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Out-Law Analysis 4 min. read

Internationally linked emissions trading systems 'could replace Kyoto credits'

A global trading system in emissions trading is emerging, just as the previous international credits system under the Kyoto Protocol expires. For such a system to work, international systems will need to be equivalent to each other. 

The Kyoto Protocol, which came into force in 2005, was the first binding treaty under international law to combat climate change and contained binding limitation and reduction obligations for emissions. It has been replaced by the Paris Climate Agreement. The Paris Climate Agreement, however, does not prescribe the binding implementation of an emissions trading system. Instead, countries are free to decide for themselves how to achieve the climate targets set for them by the agreement. The EU's emissions trading system, which was developed according to the requirements of the Kyoto Protocol, will remain in force.

The Kyoto Protocol established that emissions trading was a crucial element in achieving climate protection targets. Based on the requirements of the Kyoto Protocol, the EU had developed an independent emissions trading system (EU ETS) and linked it to certain mechanisms of the Kyoto Protocol: If an EU-based business wanted to exceed its emission allowances from the EU ETS it could invest in climate projects carried out under the roof of the Kyoto Protocol (Joint-Implementation- and Clean Development Mechanism), for example in developing countries. International credits gained with these projects could then be assigned and exchanged for EU certificates.

This is now no longer possible. The Kyoto mechanisms may soon be replaced by linkages between other national emissions trading schemes.

It is important that the systems to be linked are similar enough to each other for trading to be on a like-for-like basis.

Any linking is a step towards a global trading system, as it increases cost efficiency through access to further potential for abatement and counteracts distortions of competition through a uniform emissions price. For implementation, however, it is important that the systems to be linked are similar enough to each other for trading to be on a like-for-like basis. This requires a stringent setting of emission caps as well as comparable assessment bases, control mechanisms and sanctioning options.

Many developing countries do not yet have national emissions trading systems and therefore linking may not be a sufficient substitute for Kyoto Protocol-based international credits at this stage. However, the development of global emissions trading is an ambitious goal that should be pursued to mitigate climate change.

The EU emissions trading scheme

In the European Union, the EU ETS based on the Kyoto Protocol was introduced in 2005. It is the central political instrument for the reduction of greenhouse gases. The EU member states have committed themselves to national climate protection targets within the framework of the effort sharing regulation.

All major electricity and heat producers are obliged to participate in the EU ETS, as are certain sectors of industry and, since 2012, aircraft operators. From the beginning, the industrial sectors of iron and steelmaking, coking plants, refineries and crackers, cement and lime production, glass, ceramics and brick industries, as well as paper and cellulose production were obliged to participate. In 2013, the EU ETS was expanded to include the chemical industry, non-ferrous metals, other combustion and mineral processing industries. In total, according to the German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety, "around 11,000 installations and several hundred aircraft operators across Europe are currently subject to emissions trading." This corresponds to about 40% of all European greenhouse gas emissions. 

In contrast to international emissions trading in accordance with the Kyoto Protocol, the market participants in the EU ETS are not states, but companies operating certain emission-intensive industrial plants. Emission allowances are assigned to them in line with national allocation plans.

The EU sets an upper limit or cap for greenhouse gas emissions. The emissions of all obligated parties are limited to this total amount. A cap that is demanding in terms of climate policy ensures that the right to emit greenhouse gases becomes a scarce commodity. Companies belonging to the sectors covered by the EU ETS must hold a European Union Allowance (EUA) for each tonne of greenhouse gases emitted. The number of allowances issued is based on the emitter's historical emissions - related to a certain base year - minus a certain reduction commitment.

The caps on the issuance of allowances and the activities of the secondary market ensure that greenhouse gas emissions receive a price that is formed on the market. 

The EU issues allowances in two ways: by grandfathering and by auctioning. Today, the majority of allowances are issued through auctions. Any company can participate in the auctions. If a company emits more greenhouse gases than are covered by the allowances allocated to it free of charge, it must buy allowances at auction or on the secondary market, where other companies sell the allowances they do not need. In this case, other market participants achieve a correspondingly larger reduction due to the fixed total number of emission allowances in the system. The caps on the issuance of allowances and the activities of the secondary market ensure that greenhouse gas emissions receive a price that is formed on the market.

Possibilities for international linkage

The EU ETS can be linked to other national trading systems, provided they are similar in their principles and thus compatible by recognising emission credits from the other system for their reduction obligations. Since 2020, the EU and Swiss systems have been interlocking - the EU recognises Swiss allowances and Switzerland accepts European allowances, so allowance trading between companies in the EU and Switzerland is possible. Since 2014, the EU has also been in talks with China and is supporting China in setting up its own emissions trading system.

Around the world, other national and regional emissions trading systems have emerged since the introduction of the EU ETS in 2005. Linking emissions trading schemes from all sectors, not just those already included in the European Union scheme, creates larger and more liquid markets and can contribute to a global emissions market. Such a market is a cost-effective way to mitigate greenhouse gas emissions not only regionally but globally and to strengthen climate protection.

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