Evaluating the effectiveness of the EU Emission Trading Scheme

Evaluating the effectiveness of the EU Emission Trading Scheme

The influence of CO₂ pricing on the functioning and effectiveness of emission trading and its innovational effect within the European and German electricity sector

Source Espina, 2009

Group 07

Cristina Barber Álvarez- Buylla 921004034080 Marina Cárdenas Herrero 920525155030 Brenda Deden 901009173090 Federico Togni 890302837060

Amount of pages - 20 Course ENP – 34306 Environmental Policy: Analysis and Evaluation Dr. Judith van Leeuwen

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Index

Evaluating the effectiveness of the EU Emission Trading Scheme ............................................................ 1

Index ........................................................................................................................................................ 2

Abstract .................................................................................................................................................... 3

Introduction ............................................................................................................................................. 4

1. Theoretical Framework ..................................................................................................................... 6

1.1 Focus .............................................................................................................................................. 6

1.2 Evaluation Framework .................................................................................................................... 6

1.3 Design Cap and trade system ........................................................................................................ 11

2. Policy evaluation ............................................................................................................................. 13

2.1 Measuring output: Implementation of Cap and trade system in European/German power sector . 13

2.2 Measuring outcome: functioning and effectiveness of pricing CO2 in relation to emission trading

and innovation in electric companies in the pilot phase ....................................................................... 14

2.3 Measuring outcome: functioning and effectiveness of pricing CO2 in relation to emission trading

and innovation in electric companies in the second phase ................................................................... 17

3. Case study: Germany ...................................................................................................................... 19

Discussion .............................................................................................................................................. 22

Conclusion ............................................................................................................................................. 23

References .............................................................................................................................................. 24

Appendix ................................................................................................................................................ 27

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Abstract

The aim of this paper is to analyse the effectiveness and functioning of the EU ETS within the

European and German electricity sector. The effectiveness will be measured based on an ex- post

evaluation of the first two phases of the scheme. The EEA policy evaluation framework has been

used to measure the effectiveness in terms of output (implementation of the scheme) and outcome

(behavioural change in the target group). Each emission trade phase has been evaluated singularly in

order to show functioning, achievements and failures. A close examination of a case study in the

electricity sector of Germany has been done in order to highlight the effectiveness of the scheme in

order of its innovation effect. In terms of implementation, the scheme has been rather successful,

since it was enforced by European law so electricity companies were forced to follow emission

trading regulations imposed by Member States. In terms of behavioural change the evaluation is

more nuanced. During the pilot phase the scheme was not very successful since the price of CO₂ did

not created an economic incentive among electricity companies to start trading emissions, let alone

to invest in low carbon technologies. During the second phase it seemed that lessons were learned

from the first phase and the effectiveness increased in terms of emission trading between electric

companies. However the case of Germany shows that it is difficult to measure the correlation

between implementation of the EU ETS and its innovation effect in the German electricity sector.

Since the EU ETS innovational change has occurred in this sector, however it is unclear if these

changes occurred because of a combined effect of several policies that also stimulated a sustainable

electricity sector.

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Introduction

Climate change has become one of the most important environmental issues that countries of the

world have to face. Evidences shows that the rapidly grown CO₂ emissions due to human activities

are main responsible for climate change. The necessity of creation of policies for the reduction of

emissions is increasing every day (Mo et al, 2012).

In January 2005, the European Union Emission Trading Scheme was created, also known as the EU-

ETS. It is the largest international system for trading greenhouse gas emissions allowances. It covers

11.000 power stations and industrial plants in 31 countries: the 28 Member States of the European

Union and three more states within the “European Economic Area”, Iceland, Liechtenstein and

Norway (EC, 2013).

The EU-ETS covers approximately 50% of total CO₂ emissions of European countries (EC, 2007, p.6-7).

Trade in emissions allowances consists of giving a monetary value to CO₂ emissions and creating a

market of carbon under a “cap and trade” system, which has been an achievement of global

significance (Grubb et al, 2006).

According to the European Commission, internalizing externalities (negative environmental costs)

makes investing in clean technologies more profitable. If CO₂ has a price, companies are engaging the

ingenuity of their engineers to look for cost-effective ways to reduce their emissions (EC, 2008).

Therefore, the EU-ETS believes in economics tools instead of “command and control” techniques,

which would consist on politicians deciding the targets and then set up measures to enforce

compliance (Connelly and Smith, 2003).

The EU-ETS already finished two phases:

Phase I (2005-2007): a three year pilot period, which served as a preparation for Phase II,

where the policy should be working properly in order to manage the Kyoto protocols

objectives. Just CO₂ emissions of power generators and industrial sectors were covered.

Most of the allowances were given for free and the sanction for the non-compliance was

40€/ tonne CO₂ (EC, 2013).

Phase II (2008-2012): this phase coincided with the beginning of the Kyoto Protocol. Iceland,

Liechtenstein and Norway joined the scheme too. After knowing the results of the Pilot

Phase, it included revised monitoring and reporting rules, and more stringent emissions caps.

(Environmental Agency, 2013). The aviation sector took part of the EU-ETS in 2012. The

sanction for non-compliance increased until 100 €/ tonne CO₂ and the number of allowances

given for free decreased with 10%. (EC, 2013).

The third Phase of the EU-ETS is currently running. It began in January 2013 and will finish in

December 2020. It covers additional greenhouse gases and emission sources and allows small

emitters and hospitals to choose to be excluded from certain obligations (Environmental Agency,

2013).

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The main objective of the EU-ETS is managing a reduction of 21% (referring to 2005 emissions) by the

year 2020 (EC, 2013).

The cap system has been established in order to reduce caps in future periods by increasing the

incentive for technology investment and reduce emissions at minimum cost and by the promotion of

global innovation (Hoffman, 2007).

In this work we are going to focus on how effective the EU-ETS has been since 2005 in the electricity

sector in Europe. A case study of Germany will be used to illustrate the effectiveness of the scheme

more specific Therefore, our research question is:

“How did the pricing of CO₂ emissions influenced the functioning and effectiveness of the emission trading scheme (EU ETS) when focusing on the trading of emissions and its innovation effect in the electricity sector during the first two phases of the scheme?” After a theoretical description of the evaluation framework used and the characteristics of a cap and

trade system in chapter 1, each emission trading phase will be evaluated singularly in chapter 2 to

describe a relation between the pricing of CO₂ and the functioning, achievements and failures of

actual emission trading between electric companies. In chapter 3 the effectiveness of the scheme will

be examined more closely, by looking to what extend the EU- ETS stimulated an innovation effect

towards low carbon technologies in the case of the German electricity sector

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1. Theoretical Framework

Analytical Focus and evaluation framework

1.1 Focus

As introduced before, in this paper the EU ETS will be evaluated in the electricity sector based on an

ex- post evaluation of the first two phases of the EU ETS in Europe. In order to do so, the EEA

framework will be used with a particular focus of measuring the effectiveness in terms of output and

outcome. Subchapter 1.2 will elaborate on this.

In this paper the scope of research is narrowed by measuring the functioning and effectiveness of the

EU- ETS in the following areas:

- The European energy sector. This sector is one of the highest emitters of CO₂ and therefore

relevant to put it under regulation of the EU- ETS (Hoffman, 2007). Also it was the first sector

on which the EU-ETS was implemented, so this is also the sector where the most lessons

were learned.

- Effectiveness in terms of CO₂ prices and innovation. Regarding prices, the EU- ETS is an

economic tool in which the price of a product - CO₂ - determines if a company will change its

behavioral (Connelly and Smith, 2003). This makes it relevant to research the relation

between CO₂ pricing and effectiveness. Regarding innovation, the ultimate goal of the EU-

ETS is to achieve emission reduction targets a minimum costs and to promote global

innovation in low emission technologies (Hoffman, 2007), Therefore it’s relevant to see in

what extend the EU- ETS motivated electric companies to invest in technological innovations.

These are all kind of investments that will lead to a lowering of CO₂ emissions in the

electricity sector.

- Germany. A case study of Germany will be used to describe the innovation effect in the

German electricity sector. The reason why is chosen for Germany is because it has the largest

share of planned power generation capacity in the EU and a multitude of providers of power

generation technologies (Hoffman and Rogge, 2010, p.7640).

By doing this study insight in the base of implementation of low carbon techniques is provided, which

can improve the effectiveness in the currently running third phase.

1.2 Evaluation Framework

This chapter is dedicated to describing what evaluation is and why it is useful, what the main features

of ex- post evaluation are, a description of the EEA framework and its three tools to measure

effectiveness and a description of the main characteristics of a cap and trade system.

What is ex- post evaluation

According to Schriven (1991, p. 139): “The key sense of the term ‘evaluation’ refers to the process of

determining the merit, worth, or value [emphasis in the original] of something, or the product of that

process”. Indeed the evaluation process has a significant role in policy making, in fact that it can be

used in order to (Gupta 2013):

Understand the link between policymaking and environmental improvements;

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understand pros and cons of relying on different policy instruments;

legitimize particular policies;

improve policy processes and outcomes.

All the more so in the environmental policy sector: in this field, policies are characterized by

dynamics that contribute to make them really hard to evaluate. In fact, the environmental effects are

often unknowable and their real influences remote. This is due to several reasons, such as the

geographically dispersion of the pollution phenomenon (starting from the broad diffusion of harm

sources) and the long time being between environmentally harmful behaviours and their tangible

effects. Beside these, also the insufficient knowledge about environmental tipping points, thresholds

and carrying capacity make it hard to find univocal answer to environmental problems (Mickwitz,

2003). These considerations are summarized in table 1 (below).

Figure 1: Environmental problems have complex characteristics and features, which makes it difficult to find a univocal answer (Mickwitz, 2003, p.417).

One of the first guidelines in this direction has been the 6th Environmental Action Program for the

European Union (1600/2002/EC), adopted in June 2002, which in article n.10 describes an ex-post

evaluation as “an evaluation of the effectiveness of existing measures in meeting their environmental

objectives” (European Parliament and the Council of the European Union, 2002).

In other words, an ex-post evaluation is an assessment carried out after policy has been

implemented and there are measurable effects. Indeed it’s essential for policy makers to figure out

the effectiveness of existing measures in meeting environmental objects and to propose possible

adjustments in order to further improve efficiency of the policy (Mickwitz, 2003).

EEA policy framework

Now that is clear what an ex-post evaluation is, a distinction about the kind of ex-post evaluation will

be provided that will be used in this research. Three evaluation frameworks are relevant in

measuring the outcomes and output of a certain environmental policy (Gupta, 2013):

Simple goal-effectiveness model

EEA evaluation framework

Modified EEA evaluation framework

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In this paper the EEA evaluation framework will be considered, which feature are analysed in the

following paragraph.

The evaluation framework at issue was given by the European environmental agency through the

action of the Reporting on Environmental Measure commission. In here, it is assessed how far the

reporting obligations contained in EU environmental legislation could help to evaluate the effect and

effectiveness of EU policies (Vaz et al, 2001). The result of that action has been the creation and

implementation of a shared evaluation framework based on the following criteria for the evaluation

of an environmental policy (Mickwitz 2003, p.426):

Figure 2: Criteria for the evaluation of environmental policy instruments according to Mickwitz, 2003, p.426.

Addressing now to the requirements a report evaluation has to satisfy to be considered effective

according to EEA, the referential code is the rural development regulation 1999/1750. According to

this guideline, the information given should encompass an assessment of relevance of the measure

from different sectors’ perspective; the progress in the reaching of operational and specific

objectives; the action taken to ensure high quality and effective implementation and the measures

taken to comply with Communities policies. In addition to these, an evaluation must also be leaded

without any external interference that could influence the results and in accordance with recognized

evaluation practice (Vaz et al, 2001).

Model of the intervention theories

In every policy evaluation, a crucial point is the identification and classification of the different types

of effects resulting from a certain policy implementation. This process of identification begins with

the definition of “intervention theories” for the policy instruments that will be evaluated. These

theories are described as “a specification of what must be done to achieve the desired goals, what

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other important impacts may also be anticipated and how these goals and impacts would be

generated” (Chen, 1990 as described in Mickwitz 2003, p.423).

An intervention theory has the aim to define how the policy will be implemented and will function;

the final result is usually a forecast about the practical effectiveness of the policy intervention.

However, although an intervention theory generally does not provide any descriptions of how a

policy instruments actually works, interventions theories coming from different sources are usually

the basis for a practical intervention. They normally consist of expectations regarding the following

different elements and their causal links:

• Actor • Outputs

• Outcomes • Inputs

The two main functions intervention theories have in an evaluation are: first the establishment of the

effects of the instruments and the areas involved; second, the determination of the outputs (matters

that the target groups are faced with), outcomes (response of the target groups to the outputs, and

their consequences) and causal links to collect data on.

Therefore, evaluations can promote the learning process especially in the environmental field, where

belief systems or views of causal relationships are often conflicting. In fact learning is stimulated both

by the variance of assumptions on the explicit causalities in the intervention theories, and by the

empirical assessment of the assumptions made before the intervention (Mickwitz, 2003).

Outputs and outcomes evaluation in the electricity sector

First a brief description of what is meant with “effectiveness assessment of an environmental policy”

will be given. Vaz et al (2001, p.9) defines effectiveness as “a judgement about whether or not the

expected objectives and targets of the policy measure have been achieved”. In other words, they

claim that assessing effectiveness basically means to judge whether and how a policy has reached his

starting aims and it involves to compare intentions with performances and final results.

Gysen et al (2002) makes a further distinction in defining effectiveness of an environmental policy.

According to them, the general idea of effectiveness can be split in four sub concepts: institutional

effectiveness, target group effectiveness, environmental effectiveness and societal effectiveness. The

investigation of one kind rather than another depends on the elements that are stressed in a cause-

effect analysis of the evaluation as shown in figure 3 (Gysen et al, 2002, 5).

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Figure 3: Policy evaluation and typology of effectiveness (Gysen et al, 2002, p.5)

Since in this paper outputs and outcomes are measured the focus will mainly be on the assessment of:

Institutional effectiveness (output), which is the extent to which the output of the policy

matches the objectives of the policy. Output is the concrete consequences of a measure.

It’s about the implementation of a certain policy in the sector to be addressed (Gysen et

al, 2002, p.6 and Vaz et al, 2001); and

Target-group effectiveness (outcome), interpreted as the “degree to which the outcome,

defined as the response of the target group to the output of the policy corresponds with

the policy objectives. Where the output effects can take place in the short term,

outcome effects are most likely to occur in the middle long term” (Gysen et al, 2002,

p.6).

As broached this research focuses on the mechanism and implementation of emission cap setting

(output) and the behavioural change of electric companies in terms of emission trading and

innovation effect (outcome) as reaction on the implementation (output) of the EU- ETS. In this case,

output will be measured by determining the implementation of the scheme in chapter 2.1. However

more attention will be given to the outcome, which is measured by the capacity of the scheme to

make electric companies participate actively in the emission trading market and their motivation to

invest in cleaner, low carbon technologies in order to reduce their emissions (the innovation effect).

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1.3 Design Cap and trade system

The EU ETS cap and trade system consist in the setting of a limit (“cap”) on the total amount of

certain greenhouse gases that can be emitted by factories, power plants and other installations

within European countries covered by the scheme. The cap is reduced over time in order to reduce

the number of total emissions. In 2020, emissions from sectors covered by the EU ETS are supposed

to decrease by 21% in comparison with those of 2005 (EC, 2013)

The cap and trade system bases are inspired in on the Coase theorem. According to this theorem, if

there is low or inexistent cost of transaction and a good communication system, and if the propriety

of a resource is assigned to one of the interested parts, the market will auto regulate itself and the

equilibrium will be achieved for both parts. This system is designed as a solution for the negative

externalities issue, in this case, the emission of CO2 (Hahn et al, 2010).

Before the implementation of the cap and trade system, several different mechanisms has been tried

to distribute the propriety of the resources. The most famous alternative to the Coase theorem is the

Pigouvian Tax. This method envisages a compensation, in the form of taxes and fines, charged to the

producer of a negative externality (Baumol, 1972). However, it has rarely been used since it revealed

a few flaws. The main problem is represented by the difficulty to set the correct amount for the

money compensation (pigouvian tax). The root of the problem is the impossibility for the regulator to

obtain enough information about the marginal abatement cost curve of each company, it means that

he cannot know exactly firms’ benefits and costs and this basically causes an incorrect setting of the

fines (Hahn et al., 2010).

Cap and trade was designed by Crocker (1966) and Dales (1968) as an alternative to the pugouvian

tax to deal with negative externalities issue and it has revealed more effective because less

information are needed for the mechanism to be established and launched.

In fact, Cap and trade is a system of transferable discharge permits, where the regulator has only to

set the total amount of emissions allowed (the cap), allocate all the rights outstanding, and allow

emission producers to trade the permits in a secondary market until the achievement of an optimal

allocation. According to this model, the final allocation of the permits would be independent upon

the initial allocation and right prices will be determined through the law of demand and supply.

One important requirement in a cap and trade system setting, is a correct arrangement of the limit in

order to maintain an effective value of the emission allowances. An incorrect level of caps could drive

to several glitches: on one hand, too low caps would cause a collapse of the electricity sector, on the

other hand, too high threshold would push companies to pollute without buying new permits.

Similarly, the whole number of allowances issued should be carefully considered since it determines

the price for carbon. Too few allowances will result in too high a carbon price. Too many permits will

cause a low carbon price and therefore reduce efforts towards emission abatement (Newbery 2009).

At this stage of the analysis of the cap and trade method, a really relevant aspect to take into

consideration is the initial distribution of the allowances. There are two possibilities for the

allocation: grandfathering (permits given for free), broadly used during the pilot phase; or

alternatively auctioning, mostly used in the second and third ETS-phase allocation (from 2013 even

60% of the total permits are expected to be put up for auction).

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In grandfathering, the regulative institution gives the allowances for free to the companies on the

base of the emission levels in the previous years (historical data). In this system the opportunity for

companies to pollute is considered a right, therefore costs of distribution of the allowances are

avoided. The companies just have to pay, if need be, for additional allowances to be bought in the

second market. (Rabbani and Muhájir, 2008). This allocation system has been criticized by numerous

studies (Doble and Kinnunen, 2005; Neuhoff, 2009) because it rises windfall profits, provides few

incentives to use clean, renewable energy and to be more competitive through innovation.

Furthermore, it’s possible that in anticipation of a grandfathering allocation, industries pollute more

than usual in the period before the implementation of the ETS in order to get more permits

afterwards.

On the contrary, with auctioning distribution allowances are put up for auction and companies bid

for them on the base of a fixed starting price. According to Stavins (2013), giving a price for

allowance through auctioning can also have a positive effect on social policies. In fact, revenues can

be profitably used by regulator institutions to eliminating some deadweight loss and cutting overall

social cost, or invested for the reduction of distortionary taxes (such as taxes on labour).

Another aspect to evaluate the cap and trade system, is the need of a secondary market in which

every company can trade allowances buying new permits to comply with the law or alternatively

selling allowances in excess whether it’s emitting less than the personal cap allows. The prices of the

allowances are directly dependent from the number allowances traded on the market (Rabbani and

Muhájir, 2008). If a company has an emissions reduction costs curve lower than other companies it is

more profitable for the first company to sell some allowances until the cost of the reduction of one

unit of emissions equate to the price of the allowances, and for the second it is more profitable to

buy allowances until the price of the allowances equate the price of the cost of reduction one unit of

emissions. This is because the reduction of each new emission unit, has higher costs. So for the first

company the reduction of each unit is cheaper than the allowance prices and is more profitable to

reduce one unit and sell the allowance of that emission unit than continue polluting those emission

unit. For the second company, reducing a unit of emission is more expensive than buying an

allowance for that unit (Jacobo, 1997).

One system for lower the emission reduction cost curve is to invest in new technologies. The

companies invest in new technology if the price of investing is lower than the price of the allowances

that they would not need if they use that technology (Rabbani and Muhájir 2008). Investing in new

technologies is a long term investment, that is why on one hand the cap and trade system needs to

be based on sustainable and stable prices of the allowances, and on the other hand companies have

to trust the system. Only this way they are aware that the boundaries are not going to change and

the investing will continue to being profitable in long term (Mills, 2008).

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2. Policy evaluation

Design, functioning and effectiveness

2.1 Measuring output: Implementation of Cap and trade system in European/German

power sector

As already became clear in chapter 1.2, measuring output is about the mechanisms for the setting

and implementing of the emission cap (Vaz et al, 2011)1. In this chapter therefore the focus will be

on how the EU- ETS was implemented in the target group – the electricity sector – in Europe and

more specific in Germany.

Implementation of EU-ETS in European electricity sector

Figure 4: Total greenhouse gas emissions by sector in 27 Member States of the European Union in 2005 (EC, 2007, p.14).

The initial focus of the EU-ETS was on CO₂ from big industrial emitters. Due to the large-scale use of

fossil fuels, the electricity sector is the largest contributor to overall CO₂ emissions in Europe (see

figure 4). Therefore the focus of the first trading period of the EU- ETS (2005-2007) was limited to

emissions from the power and heat generation industry. Even with this limited scope, some 10.500

installations in the 27 Member States were covered. Together they account for around 50% of the

EU’s total CO₂ emissions and about 40% of its overall greenhouse gas emissions (EC, 2007).

According to the Kyoto Protocol and its implementation in the EU and the EU ETS, Member States of

the EU are committed to reduce their collective emissions of greenhouse gases by 8% from 1990

levels during the Protocol’s first commitment period from 2008 to 2012 (the second phase of the EU-

ETS). This commitment from the Kyoto Protocol was used for setting the overall emission cap in the

EU-ETS and were translated into differentiated national emission reductions targets that are fixed in

National Allocation Plans. Appendix 1 gives an overview of the allocation of CO₂ reduction targets for

each Member State. The EU ETS has been established through binding legislation proposed by the

European Commission and is approved by the EU Member States and the European Parliament. This

means that all electricity companies within the EU are required by law to participate in the EU ETS

(EC, 2007).

1 See chapter 1.2, page 10.

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Implementation of EU-ETS in German electricity sector

Also in Germany the electricity sector is the main contributor of the countries CO₂ emissions. In 2004,

electricity generation was responsible for 37,3% of the 885,9 million tons of Germany’s CO₂

emissions. Therefore the electricity sector plays a key role in Germany’s efforts to reach the long-

term greenhouse gas emission reduction goals declared by the Kyoto Protocol and adopted by the

EU-ETS, which are set at a reduction goal of 21% below 1990 levels (see Annex 1) (Hoffman, 2007

and EC, 2007, p.10).

German electricity production relies on a mix of different energy sources. The distribution between

these sources is showed in table 1. It is clear that in 2004 most of the country’s electricity production

comes from lignite (25,5%) and hard coal (22,7%), which makes coal-fired plants the largest supplier

of electricity in Germany. In 2004 Nuclear power was also a major source of electricity and

accountable for 26,9% of total electricity production (Hoffman, 2007). However since the nuclear

accident with the power plant in the Japanese city Fukushima, Germany adopted a policy which will

gradually phase-out future use of nuclear power (Gueldner, 2013).

Production of renewable energy sources are promoted by the Renewable Energy Sources Act (EEG),

which was already implemented before the introduction of the EU ETS. This law provides subsidies

for investments especially in wind and solar power generation (Hoffman, 2007).

Table 1: Overview of Electricity generation in Germany in 2004 (Hoffman, 2007, p.466).

2.2 Measuring outcome: functioning and effectiveness of pricing CO2 in relation to

emission trading and innovation in electric companies in the pilot phase

Electricity represents a 50% of overall emissions regulated by the EU-ETS. It is, therefore, one of the

most important sectors where this European policy was imposed, being key for CO2 prices, and of

course for the success of the project (Neuhoff et al, 2011). The electricity providing sector is also

responsible for one third of Green House Gases emissions in Europe, so it is not surprising that it was

particularly affected by the creation of the EU-ETS (EC, 2007 and Alberola et al, 2007).

The main objective of the Pilot Phase was incenting Power Plants and Energy- Industrial Sectors to

reduce their emissions of CO2 by the promotion of low carbon technologies (Alberola, E. et al, 2007).

Hence, at the beginning, the EU-ETS was mainly focused on electricity producers and industries and

just on CO2 emissions.

In this part of this research the focus is on how effective the EU-ETS was in its pilot phase, in terms of

EUA prices (European Union allowances) and emission trading. These are the prices of the CO2

permits that electric companies could buy in order to emit CO2 if they exceed the cap level.

It is difficult to measure the effectiveness of the EU-ETS in terms of electricity prices because data are

complex to obtain and, as there is no common market of electricity in Europe and, although prices

have decreased over the years, they have not achieve a convergence (Germany involves the biggest

15

electricity market in Europe and the European Energy Exchange (EEX) is one of the most important

European power exchange market) (Mo et al, 2012)

Energy prices were the main drivers of carbon prices, as power generators were able to change their

fuel inputs from coal to natural gas, which would rapidly reduce CO2 emissions. (Alberola et al, 2007).

The increase of gas prices was the main issue that affected the implementation of the EU-ETS in

electricity sector on the pilot phase because it reduced the possibility for electricity producers to

switch from the most pollutant sources (coal and oil) to a cleaner fuel as gas. Clearly, this missed

switch was due to the still higher profitability of using coal instead of gas (Grubb et al., 2006).

Brent (i.e. crude oil) prices are recognized as the main drivers of natural gas prices. In fact, they affect

power prices in general and, consequently, carbon prices. High energy prices always contribute to an

increase of carbon prices (Alberola et al, 2007).

Figure 5: Evolution of natural

gas, coal and Brent prices per

month during the pilot phase

of the EU-ETS. (Alberola et al,

2007).

Figure 5 represents the

evolution of coal,

natural gas and Brent

prices during the pilot

phase of the EU-ETS.

Natural gas prices

increased excessively

among the last months of 2005. So it was more profitable for electric companies to use coal as fuel

input, as its price was also high but more constant. Hence, as coal is responsible of much more CO2

emissions than natural gas, the demand for permits and allowances was significantly increased and,

as a result of that, the price of CO2 (permits/allowances) got much higher. (Alberola et al, 2007)

However, this phenomenon of CO2 prices was not maintained: On April 2006 operators disclosed the

verified emissions data of 2005 (which were unknown when the EU-ETS began to work) and showed

that the scheme was oversupplied. Therefore, the process of grandfathering in the pilot phase

allowed more CO2 emissions than actually existed in 2005. So after it was disclosed a price collapse

occurred and CO2 prices began to decrease rapidly (Alberola et al, 2007).

This is the reason why electric companies did not change their fuel input during the pilot phase: on

one hand they could not trust the natural gas prices, which used to change price significantly in

short-time periods; on the other hand, they hadn’t any incentive to change to a cleaner source such

as gas since it was now clear that European countries taking part of the EU-ETS were emitting bellow

the maximum level allowed, therefore reducing emission was not a priority anymore. The immediate

consequence of this discover was a significant drop in the price of CO2 allowances in May 2006 (as

shown in figure 6).

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Figure 6: EUA prices evolution during the Pilot Phase of the EU-ETS (Alberola et al, 2007)

Furthermore there was an over allocation of allowances. In general the electricity companies had

enough EUAs in the pilot phase so it was not necessary for them to participate in the EUA market and

trading didn’t really occurred. In fact, after the verification that the EUAs allocated were more than

the needed, as it is showed in figure 6, the dramatic price break took place until the end of the Pilot

Phase, when the price of allowances reached zero. (Mo et al, 2012)

Figure 7: CO2 Emissions of the

twelve most important electric

companies in Europe during the

Pilot Phase of the EU-ETS (within

the circle)(Mo et al, 2012)

Figure 7 is the final evidence that demonstrates that the rate of CO2 emissions due to electric

companies did not change during the pilot phase of the EU-ETS. The only company that apparently

reduced its emissions during this first period was “International Power”.

We can conclude after this evaluation applied to electric companies, that the pilot phase was a

period of uncertainties, with relation to the volatility of natural gas prices and to the absence of data

of emissions of 2005, which led to a permit issuance above the necessary.

It is also important to mention that another flaw of the pilot phase was the absence of “banking”,

which means that the amount of permits bought by companies during this period was not

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transferable to the second phase. Therefore, the extent of allowances that were bought and not used

in the pilot phase lost their value in entirety (EC, 2012).

The pilot phase was not really effective if we consider the emissions of CO2 which, on the other hand,

never surpassed the limits established when the EU-ETS was created. However, it was a preparatory

phase and it was useful to get information to keep developing the project during the Second Phase.

2.3 Measuring outcome: functioning and effectiveness of pricing CO2 in relation to

emission trading and innovation in electric companies in the second phase

The second phase started in 2008 and continued until 2012. This period coincides in time with the

Kyoto protocol and the objective cap is set according to targets set in the protocol. The main purpose

of this second phase was to achieve an emission reduction of 12% compared to the pilot phase

(Convery et al., 2013).

Other changes that were made in the pilot phase was an increase of the kind of industries under the

EU- ETS and a decrease of 6,5% of the number of allowances divided in the electric sector (Ahamada

et al, 2012). This decrease of allowances was to elude legal and distributional problems. If there is an

excess of allowances, the allowances loss their value and are not needed to achieve the pollution

objectives, so the market system does not work and the Kyoto protocol caps will not be achieved

(Grubb and Neuhoff, 2006).

The free assignation of allowances was reduced from 95% in the pilot phase to 90% in the second

phase. The penalties were increased from 40€/ton CO2 in the first phase to 100€/ ton CO2 in the

second phase. These new measures made that the profits of the electricity sector were more

determined by the allowances, therefore, participating CO2 trading was increased and reduction

became more attractive/profitable for electric companies (Mo et al, 2012).

Due to the no allowance of banking, and the coal crash caused by the economic recession, the

unstable prices in the allowances continued along the first period of the second phase (Cummins,

2013). Reducing the amount of CO2 is more difficult than reducing other pollutants. So there was a

controversy about the reduction of allowances because this makes prices unstable. Due to the big

dependency of the electricity sector on the CO2 emissions, the instability of the prices in this sector

could be even higher (Grubb and Neuhoff, 2006). This instability disincentives electric companies to

invest in renewable energies, This is one of the most criticized points against the effectiveness of the

cap-and-trading system (Linares et al, 2013).

18

Figure 8: the evaluation of CO2 prices from 2005 to 2010 (Aatola et al, 2013).

In figure 8 the evolution of prices of the allowances since 2005 to 2010 is shown. In this part of the

paper the focus is on the second phase which was from 2008 to 2012. In that part of the graph the

prices were between 20 or 30€/ton CO2 from March to October 2008 with a maximum of 28 €/ton in

July. There is a decreasing of the prices under the 20 €/ton CO2 with a minimum in February of

8€/ton CO2 and a recovering of the prices until December 2010 of 13-14€/ton CO2 A stabilization of

the prices was maintained in 2009 until the end of the second phase (Ahamada et al, 2012). This

sustainability of the prices in the second period of the second phase was due to the increasing of

liquidity; the mellowing of the markets; the allowance of banking and the extension of the cap and

trading system to other sectors (Aatola et al., 2013).

In the second phase the effectiveness of the emission allowances could be measured by its increased

capacity for creating an adequate framework for the actual occurrence of emission trading and some

small investments in new technology. These incentives for trading and investing were mostly a result

of lowering the emission cap, higher penalties for exceeding the cap, less grandfathering and the

stabilization of carbon prices. The stabilization of the prices created reliability in the cap and trade

system and its functioning. So the risk of the inversion in new technologies became lower and the

profitability of buying allowances instead of continuing polluting and paying the fines increased. The

companies dared to invest in (research for) new, cleaner technologies because the risk of losing

money in long term decreased and they were able to assume this risk. Also the allowance of banking

ensured the profitability of the allowances in long term increasing its market value (Mo et al, 2012).

19

3. Case study: Germany

relation between CO₂ pricing and innovation effect in Germany

In chapter two the effectiveness of the EU ETS in the electric sector was evaluated by measuring the

outcome of a policy measure (Vaz et al., 2001); it was explained how the pricing of CO₂ influenced

the implementation and functioning of the EU ETS in this target group during the first two phases of

the scheme.

Concluding from chapter two, different factors influenced the development of the CO₂ pricing and

therefore the effectiveness of the implementation of the emission trading scheme in electric

companies. During the first phase the implementation of the EU ETS was not very successful. The

emission ceiling was too high, there was an oversupply of free allowances which strongly reduced the

price of CO₂ and cleaner substitutes like natural gas were too expensive. Altogether this created an

environment in which the trading of CO₂ permits was unnecessary and there was no economic

incentive to change fuel input towards more sustainable ones. In the second phase it seemed that

lessons were learned from the first phase. The emission cap level was reduced by coupling it to the

Kyoto Protocol reduction targets, the system of free allocation was adjusted which created a higher

and more stable price of CO₂ and the penalties for exceeding the emission cap increased. These

measures forced electric companies to start trading permits, but economically speaking it became

also more attractive to cut emissions below the emissions cap. This resulted in a higher effectiveness

of the implementation of the EU ETS in the European electricity sector during the second phase.

In terms of EU ETS implementation in the target group, it can be said that the scheme increased

effectiveness during the second phase. However, the ultimate goal of the EU ETS is to achieve

emission reduction targets at minimum costs and to promote global innovation in low emission

technologies (Hoffman, 2007). The implementation of the EU ETS in its pilot phase made researches

question whether the scheme does indeed promote innovation of low emission technologies

(Gagelmann and Frondel, 2005). Empirical evidence on the innovation effects of the EU ETS is

important, since it could guide policy makers around the world with regard to instrument design for

CO₂ emission reduction in relation to climate policies (Hoffman and Rogge, 2010). Therefore, in this

chapter the effectiveness of the outcome will be measured one step further. An in-depth analysis will

be done by evaluating how the pricing of the CO₂ emissions influenced the innovation potential

within the target group, meaning: did the EU ETS pricing of CO₂ really stimulated electric companies

to change their behavior by investing in cleaner technologies that will reduce their CO₂ emissions?

This question will be answered by analyzing the innovation effect of electric companies in Germany.

In studying the impact of the EU ETS on the innovational level, the main source of data collection is

provided by a study done by Hoffman and Rogge (2010). Based on 42 interviews with experts of

power generation technologies, they carried out an empirical analysis about the impact of the EU ETS

on the innovation system of power generation technologies in the German electricity sector.

Malerba (2004) distinguishes four building blocks that are important for describing technological

change within a certain economic sector: ‘knowledge and technologies’, ‘actors and networks’,

‘institutions’ and ‘demand’. Whereas the building blocks ‘knowledge and technologies’ and ‘demand’

directly refers to the effect of technological change in a specific sector, ‘institutions’ and ‘network

20

and demands’ takes a closer look to the role that interrelated sectors and institutions play in

promoting technological change (Malerba, 2002, 2004). Since the focus of this case study will be on

the innovation effect of the EU ETS on the German electricity sector, the research on the role of

institutions, actors and networks will be left out.

Knowledge and technologies

Knowledge and technologies refers to EU ETS driven investments in energy efficiency that reduces

CO₂ emission of existing power plants and investments in Research Development and Demonstration

(RD&D) within emerging renewable or CO₂ reducing technologies (Rogge and Hoffman, 2010).

Rogge and Hoffman (2010) found that the introduction of the EU ETS promoted the research for CO₂-

free technologies in three main areas in Germany.

Firstly, the EU ETS significantly increased RD&D activities on carbon capture and storage (CCS)

techniques in Germany. Climate policies as a whole is the driver for CCS, but it is the EU ETS that

brings the monetary effects into businesses so, ultimately, the EU ETS can be seen as the main driver.

Secondly, in chapter 2.2 it was seen that the electricity supply in Germany depends for almost 50%

on coal-fired power plants (Hoffman, 2007, p.466). Since the impact of the CO₂ price is particularly

strong for coal, it makes economic sense to reduce the carbon emissions of electricity production by

coal. Therefore the EU ETS reinforced on-going energy efficiency RD&D for large fossil-fuel-fired

power plants. Again, efficiency was already on the agenda of these power plants, but due to the

monetary effect of the EU ETS these tendencies were reinforced. Thirdly, the EU ETS appears to only

indirectly benefit RD&D on technologies for renewable energy sources. Since the implementation of

the EU ETS more projects on renewables are carried out, however in itself the trading scheme does

not significantly affect the RD&D on renewables. Instead other policies and developments, like

governmental support measures is are main drivers for RD&D on renewables.

In general the technical system of electric companies tends to evolve relatively slow because of the

long lifetime of power generation equipment, which varies from 20 up to 90 years (IEA, 2008). This

makes it rather difficult to already draw conclusions about the innovation effective of the EU ETS

within the area knowledge and technologies (Hoffman and Rogge, 2010).

Demand

This topic refers to the demand of electricity companies to power generating technologies. In this

case it is interesting to see if the EU ETS created an incentive for the electricity sector to increase the

demand for low carbon power generating technologies (Hoffman and Rogge, 2010). The research of

Hoffman and Rogge (2010) shows that mostly during the second phase, the pricing of carbon created

five developments in this demand. Firstly, in the beginning years of the EU ETS, the pricing of carbon

seemed to cause a negative reversed effect. Due to oversupply of free allowance and a German

allocation rule of guaranteeing an unchanged level of free allocation for power plants for 14 years,

investments in new power plants were economically attractive for companies. This created a

temporally interest of electric companies to build new fossil-fuel plants in Germany. However during

the second phase both of these rules were cut, which made it more difficult to establish profitable

new fossil-fuel power plants. Secondly, in principle the pricing of carbon incentivized German electric

companies to switch to fuels with lower carbon intensities in the second phase of the EU ETS. But in

Germany these incentives were not all decisive for investment decisions in cleaner technologies,

since this decision was also based on other factors than just the price of CO₂. In this sense the high

21

price of a cleaner substitute – natural gas – played a big role. The price of carbon had to be €60,- to

€70,- per ton of CO₂ to make gas a profitable alternative. But also supportive laws and public

acceptance of new power plants played a role in stimulating innovational change. Thirdly, investment

decisions for cleaner technologies mainly took place in existing or planned coal plants and were

mostly focused on carbon storage techniques. This development was not driven by the EU ETS alone,

but also by authorities that made CCS techniques a precondition for granting a construction permit

for new fossil- fuel power plants and by the price of CO₂, which had to be high enough to compete

with these kind of innovations. Fourthly, it is shown that the EU ETS revealed an incremental increase

in the investments of energy efficiency improvements in new and existing plants, mostly in coal-fired

ones. And lastly, the EU ETS contributes only indirect and relatively weak to an increased demand for

renewable power generation technologies (Rogge and Hoffman, 2010).

In the case of Germany it can be concluded that the system of CO₂ pricing under the EU ETS

stimulated some innovational effect, mostly noticeable since the second phase. Largely, this

accounted for incrementally effects influencing the rate and direction of technological development

and implementation of cleaner power generation technologies, with the main impact occurring in the

high- emitting coal-fired plants. In the case of ‘knowledge and technologies’, innovation took place in

the research fields of energy efficiency and carbon capture techniques. Up to now, these have been

the most prominent direct innovation effects of the EU ETS on the electricity sector of Germany.

Regarding demand, so far the influence of the pricing of CO₂ under the EU ETS had only a limited

effect on the demand of German electricity companies for low emitting technologies. Mainly this can

be explained due to the lack of stringency and predictability of the scheme and the relatively greater

importance of other factors, such as fuel prices of cleaner substitutes and public and governmental

support. When investments in cleaner technologies took place, it mostly concerned innovations

regarding energy efficiency and carbon storage implemented in existing high- emitting- and future

planned power plants (Hoffman and Rogge, 2010). So far, the EU ETS had only a small and indirect

effect on the investments of renewable power generation technologies, so here is room for

improvement during the third phase of the EU ETS.

Above all it can be concluded that the EU ETS triggered innovational change in the implementation

and research of power generation technologies in a limited set of areas of the German electricity

sector. More precisely, changes in the innovation system of the electricity sector occurred because of

a combined effect of several policies that are working towards the same goal: a more sustainable

German electricity sector (Hoffman and Rogge, 2010). Also it can be stated that context factors, e.g.

the price of a cleaner substitute, play a major role in the innovation effect. As a recommendation for

implementation in other and future areas, policy- makers can increase the innovation effect of the

EU ETS by focusing on the interplay of the EU ETS with other policies that work towards the same

goal and by being aware of the decreasing innovation effect that external factors can play.

22

Discussion The EU-ETS is an ambitious project of international significance, a long-range project referring to CO₂

reduction that shows how important the cooperation between different countries is in order to solve

global problems, as climate change.

As it is a policy of such big dimensions, the EU-ETS is based upon lots of facts. This requires that all

those facts come to an equilibrate state in which this project will be working properly to finally

manage all the objectives purposed in the EU-ETS and in the Kyoto Protocol.

One of the main lessons learned from the EU-ETS, and from which policy-makers should always take

care, is the necessity of complete information when creating and environmental policy. Concretely,

this lesson was showed in the pilot phase when the cap levels were imposed without knowing the

emissions data of the year 2005. This conducted to a wrong establishment of boundaries for CO₂

pollution, that were over the levels that were actually necessary.

Lots of uncertainties have surrounded this European Policy since its creation. One of the main

uncertainties we are facing in this project is: Until what point is the reduction of CO₂ actually related

to the cap and trade system and not to other variables or policies? Or how can we know that the

decrease of Green House Gases is mainly caused by this policy and not to economic crisis that led to

a reduction of carbon consumption during those years? Or to an increase of reforestation in Europe?

Or because of other environmental policies or taxes imposed for pollutant activities?

Germany is a good example of this situation, as is one of the most important European countries in

CO₂ reduction, but not just because of the EU-ETS, but for other policies that were being developed

there before 2005. Hence, the EU-ETS can be effective, but it also depends on other policies.

According to Rogge and Hoffman, 2010, p.764, a coordinated policy mix may benefit from a closer

cooperation of environmental, energy and innovation policy departments to achieve a better

alignment of the various regulatory measures.

The point that this system is completely related to economy, creates an ethical problem as

environment should not only be tied to economy: the cap and trade system is managing reduction

objectives in terms of establishing limits that involve the payment of fees in case of non-compliance.

This makes the reduction of CO2 an obligation for pollutant companies and not a moral issue for

society which it should be. If the protection of the environment turns to an obligation for the

companies and thee economy crashes, the environment is often seen as a luxury of better times

instead of a necessity in the society.

On the other hand, the introduction of the environmental issues in the economic system helps to

promote the environmental problems and introduces them in the society as something more

tangible.

However, the EU-ETS is a necessary and effective policy which requires a continuous evaluation of

each of its phases in order to learn from the previous phases and therefore, to work properly.

Lessons learned from the first phase (necessity of knowing emission data, necessity of banking) were

useful in order to improve the policy in its second phase. Therefore it is expected, that the EU-ETS (if

regular revise) will continue to be an important, although in itself insufficient, element in the policy

23

mix needed to decarbonize the electricity sector (Hoffmand and Rogger, 2010). Now it is time to take

into account every error and uncertainty faced previously to achieve the objectives of the third phase

until 2020.

Conclusion

This paper basically underlines EU ETS effectiveness and functioning about the electric sector

throughout the first two phases. It was tried to find an answer on the following research question:

“How did the pricing of CO₂ emissions influenced the functioning and effectiveness of the emission trading scheme (EU ETS) when focusing on the trading of emissions and its innovation effect in the electricity sector during the first two phases of the scheme?”

It’s shown that in the pilot phase the EU-ETS has not been very effective yet. The setting of the cap

was too high, there was an oversupply of free allowances which caused a low and unstable CO₂ price

and cleaner substitutes like natural gas were too expensive. This created an environment in which

emission trading was unnecessary and there was no economic incentive for electric companies to

switch to more cleaner fuel inputs. The second phase saw a decisive improvement. The coupling of

the Kyoto Protocols reduction targets to the EU-ETS had a significant role in this success. Other

important factors for this improve were: the insertion of auctioning in allocation of permits, an

increase of penalties for exceeding the emission cap, adjustment of the system of free which created

a higher and more stable price of CO₂ and the authorization of banking. These measures forced

electric companies to start trading emissions. But economically speaking it became also more

attractive for electric companies to cut emissions below the emission cap and it seemed that the

companies were willing to invest in cleaner technologies. This resulted in a higher effectiveness of

the output and outcome of the EU-ETS in the European electricity sector during the second phase. At

first glance, the case study seems to confirm that the EU- ETS pushes firms to invest increasingly in

RD&D, energy efficiency and carbon storage techniques to lower their emission output. A relation

between the EU-ETS and the investment in technologies for renewable energies is still very small, so

here is room for improvement for the third phase. However, when taking a more holistic, it seems

that other factors than the EU-ETS has also played a big role for stimulating German electric

companies to invest in cleaner technologies. Factors that can be mentioned are: the whole set of

German environmental policies stimulating a sustainable future of the electricity sector; the variation

of fuel prices; the price of cleaner substitutes; public support for new power generation plants and

security of a stable competitive position.

Thus, it can be confirmed that EU ETS is a trigger of technological change only for few elements

within the electric sector in Germany. However, it have to be consider that Germany had already

engaged in emission reduction targets some years before the implementation of EU ETS. Therefore

the role of the policy mix needs to be included in giving a judgment on effectiveness. Such a policy

mix can make EU-ETS constraints less arduous to bear for German electricity firms was still existing

and, of course, it made EU ETS constraint less arduous to bear for German firms. Such a context need

to be kept in mind when measuring the effectiveness of the EU-ETS in other countries.

24

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Appendix

Appendix 1

Figure 1: National Allocation Plan for each Member State of the EU. Reduction target is % change compared to base year of the Kyoto target in 1990 (EC, 2007, p.10).