In 2005, the European Union began a bold experiment in environmental regulation by instituting a cap and trade program for carbon emissions, the European Union Emissions Trading Scheme (EU ETS). Under the plan, the European Union's member states were allocated carbon allowances, which the states in turn distributed to industrial establishments within their jurisdictions. Those industrial concerns that emitted more carbon than their allocations covered would have to either curb their emissions or purchase carbon allowances from those establishments which had more carbon allowances than they needed. This, planners believed, would create an active market for carbon allowances.
When the first phase of allocations (for emissions allowances expiring in December 2007) began trading, the newly established carbon exchanges recorded a steadily increasing price, reaching a high of €31.5 for a ton of carbon by early April 2006. Then in mid-April of 2006, regulators issued reports that showed more allocations had been issued then would be required to cover Europe's emissions. Prices plummeted; by the end of 2006, carbon allocations were trading at €6.7 a ton and by April of 2007, a year after the peak, first-phase carbon allowances were going for just €0.76.
Most environmental regulators shrugged off the crash of the first phase since it had been meant as a trial that was not designed to have much effect on emissions. Government officials acknowledged that they did not have much experience with regulating carbon. It was only in the 1990s that scientists reached consensus about the role that man-made emissions of greenhouse gases (GHGs) such as CO2 were playing in the rapid warming of the earth. Until this connection with global warming had been established, CO2 had been considered a trivial emission, since it was not harmful to human health like other pollutants. Inspired by the increasingly frightening data, the nations of the world had met in Kyoto in 1997 and hammered out a series of accords (the United Nations Framework Convention on Climate Change) calling for developed nations to limit the amount of GHGs they emitted. (The U.S. played a major role in the negotiations but never ratified the agreement, formally known as the Kyoto Protocol.)
In the years since Kyoto, the 25 member countries of the European Union decided that a cap-and-trade scheme would be the best way to reduce GHGs, but many questions remained. Regulators hoped that the first phase of the EU ETS would allow for the collection of better information and the formation of market institutions for trading allowances. Despite the over-allocation of allowances, much had been learned. Indeed, futures for a second phase of the EU ETS (that would be in effect from 2008-2012) had started trading in late 2005 and the value of carbon allocations was holding firm in spite of the collapse of the first-phase allowances.
Business analysts and strategists were also studying the collapse of the first phase for clues on how the cap-and-trade scheme would affect corporate value and competitive dynamics. The collapse of the first phase provided a "natural experiment" to see how the market would react to the sudden lifting of the carbon cap.
Published Date: 05/11/2009
Suggested Citation: Fiona M. Scott Morton, Erin T. Mansur, Allison Mitkowski, Jaan Elias, and Michelle Zhao, "European Union Emissions Trading Scheme-First Phase," Yale SOM Case 09-031, November 9, 2009.