John Wood discusses the interplay between the EU-ETS and the project mechanisms under the Kyoto Protocol, as set out under the Linking Directive, and, in particular, the constraints placed on the use of project-based credits.
The EU Emissions Trading Scheme (EU-ETS), established by the EU Emissions Trading Directive 2003/87/EC, is just one of a number of measures taken by the EU to meet its obligations under the Kyoto Protocol. It is not solely a mechanism for that purpose, as it commenced before the first Kyoto commitment period (2008 to 2012) and will continue indefinitely even if the Kyoto Protocol is not extended beyond 2012. The directive applies to certain types of installations in specified industries covering over 40% of total EU emissions of CO2.
Under the EU-ETS, each EU member state is required to set a cap on emissions from all the installations covered by the directive and allocate a number of allowances (known as EUAs, equivalent to one tonne of CO2 or tCO2e) to each installation under a National Allocation Plan (NAP). The EU-ETS is implemented in phases: phase I runs from 2005 to 2007 and phase II runs from 2008 to 2012, the latter coinciding with the first Kyoto commitment period.
Installations must surrender an amount of allowances equal to the amount of CO2 that they emit over the course of each year. The number of allowances allocated under each NAP should be less than the expected business-as-usual level of emissions. In the UK, the burden of the shortfall in phase I falls almost entirely on the power generation sector (being an industry that is not subject to significant international competition and whose additional costs will generally be passed on to society as a whole). Operators of installations can comply by taking abatement measures (where possible), reducing output or buying allowances from other operators. The market is open and many traders and intermediaries have entered, helping to provide a reasonably liquid market. Trading occurs on a registry, with the price set by supply and demand as in any other free market. The net effect is to reduce CO2 emissions in a cost-effective way.
Unlike some other traded certificate markets, there is no buy-out option (such as under the UK’s Renewables Obligation). Any non-complying operator will have to pay a penalty of €40/tCO2e in phase I and €100/tCO2e in phase II (EUAs are currently trading at about €15) and in each case will still have to make up the shortfall in the next year through a deduction from its free allowances.
Kyoto project mechanisms
The Kyoto Protocol divides contracting states into developed countries that have undertaken legally binding emissions reduction commitments (Annex B Parties1) and those, generally developing countries, whose obligations are less specific (Non-Annex B Parties). The Kyoto Protocol provides for three flexible mechanisms to help Annex B Parties to meet their commitments: international emissions trading, the clean development mechanism (CDM) and joint implementation (JI).
CDM and JI allow governments to implement emission-reduction projects abroad and count the achieved reductions against their own Kyoto targets. JI projects can be undertaken in other industrialised countries with Kyoto targets, while CDM projects can be hosted by developing countries, which under the protocol have no targets.
Clean development mechanism
This mechanism permits Annex B Parties, or private organisations authorised by them, to develop emissions reduction projects in Non-Annex B Parties. This mechanism is subject to the overall supervision of the CDM executive board. Provided that the project complies with a complex set of rules designed to ensure the integrity of the system, the project can earn allowances in the form of certified emissions reductions (CERs). The rules cover the use of an approved methodology, preparation of a project design document, letters of approval from the sponsoring and host state, validation of project and verification and certification of the actual emissions reductions achieved.
Unlike the EU-ETS, which presently only covers CO2 emissions, CDM projects can earn CERs from reductions in emissions of other, more potent, greenhouse gases such as methane, HFCs and nitrous oxide.
Joint implementation
This mechanism permits Annex B Parties, or private organisations authorised by them, to develop emissions reduction projects in other Annex B Parties. This mechanism is subject to the overall supervision of the JI supervisory committee. In this case, a different type of allowance, called emissions reduction units (ERUs), are created and for each one that is created an assigned amount unit (AAU), being the type of allowance held by the Annex B Parties, must be cancelled. A simplified track 1 procedure can be used if the host country meets certain eligibility criteria.
The Linking Directive
The Linking Directive 2004/101/EC (implemented into UK law by the Greenhouse Gas Emissions Trading Scheme (Amendment) and National Emissions Inventory Regulations 2005) allows operators of installations covered by the EU-ETS to use CERs and ERUs earned under the Kyoto project mechanisms towards compliance with the EU-ETS, subject to certain limitations.
It is often said that EUAs, CERs and ERUs are fully fungible – each represents emissions of one tonne of CO2. In some respects, CERs are more valuable than EUAs because they can be banked, that is retained in a registry account from phase I to phase II of the EU-ETS, whereas EUAs cannot be banked. Yet CERs can be acquired at considerably less cost than EUAs.
The main reason for the differential pricing is that CERs and ERUs are derived from projects and, until they are issued, they carry significant delivery risks associated with the particular project from which they will derive: regulatory risk that the project is not approved by the CDM executive board or that the methodology is not approved or is re-examined, construction and technology risk, host country risk, counterparty risk, etc. In contrast, EUAs are allocated by governments of EU member states and the quantities that have been and will be allocated for phase I are known – so they carry very little risk.
There are additional reasons why CERs and ERUs will continue to trade at a discount to EUAs, even once they have been issued. The Linking Directive places a number of limitations on their use:
• ERUs may not be used in phase I of the EU-ETS, ie. before January 1, 2008.
• The use of CERs and ERUs from January 1, 2008 is only permitted up to a percentage of the allocation to each installation, to be specified by each member state in its NAP. Member states are required to demonstrate that use of such mechanisms is supplemental to domestic action to reduce emissions. The UK’s draft phase II NAP proposes to limit the use of CERs and ERUs to a proportion – yet to be decided – of the ‘distance to target’ (the difference between the free allocations and the projected business-as-usual emissions). However, the UK has still not decided whether to set this limit at an installation level, at sector level or at a national level for all UK installations. It is hard to see how it could work other than as an installation-level limit.
• The use of CERs and ERUs from nuclear facilities or land use/land use change and forestry activities is not permitted.
• The use of CERs and ERUs from large hydro (>20MW) projects is only permitted if certain international criteria and guidelines (such as are contained in the November 16, 2000 report by the World Commission on Dams entitled Dams and Development – A New Framework for Decision-Making) are respected.
The International Transaction Log
There is a further practical issue regarding the use of CERs. Although there is no legal limit on the use of CERs in phase I of the EU-ETS, they cannot yet be used. All CERs that have been issued are currently stuck in the central CDM Registry and cannot be transferred into the national registries of EU member states until the International Transaction Log – an IT system that will link the CDM Registry with other registries, and control and validate the flow of emissions credits – has been built, tested and made live.
It is planned that the ITL will become fully operational in April 2007. However, if there are delays beyond December 31, 2007, there could be serious implications. Operators of installations in the EU-ETS can ‘borrow’ EUAs from next year’s allocation because they are issued in February and the deadline for surrender of the previous year’s allowances is April 30. Operators may be doing so in reliance on CERs that they have bought and that are sitting in the CDM Registry, which they expect to use to make up the shortfall in the final year of phase I. If they are unable to use those CERs, they may have difficulty in meeting their obligations for 2007.
Project credits will continue to trade at a discount to EUAs. The level of discount will depend on the restrictions contained in phase II NAPs, which will not be finalised until approved by the European Commission, which may be as late as the end of 2007. CERs and ERUs will nevertheless make a highly important contribution to meeting the compliance obligations of installations covered by the EU-ETS.
1The list in Annex B of the Kyoto Protocol is almost identical to the list in Annex 1 of the United Nations Framework Convention on Climate Change (UNFCCC), and the expressions ‘Annex B Parties’ and ‘Annex 1 Parties’ tend to be used interchangeably.
John Wood Partner, Norton Rose +44 (0)20 7444 2708 john.wood@nortonrose.com
