final report - european...

FINAL REPORT

Foundation forInternationalEnvironmentalLaw andDevelopment

To the European CommissionDG Environment

Contract B4-3040/98/000795/MAR/B1

FINAL REPORT

Designing Options for Implementing an Emissions Trading Regimefor Greenhouse Gases in the EC

22 February 2000

Final Report: Options for EC Emission TradingFIELD, 22-2-2000

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Foundation for International Environmental Law and Development

The Foundation for International Environmental Law and Development(FIELD) was founded in 1989 to contribute to the progressive development ofinternational and EC law for the protection of the environment and attainmentof sustainable development. From its base at the Law Department of theSOAS, University of London, FIELD promotes law through international legaladvice and assistance, research, publication and teaching.

Further information about FIELD can be obtained from:

FIELDSOAS

University of London46-47 Russell Square

London WC1B 4JPTel: +44 71 637 7950Fax: +44 71 637 7951http://www.field.org.uk

This Report was written by Farhana Yamin and Jürgen Lefevere. It has beenprepared on the basis of inputs from the Center for Clean Air Policy (CCAP),Washington and FIELD, The authors would like to thank Jacob Werksman,FIELD, Erik Haites (Margaree Consultants, Canada), Onno Kuik and RichardTol (Institute for Environmental Studies (IVM), the Netherlands), FannyMissfeldt (Risoe National Laboratories, Denmark), Per Schreiner (Centre forEconomic Analysis, Norway), and Richard Stewart, (New York University,U.S.A) for additional input, comments and guidance during the course of theStudy and the preparation of this Report. The Report should be read inconjunction with a supplementary paper from CCAP which accompanies thisReport, "Design of a Practical Approach to Greenhouse Gas EmissionsTrading Combined with Policies and Measures".


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TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................ 4List of Boxes and Tables ............................................................................. 7Abbreviations............................................................................................... 8

1 INTRODUCTION....................................................................... 91.1 The Study Team................................................................................... 91.2 Terms of Reference.............................................................................. 91.3 Study Process .................................................................................... 101.4 Structure of Report ............................................................................. 111.5 Key Concepts ..................................................................................... 11

1.5.1 Emissions Trading....................................................................... 111.5.2 EC Emissions Trading................................................................. 121.5.3 Kyoto Mechanisms ...................................................................... 121.5.4 Joint Fulfilment ............................................................................ 121.5.5 Pre- and post-2008 Domestic Emissions Trading ....................... 131.5.6 Inter-governmental and Entity Level Trading............................... 131.5.7 Policies and Measures and Common and Co-ordinated Policiesand Measures ........................................................................................ 13

2 THE CASE FOR EMISSIONS TRADING IN EUROPE ......... 152.1 Expected Economic Gains from EC Emissions Trading ..................... 152.2 Advantages of Emissions Trading as an Instrument........................... 172.3 Recommendations.............................................................................. 18

3 THE ROLE OF THE EUROPEAN COMMUNITY................... 193.1 Climate Policy and Community Competence...................................... 193.2 Extent of Community Intervention....................................................... 203.3 Recommendations.............................................................................. 22

4 DESIGN OPTIONS ................................................................. 234.1 Overview of Design Options ............................................................... 234.2 Upstream versus Downstream with PAMs/CCPMs ............................ 254.3 What Level of Community Diversity Is Possible?................................ 264.4 Recommendations.............................................................................. 27

5 ALLOCATION......................................................................... 285.1 Allocation Responsibilities under the Kyoto Protocol and the BurdenSharing Agreement.................................................................................... 285.2 Allocation Responsibilities between Sectors ...................................... 295.3 Distribution of Permits to Entities........................................................ 295.4 Recommendations.............................................................................. 31

6 COMPLIANCE RELATED ISSUES........................................ 326.1 Member State and Community Level Tiers ........................................ 326.2 Ensuring Compliance at the National Level........................................ 32

6.2.1 Rules on monitoring and reporting .............................................. 326.2.2 Rules on verification .................................................................... 336.2.3 Enforcement ................................................................................ 33

6.3 Ensuring Compliance at the Community Level................................... 346.3.1 Implications of Article 4, Kyoto Protocol ...................................... 346.3.2 Reporting and verification of national emissions ......................... 356.3.3 Enforcement against Member States .......................................... 35

6.4 Recommendations.............................................................................. 36


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7 RELATION TO COMMON AND COORDINATION POLICIESAND MEASURES ......................................................................... 37

7.1 Compatibility with Existing Instruments .............................................. 377.1.1 Monitoring Mechanism ................................................................ 377.1.2 Integrated Pollution and Prevention Control ................................ 377.1.3 Negotiated Agreements............................................................... 387.1.4 Taxation of Energy Products ....................................................... 397.1.5 Large Combustion Plants Directive ............................................. 397.1.6 CCPMs to Cover Non-CO2 Gases............................................... 397.1.7 Carbon Taxes.............................................................................. 40

7.2 Recommendations.............................................................................. 408 TECHNICAL ISSUES RELATING TO ORGANISING THEMARKET ....................................................................................... 42

8.1 Technical and Operational Issues ...................................................... 429 CONCLUSIONS...................................................................... 44

APPENDICES ............................................................................... 45APPENDIX 1: Potential Efficiency Gains of Greenhouse Gas EmissionTrading ...................................................................................................... 46APPENDIX 2: CORINAIR and the EPER draft proposal - examples ofharmonised monitoring and reporting ........................................................ 50

Endnotes ...................................................................................... 51


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EXECUTIVE SUMMARY

Objective

This Final Report presents results from a study commissioned by theCommission’s Environment Directorate General entitled "Designing optionsfor implementation of an emissions trading regime for GHGs in the EC". Theobjective of the Study was to propose design options for an emissions tradingsystem for GHG in the EC which would take into account existing experienceand ongoing FCCC negotiations and assess how such a system could becombined with Community legislation, domestic policies and measures anduse of the Kyoto mechanisms.

The study was undertaken by the Foundation for International EnvironmentalLaw and Development (FIELD), London, with assistance from the Center forClean Air Policy (CCAP), Washington. A draft version of this Report and theaccompanying paper describing a downstream approach formed the basis forconsultations with Member States on 8 December 1999 at a workshop held inBrussels.

The conclusions of this Report are that EC emissions trading should form animportant part of the Community's implementation strategy for the KyotoProtocol. It establishes that a diversity of options is possible in the design ofan EC emissions trading system. The key choices turn on what degree of co-ordination or harmonisation by the EC is considered justified and desirable byMember States and what level of coverage of GHGs can realistically beachieved.

The Benefits of EC Emissions Trading

EC emissions trading can reduce abatement costs by an estimated 10%. Itshould play a significant role in the Community's implementation strategy forthe Kyoto Protocol. An EC trading scheme should allow for entity level tradingand be available throughout all Member States. Subject to the outcome ofnegotiations on supplementarity, entities in the EC should have equal accessto the Kyoto mechanisms during 2008-2012.

The Legal Basis for Community Intervention

Substantial competition and trade aspects (internal and potentially external)justify Community action to protect the environment and curb potentialviolations of Community law. At a minimum, Community action should provide acommon framework for a Community-wide scheme based on co-ordinationand/or harmonisation.

A "shared competence" scheme, with the Community and Member Statesacting in their respective areas of advantage, appears to strike an appropriatebalance between the need for harmonisation and the subsidiarity principle. Italso provides a useful point of departure for Member State and EC


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discussions on emissions trading. The elements that would benefit most fromCommunity harmonisation are the unit of trade, the participation of legal entitiesand the monitoring, compliance and enforcement requirements applicable tothese. For a downstream approach, the Community should also establish EC-wide and Member State sectoral caps.

Practical Design Options

An upstream approach rates more highly than a downstream approach onefficiency, environmental effectiveness, pro-competitiveness andadministrative feasibility grounds. The adoption of an upstream approach isunlikely given vested interests and institutional and political obstacles. Adownstream approach with policies and measures still provides efficiency andenvironmental gains and can improve the efficiency of existing policies andmeasures.

Establishing either option on a Community-wide basis provides more benefitsthan if only some Member States participate. If agreement cannot be reachedon a Community upstream or downstream option, the Community should, at aminimum, devise a common framework for trading allowing interestedMember States, and in due course, accession countries, to opt-in over time.

Allocation Issues

Allocation issues arise between the EC and Member States, among MemberStates on the issue of regulated and excluded sectors, and at the entity levelconcerning distribution of allowances. Issues relating to the allocation ofresponsibilities between the EC and Member States, such as who will tradeinternationally with assigned amounts, should be clarified as part of the ECjoint fulfilment agreement.

Selective inclusion of sectors by Member States is likely to give rise tosignificant, macro-economic competitiveness concerns which should beavoided by mandating trading for certain sectors and agreeing Community-wide and national caps. Where possible, permits should be auctioned andrevenues recycled. Grandfathering is a second-best option. Distributiondecisions should remain at the Member State level subject to the Commissionplaying an active watchdog role to ensure compliance with competition andstate aid rules.

Compliance Related Elements

The compliance components of international, EC and Member State tradingsystems should be mutually reinforcing to avoid duplication of effort andinconsistency of approach. The draft proposal for a European PollutantEmission Register is a step in the right direction because it will promote thecollection of Europe-wide standardized information and uniform monitoringand reporting guidelines for entities.


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An EC emissions trading system should leave verification of compliance byemission sources to Member State authorities. But to avoid gaming, commonlevels of penalties in Member States should ultimately underpin a Community-wide trading system.

The possibility that individual Member States may need to demonstratecompliance with their revised commitments internationally requires thatMember States maintain their national inventory and registry. A separate ECinventory and registry could combine the data provided by the nationalinventories and registries. The question of what, if any, mechanisms the ECmight use to discharge its responsibility for achieving the Kyoto target, inparticular how it could bring a Member State into compliance, should beaddressed.

Relationship to National and Community Policies and Measures

Most existing common and co-ordinated policies and measures (CCPMs),such as the Large Combustion Plant Directive, EC Monitoring Mechanismsand energy taxation, would not significantly conflict with an emissions tradingscheme. The inclusion of GHGs in IPPC permits and its energy efficiencyrequirements is one significant exception. These policies may need to bereconsidered if trading were to be established.

Negotiated agreements may conflict with emissions trading if they takeentities outside the regulated sector . In the short term, however, they canassist the introduction of emissions trading because they allow progressiveindustries to come on board, revealing information to regulators about howallocation might take place, earlier than otherwise might be the case.

Development of new common and co-ordinated policies and measuresinitiatives should be undertaken urgently, in particular, to address "regulatorygaps" such as the long-lived gases. For Europe, national taxes remain aflexible and effective tool for spurring interest in climate change, and can bestructured to provide an incentive to join emissions trading schemes.


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List of Boxes and Tables

Box 1: Options for levels of implementation Para. 3.2Box 2: Upstream, Downstream and Hybrid Options Para. 4.1

Table 1: Comparison of Initial Design Options Para. 4.1


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Abbreviations

AA Assigned AmountACEA European Automobile Manufacturers AssociationBSA Burden-Sharing AgreementCCAP Center for Clean Air PolicyCCPMs Common and Co-ordinated Policies and MeasuresCDM Clean Development MechanismCER Certified Emission ReductionCH4 MethaneCO2 Carbon DioxideDG Directorate GeneralECON Centre for Economic AnalysisEC European CommunityEEA European Environment AgencyELVs Emission Limit ValuesEMAS Eco-Management and Audit SchemeEPER European Pollutant Emission RegisterERU Emission Reduction UnitEU European UnionFIELD Foundation for International Environmental Law and

DevelopmentGWP Global Warming PotentialGHG Greenhouse GasHFCs HydrofluorocarbonsIVM Institute for Environmental StudiesIPPC Integrated Pollution Prevention and ControlKP Kyoto ProtocolLCP Large Combustion PlantsN20 Nitrous OxideNOx Nitrogen OxidesPAA Part of Assigned AmountPAMs Policies and MeasuresPFCs PerfluorocarbonsQELRO Quantified Emission Limitation and Reduction ObjectiveREIO Regional Economic Integration OrganisationSF6 Sulphur hexafluorideSO2 Sulphur DioxideSOAS School of Oriental and African StudiesUK United KingdomUNCTAD United Nations Conference on Trade and DevelopmentUNFCCC United Nations Framework Convention on Climate

ChangeUS United States of AmericaWTO World Trade Organisation


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1 INTRODUCTION

This Report presents the results of a Study undertaken at the request of theEuropean Commission, the Environment Directorate General, to designoptions for implementing an emissions trading regime for greenhouse gasesin the European Community. The objective of the Study was to:

§ develop options concerning the structure and design of emissionstrading in the EC taking into account existing experience and ongoingFCCC negotiations; and

§ assess how such a system could be combined with Communitylegislation, domestic policies and measures and use of Kyotomechanisms (emissions trading, joint implementation and the CleanDevelopment Mechanism).

This Report draws together the analytical work undertaken by the StudyTeam in the form of concrete recommendations for an emissions tradingscheme for the EC. An interim report (July 1999), an earlier draft of thisReport, and the accompanying paper, "Design of a Practical Approach toGreenhouse Gas Emissions Trading Combined with Policies and Measures",provided a basis for consultations between the Study Team, Member Statesand stakeholders at a workshop held in Brussels in December 1999.

1.1 The Study Team

This Report is submitted by the Foundation for International EnvironmentalLaw and Development (FIELD), London who co-ordinated the Study Team. Ithas been prepared by FIELD with the assistance of the Center for Clean AirPolicy (CCAP), Washington. As core members of the Study Team, FIELD andCCAP gratefully acknowledge extensive technical information, guidance andcomments provided by the other members of the Study Team and individualadvisors: Erik Haites (Margaree Consultants, Canada), Onno Kuik andRichard Tol (Institute for Environmental Studies (IVM), the Netherlands),Fanny Missfeldt (Risoe National Laboratories, Denmark), Per Schreiner(Centre for Economic Analysis, Norway), and Richard Stewart, (New YorkUniversity, U.S.A).

1.2 Terms of Reference

Begun in early 1999, this Study was intended to support the Community'spreparation for ratification of the 1997 Kyoto Protocol. These preparationsrequire the Community to develop its own implementation strategy andcontribute to the ongoing international negotiations, particularly those relatingto the operation of the Protocol's flexibility mechanisms.

The specific task of the Study Team was to explore what kind of emissionstrading scheme might be suited to the EC and the optimal level at which thisshould be implemented – Community or Member State. The Team was


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required to consider the design of an EC emissions trading scheme on thebasis of five assessment criteria: cost-efficiency, environmental effectiveness,administrative feasibility, legal compatibility and political acceptability. Thedesign issues to be covered by the Study Team include the following issues:

§ How to organise trading§ Overall cap and allocation§ Organising the market§ Administrative set-up

In addition, the terms of reference required the Study Team to examine therelation of EC emissions trading to domestic and Community policies andmeasures and the Kyoto mechanisms. The linkages between such a schemeand the operation of the Kyoto mechanisms, whilst important, were given lessattention because much of the analysis would have been speculative, giventhe many outstanding issues relating to the operation of the Kyotomechanisms at the international level. In addition to these assessmentcriteria, the Study Team focused on the competitiveness effects of differentoptions within the EC.

1.3 Study Process

The Study was scheduled to take nine months from January 1999. In additionto using the usual methodological tools such as literature reviews and theassessment of experience of trading, the terms of reference specifiedinterviews with key actors and the organisation of two consultation workshopswith Member States and stakeholders.

The first workshop took place on the 8 July 1999 in Brussels when the StudyTeam discussed the results of the Interim Report with the Environment DGand other interested Commission services. Workshop participants discussedthe Interim Report, which sets out preliminary conclusions from the extensiveresearch undertaken by the Study Team. Workshop participants also receivedseven scoping papers produced by FIELD and CCAP, which underpin theanalytical work undertaken for this Study. These papers are available fromFIELD on request.

§ Scoping Paper 1: ‘The EC Emissions Trading Regime and ECCompetition Law ’, Jürgen Lefevere and Farhana Yamin, FIELD.

§ Scoping Paper 2: ‘The EC as a Party to the FCCC/KP: An examinationof EC competence’, Jürgen Lefevere and Farhana Yamin, FIELD.

§ Scoping Paper 3: ‘WTO Issues Raised by the Design of an ECEmissions Trading System under the Kyoto Protocol, Jacob Werksmanand Jürgen Lefevere, FIELD1.

§ Scoping Paper 4: ‘Identifying the Proper Incidence of Regulation in aEuropean Union GHG Emissions Allowance Trading System’, TimHargrave, CCAP.

§ Scoping Paper 5: ‘Allocation of GHG Reduction Responsibilities amongand within the countries of the European Union’, Suzi Kerr, CCAP.


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§ Scoping Paper 6: ‘Aggregate versus Gas by Gas Models ofGreenhouse Gas Emissions Trading’, Tim Denne, CCAP.

§ Scoping Paper 7: ‘Compliance-Related Aspects of GHG EmissionsTrading in the EU, 'Tim Hargrave, CCAP, and Jürgen Lefevere, FIELD.

A second workshop allowed the Study Team to undertake consultations withMember States. This took place on 8 December 1999 in Brussels. A draftversion of this Report and a CCAP draft paper entitled "Design of a PracticalApproach to Greenhouse Gas Emissions Trading Combined with Policies andMeasures" formed the background documentation for these consultations.This lReport was prepared on the basis of these consultations. A final versionof the "downstream options" paper is also available.

1.4 Structure of Report

This report is structured as follows:

Part 1 Provides orientation about the Study.Part 2 Argues the case for emissions trading in the EC.Part 3 Examines the legal basis for Community intervention.Part 4 Discusses design options for EC emissions trading.Part 5 Reviews allocation issues for Member States and entities.Part 6 Examines monitoring, verification and compliance issues.Part 7 Focuses on the relationship of emissions trading with policies

and measures.Part 8 Examines technical issues relating to organising the market.Part 9 Draws together recommendations for design options and

suggests next steps.

The Appendices to the Report provide more detailed analysis as follows:

APPENDIX 1: Potential efficiency gains of greenhouse gas emission tradingAPPENDIX 2: CORINAIR and the EPER draft proposal - examples ofharmonised monitoring and reporting

1.5 Key Concepts

This section sets out some key concepts and assumptions used by the StudyTeam.

1.5.1 Emissions Trading

This Study focuses on designing a cap-and-trade programme. This involvessetting a limit on total emissions of GHGs, distributing permits equal toallowable emissions and requiring entities to hold sufficient permits to covertheir emissions during a given compliance period. A trading system can alsobe implemented on a "baseline and credit" basis, whereby participants receive"credits" for emission reductions achieved against a hypothetical baseline.


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The most successful trading schemes around the world are cap-and-tradingschemes, although it is possible to use them in combination.2

1.5.2 EC Emissions Trading

The term "EC emissions trading" is used in the Report to cover a number ofoptions as regards the political level at which emissions trading is organised.Emissions trading could be implemented at the Member State level or at theCommunity level in the form of a Community-wide scheme. It could also beimplemented with a "shared competence" scheme, with Member States andthe Community undertaking tasks according to their respective comparativeadvantages. These options are broad characterisations on a sliding scale ofpossible approaches to balance Community intervention with Member Statesovereignty. The term EC emissions trading is intended to encompass therange of approaches to defining the extent and form of Communityinvolvement in emissions trading.

1.5.3 Kyoto Mechanisms

The Kyoto Protocol requires Parties listed in Annex B to ensure their emissionof GHGs during the commitment period 2008-2012 does not exceed theirassigned amounts (AAs). The Protocol establishes three mechanismsallowing Parties to stay within their listed AAs other than by abating domesticemissions. These mechanisms are emissions trading (Article 17), jointimplementation (Article 6) and the clean development mechanism (Article 12).A number of significant issues about the operation and inter-relationship ofthese mechanisms could be relevant to the design of any domestic (or REIO-wide) trading scheme.3 These include, inter alia, banking of PAAs, substitutionor fungibility, supplementarity, participation by legal entities, liability and theregistries. Rather than speculate about how the results of future internationalnegotiations might impact EC emissions trading, the Study Team haveexamined these issues in the EC context.

1.5.4 Joint Fulfilment

The EC and all Member States have the same Kyoto commitment: an 8%reduction of GHGs listed in the KP from their 1990 levels in 2008 - 2012. EachMember State is responsible for achieving this commitment unless it entersinto a joint fulfilment agreement to redefine its commitment. The EC and itsMember States have stated that they will fulfil their respective commitmentsjointly in accordance with the provisions of Article 4. We have assumed thatthe burden-sharing agreement (BSA) reached at the Environment Councilmeeting on 16-17 June 1998 will form the basis of EC and Member States'ratification of the Kyoto Protocol and that it will become binding as part of thatprocess. The BSA is currently not legally binding and relates only to the 2008-2012 period.


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1.5.5 Pre- and post-2008 Domestic Emissions Trading

The time horizon of the Study was in line with the commitment period for theKyoto Protocol (2008-2012). Like any other Parties to the Protocol, the ECand Member States could establish a trading system prior to 2008. Such atrading scheme(s) would involve caps set and permits issued nationally or onan EC-wide basis because assigned amounts do not become available until2008. The BSA provides an agreed basis for allocations of abatement effortfrom Member States for the 2008-2012 commitment period. A Community-wide emissions trading scheme could commence prior to this period but capsfor Member States would have to be set either nationally or at the Communitylevel for the pre-2008 trading period. Implementation of emissions tradingprior to 2005 could contribute to demonstrating progress towards achievingthe Protocol commitments as required by Article 3.2.

1.5.6 Inter-governmental and Entity Level Trading

Emissions trading can take place at two levels: the level of sovereignexchanges of Parts of Assigned Amount (PAAs) between Parties to theProtocol, and exchanges of emissions permits between private entities.Sovereign exchanges of PAAs can only take place after 2008 when AAsbecome available to Parties to the Protocol.

As Parties to the Protocol, both the EC and individual Member States wouldbe entitled to engage in sovereign level trading. Member States and the ECmust agree whether the EC as a Party or Member States individually asParties will be responsible for trading in assigned amounts as redistributedunder their joint fulfilment agreement. Neither the Protocol nor the BSA fullysettle the issue of whether the EC itself will engage in trading.

Permits for the EC or national emissions trading schemes would be owned bythe entities to whom they are distributed. We have assumed that post-2008,transboundary transfers between private entities will need to be "shadowed"by a parallel and equivalent transfer of sovereign obligations (PAAs) betweenrespective Parties.4 National emissions trading systems established prior to2008 could be co-ordinated to allow entities from one country to use permitsissued by another towards compliance. An EC emissions trading schemeimplemented prior to 2008 could use a common permit recognised by allMember States toward compliance with entity obligations.

1.5.7 Policies and Measures and Common and Co-ordinated Policiesand Measures

Emissions trading is one instrument among many different types of policiesand measures (PAMs) that could be adopted to abate GHG emissions. Otherinstruments include emission taxes, industry standards, efficiencyimprovements and technological innovations. PAMs could be adopted at thenational and Community level. When adopted at the Member State level only


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these policies and measures will be described as "national PAMs". Whenadopted at Community level, such policies and measures will be referred to inthis Study as common and co-ordinated policies and measures (CCPMs).


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2 THE CASE FOR EMISSIONS TRADING IN EUROPE

The Kyoto Protocol is one of the most flexible international instruments todate. It establishes quantified emission limitation and reduction commitments(QELRCs) for Annex I Parties without prescribing the domestic policyinstruments to be used for their achievement. Additionally, the Protocolprovides a range of international mechanisms, which Parties may choose touse to lower compliance costs in place of domestic policies.

The immediate challenge for the EC and Member States, as for other Parties,is to devise an implementation strategy determining how much use to make ofthe Kyoto mechanisms and what domestic policy instruments should be put inplace. The latter could include domestic tradable permit systems, domesticcarbon taxes or direct regulation.

This section suggests that a domestic emissions trading programme withentity level trading across the EC would be a powerful tool to lower the costsof compliance and reduce adverse competitive impacts. It also recommendsthat emissions trading would be a particularly appropriate instrument for aregional economic integration organisation like the EC to deploy as part of itsimplementation strategy.

2.1 Expected Economic Gains from EC Emissions Trading

Emissions trading equalises marginal control costs ensuring that controls canbe achieved at lower costs than would otherwise be the case. The extent ofsuch potential cost savings has not been subject of this Study. The mainconclusions from a review of literature on this subject can be found inAppendix 1.

The studies discussed in Appendix 1 conclude that allowing inter-countrytrades within the EU results in considerable reductions in the overall costs ofmeeting the EC's Kyoto target. A 1998 study by Böhringer et al.5 assesses thewelfare consequences of meeting the Kyoto Protocol targets by the EU viathree different burden sharing schemes, with and without internal carbontrading among EU member countries. For the flat rate reduction scheme andthe BSA scheme, efficiency gains from a policy of tradable CO2 emissionspermits within the EU are around 10% of EU-wide abatement costs. Thesefindings are consistent with those of the Capros GEM-E3 study which foundthe overall costs of meeting an EU target of –10% of 1990 emissionscompared with the case where no inter-country trades were allowed resultedin considerable savings6. But they are lower than estimates from otherstudies7. A Study for the Nordic Council of Ministers reporting the results ofthe Nordic Quota Trade Experiment confirms that significant economicbenefits are available from trading, due in part to the very different energysystems of these otherwise quite similar countries.8 Aggregate costs forDenmark, Finland, Norway and Sweden to stabilise emissions at 1990 levelsby 2000 were reduced by almost 50% (from US $713m to $368m) as a resultof trading. This experiment was implemented as government to government


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trade, with government officials as players who managed to exploit 97% of thepotential gains from trade.

The general conclusions for emissions trading from this and other emissionstrading studies are that aggregate trade benefits are larger (and the carbonleakage problems smaller) if the sectoral and regional scope of the trading islarger (i.e. the larger the number of participating countries, sectors andentities). Additionally, there are more gains the more emission allocationsamong these deviate from the cost-effective distribution of emissions.Aggregate and individual country gains from trading are larger the bigger thespan between buyers' and sellers' costs of abatement.9

These conclusions, and the likely size of these potential benefits, should be ofgreat interest to EC countries. Each needs to determine the extent to whichthey would like to participate in emissions trading and the trading scheme theywould prefer. Post-Kyoto, however, there is little literature on the benefits oftrading to individual Member States and their entities from trading within theCommunity.

All the studies to date indicate that emissions trading within the EC couldproduce significant economic benefits A more systematic comparison of theeconomic, including macro-economic, benefits of emissions trading vis-à-vispolicies and measures would be helpful for guiding future policy-making in thisarea. Such a comparison should also look at the issue of "ancillary benefits"produced by policies and measures, as these are not always taken intoaccount when the efficiency of different policy instruments is assessed.Whilst more efficient than no trading, trading by governments is not the mostefficient form of trading. Governmental trading would equate national marginalcosts of abatement, but this would not equalise marginal abatement costsacross sources within each country.10 Achievement of emissionscommitments at lowest cost requires that marginal abatement costs are thesame for all sources. Access to such abatement opportunities by sourcesshould yield significant efficiency gains, thereby reducing adverse impacts oncompetitiveness.. Reducing adverse impacts on competitiveness is asignificant consideration for Member States and the EC. Trading by entitiesshould reduce costs more than trading by governments alone. Hencecompetitiveness impacts and leakage are reduced further. Theseconsiderations strongly suggest that entity level emissions trading should beavailable across the EC, rather than just in a handful of Member States.

The efficiency of emissions trading would be further enhanced if EC entitieswere free to utilise abatement opportunities outside the EC to achievedomestic compliance. Ensuring equal access to the three Kyoto mechanismsfor all EC sources with limitation obligations will therefore bring additionalefficiency gains. Equal access to use of the Kyoto mechanisms by EC entitieswill also reduce adverse impacts on competitiveness. If supplementarityconstraints are agreed at the international level in respect of one or all of theKyoto mechanisms, these should apply equally to entities in the EC.


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The efficiency gains provided by Annex I-wide trading and a global credits-based system of trading that could be provided by the CDM have beenexamined by a number of recent studies. These studies examine the cost ofimplementing the Protocol through the availability of different trading regimesto countries or groups of countries.11 These suggest that the EU should usethe trading opportunities provided by the Kyoto mechanisms and not confineemissions trading to its Member States. It should be noted that most of thesestudies treat the EC as a single actor, already assuming that trading occurswithin the "bubble".

2.2 Advantages of Emissions Trading as an Instrument

This section explains why a domestic EC emissions trading system would bea particularly apt instrument for the EC to deploy based on policyconsiderations beyond the economic benefits discussed in the previoussection.

Where a quantitative target must be achieved, emissions trading is a moreenvironmentally effective domestic policy option than policy instruments suchas carbon taxes or direct regulation.12 As pointed out by Bohm13, whentradable permits are deployed nationally, a country "cannot" go wrong inattaining compliance with the target prescribed by the Protocol (or BSA),provided there is a robust compliance regime. Regulations focused on settingemissions limits for sources or taxes, by contrast, cannot guarantee aparticular quantitative outcome and may need to be continually adjusted to doso. This would also impose additional administrative burdens.

Emission trading has an additional advantage over command-and-controlinstruments, however smartly designed, that it achieves its targets atminimum costs also under economic variability or if emission reduction coststurn out to be different from those initially thought. The process of cost-minimisation, left to the market rather than the regulator, is endogenous andadaptive. Again this would reduce administrative burdens and create greaterlevels of certainty.

Certainty of environmental outcome, of making sure each Member State hasdone its share, is a weighty consideration for the EC. Under the KyotoProtocol the EC and its Member States are individually and jointly responsiblefor the failure of the joint fulfilment agreement. This fact is a good reason whyit should favour an environmental policy tool like emissions trading which willdeliver pre-specified environmental outcomes.

Finally, an additional factor favouring the use of emissions trading in the ECcontext lies in the fact that emissions trading would make a significantcontribution to the goals of the EC as a REIO, namely the fundamentalobjective and core activities of the EC stated in Articles 2 and 3 of the ECTreaty. Emissions trading can make an important contribution to theprotection of the environment and to the development of the internal market,the free movement of goods, persons, services and capital, and reinforcedcohesion and integration.14


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EC emissions trading would better provide the foundations for a fair andcompetitive market for achieving the Kyoto commitments than a patchwork ofdiscrepant national policies and measures. Of course, the introduction of ECemissions trading poses a number of challenges to existing EC rules oncompetition policy and state aid, particularly those relating to the allocation ofpermits. In any case, the significance of these potential problems must be setin context: emissions trading is being introduced as a corrective, rather than adistortionary measure, to tackle a global environmental concern caused bymarket failure.

2.3 Recommendations

Based on the above conclusions, we make the following recommendations forthe design of an EC emissions trading scheme.

§ On the basis of existing literature and experience, EC emissionstrading should play a significant role in the Community'simplementation strategy for the Kyoto Protocol;

§ An EC trading scheme should allow for entity level trading andbe available throughout all Member States; and

§ Entities in the EC should have equal access to the Kyotomechanisms during 2008-2012.


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3 THE ROLE OF THE EUROPEAN COMMUNITY

3.1 Climate Policy and Community Competence

Not all good ideas can be implemented by the Community. To act, theCommunity must have competence. Climate change is an area of sharedcompetence. This section therefore examines the extent and form thatCommunity intervention in emissions trading might take.

Community competence in environmental policy is defined in theenvironmental provisions of the EC Treaty.15 The need to protect theenvironment is only one justification for enacting Community environmentallegislation. A second justification is the creation of equal conditions ofcompetition, which is necessary for the functioning of the internal market.16

Harmonised legislation adopted at the EC level has often been necessary toeliminate disparities between national environmental legislation which causeunequal competitive conditions for industry. In fact, the level playingfield/equalisation of competition concern across given sectors in all MemberStates has been one of the most important justifications for EC environmentallegislation over the past 25 years.

Applying it in the context of the establishment of emissions trading would benothing new. And in some senses it would be far more justified than in thetraditional environmental directives. This is because unlike emissions trading,these impose uniform emission or quality standards, which generally equalisecosts or establish a fully level playing field to a lesser extent. Additionally, manyof the environmental effects they are concerned with are local, whereas climatechange is an EU-wide and global concern.

On whatever basis it is exercised, Community intervention must respect thesubsidiarity principle. In the current political climate, Member States willaccept Community intervention provided it can be demonstrated to benecessary. Guidance issued by the European Council issued on theapplication of the subsidiarity principle suggests that Community interventionmay be necessary if:

§ The issue under consideration has transboundary aspects whichcannot be satisfactorily regulated by action by Member States;and/or

§ Actions by Member States alone or lack of Community action wouldconflict with the requirements of the Treaty (such as correctingdistortions of competition, or strengthening economic and socialcohesion); and/or

§ Action at the Community level would produce clear benefits byreason of its scale or effects compared with action at the level ofMember States.17

The conclusion of this Study is that each of these criteria can be met tosupport the case for Community action on emissions trading. Climate change


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is a global concern, which cannot be dealt with unilaterally. The abundantbenefits evidenced in Section 2 support Community intervention because thegains depend, among other things, on the regional and sectoral coverage ofemissions trading, i.e. that it be EC-wide and applicable to the same sources.These considerations support a prima facie case for Community intervention.The real issue is the extent and form of such intervention.

3.2 Extent of Community Intervention

Emissions trading could be organised at a number of different levels withvarying degrees of Community intervention. Three options were examined bythe Study Team (see Box 1). It is important to note that these options aresomewhat simplistic and broad characterisations on a sliding scale of possibleapproaches to balancing Community intervention with Member Statesovereignty, and that other characterisations are possible. The options are:

§ A scheme developed at the domestic level, by individual MemberStates, and linked through intra-Community co-operation;

§ A Community-wide scheme which regulates all the essentialelements of an EC-wide emissions trading scheme with limitedregulatory discretion at the national level; and

§ A “shared competence" scheme developed and jointly run by theEC and Member States.

Box 1: Options for levels of implementation

Option 1: Member State led trading scheme

This option involves independent trading schemes tailor-made by each Member State withminimal Community intervention. The Community's role would be limited to makingsuggestions for different design options and maintaining an oversight of national schemes toensure conformity with Community law and to monitor progress with Communitycommitments.

Option 2: A Community-wide scheme

This option would give the Community competence to develop and regulate all the essentialelements of an EC-wide emissions trading scheme. Once agreed at the EC level, MemberStates would implement the scheme in a consistent manner with limited regulatory discretionat the national level.

Option 3: A “shared competence scheme”

This option would involve the creation of a single Community-wide scheme, but one based onshared competence resulting in Member States and the Community undertaking tasksaccording to their respective comparative advantage. Elements that touch on efficiency andbarriers to trade might, for example, be better regulated at the Community level, leavingchoices which do not touch on these aspects to Member States, together with the detailedand day to day regulation.

EC emissions trading requires a certain degree of regulation to avoid barriersto trade and adverse competition effects. The level of Community interventionrequired would appear to go beyond the minimum level of prohibition by EC


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law of unjustifiable national measures which may have a negative impact onthe internal market. Co-ordination with Member States on some aspects, andsome degree of harmonisation on others, would appear necessary. Theelements which could benefit most from some degree of Community co-ordination and/or harmonisation are:

§ Provision of a common unit of trade to underpin Community-widetrade;

§ Criteria for participation of entities to minimise distortions ofcompetition in the internal market;

§ Framework for distribution of emissions allowances to preventviolation of the state aid rules, to prevent indirect discrimination andto minimise distortions of competition;

§ Monitoring, verification and enforcement.

The potential impact of an emissions trading system on competition and trade,both internally and externally, should also be borne in mind. Although thestudy team has found that refusing to recognize as valid permits originatingfrom certain countries or from categories of activities taking place in certaincountries is not likely to infringe on any trade rules. Other aspects of a tradingsystem may.18 This conclusion provides an additional reason for Communityintervention. WTO rules allow customs unions and free trade areas, such asthe EC, to provide, under certain circumstances, preferential treatmentamongst its membership as compared to non-members. Recent WTOjurisprudence also suggests that the WTO dispute settlement system will lookmore favourably on trade related environmental measures that enjoy thesupport of a grouping of countries, than it does on measures imposed by onecountry acting unilaterally. Nevertheless, the careful design andharmonisation of standards for mutual recognition, for incidence of regulation,and for non-discriminatory allocation methods in a manner that is as leasttrade restrictive as possible, provides the best means for avoiding WTOdisputes and for protecting the integrity of an EC emissions trading scheme.

Finally, the fact that Member States have agreed to fulfil their Kyotocommitments jointly strengthens the case for a pro-active, supervisory andassessment role for the Community. This is particularly so in respect of thepost-2008 period when we have assumed that the Kyoto Protocol will be inforce and the BSA will have become a binding joint fulfilment agreement.

The lack of binding commitments for the pre-2008 period could provide ajustification for a lesser Community role. But a number of considerationssupport the need for Community intervention which is comparable for the pre-2008 period. First, the Kyoto Protocol requires Annex I Parties to have made"demonstrable progress" in achieving their commitments – a clause stronglysupported by the EU in negotiations. Secondly, as has been stated, unilateralMember State measures resulting in trade distortions and adverse competitiveeffects may be more vulnerable to legal challenge at the EC and the WTOlevel than a co-ordinated scheme.19 Any type of EC emissions trading schemewill have to curtail demand for fossil fuel, domestic and imported, if it is to beconsidered a success. Success will dislocate vested economic interests who


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may be expected to use every means possible, including trade disputes, toprotect their interests.

The conclusion of our analysis suggests that, at least on the matters indicatedabove, there is a legitimate basis for Community intervention in the form of co-ordination and/or harmonisation. We recognise, however, that the applicationof the subsidiarity principle to EC emissions trading does not lend itself to cut-and-dried conclusions. As with all "shared competence" matters, the extentand form of Community intervention will ultimately be a matter for politicalnegotiations between Member States and Community institutions. Thefollowing recommendations provide a reasoned starting point for suchnegotiations.

3.3 Recommendations

Based on these conclusions, we recommend the following:

§ Substantial competition and trade aspects (internal and external)justify Community action to protect the environment and ensure thefunctioning of the internal market;

§ Community action should provide a common framework for aCommunity-wide scheme based on co-ordination and/orharmonisation;

§ Emissions trading would require co-ordination and/orharmonisation in respect of the following: unit of trade, distributionof allowances, participation of legal entities and monitoring,compliance and enforcement applicable to these; and

§ A "shared competence" scheme with the Community and MemberState acting in their respective areas of advantage appears tostrike an appropriate balance between the need for harmonisationand the subsidiarity principle, and provides a useful point ofdeparture for Member State and EC discussions on emissionstrading.


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4 DESIGN OPTIONS

4.1 Overview of Design Options

The key consideration for the design of any trading scheme is who will berequired to surrender allowances or permits (the "incidence of regulation").20

During the first phase of the Study, three main options were examined:upstream, downstream and a hybrid model as described in Box 2. The meritsof these design options were assessed in accordance with the criteriaprescribed for the Study: cost-efficiency, environmental effectiveness,administrative feasibility, legal compatibility and political acceptability.

Box 2: Upstream, Downstream and Hybrid Options

For all options coverage is initially limited to energy-related CO2 emissions, with sequestrationactivities and non-CO2 gases being added over time.

An upstream scheme requires producers of fossil fuel, processors and transporters tosurrender allowances for the CO2 emissions embodied in fuel processed, transported or soldby them. Participating entities include: refineries, coal preparation plants, some coal mines,gas pipelines, gas processing plants and fossil fuel importers. Nearly all emissions from fossilfuels would be covered.

A downstream approach requires fuel users to surrender allowances for their emissions.Users could include power generators, large industrial users, commercial facilities, householdand car owners. Because direct regulation of millions of individual fuel users is notadministratively feasible, downstream sectoral coverage is assumed to be limited to majorindustrial sectors: electricity, steel, chemicals, cement. Other users are assumed to becovered by national and/or Community policies and measures.

A hybrid scheme would require larger users to surrender allowances for their emissions.Smaller energy users not directly regulated would be covered upstream by requiring fuelproducers to surrender allowances for fuels consumed by users.

A description of these options and a comparison of their merits anddisadvantages is provided below in Table 1 (on the next page).

The Interim Report concluded that an upstream system was the more efficientand environmentally effective option because of its wider coverage. The fewernumber of participants meant it scored highly on administrative feasibility but itmight be more difficult to adopt at the Community level and appears not tocommand political support.21

The Interim Report considered that a downstream system could beeconomically and environmentally effective if sources not covered by tradingwere regulated with effective PAMs/CCPMs and it represents an efficiencyimprovement over the current situation with no trading. The Study Teamrecognised that this conclusion warranted a closer examination of theinterplay between an EC emissions trading scheme and implementation ofappropriate PAMs/CCPMs.


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Table 1: Comparison of Initial Design Options

Upstream System Downstream/PAMsSystem

Hybrid System

Description Fuel producerssurrender allowancesfor carbon processed,transported or sold

Large fuel userssurrender allowancesfor carbon in fuelconsumed; smallusers covered byPAMs

Large fuel userssurrender allowancesfor carbon in fuelconsumed; otherenergy use coveredupstream

Point of Imposition Refineries, coalpreparation plants,some coal mines,natural gas pipelines,natural gas processingplants, fossil fuelimporters

Trading system coversmajor industrialsectors (electricity,steel, chemicals,cement, others)

All those listed for bothupstream anddownstream systems

Options forExpansion

Covers nearly all fossilfuels. Could expand toinclude non-CO2gases.

Other industrialsectors can be addedover time, so couldland use, other gases;high transaction costsif expanded to coversmall sources

Same as upstream.

Options for ExcludedSources

Sequestration, othergases could bebrought in on a projectby project basis orcovered through PAMs

Sequestration, othergases could bebrought in on a projectbasis, but would behard to bring in smallCO2

Same as upstream

Allocation Auction,grandfathering orcombination

Auction,grandfathering orcombination

Auction,grandfathering orcombination

Other Implications Requires closetracking of energyimports, exports

Additionaladministrativecomplexity involved inco-ordinatingupstream, downstreamcomponents

Advantages Comprehensivecoverage of energy-related emissionsimproves economicefficiency,environmentaleffectiveness; may bepossible to phase inone State at a time

Can be tailored aroundexisting measures,phased in over time;more attractive tocompanies and canimprove efficiency ofexisting PAMs

Similar to upstreamsystem in terms ofefficiency,environmentaleffectiveness

Disadvantages An EC-wide schememeans M. Statescannot tailor it,unfamiliar instrument

Low coverage oftrading systemreduces economicefficiency; uncertaintyre: environmentaleffectiveness

Like an upstreamsystem, cannot becrafted or phased in atCommunity level

Despite its many advantages, the team chose not to study the hybrid optionfurther in view of the need to focus on the downstream plus PAMs option, andthe limited time and resources available to the Study Team.


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The accompanying paper, "Design of a Practical Approach to GHG TradingCombined with Policies and Measures in the EC", summarises researchundertaken by the Study Team on the issue of how a downstream schemecould fit with existing PAMs/CCPMs. The paper provides a "strawmanproposal" which sets out one possible approach to designing a "downstreamplus PAMs" system of emissions trading that could be implemented on a"shared competence" basis. This proposal is intended to form the basis forfurther consultations. It is not intended to replace the need for additional moredetailed work on the upstream and hybrid options. This would facilitate futuremore detailed consultations on the design of an EC emissions trading regime.

4.2 Upstream versus Downstream with PAMs/CCPMs

The following section compares the upstream option with a downstream pluspolicies and measures option.22 Both design options are assumed to be "capand trade" trading schemes applying initially to CO2 sources. Both areassumed to be implemented on a Community-wide basis.

For both the upstream and downstream option, an initial cap (or allowableemissions) would have to be set. Tradable permits23 equal to the total ofallowable emissions would then be made available, it is presumed on anannual basis, to participating entities.

The costs to participants of the trading scheme are determined by thestringency of the cap and how it is shared amongst them. The cost-effectiveness of the upstream and downstream options is a function ofemissions coverage (higher coverage reduces the total and average overallcompliance costs) and the costs of including more participants (highernumbers are assumed to increase total administrative costs).

The method of allocation of permits to participating entities (auctioning orgratis) for both options raises complex efficiency, equity and legal issues.Accordingly, this aspect is discussed more fully in the section 5.

As gases other than CO2 are initially excluded for both options, the choice ofpolicies and measures for sources of excluded gases must be addressed forboth options. The same policies and measures used to regulate such gasescould be applied for either an upstream or downstream approach. Options forexcluded gases (methane, N2O, and the long-lived gases) are addressed insection 6 below.

Sectoral coverage is relevant to the design of the downstream option becauseit is not feasible to cover sectors comprising small users like transport andhouseholds.24 Because the transport sector accounts for 26% and thehousehold for 22% of EC CO2 emissions, the more limited coverage of thedownstream option means it is not as economically and environmentallyeffective as an upstream option. The "threshold" issue for the inclusion of asector in the trading system is the average size of a user within that sector. Asin an upstream system producers tend to be few in number and all relativelylarge this is really only an issue relevant to a downstream system.


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Equal treatment refers to PAMs/CCPMs which impose the same costs pertonne of CO2 on entities not participating in trading. Comparable treatmentmeans that all sources in the EC face at least the same costs as thoseimposed on the entities included in the trading programme.

The analysis in the accompanying paper on the "strawman proposal"suggests that shared competence can increase efficiency and reducecompetitiveness concerns if it promotes more consistency of approachbetween Member States over the issues discussed above, in particular inrelation to the stringency of the cap, the sectoral coverage, the participationthresholds; and equal and comparable treatment for excluded sectors.

Harmonisation of these elements would certainly increase the cost-effectiveness of a downstream system and reduce competitiveness concerns,perhaps making it somewhat comparable in these respects to an upstreamapproach. But they would do so at the expense of the most attractive aspectsof the downstream approach: its flexibility and deference to sovereignty-basedconcerns. A downstream system implemented with a higher degree ofCommunity intervention on these elements is likely to encounter the samepolitical and legal challenges that would confront the development of aCommunity-wide upstream system.

4.3 What Level of Community Diversity Is Possible?

Environmental policy should maximise efficiency and lower the administrativeburdens of the most environmentally effective solutions. But optimumsolutions are rarely implemented. Regulatory design takes place withininstitutional structures and political constraints. And environmental protectionis one social goal amongst many. Political dynamics and Communitystructures define limits for the EC and Member States to pursue independentaction, internally and externally. In this context, agreement of a Community-wide upstream or downstream system may not prove possible in the time-frames envisaged for EC ratification of the Kyoto Protocol.

Should such an agreement prove unlikely it would be preferable for theCommunity to establish a common framework for emissions trading allowingMember States to opt-in to a Community-wide emissions trading scheme. Thecommon framework would provide co-ordination on essential elements of atrading scheme (described in Section 3.2). Such a framework would reducethe risks faced by individual Member State schemes of falling foul ofCommunity law on competition and state aid rules.25 For example, the Danishtrading scheme, due to commence in 2000, is currently under Commissionscrutiny to ensure that it is not a covert measure to subsidise Danishelectricity production.

If Member States go ahead with trading, it would be desirable for theCommunity, rather than the individual Member States concerned, to establishappropriate practical modalities and ensure that transaction costs do notoverwhelm gains. US experience indicates that transaction costs can be a


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considerable deterrent to trading. Economies of scale and the Community'smandate to promote market integration and the internal market suggest thatthe development of such modalities would be better done at the Communitylevel. If successful, it is likely that more Member States (and for futurecommitment periods, the accession countries) may wish to opt-in to thissystem, making it more comprehensive over time.

4.4 Recommendations

§ An upstream approach rates more highly than a downstreamapproach on efficiency, environmental effectiveness, pro-competitiveness and administrative feasibility grounds;

§ A downstream approach with policies and measures still providesefficiency and environmental gains, and can improve the efficiencyof existing policies and measures;

§ Establishing either option on a Community-wide basis providesmore benefits than if only some Member States participate;

§ If agreement cannot be reached on a Community upstream ordownstream option, the Community should devise a commonframework for trading, allowing Member States and, in due course,accession countries, to opt-in over time.


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5 ALLOCATION

The term “allocation” is used in a number of senses. First, it refers togovernment decisions about which sectors will be regulated to achieve aparticular environmental outcome. Participants in a trading scheme are"allocated" responsibility for reducing emissions by a given amount. Sectorscovered by policies and measures bear "implicit" responsibility for contributingto a national target, but it may be difficult to express their obligation in aquantified manner.

Allocation is used in a second sense to refer to the distribution of permits orallowances to entities participating in a trading scheme. Permits can bedistributed for free, with the quantum being determined on past emissions orcurrent output. Alternatively, they can be auctioned. For clarity, this secondsense will be referred to as "distribution".

A third layer of allocation issues arises from the delineation of responsibilityallocated in respect of Article 3 commitments contained in the Kyoto Protocoland the redistribution of these responsibilities contained in the EC burden-sharing agreement.

5.1 Allocation Responsibilities under the Kyoto Protocol and theBurden Sharing Agreement

The Parties to the Convention have not yet clarified the terms under whichAnnex I Parties may transfer their AAs under the Protocol. In particular,Parties have yet to agree rules indicating whether to invalidate parts of AAstransferred by a Party if that Party is later found to have exceeded its adjustedAA. These rules on so-called “buyer and seller responsibility” are still underdiscussion. Even if this issue was clarified for the Parties as a whole, thereare unique issues relating to the division of responsibilities between the ECand Member States.

The following issues should be clarified as part of the competence issuesrelating to the submission of a joint fulfilment agreement for ratificationpurposes:

§ Will PAAs be denominated as EC or Member State PAAs;§ Will the EC engage in trade, or only Member States;26 and§ In what circumstances will Member States be allowed to use the

Protocol's banking provisions, and to whose account will thesebe deposited?

The BSA does not resolve these issues. The agreement redistributes theburden of abatement efforts among Member States, but is premised on theadoption of further policies and measures by the EC that remain to beelaborated.


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5.2 Allocation Responsibilities between Sectors

Allocation issues at the national level touch on competition and tradeconcerns which are the economic heart of the EC Treaty. Politicalconsiderations might lead governments to favour action in some sectors morethan others. Member States may, for example, exempt particular sectors fromregulations altogether, set unchallenging sectoral goals and/or be lax in theenforcement of goals. Governmental decisions may raise the costs ofproduction of one firm more than that of another firm in the same industry inanother Member State. Selective inclusion of sectors could give rise tocompetitiveness concerns fundamental to the functioning of the internalmarket.

Under EC law governments and firms are barred from carving out marketsprotected from the reach of others, and from favouring their nationals. Froman efficiency perspective, subsidisation of domestic sectors is usually at theexpense of others and only makes sense if long-run economic advantagesflow from the short-run subsidies.27 In real life, indirect state aid through lax orlack of regulation for favoured sectors are far more pervasive than economistspredict. They are rarely conferred directly, and tend to be disguised in theform of criteria the application of which leads to advantages for nationals. Adecision to prevent entity level trading, coupled with negotiated agreementswith domestic industry, could have the indirect effect of "shielding" domesticindustry from the intensity of regulations faced by other domestic sectors andcompetitors in other Member States. The potential for Member States to“shield” sectors of domestic industry is larger if EC emissions trading were tobe confined to the inter-governmental level.

The comprehensive coverage of an upstream system gives government fewopportunities for conferring preferential treatment. A downstream tradingsystem, by contrast, does the opposite. It gives Member States theopportunity to design a system to boost the position of exporting sectors(which are likely to be particularly sensitive to international competitivenessconcerns).28 A Community emissions trading scheme, with agreed sectoralcoverage, will allow the discussion on the protection of specific domesticinterests to take place at the EC level. This would provide better conditions forequal competition between participants.

It would also provide greater transparency and legal certainty. Competitionrules are largely enforced by the Commission. The Commission isempowered to enact subordinate legislation granting individual and groupexemptions from the competition provisions. It can require undertakings toterminate infringements and can impose fines. Its work would be facilitated bythe adoption of agreed rules on how it should approach competition issues inthe new markets.

5.3 Distribution of Permits to Entities

Both upstream and downstream systems involve the distribution of permits orallowances to entities. Permits can be auctioned or given for free on the basis


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of past emissions or output.29 A key issue for the design of an EC emissionstrading scheme is the level at which decisions about distribution should betaken.

Auctioning allowances is an unambiguously more efficient thangrandfathering, assuming auction revenues are not wasted. It is also thesimplest. Auctions can produce a "double dividend" if revenues are used toreduce tax distortions in labour markets, increase returns to capital and henceattract more investments. These benefits are long-term and spread out acrossthe economy, so all benefit - arguably a fairer way to spread the benefits of anewly created resource. Using auctions and recycling revenue through taxcuts might reduce the cost of GHG regulation by 95% from the cost ofgrandfathered allowances.30

Grandfathering is less efficient, but politically far more attractive because itallows wealth to be transferred to specific firms and individuals.Grandfathering can be targeted to compensate owners of stranded assets orworkers with obsolete skills. It can also be used to generate political supportfor emissions abatement. Auctioning and grandfathering are not mutuallyexclusive and most countries will probably use a combination of both methodsto allocate allowances.

The key issue of at what political level decisions about allocation should bemade turns on the magnitude and likelihood that significant adversecompetition issues may occur.

Most economists argue that competitiveness between firms is not affected bythe free distribution of allowances because this provides a one-off lump sumpayment, which makes the recipients wealthier without altering their marginalcosts of abatement. It is arguable whether this holds true in all situations.Giving the allowances for free provides windfall profits for current owners.Depending on their access to capital, they may use this to make investmentswhich confer a competitive advantage, although theory would suggest thatthey (or their shareholders) would invest in the most profitable opportunitywherever this existed. Regardless of this, there are clear equity issues atstake. If one Member State distributes allowances for free to its steel sectorwhilst the steel sector in another Member State has to buy them, the latter areunlikely to consider themselves as being treated equitably.

Even if the argument that grandfathering does not affect competitivenessbetween firms is accepted, its implication, that Member States should be leftfree to make decisions about distribution, must be set in the context of ECcompetition law. The aim of the competition provisions of EC law is to securea level playing field for competitors wherever they are located in the EC. Thisnotion goes beyond the narrow conception of competitiveness whicheconomists focus on. The notion of competitiveness in the context of EC lawis much broader, in part because market integration has been elevated tobeing a goal in itself; and in part because the competition provisions of theTreaty have also been informed by the notion of "fair competition".31 EC rulesprohibiting discrimination between Member States' nationals and regulating


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the use of state aids will continue to have applicability to distribution relateddecisions by Member States.

Although entity level distribution raises competition concerns, decision-makingshould remain at Member State level for three reasons:

§ Member States are better placed to make decisions about howto combine auctioning and grandfathering to maximise efficiencyand political support;

§ The magnitude of adverse effects on competition resulting fromdistribution to particular entities is likely to be much smaller thanthat of those arising from the preferential treatment of wholesectors across the EC; and

§ Any potential incompatibility with Community law based oncompetition or state aids can be checked by the Commission.

This could be done on an ex ante basis through the specific guidance issuedby the EC on how allocations (on the basis of auctions or grandfathering)could be undertaken in conformity with Community rules, as well as throughthe normal procedures.

5.4 Recommendations

§ Issues relating to the allocation of responsibilities between the ECand Member States should be clarified as part of the burdensharing agreement when ratifying the Kyoto Protocol;

§ Selective inclusion of sectors by Member States is likely to give riseto significant, macro-economic competitiveness concerns whichshould be avoided by mandating trading for certain sectors andagreeing Community-wide caps;

§ Where possible, permits should be auctioned and revenuesrecycled; and

§ Distribution decisions should remain at the Member State levelsubject to the Commission playing a more active watchdog role toensure compliance with competition and state aid rules.


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6 COMPLIANCE RELATED ISSUES

6.1 Member State and Community Level Tiers

A Community-wide emissions trading scheme will require a system formonitoring, reporting, verification and enforcement at the Member State andCommunity level. At the national level the following elements would beneeded to assess compliance by entities:

§ monitoring of the emissions of entities;§ reporting these emissions to the national competent authority;§ verification of compliance with the monitoring and reporting

requirements; and§ enforcement of the monitoring and verification requirements and

other elements of the trading regime.

At the EC level the following elements are needed in order to ensurecompliance by individual Member States:

§ reporting of national emissions to the EC controlling authority;§ verification of national reporting; and§ enforcement of the reporting requirement, the national trading

cap and other elements of the trading regime.

The linkages and implications of demonstrating compliance with the Kyotoprotocol should not be overlooked.

6.2 Ensuring Compliance at the National Level

Member States should be responsible for assessing compliance by theirentities. This should be done as far as possible using existing administrativeand legal structures. A certain degree of harmonisation of Member Statemonitoring, reporting and verification rules, as well as their enforcement,appear to be necessary for the effective functioning of the regime.

6.2.1 Rules on monitoring and reporting

Harmonised methods to improve the quality and comparability of monitoringand reporting information from entities to Member States is necessary. Todate, most of this work has been co-ordinated through the EuropeanEnvironment Agency (EEA), most notably in its elaboration of the CORINAIRsystem, which is described in more detail in Appendix 2.

More recently, the Commission has prepared a draft proposal for a EuropeanPollutant Emission Register (EPER). Such a register could be important in thedevelopment of harmonised monitoring and reporting guidelines. The EPER isan important component of the IPPC Directive, which provides for theelaboration of an EPER in its Article 15. If adopted in its current form, theEPER will provide information on the GHG emissions above a certainthreshold from all single installations covered under the IPPC regime followinga standardised reporting format. If an EC emissions trading system is to be


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based on or closely linked with the IPPC Directive, then the EPER couldprovide an important first step in the necessary harmonisation of monitoringand reporting methods.

6.2.2 Rules on verification

An EC emissions trading system should in principle leave verification ofcompliance by emission sources to Member State authorities.

Differences in verification efforts between Member States are howeverincreasingly seen as distorting the internal market and reducing theeffectiveness of EC environmental legislation. In response to this, theCommission adopted on 12 December 1998 the Proposal for a CouncilRecommendation Providing for Minimum Criteria for EnvironmentalInspections in the Member States.32 The current proposal, which is still in avery early stage of the decision-making procedure, aims at harmonising anumber of key elements in Member States’ verification and inspection efforts,such as the requirement to elaborate plans for environmental inspections andcriteria for site visits.

There is thus a clear need for a harmonisation of minimum verificationrequirements. This harmonisation could, for instance, encompass therequirement to grant inspection competencies to the verifiers, require aminimum number of site visits, and allow for on-site control measurementsand access to files and data. To reduce administrative burdens, MemberState authorities may want to employ private sector auditors in the verificationprocess. This could, for example, be based on the experience gained underthe Community’s Eco-Management and Audit Scheme (EMAS).33 EMASprovides for a system of accredited environmental verifiers. These verifiersare accredited by the Member States on the basis of Community criteria.

6.2.3 Enforcement

The project team proposes a robust enforcement regime for compliance bythe emission sources in order to ensure compliance with:

§ the monitoring, reporting and verification requirements; and§ the requirement to surrender allowances at the end of each

compliance period.

Non-compliance with the monitoring, reporting and verification requirementscould result in exclusion of the source from (parts of) the trading regime.Financial penalties could be imposed on top of, or in lieu of, the above,depending on the severity and frequency of non-compliance.

Non-compliance with the requirement to surrender allowances at the end ofeach compliance period should be addressed through strong, automaticfinancial penalties that far exceed the price of allowances. US experiencesuggests that strong penalties will provide an important incentive forparticipating sources to prevent non-compliance and stimulate trading.


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To avoid gaming, a Community-wide trading system should ultimately beunderpinned by minimum penalties in Member States. This is a politicallysensitive area, but Member States with weak enforcement and low penaltiesneed to be aware that low penalties for non-compliance within their jurisdictionmay encourage may encourage greater levels of non-compliance within thoseMember States, endangering the Member State compliance with its cap.

6.3 Ensuring Compliance at the Community Level

6.3.1 Implications of Article 4, Kyoto Protocol

For the 2008-2012 period, the Community's internal compliance frameworkmust operate in the context of the Kyoto Protocol. The Protocol allows the ECand Member States to achieve their commitments through joint fulfilment(Article 4). The EC and Member States shall be deemed to have met theindividual emission reduction commitments if their combined total of GHGemission reductions is equal to the 8% reduction target for the EC as a whole,laid down in Annex B of the Kyoto Protocol.

If the EC fails to achieve its Annex B target, Article 4.6 provides for joint andseveral liability for the EC and Member States. In the event of non-compliance, each Member State will be held responsible in two different legalcapacities at the international level. Once in its capacity as a sovereign stateand once in its capacity as a member of a RIEO, jointly with all the othermembers. The extent of the responsibility that each Member State and the ECwill bear is in a non-compliance situation is as follows:

§ Member State as sovereign Party: the individual target specifiedin joint fulfilment agreement.

§ Member State collectively as REIO Members: the Collectivetarget34

§ European Community: Responsible for the collective target inaccordance with the declaration of competence

The possibility that individual Member States may need to demonstratecompliance with their revised targets internationally requires that MemberStates should also maintain a national inventory and registry of emissions andtrades, based on harmonised rules. A separate EC inventory and registrycould easily be composed on the basis of these national inventories andregistries.

The question of what, if any, mechanisms the EC might have to use to bring aMember State into compliance has not been addressed much internationallyor within the EC. It is possible, for example, for the EC to hold a collectivereserve on behalf of all Member States. It is also possible to envisage the ECbeing sanctioned to buy AAs (or Certified Emission Reductions (CERs) orEmission Reduction Units (ERUs)) on the market if it looks like the collectivetarget may not be met. The funds for doing so might be imposed by way of


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automatic fines or deducted from the EC budget provided by the "guilty"Member State(s).

The issue of who would bear responsibility for non-compliance within the ECin respect of the failure of the burden-sharing agreement has not beenaddressed by Member States. The above options could be modified to applywithin the EC. Recourse to the European Court of Justice remains an optionas discussed in the next paragraph.

6.3.2 Reporting and verification of national emissions

If a Community-wide system is implemented, Member States will need toreport the total of national emissions covered by emissions trading to theCommunity. If harmonised monitoring and reporting requirements for singlesource emissions are in place nationally, this reporting should be relativelystraightforward. The EPER (Discussed in Appendix 2) or a similar databasecould serve for reporting national emissions. The reporting system wouldrequire standardised reporting of all GHG emissions by participating sources,which would then be fed into the Community database. At the end of eachcompliance period the single source GHG emissions for each installationcovered by emissions trading would simply have to be added up for eachMember State. The result would be the aggregate Member State’s GHGemissions from installations covered by the trading system during thatcompliance period.

A mechanism for the verification of Member State emissions is required. Thiscould be subject to one or more of the following:

§ In-depth review process of Member State application of thetrading system;

§ occasional spot checks by a Community ‘inspectorate’;§ independent review of Member State application of the trading

system (in line with EMAS).

In any case, the system will need to be in conformity with the post-2008requirements for trading under the Kyoto Protocol.

6.3.3 Enforcement against Member States

Member States could fail to comply with procedural requirements, such asreporting, or else fail to reach their cap. A range of compliance responseswould be needed to address different types of non-compliance. Eligibilityconditionalities for international emissions trading proposed by the Communitycould apply equally to internal REIO trading. Restrictions on a Member State’sright to participate, as long as it does not remedy the non-compliance and/orfines, could be imposed. The latter could be particularly appropriate and couldbe used to finance compliance measures as well as being levied at levelswhich are likely to deter non-compliance.


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The possibility of imposing high fines on Member States for non-compliancewith Community law is not new within the EC. Under current Community lawCommission has the primary responsibility for the correct application ofCommunity law35. The main procedure the Commission uses to check thisapplication is the infringement procedure, laid down in Articles 226 and 228 ofthe EC Treaty. Since 1993 this procedure also allows the EuropeanCommission to request the European Court of Justice to impose a lump sumor penalty payment upon Member States for violation of Community law. TheCommission now regularly requests the imposition of fines on Member States.The fact that so far not a single fine has actually been imposed proves theirdeterrent effect. The average length of the infringement proceedings doeshowever make them unsuitable as the central compliance mechanism for aCommunity emissions trading system.

6.4 Recommendations

§ The compliance components of international, EC and MemberState trading systems should be mutually reinforcing to avoidduplication of effort and inconsistency of approach.

§ The draft proposal for a European Pollutant Emission Register(EPER) is a step in the right direction for harmonisation ofmonitoring and reporting guidelines for entities;

§ An EC emissions trading system should leave verification ofcompliance by emission sources to Member State authorities;

§ A Community-wide trading system should ultimately beunderpinned by minimum levels of penalties in Member States;

§ The possibility that individual Member States may need todemonstrate compliance with their revised targets internationallyrequires that Member States maintain their national inventory andregistry. A separate EC inventory and registry would appear to beof little value;

§ The question of what, if any, mechanisms the EC might use tobring a Member State into compliance should be addressed.


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7 RELATION TO COMMON AND COORDINATION POLICIESAND MEASURES

Emissions trading is one instrument among many different types of policiesand measures that could be used to mitigate climate change. A key issue ishow emissions trading will fit with existing and planned PAMs/CCPMs.36 Thissection examines the compatibility of existing and planned CCPMs,highlighting gaps and synergies.

In general terms, the efficiency of existing PAMs/CCPMs will often beimproved by the addition of a trading system. Research and developmentprogrammes and efforts to overcome market and institutional barriers blockinggreater diffusion of technologies also tend to complement all kinds ofemissions trading. If trading is put in place first, policies and measures suchas energy and carbon taxes, negotiated agreements, standards (e.g.,buildings, appliance and minimum renewable energy levels) and subsidiesand tax credits, may reduce the efficiency of the trading system. Of course, iftrading is introduced first, it is also possible that fewer such policies andmeasures may need to be adopted.

7.1 Compatibility with Existing Instruments

7.1.1 Monitoring Mechanism

The Monitoring Mechanism37 is the EC’s instrument to monitor greenhousegas emissions by the Member States and to evaluate the progress ofindividual Member States, and the European Community as a whole, towardstheir UNFCCC and KP targets. Apart from providing an instrument to monitorand evaluate progress, the monitoring mechanism also obliges MemberStates to “devise, publish and implement” national programmes for limitingtheir emissions of greenhouse gases in order to “contribute to” the fulfilment ofthe limitation or reduction targets in the UNFCCC and the KP.

The proposed emissions trading system appears to be fully compatible withthe EC Monitoring Mechanism. It focuses on aggregate emissions rather thanon emissions at entity level, which would be required for emissions trading. Itwill, nevertheless, play a useful role in the development of further assessmentmechanisms for the EC to ensure that it is on track to achieve its Kyoto target.

7.1.2 Integrated Pollution and Prevention Control

The Integrated Pollution Prevention and Control (IPPC) Directive seeks toregulate emissions in the air, water and land through requiring an integratedpermit for categories of industrial activities listed in its Annex I.38

Each IPPC permit is to set out emission limit values (ELVs) for pollutants thatare emitted from the particular installation. GHG emissions need to becovered in the IPPC permit if these GHGs are “likely to be emitted from the


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installation concerned in significant quantities”. IPPC permits are issued byMember State authorities. The Directive requires the ELVs and otherparameters in the permit to be based on “best available techniques."Authorities issue permits on the basis of, inter alia, “the consumption andnature of raw materials (including water) used in the process and their energyefficiency… ”.

IPPC could reduce the scope for trading somewhat because obligatory energyefficiency measures could reduce the demand for credits by these sources. IfELVs for one or more GHGs were contained in the IPPC permit, there couldbe a direct conflict with emissions trading. Companies could argue that theydo not need to buy an emissions permit for the GHG covered by their IPPCpermit, as their emissions would already be covered and allowed by the IPPCpermit. GHG emissions covered under emissions trading should thereforeeither be excluded from the IPPC permit or given a separate ‘tradable’ status.The IPPC Directive also provides the basis for a harmonised collection of dataof emissions from individual sources. Article 15 of the IPPC Directive requiresthe publication once every three years of an inventory of principal emissionsand sources, the European Pollutant Emission Register (EPER), on the basisof the data supplied by Member States (see Appendix 2).

7.1.3 Negotiated Agreements

In 1998 the European Commission and the European AutomobileManufacturers Association (ACEA) reached an environmental agreement onthe reduction of CO2 emissions from passenger cars, known as the "ACEAAgreement". Under this agreement, car manufactures have committedthemselves to substantially reducing new car CO2 emissions, throughtechnological innovation, by approximately a third of the average emissions ofnew cars currently being sold in the EU. Twenty per cent of this reduction is tobe achieved by 2008, and further cuts will be made in view of 2012. Recently,similar agreements have been achieved with the Japanese (JAMA) andKorean (KAMA) car manufacturers. These negotiated agreements werenegotiated with the understanding that they would provide a “complete andsufficient substitute” for other Community regulatory measures for carmanufacturers aimed at limiting fuel consumption or reducing CO2 by cars.

Agreements with a similar clause are completely incompatible with tradingbecause they indicate that firms do not wish to be regulated. In the short-term,however, negotiated agreements can play an important transitional role inestablishing emissions trading, particularly in the pre-2008 period in whichthere is currently no binding EC cap. This is because the they can:

§ Get industry moving while laggards catch up;§ Provide information to regulators relevant to determining future

allocations ; and§ Give industries incentives to join trading.

Further agreements might be negotiated in this context.


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7.1.4 Taxation of Energy Products

In 1997 the Commission adopted a new proposal for a Directive onRestructuring the Community Framework for the Taxation of EnergyProducts.39 The proposal broadens the current scope of EC minimum taxrates beyond mineral oils, to cover all energy products, including mineral oils,natural gas and solid fuels (coal, peat, lignite), when used for heating or motorfuel, as well as electricity. The proposal does not of itself introduce aCommunity energy or carbon tax. Rather, it imposes minimum levels oftaxation on energy products (including electricity and heat generated duringthe production of electricity) to be applied by Member States.

The proposal has proved controversial and its adoption is uncertain. If theproposal is adopted, it would cover many of the activities within the scope ofemissions trading. There is no incompatibility between the goals of thisinstrument and emissions trading. From an environmental perspective,regulation by the energy product tax and emissions trading may be thought ofas a "belt and braces" strategy, but could impose additional costs forparticipation.

7.1.5 Large Combustion Plants Directive

The Large Combustion Plants Directive (LCP Directive) is a daughterDirective to Directive 84/360/EEC on the combating of air pollution fromindustrial plants, which is currently being replaced by the IPPC Directive. TheDirective should thus be seen as one containing specific emissionrequirements for certain types of installations under Article 18 of the IPPCDirective, to which the provisions of the IPPC Directive are to be applied. TheLPC Directive requires Member States to set emission limit values foremissions by large combustion plants designed for the production of energyand those which make direct use of the products of combustion inmanufacturing processes. The Directive in principle only requires the settingof ELVs for sulphur dioxide (SO2), Nitrogen Oxides (NOx) and dust. Althoughits Article 4(3) allows the inclusion of other pollutants, these will now beintegrated in the general IPPC permit.

The LCP Directive does not overlap with the proposed emissions tradingsystem. Possibilities for linking the LCP and emissions trading exist. LargeCombustion Plants will be one of the main categories of industry to becovered by the emissions trading system. The LCP Directive containsextensive provisions for monitoring emissions, which also provided one of thefoundations for the CORINAIR system (discussed in Appendix 2). Theexperience with monitoring of emissions, as well as the reporting systemsdeveloped under the LCP Directive, may provide important information for thedevelopment of similar requirements under emissions trading.

7.1.6 CCPMs to Cover Non-CO2 Gases


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The design options considered in this Study have focused on CO2 emissions.Other gases and sources could be bought in over time. The followingmeasures are addressing, or have the potential to address, emissions fromthese gases.

The IPPC Directive covers other GHGs when these are emitted in significantquantities, requiring ELVs to be set by Member States. The compatibilityissues would be the same for these gases. The Landfill Directive40, adoptedthis year, inter alia, aims to minimise emissions of methane (CH4) from landfillsites. It limits the amount of biodegradable waste to be dumped in landfills,thereby reducing the emissions of CH4 from landfills. It will also significantlyreduce CH4 emissions from landfills by requiring its the collection andtreatment or use. When the Directive is fully implemented, the emission ofCH4 from landfill sites will be eliminated or reduced to a minimal level. Therewould thus be no need to include this sector in emissions trading.

Possible future instruments include reforms in the Common Agricultural Policythat would reduce GHG emissions. The Commission has furthermore finisheddata and scoping studies on the emissions of hydrofluorocarbons (HFCs),perfluorocarbons (PFCs) and Sulphur hexafluoride (SF6) and is preparingpolicy responses. Their compatibility cannot be addressed at present.

7.1.7 Carbon Taxes

Issues raised by carbon taxes are covered in more detail in the accompanyingpaper on a downstream option. Five Member States have taxes or areplanning the introduction of one (Denmark, Finland, Sweden, the Netherlandsand the UK). Taxes can be a "stick or a carrot". In the UK, companies areentering into negotiated agreements, which would make them participants in atrading system to avoid payment of the Climate Change Levy. If set at a highenough rate, firms may want to opt-in to trading. These examples suggest thatfor Europe, national taxation may be an important regulatory instrument in itsown right and as well as a spur to trading.

7.2 Recommendations

§ Most existing CCPMs, such as LCP, the Monitoring Mechanismand energy taxation, would not significantly conflict with anemissions trading scheme.

§ The possible inclusion of GHGs in IPPC permits and the IPPC’senergy efficiency requirements are a significant exception. Theseelements may need to be reconsidered if trading wereestablished.

§ Voluntary agreements conflict with emissions trading if they takeentities outside of the regulatory sector. In the short term they canassist in the introduction of emissions trading because they allowprogressive industries to come on board and reveal information toregulators about how allocation can take place.


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§ Development of new CCPM initiatives should be undertakenurgently, in particular, to regulate "gaps" such as the long-livedgases.

§ National taxes remain a flexible and effective tool for spurringinterest in climate change.


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8 TECHNICAL ISSUES RELATING TO ORGANISING THEMARKET

8.1 Technical and Operational Issues

Establishing emissions trading involves a number of technical andadministrative issues which do not impinge on the choice of system design.41

Approaches to these common issues are outlined below.

§ Unit of trade§ Unit of measure§ Change to Global Warming Potential (GWP)§ Calculation of energy-related CO2 emissions§ Duration of compliance period§ Permit life§ Credit creation§ Allocation of permits to new sources§ Allocation of permits from sources that cease to operate§ Auction design§ Auction and gratis allocation§ Emissions Registry

Aspects of monitoring, reporting, verification and enforcement are alsocommon features of both the upstream and downstream but as these involvesome sensitive issues of Member State and EC competence, they have beendealt with in other sections of the Report.

Unit of trade: After 2008, trade could be based on AAs or on nationallyissued permits. The former appears to involve the direct handling of PAAsissued to sovereign Parties by legal entities. The latter would require privateinternational transactions to be shadowed by a parallel and equivalentsovereign trade respecting the public international nature of the KyotoProtocol. We have assumed that the legal compatibility of the direct AAoptions will be too difficult to resolve. Accordingly, trade for entities innationally issued permits or allowances is recommended. The EC andMember States need to clarify who will exercise sovereign rights over AA andin what circumstances.

Unit of measure: Permits should be issued in metric tonnes of CO2equivalent to ensure compatibility with the Kyoto protocol.

Change to GWPs: GWPs should be those adopted by the Kyoto Conferenceof the Parties (COP-3) in 1997.

Calculation of energy-related CO2 emissions : Energy related CO2emissions can be estimated quite accurately from the quantity of energy usedby fuel type multiplied by an appropriate emissions factor.


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Duration of compliance period: This refers to the period for whichparticipants in an emissions system report their emissions and for whichentities must match emissions with permits surrendered. The Kyoto Protocoland BSA establish a five year compliance period. For national systems, a oneyear period may be more appropriate and in keeping with the majority of othertypes of environmental regulations.

Banking: Allows participants to save unused permits for future complianceperiods giving them additional flexibility. Pre-2008 permits cannot be bankedfor use against Protocol commitment unless agreed.

Permit life: Should permits expire or have an indefinite life. If not, whatshould their duration be? Allowing permits to be used in future commitmentperiods gives them greater value, increasing their current price and thusensuring higher levels of emission reduction in current periods. Butenvironmental and political considerations may speak for limiting their life to aspecified period.

Credit creation: It is possible to include sequestration activities through a"credit and baseline" programme. We have not addressed how sequestrationactivities may be included in the trading system.

Allocation of permits to new sources: Permits for new sources could beavailable through auctions or the regulator, particularly if access to capital isfelt to be a significant issue for new entrants.

Auction design: An auction can allocate emission reductions efficiently,maximise revenue to governments and reveal information about marginalcosts of abatement. Monthly auctions would suffice to reduce cash flow needsand meet firms' needs. An active secondary market would allow firms to buyalmost any quantity of allowances at any time. Almost any well-organisedauction will operate in a satisfactory way, but some have more advantagesover others.42 An ascending-clock auction is preferable because it provides areliable process for price discovery, yields a single market-clearing price,minimising collusion and market power related problems, and is easier toimplement than other options.

Emissions Registry: A system to track transfers of permits is needed at thenational level for each country.


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9 CONCLUSIONS

The purpose of this Study was to design options for an emissions tradingsystem for GHGs in the EC. A diversity of options is possible. Theseencompass, on the one hand, a centralised scheme that would cover virtuallyall economic activities in Europe (Community-wide upstream option) and onthe other, a loosely co-ordinated scheme between a handful of MemberStates with a limited number of sources (a decentralised, downstreamapproach).

It was not feasible to examine each possible option in depth. The key choicesturn on what degree of co-ordination or harmonisation by the EC isconsidered justified and desirable by Member States, and what level ofcoverage can be realistically achieved.

This Report concludes that there are significant environmental and economicbenefits of an EC-wide emission trading scheme which merit a greater role foremissions trading in the EC's implementation strategy.

These benefits, competitiveness concerns and the Community's uniqueinternational responsibility for achieving the collective commitments of the ECand its Member States under the Kyoto Protocol justify Communitycompetence on emissions trading.

A Community-wide upstream approach would capture an outstanding level ofcost-effective GHG reductions compared with a downstream approach.Adoption of an upstream approach is likely to prove difficult given vestedinterests and institutional and political obstacles.

A Community-wide downstream approach would still result in considerableenvironmental and economic gains, making a significant contribution to theimplementation of the Kyoto Protocol and at the same time respecting themajority of existing policies and measures.

Subsidiarity suggests that Member States should take the lead on entity levelallocation of permits, monitoring, reporting and enforcement issues. Sectoralcoverage, stringency of caps and participation of entities raise significantcompetition and trade law issues demanding Community intervention toprotect the integrity of the internal market and curb violations of fundamentalCommunity laws promoting competition.

At crucial moments of the international climate regime, the Community and itsMember States have courageously stepped forward to point the way and leadby example. That step right now is the elaboration of a credibleimplementation strategy for the Protocol. Emissions trading could provide themetric to judge the efficacy of other instruments.


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APPENDICES


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APPENDIX 1: Potential Efficiency Gains of Greenhouse Gas EmissionTrading

Note by Onno Kuik, IVM, Netherlands, January 2000

This Study has assumed that greenhouse gas emission trading amongsources in different EU Member States will produce cost savings, therebycontributing to cost-effective implementation of the emission reduction targetsof the Kyoto Protocol. The extent of such potential cost savings has not beenthe subject of this study.

This section reviews some earlier studies in order to give a broad indication ofpotential cost savings. This is important, not only from an economic orefficiency perspective (will the benefits of action exceed the costs, includingthe cost of inaction?), but also because it is the cost savings that wouldprovide the argument (“clear benefits”) for the legitimacy of Community actionin setting-up or co-ordinating an EU-wide greenhouse gas emission tradingscheme.

The efficiency gains of a greenhouse gas emission permit trading systemdepend, among other things, on the sectoral and regional scope of thescheme. The more sectors and regions are involved in the scheme, the largerthe expected efficiency gains. A global and unrestricted emission tradingscheme would generate the largest efficiency gains, as it offers the largestscope to take advantage of differences in marginal abatement costs acrosssources.

The COHERENCE study of the European Commission estimates that thepotential cost savings of a global emission-trading scheme for the EU wouldbe 56 per cent of total abatement costs in 2010. In absolute values totalabatement costs in the EU in 2010 would fall from USD 10.4 billion to USD4.5 billion (at 1990 prices). The EU would then realise 70 per cent of itsrequired emission reduction through the acquisition of CO2 permits fromabroad. For the purposes of comparison, this analysis was done withoutregard to the EU's position on the question of supplementarity. Restrictingtrade to industrialised (Annex B) countries only would lower the cost savingsin the EU to about 15 per cent (European Commission, 1999).

In the calculations of the COHERENCE study it is assumed, however, that aleast-cost package of abatement options is implemented within the EU.Emissions trading within the EU can promote the efficiency and reduce thecosts of CO2 abatement that is necessary to meet the targets of the KyotoProtocol.

Several governments are exploring the possibilities of establishing domesticemissions trading schemes. Norway, Denmark, United Kingdom, Australia,New Zealand, Canada and others are studying the issue or are in the processof setting up pilot schemes (NRTEE, 1999). Remarkably, the only operationalglobal emissions trading scheme as yet has not been set up by government


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but by the private company BP Amoco. In 1998, BP announced that it wouldreduce its greenhouse gas emissions by 10 per cent below 1990 levels by2010. To do this in the most cost-effective and flexible manner BP Amocouses the instrument of emissions trading within the group, i.e. amongst its 127individual business units, operating in 100 countries. After a pilot project,actual trade started on January 1, 2000. BP Amoco is convinced that a capand trade system allows the greatest flexibility for individual business units toachieve the most efficient emissions reductions, and that it will provide forappropriate price signals to encourage efficient investments in abatementtechnology (BP Amoco, 1999).

A number of studies have assessed the economic and environmental effectsof an EU emissions trading scheme.

Böhringer et al. (1998) assess the welfare consequences of meeting theKyoto Protocol targets by the EU with and without carbon trading amongst EUMember States. For the initial allocation of permits they distinguish betweenthree burden sharing schemes, but for our purposes the differentiatedreductions agreed under the Burden Sharing Agreement (BSA) of the EUCouncil of Ministers of 1997 are of most interest.

Böhringer et al. use an applied general equilibrium model for the EU that iscalibrated on projected economic transactions in 2010. The projections forGDP, energy prices, fuel mix, and energy (carbon) efficiency are taken froman official EU scenario (European Commission, 1996). The welfare effects aremeasured in percentage changes in (Hicksian) equivalent variation in realincome, that is the money income that should be given to consumers tocompensate them for the loss of utility due to the CO2 reduction measures.

The calculated welfare changes for the year 2010 are relatively modest. Forthe EU in total they range from –0.35 per cent without trade to –0.32 per centwith trade. For the individual Member States, welfare effects range from –0.15(Netherlands, UK) per cent to –0.66 per cent (Denmark).

The efficiency gains of trade in emissions permits are around 10 per cent ofEU-wide abatement costs. According to Böhringer et al. this relatively modestresult stems from the fact that cross-country differences in marginalabatement costs within the EU are relatively small and are quickly “absorbed”when limited low-cost abatement options are exhausted by polluters with highabatement costs.

The authors stress the many uncertainties surrounding their calculations.They explicitly refer to the critical role of the baseline projections of energyuse and carbon emissions. In a sensitivity analysis in which baseline carbonemissions in 2010 are higher, total abatement costs increase as well as thegains from trade, even in percentage terms (up to 17 per cent).

A somewhat different perspective on the potential efficiency gains of carbonemissions trading is presented by a (hypothetical) quota trade experiment thatwas carried out among the four Nordic countries (Denmark, Finland, Norway


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and Sweden). In that experiment it turned out that even for these, in manyrespects, quite similar countries, abatement costs differed a great deal andgave rise to considerable trade gains. In fact, with trade, total abatement coststo meet the ‘Rio’ targets (return to 1990 emission levels in the year 2000) inthese four countries fell by almost 50 per cent (Bohm, 1999).

Capros et al. (1999) calculate the macroeconomic effects of reducing CO2emissions in the EU with permit trading among all sectors and all EU MemberStates. They use the GEM-E3 model, which is a dynamic, multi-countrycomputable general equilibrium model for the EU Member States that linksthe economies with energy systems and the environment. Mandatory CO2reductions of respectively 10 and 20 per cent below the 2010 baseline reduceGDP by 0.16 and 0.61 per cent, respectively. The reduction measures alsoreduce private consumption, trade, and the real wage rate, but they stimulateprivate investment (up to a certain level of reduction) and employment. Themarginal abatement costs (and thus the equilibrium permit price) in 2010 are100 and 277 ECU per ton C, respectively. When the permits are allocatedaccording to the “grandfathering” principle, countries that experience thelargest drop in GDP are Greece, Spain and Ireland. Countries that experiencea below-average reduction of GDP include Finland, the Netherlands, Italy andPortugal. On the CO2 emissions permit market, the largest net sellers are theUK, Belgium and Spain; the largest net buyers are the Netherlands, Germanyand France. Between sectors the flow of permits is from electricity andenergy-intensive industries to households and transport. At the equilibriumpermit price, electricity and energy-intensive industries find it profitable toreduce their CO2 emissions and sell their extra permits. Households andtransport, on the other hand, find it more profitable to buy permits instead ofsubstituting to less CO2 intensive activities and techniques, at least in theshort term.

In sum, there seems to be a large margin of uncertainty around assessmentsof the potential efficiency gains of tradable carbon emissions permit schemes.Nevertheless, many governments are studying the opportunities and oneprivate company has already started an in-company trading scheme. For afull-blown carbon emissions permit scheme within the EU, efficiency gainscould be 10 per cent of total carbon abatement costs or more. Klaassen(1999) cites an unpublished Commission staff working paper (1997) thatestimates the cost savings of an EU-wide permit trading system at 5 to 13billion ECU per year. Most studies on emissions trading concentrate on CO2or use CO2 as a proxy for greenhouse gases. Tol et al. (1999) show that therelative cost savings from trading increase if the trading scheme covers moregreenhouse gases.

If the choice is made to start with a downstream approach to emissionstrading in combination with policies and measures (PAMs), including largeemitters only, not all potential cost savings will be realised. Without additionalresearch it is impossible to assess the magnitude of the cost savings undersuch a system. An indication of the order of magnitude is provided by the factthat the trading part of such a system would probably cover about 40 per centof carbon emissions in the EU. Notwithstanding the large uncertainties that


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surround the efficiency assessment of the trading scheme (including theuncertainties around estimates of EU compliance costs in the first place), theorder of magnitude of the aforementioned potential cost savings seems toindicate that Community action in this area could well produce clear benefits,especially if the trading scheme is considered as a pilot for a morecomprehensive global trading scheme.

References:- Bohm, P. (1999). International Greenhouse Gas Emission Trading – with

special reference to the Kyoto Protocol. TemaNord 1999: 506.- BP Amoco (1999). Greenhouse Gas Emissions Trading in BP Amoco,

Brochure.- European Commission (1997). Climate change – Analysis of proposed EU

emission reduction objectives for Kyoto, Commission Staff Working Paper(unpublished).

- European Commission (1999). Economic Evaluation of QuantitativeObjectives for Climate Change. Report produced by COHERENCE, withsupport of ECOFYS, NTUA, ECOSIM, Brussels.

- Böhringer, Ch., G.W. Harrison, Th. F. Rutherford (1998). Sharing theBurden of Carbon Abatement in the European Union. Paper for theMobiDK project of the Danish Ministry of Business and Industry,Copenhagen.

- Capros, P., P. Georgakopoulos, D. Van Regemorter, S. Proost, T.F.N.Schmidt, H. Koschel, K. Conrad, E.L. Vouyoukas (1999). ClimateTechnology Strategies 2: The Macro-Economic Cost and Benefit ofReducing Greenhouse Gas Emissions in the European Union, ZEWEconomic Studies 4, Physica-Verlag, Heidelberg, New York.

- Klaassen, G. (1999). Potential Scope for Emissions Trading in the EU, in:S. Sorrell and J. Skea (eds.), Pollution for Sale: Emissions Trading andJoint Implementation, Edward Elgar Publishing Ltd., Cheltenham. pp. 83-100.

- NRTEE (National Round Table on the Environment and the Economy)(1999). Workshop on Progress Toward Development of DomesticEmissions Trading Programmes for Greenhouse Gases: A Comparison ofProgress around the World, Toronto, Canada, March 1-3, 1999.

- Tol, R.S.J., R.J. Heintz and P.E.M. Lammers (1999), Methane EmissionReduction: An Application of FUND, Institute for Environmental StudiesD99/3, Vrije Universiteit, Amsterdam (submitted to Climatic Change).


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APPENDIX 2: CORINAIR and the EPER draft proposal - examples ofharmonised monitoring and reporting

CORINAIR is a European air emissions inventory system, originally set up inorder to collect data on Member States’ implementation of the Convention onLong Range Transboundary Air Pollution and the Large Combustion PlantDirective.43 CORINAIR has been gradually expanded to be used for otherpurposes as well, and now also covers the emissions of a number ofgreenhouse gases (CH4, CO2 and N2O). CORINAIR mostly containsemissions data on an aggregated sectoral level and in some cases (on avoluntary basis) also data from large point sources.

The European Pollutant Emission Register draft proposal will be broughtforward by the Commission under Article 15(3) of the IPPC Directive. Thedraft proposal is to create a register of emissions of polluting substances byinstallations covered by the IPPC Directive. The draft proposal lists 50substances, including all 6 GHGs regulated under the KP. Member Statesneed to report on all emissions above a certain threshold of these substancesby individual IPPC activities. This will allow the EPER to provide informationon about 90% of all industrial emissions in Europe. The draft proposalintroduces a fixed format for reporting. Data is to be reported electronicallyand stored in a European Database. The data is to be provided on the basisof agreed estimation techniques and use of accepted methodologies andemission factors. It also contains a coding system for identification of theestimation methodology used (whether data was obtained throughmeasurement, calculations or estimations). It is expected that it will includearound 20,000 facilities throughout the entire Community. One drawback ofthe EPER draft proposal is that it does not require the reporting of energyconsumption by installations, which makes the verifiability of the emissionsdata more difficult.


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Endnotes 1 An updated version of scoping paper 3 is publised as: J. Werksman, ‘Greenhouse GaseEmissions Trading and the WTO’, 8:3 RECIEL (1999), p. 251-264.2 For an introduction to the concept of emissions trading and assessment of existing schemessee UNCTAD, August 1998, Greenhouse Gas Emissions Trading – Defining the Principles,Modalities, Rules and Guidelines for Verification, Reporting and Accountability.3 Erik Haites and Malik Aslam, Kyoto Mechanisms and Global Climate Change: Co-ordinationIssues Across Mechanisms and with Domestic Policy, Pew Center on Global ClimateChange, forthcoming.4 The direct participation of entities on the international legal plane implied by the alternative(allowing legal entities to hold PAAs and freely transfer these internationally) is difficult toreconcile with international law. See Jacob Werksman, Scoping Paper 3, WTO Issues Raisedby the Design of an EC Emissions Trading Scheme.5 Böhringer, Ch., G.W. Harrison, Th. F. Rutherford (1998). Sharing the Burden of CarbonAbatement in the European Union. Paper for the MobiDK project of the Danish Ministry ofBusiness and Industry, Copenhagen.6 Capros, P., P. Georgakopoulos, D. Van Regemorter, S. Proost, T.F.N. Schmidt, H. Koschel,K. Conrad, E.L. Vouyoukas (1999). Climate Technology Strategies 2: The Macro-EconomicCost and Benefit of Reducing Greenhouse Gas Emissions in the European Union, ZEWEconomic Studies 4, Physica-Verlag, Heidelberg, New York.7 Such as those by Scott Barrett in European Economy, No 1, 1992 and Weyant and Hill inEnergy Journal, 1999.8 Bohm, P. (1999). International Greenhouse Gas Emission Trading – with special referenceto the Kyoto Protocol. TemaNord 1999: 506.9 Ibid.10 Haites and Aslam, above, n. 3.11 Weyant and Hill, above, n. 7.12 The simplest means of establishing the appropriate carbon tax to meet the emissions limitis to implement an emissions trading scheme and to auction the permits.13 Bohm, P., above, n. 8.14 The justification for these conclusions is dealt with in more detail in Scoping Paper 1,Jürgen Lefevere and Farhana Yamin, The EC as Party to the FCCC/KP: An examination ofEC competence.15 Article 175 EC Treaty. EC competence on environmental matters is examined in moredetail in the Scoping Papers 1 and 2.16 Article 95 EC Treaty.17 See Edinburgh European Council Meeting Conclusions, 11-12 December 1992.18 For a more detailed explanation, see Scoping Papers 1 and 3.19 See Scoping Paper no. 3. An updated version of scoping paper 3 is publised as: J.Werksman, ‘Greenhouse Gase Emissions Trading and the WTO’, 8:3 RECIEL (1999), p. 251-264.20 Allowances can be distributed and held by individuals, NGOs or other kinds of legal entities.They need only be "surrendered" by those regulated by the trading scheme.21 Under the EC Treaty any environmental measure significantly affecting a Member State'schoice between different energy sources and the general structure of its energy supply mustbe adopted unanimously by the Council of Ministers (Article 175 (2) EC Treaty).22 To assist consultations, a "strawman proposal", setting out how one downstream optionmight work, is elaborated in the accompanying paper, "Design of a Practical Approach toGreenhouse Gas Emissions Combined with Policies and Measures in the EC".23 A Community-wide scheme could be based on the mutual recognition of national permits oran EC permit. The issues relevant to the choice between these are discussed in Section 7.24 See Table 1 at page 23 in accompanying paper.25 Articles 81-89. See Scoping Paper 1, “EC Trade and Competition Law Issues Raised by theDesign of an EC Emissions Trading System”.26 Based on the joint and several liability of the EC and Member States, there is a strongargument to allow the EC to buy PAAs, CERs or ERUs if it appears likely not to meet itsKyoto targets.


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27 See accompanying paper, Appendix 1, “Potential efficiency gains of greenhouse gasemission trading”.28 The Commission is currently examining the Danish trading scheme to assess if it might beconstrued as a covert measure to subsidise Danish electricity exports.29 The merits of these alternatives are discussed in the Interim Report in more detail.30 In the EC, it has been estimated that auctions might raise $76 billion annually, withcompensating tax cuts increasing EC GNP by up to $23 billion. Estimate by Suzi Kerr,Scoping Paper 5.31 The term "fair competition" is mentioned in the preamble to the Treaty, but its precisemeaning is not always clear. This notion has sometimes appeared to justify assistance tosmall and medium sized firms to compete against larger firms on grounds of protectingcompetition, even though the latter may be more efficient. Large capital requirements, forexample, are not considered by most North American economists as important barriers toentry. It is argued that if a market is profitable, there are enough large firms that can raise thefinance to enter it. In the EC context, the fact that small firms raise capital at greater cost thanlarger incumbents is accepted as relevant to defining the notion of competition (Korah, 1990).32 COM(98)772.33 Council Regulation (EEC) No 1836/93 of 29 June 1993 allowing voluntary participation bycompanies in the industrial sector in a Community eco-management and audit scheme34 It should however be noted that the distribution of responsibility for the EC collective andredistributed targets has not been resolved. The broader issue of legal personality of the ECis beyond the scope of this report.35 Apart from the Commission also Member States and even individuals have been givenways to enforce the correct implementation of Community law by Member States. Thesepossibilities, however, will not be discussed here.36 A complete list of existing and planned EC PAMs is contained in "Preparing forImplementation of the Kyoto Protocol", Annex 3, COM (1999) 230 final, 19 May 1999.37 Council Decision 93/389/EEC of 24 June 1993 for a monitoring mechanism of CommunityCO2 and other greenhouse gas emissions, amended by Council Decision 1999/296/EC of 26April 1999.38 Council Directive 96/61/EC of 24 September 1996 concerning integrated pollutionprevention and control. The Directive needed to be implemented in the Member States by 30October 1999 with regard to new installations. Existing installations will need to be covered by30 October 2007. Until that time these installations are, in relation to emissions into the air,covered by other existing Community legislation, inter alia Council Directive 84/360/EEC of 28June 1984 on the combating of air pollution from industrial plants.39 COM(97)30 final.40 Directive 1999/31/EC.41 These issues are discussed in greater length in Design of a UK Greenhouse GasEmissions Trading System. A Report by the IPE, September 1999.42 Scoping Paper 5 describes forms of auctions.43 Council Directive 88/609/EEC of 24 November 1988 on the limitation of emissions ofcertain pollutants into the air from large combustion plants. This Directive is further discussedin para. 7.1.5.

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