of prices during the first period reflects those imperfections. "Obviously you're better off having things all settled and worked out before it gets started," said Ellerman. "But that certainly wasn't the case in Europe, and yet a transparent and widely accepted price for CO2 emission allowances emerged rapidly, as did a functioning market and the infrastructure to support it." Moreover, a significant segment of European industry soon began to factor the price of CO2 emissions allowances into their business decisions.

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