The European Commission released a proposal this week for the governance structure of Phase 3 (2013 to 2020) of the European Union Emissions Trading System (EU ETS).

The EU ETS proposal, which was published as part of a “climate action and renewable energy package,” must be approved by the Council of the EU and the European Parliament before it becomes law. The European Commission hopes that this will take place by 2009, which could coincide with the adoption of a new international climate change agreement.

The proposal calls for an 20% reduction in emissions across the European Union compared to 1990 levels. The Commission proposes a 30% reduction if other countries agree to take similar measures under a global agreement- i.e., if a meaningful successor to the Kyoto Protocol is negotiated and implemented.

The distribution of emissions reductions is based around the concept of “effort sharing.” Member States are assigned emissions limits along a range according to the country’s “relative wealth.” Denmark and Ireland fall at the high end of the spectrum (20% reduction from 2005 emission levels by 2020), and Bulgaria at the low end (a 20% increase from 2005 levels by 2020).

The most significant features of the new proposal include:

• A move to a single EU-wide cap on emission allowances instead of 27 national caps.
• Fewer allowances will be given free to industry; instead, countries will auction the allowances. In 2013, approximately 60% of the allowances will be distributed by auction, and that share will increase in later years.
• The petrochemical, ammonia, and aluminum industries will be added to the EU ETS for their CO2 emissions. The new proposal covers nitrous oxide emissions from nitric, adipic and glyoxylic acid production and perfluorocarbons from the aluminum sector. This would be the first time covering non-CO2 emissions.
• Credits from Clean Development Mechanism (CDM) projects implemented in Least Developed Countries will be allowed for project types that were accepted by all member states between 2008 and 2012.
• Restrictions on the use of CERs and ERUs become particularly stringent if the international community fails to reach agreement on a successor to the Kyoto Protocol. Under this scenario, installations subject to the carbon cap may only utilize Phase 2 surplus CERs/ERUs for compliance purposes during Phase 3.
• Credits from land use, land-use change and forestry projects - generally those that either preserve forested areas or engage in reforestation - will not be allowed into the system.
• Provisions to allow linking the EU ETS to other emissions trading systems, so long as the design elements do not undermine the environmental integrity of the EU ETS. The proposal eliminates the requirement that the other system be in a Kyoto Protocol signatory country. Thus, the EU ETS could be linked with one of the regional systems in the United States.

The European Commission estimates that adopting the proposed changes — will cost roughly 60 billion Euros ($90 billion dollars). Electricity costs will likely rise roughly 15% in the short term for European customers. Although these prices seem steep, experts claim that the costs of inaction will be at least ten times greater than the current upfront costs.

The market so far has viewed the proposal as a bullish signal for carbon prices; initial reactions to the proposal generally has been positive. However, a variety of sectors and constituencies are likely to mount considerable resistance as we work through the details and potential economic implications. If the proposal is adopted in its current form, it will raise the costs for many energy-intensive manufacturing industries, particularly those likely to get hit the hardest in the transition to an auction system.

The state of the world economy should not be ignored. Recent uncertainties in the global capital markets and talk of a recession in the United States have the potential to derail the proposal as the approval process moves forward. The proposed changes have the estimated potential to decrease the GDP of the European Union by roughly 0.5%. At a time of reduced economic growth, lawmakers may be less willing to negatively impact the economy.

Although the proposal may not cover all of the key issues framed in the Bali Action Plan, the Commission has thought through and detailed many of its negotiating positions, boldly challenging the rest of world to commit to monumental emission reductions as we embark on a journey down the road from Bali.

For further information about this topic, please contact Akin Gump.