Explanatory Memorandum to COM(2001)581 - Scheme for greenhouse gas emission allowance trading within the EC

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dossier COM(2001)581 - Scheme for greenhouse gas emission allowance trading within the EC.
source COM(2001)581 EN
date 23-10-2001
1. General remarks

Contents

1.

1.1. An environmental policy instrument to lower the costs of reducing greenhouse gas emissions


This proposal arises from the need for the European Union to reduce its emissions of greenhouse gases cost-effectively and meet its obligations under the United Nations Framework Convention on Climate Change and the Kyoto Protocol. Emissions trading is, first, an instrument for environmental protection, and, second, one of the policy instruments that will impair competitiveness the least.

In March 2000, the Commission adopted a Green Paper on greenhouse gas emissions trading within the EU i that successfully launched a debate across Europe on the suitability and possible functioning of emissions trading. The 100 or so responses received were overwhelmingly in favour of emissions trading. Within the multi-stakeholder European Climate Change Programme, emissions trading has been the subject of extensive discussions and analysis that have added to the understanding both of the instrument and the points of view of different actors. Further consultation meetings with stakeholders, Member States and Accession countries in September 2001 demonstrated strong support for emissions trading. The present proposal draws on all those discussions.

This proposal, based on Article 175 i of the Treaty, places direct emissions of the greenhouse gases covered by the Kyoto Protocol within a regulatory framework. The total quantity of greenhouse gas emissions covered by this scheme would be limited. Furthermore, installations would have the possibility to engage in Community-wide emissions trading. This possibility constitutes the key element for harnessing the available cost-effective emissions reduction potential. Emissions reductions will then be made wherever in the Community it is cheapest to make them. The benefit of these cheaper reductions will be available to others elsewhere in the Community who may not themselves have as cheap reduction possibilities. This is why emissions trading is of benefit to those who buy as well as to those who sell. The economic case for a Community-wide scheme is supported by several recent studies demonstrating efficiency gains i. A Community scheme would minimise distortions of competition and potential barriers to the internal market that might otherwise arise as a result of a number of disparate trading schemes (and hence prices for carbon) being established in the European Union.

A precondition for emissions trading, however, is that participating installations accept the limitation of the emissions from sources covered by the scheme in the relevant national jurisdictions. Limitation of emissions will require an effort to be made by installations, but emissions trading will enable reductions to be made more cost-effectively.

2.

1.2. The structure and functioning of the proposal


Central to this proposal lies two concepts. The first of these is that of the greenhouse gas 'permit', that will be required by all installations covered by the scheme. The second concept is that of greenhouse gas 'allowances', denominated in metric tonnes of carbon dioxide equivalent, which entitle the holder to emit a corresponding quantity of greenhouse gases.

Member States, or their relevant authorities, will grant a greenhouse gas permit that sets an obligation to hold allowances equal to the actual emissions as well as requires adequate monitoring and reporting of emissions. The allowances will be transferable, while the permit itself is attached to a specific installation or site. In addition to the permits, Member States, or their relevant authorities, will allocate allowances. These allowances can be traded between companies if they choose to do so. Each year, companies must submit for cancellation a number of allowances that corresponds to their actual emissions. If they do not have enough allowances, sanctions will be imposed on them. The holding and tracking of allowances will be done through an electronic register.

The first phase of the scheme, between 2005 and the end of 2007, is a period that precedes the Kyoto Protocol's commitment period. In this preliminary phase, the Commission believes that the Community would greatly benefit from experience of greenhouse gas emissions trading, so that it is prepared for the commencement of international emissions trading under the Kyoto Protocol that will begin in 2008. The present proposal recognises, however, that during the preliminary phase from 2005 to the end of 2007, there are no legally binding targets limiting the emissions of greenhouse gases of Member States. In view of this, specific differences have been incorporated into the preliminary phase. These include that, in the initial phase, allowances should be allocated to participating installations free of charge and that there is a lower common level of penalty for non-compliance.

From 2008, the exchange of allowances between installations in two different Member States will give rise to the adjustment - through the national registries - by a corresponding number of tonnes of the total quantity of emissions allowed for each Member State as contained in the proposal for a Council Decision on the ratification of the Kyoto Protocol.

The first accessions are likely to have taken place by the commencement of this scheme and so would be covered by this proposal. However, for countries that are not part of the EU when this scheme comes into force, there exists the possibility to link the Community scheme with those of other Parties to the Kyoto Protocol by entering into agreements with those other Parties to mutually recognise each other's allowances.

3.

2. The Environmental and Economic value of emissions trading


The environmental benefit is provided by the stringency of the total quantity of allowances allocated that represents the overall limit on emissions allowed by the scheme. One main attraction of emissions trading is that it provides relative certainty of environmental outcome. However, emissions trading does not of itself reduce emissions.

This proposal places direct emissions of all the Kyoto Protocol's greenhouse gases from the specified sources within a Community regulatory framework. This framework limits the emissions of the covered sectors and imposes sanctions, including financial penalties, for non-compliance.

The key economic rationale behind emissions trading is to ensure that emissions reductions required to achieve a pre-determined environmental outcome take place where the cost of reduction is the lowest. Emissions trading allows individual companies to emit more than foreseen by any initial allocation that it receives on condition that they can find another company that has emitted less than allowed and is willing to transfer its 'spare' allowances. The overall environmental outcome is the same as if both companies used their allowances exactly, but with the important difference that both buying and selling companies benefit from the flexibility offered by trading, without disadvantage to the environment.

4.

3. The Burden Sharing Agreement and the Monitoring Mechanism


Under this proposal each Member State will make its initial allocations taking into account the requirements of this Directive and on the basis of its overall commitment under the Burden Sharing Agreement. The Member States have agreed to redistribute their targets under the Kyoto Protocol in accordance with the Burden Sharing Agreement as contained in the Council Conclusions of 16 June 1998.

If installations trade allowances with other installations within the same Member State, there would be no change to the number of tonnes that a Member State can emit under the Burden Sharing Agreement. However, if an installation buys allowances from an installation in another Member State, then there will need to be a corresponding adjustment, recorded by the national registries, to the number of tonnes that each Member State can emit under the Burden Sharing Agreement. Selling an allowance to an installation in another Member State would mean that the 'originating' Member State loses its entitlement under the Burden Sharing Agreement to emit a tonne of carbon dioxide equivalent. Buying an allowance from another Member State, on the other hand, entitles an extra tonne of carbon dioxide equivalent to be emitted within the Member State in which the buying installation is located.

Overall, the Community will emit the same number of tonnes as were foreseen under the Kyoto Protocol. But the precise entitlements of each Member State will be adjusted to correspond with trades that its installations undertake. There should be no danger of non-compliance arising from this scheme by any Member State as long as installations individually have enough allowances to cover their actual emissions. If installations sell, they must actually reduce their emissions correspondingly. That is why there needs to be strong national non-compliance provisions for participating installations.

The system of linked national registries is central not only to the holding of allowances and the tracking of trades, but also for the adjustment of the Member States' commitments under the Burden Sharing Agreement. The linked national registries will be a crucial component of the Community Monitoring Mechanism established by Council Decision 93/389/EEC, in enabling the accurate tracking of what the entitlements of individual Member States are under the Burden Sharing Agreement. Furthermore, the national registries will provide accurate information on the emissions entitlement of the trading sectors in each Member State, and thereby serve as a check on the likelihood of Member States individually, and the European Community as a whole, living up to their commitments.

5.

4. Basic obligations


This proposal requires operators of installations undertaking the activities covered by Annex I of the Directive to hold a greenhouse gas emissions permit as a condition for emitting greenhouse gases from their installations. The greenhouse gas emissions permit will lay down monitoring, reporting and verification requirements in respect of direct emissions of greenhouses gases specified in relation to those activities, creating the framework for the participation of the installation in the emissions trading scheme.

The permit further requires operators of installations undertaking the activities covered by the scheme to surrender, on an annual basis, sufficient allowances to match their verified emissions of the relevant greenhouse gases for the previous calendar year. A failure to surrender sufficient allowances to match verified emissions would result in the imposition by Member States of substantial penalties.

6.

5. Striking the balance between simplicity, effectiveness, subsidiarity and transparency


It is difficult to reconcile simplicity with the different interests of various stakeholders. Nevertheless, this proposed Directive endeavours to remain as simple as it can be. This has been a repeated wish of industry. In order to protect the internal market, it would establish a common method of allocation in the period 2005-2007. Member States would be required to allocate allowances for free, based on objective and transparent criteria. The quantities of allowances issued would not be harmonised. This reflects the fact that the Burden Sharing Agreement redistributes effort by Member States to reflect Community solidarity. National policies and measures also create varying impacts on businesses. Furthermore, the proportions of emissions that the relevant sectors contribute in different Member States varies according to the fuel mix of its power generation sector, for example. A balance has therefore been struck between the benefits of having a European-wide market, and the principle of subsidiarity. Therefore, Member States would be required to base their allocations on a number of common criteria. Moreover, Member States would also have to communicate to the Commission in advance their proposed intentions in respect of the allocation of allowances, which will be rejected by the Commission if the common criteria are not observed. The Commission may revise the criteria to be applied to allocation in the light of experience.

The proposal would create a European market in allowances. This contrasts with the fragmented approach that would occur in the absence of a Community instrument, where Member States gradually build up national schemes and then try to link them.

The reporting requirements on Member States will ensure transparency. The Commission will continue to exercise vigilance in respect of State aid, restrictions on market access, anti-competitive behaviour or abuse of dominant position - but these are existing Treaty obligations that will apply anyway.

7.

6. Liberalisation of energy markets and the internal market


It is essential that this instrument is compatible with the liberalisation of energy markets. Emissions trading offers two important advantages over traditional environment policy instruments.

First, if an electricity producer in a particular Member State is successful in winning market-share in other Member States, it may be that the emissions increase in the producer's Member State. Without emissions trading, the Member State would have to bear the consequences of these increased emissions, which may require a further policy response from other sectors, while the electricity producer retains the benefit of increased market-share. With emissions trading the Member State in which the producer is located can be sure that the producer of electricity will acquire allowances sufficient to cover any extra emissions.

Second, in the context of the internal market - whether for electricity or any other competing product - an EC-wide emissions trading scheme will provide at any moment in time a uniform price for an allowance across the whole trading scheme. From the moment that trading starts, all installations covered by the scheme will be faced with the same price of emitting an extra tonne of carbon dioxide equivalent, from one side of the Community to the other. Emissions trading is an instrument which, once the initial allocations are made, should effectively 'level the playing-field' by providing a single market for the emissions of a tonne of carbon dioxide equivalent, at least for those participating in the emissions trading scheme. However, the way the initial allocation is done is vital. Different principles for initial allocations to companies competing within the EU-wide internal market for electricity, for example, may significantly distort competition. In order to protect the internal market, measures have been introduced in the proposal, notably the requirement for Member States to apply common criteria for their national allocation plans, to notify the Commission and other Member States, and the possibility for the Commission to reject a national allocation plan that does not comply with the criteria. The principles behind the proposal's provisions concerning the allocation of allowances are further described below in Section 13.

There is no limit on the emissions of an individual installation as long as it acquires sufficient allowances. Having to pay for extra allowances that may be needed is consistent with the 'polluter-pays' principle. The number of allowances that a Member State issues could anticipate future growth in output, if the Member State is prepared to take this risk. The number of allowances will not necessarily be less than past emissions, although it is expected that Member State will issue less in view of meeting their own commitments under the Burden Sharing Agreement. But it will still be illegal for Member States to give incompatible State aid, in the form of allocations that exceed the likely needs of a sector or installation. If allowances are allocated more generously to sources covered by emissions trading, Member States will have to ask more of other sectors, or be ready to acquire more 'assigned amount units' or project mechanism credits within the context of the Kyoto Protocol, when they become available.

8.

7. Interactions with energy taxes


Energy taxes aimed at tackling carbon dioxide emissions and emissions trading should be designed in such a way that they act as complementary instruments for covering the totality of emissions. While both instruments can be used at the same time in different sectors of the economy, this may give rise to adverse impacts on competitiveness if they are used at the same time within the same sector. The Commission recalls its proposal of 1997 i for an energy products tax, and continues to believe that the Community needs a general framework for the taxation of energy products. However, within this general framework, where activities are covered by the Community greenhouse gas emissions trading scheme, it would be appropriate to take into account the level of taxation that pursues the same objectives, without prejudice to the application of Articles 87 and 88 of the Treaty.

9.

8. Interactions with environmental agreements


Environmental agreements exist in several Member States. Such agreements are essentially collective agreements to meet a pre-determined target. Most importantly, these agreements are compatible with emissions trading, as agreements limit the emissions of the participants.

In practice, almost all environmental agreements in place can be adapted to take account of the emergence of new elements, such as the introduction of an EC-wide emissions trading scheme. The targets set under the environmental agreements can serve as a useful basis for the allocation of allowances by Member States. If a Member State wishes to allocate to its industry allowances on the basis of output-related performance standards, or 'relative targets', this would be possible. Although this Directive requires the fixing of quantities of emissions expressed in tonnes of carbon dioxide equivalent, relative targets can always, by using output forecasts, be converted into quantities of emissions in a given period.

Within such agreements, some companies may do more than others towards reaching the collective pre-determined targets. Furthermore, the agreements may or may not provide for some compensation to be paid to reflect the different contributions between what are, after all, competing companies within the same sector.

In practice, emissions trading enables similar flexibility. If participating installations wish, they could pool their allowances, by sector for example, with a view to the sectoral association buying any extra allowances or selling surplus allowances on behalf of all. Each installation would have to monitor its emissions, as is already the case for environmental agreements. At the end of the year, the sectoral association would have to hand back to participating installations the necessary number of allowances to cover their actual emissions. The operators of participating installations, who would bear the consequences of non-compliance, would have to ensure that at the moment of reconciliation, each would have access to sufficient allowances to cover its actual emissions. These provisions are without prejudice to Articles 81 and 82 of the EC Treaty concerning the rules on competition applicable to undertakings concerning agreements between them and abuse of dominant position.

There are two respects in which emissions trading can offer even greater flexibility than environmental agreements. The first is the case where participating installations emit more than foreseen under the environmental agreement. Having the possibility of buying more allowances from other sectors could make the difference between an agreement being respected - and its continuance in the future - and one that is not. The second is that if emissions are lower than provided for by the agreement, the surplus can be sold on the market and the proceeds distributed to the participants.

10.

9. Links with existing Community environmental legislation


This proposal harnesses the synergies with existing legislation, and in particular, the IPPC Directive i. The scheme would apply to most of the significant greenhouse gas emitting activities that are already covered by the IPPC Directive, as well as some installations not covered by the IPPC Directive. Member States will be able to combine the permitting procedures for both this Directive and the IPPC Directive, while respecting the differences in the nature of the permits and their respective objectives.

This proposal allows Member States to build upon the permitting procedures under the IPPC Directive, albeit these would result in the grant of a different type of permit - the greenhouse gas emissions permit - based on submission of further information than is currently required under the IPPC Directive. A grant of such a permit is a prerequisite to continue the operation of the installation and would require the installation to hold a sufficient number of allowances to cover its actual emissions in a given period. The installations concerned would be able also, if they so choose, to participate in emissions trading - to acquire and transfer allowances across the EU - with all the flexibility and cost advantages this affords over more traditional means of regulation.

The IPPC Directive covers emissions of greenhouse gases. It requires Member States to ensure that installations are operated in such a way that all the appropriate preventive measures are taken against pollution, in particular application of the best

available techniques. The IPPC Directive defines 'pollution' in a very broad sense i. Normally under the IPPC Directive, the competent authorities should fix emission limit values for pollutants that are likely to be emitted from the installation concerned in significant quantities. Such limit values should be based on the best available techniques.

Under the approach taken in this proposal, an installation covered by the emissions trading scheme should not have a limit set by its IPPC permit on its direct of emissions of carbon dioxide and other greenhouse gases insofar as they are covered by the emissions trading scheme, except insofar as these may have significant local effects. So as to ensure the smooth interplay between this emission trading scheme and the IPPC Directive, an amendment to the IPPC Directive is necessary. This amendment would make explicit that if pollutants from an installation are covered by this Directive, then emission limit values shall not be set in respect of the direct emissions of those gases from that installation under the IPPC Directive unless they have a significant local impact. Until such a time as greenhouse gases from particular sources are covered by emissions trading, by their inclusion in Annex I of this proposal, the IPPC Directive would continue to apply.

The IPPC Directive also requires efficient use of energy to be regulated in the permitting procedure, and this proposal is without prejudice to those requirements. So whilst this proposal in principle leaves Member States to determine the stringency of carbon dioxide abatement efforts that activities covered must achieve, provided that certain criteria are met, efficiency requirements for the use of energy (electricity, steam, hot water, cooling, etc.) under the IPPC Directive provide a common level of effort that must be undertaken by IPPC-regulated activities.

11.

10. Coverage of gases


The Community scheme being proposed by this Directive covers, in principle, emissions of all the greenhouse gases covered by the Kyoto Protocol - as listed in Annex II. However, only carbon dioxide emissions from the activities listed in Annex I will be included from the start. In 1999, carbon dioxide accounted for over 80% of the Community's greenhouse gas emissions. Emissions of carbon dioxide are widely recognised as capable of generating good quality monitoring data on a consistent basis.

Inclusion of the other greenhouse gases listed in the Kyoto Protocol is desirable but would be dependent on resolving monitoring, reporting and verification issues, possible local impacts as well as other Community policies and measures addressing emissions of these gases. In particular, emissions trading presupposes a sufficiently accurate monitoring of emissions, but the monitoring uncertainties are still too great for greenhouse gases other than carbon dioxide. For these reasons, emissions of greenhouse gases other than carbon dioxide are not included in the first phase of the scheme.

It is proposed that the inclusion of greenhouse gases other than carbon dioxide in Annex I should be considered in the context of an amendment of the Directive, as their inclusion is not an appropriate subject matter for a Regulatory Committee to decide.

12.

11. Coverage of sectors


The sectoral coverage of this Directive builds upon the framework of regulation arising from the IPPC Directive.

Initially, only carbon dioxide emissions from the activities listed in Annex I will be covered by the scheme. Inclusion in the scheme of the 'core activities' listed in Annex I will result in coverage of approximately 46% of estimated EU carbon dioxide emissions in 2010 i comprising some 4 000 to 5 000 installations. Significant carbon dioxide emitters currently not covered by the IPPC, such as power and heat generation installations between 20-50 MW, will also be included as these are also significant sources of carbon dioxide emissions, and their number is likely to increase in the future.

The chemical sector and waste incineration sectors would not be included, although carbon dioxide emissions from any on-site power and heat generating capacity would be included if it exceeds the threshold of 20 MW. The decision not to include the chemical sector initially is taken for two reasons: first, the chemical sector's direct emissions of carbon dioxide are not so significant (approximately 26 million tonnes of carbon dioxide in 1990, which is less than 1% of the EU's total emissions of carbon dioxide in the same year). Second, the number of chemical installations in the Community is high, in the order of 34 000 plants, and their inclusion would substantially increase the administrative complexity of the scheme. Finally, the waste incineration sector is not included due to the complexities of measuring the carbon content of the waste material that is being burnt.

It is proposed that the inclusion of additional activities in Annex I should be considered in the context of an amendment of the Directive, as their inclusion is not an appropriate subject matter for a Regulatory Committee to decide.

13.

12. Permitting Process


Member States' competent authorities would grant greenhouse gas emissions permits. These authorities could be the same as those implementing the IPPC Directive or new authorities, depending on each Member State's preference. For activities covered under the IPPC Directive, the greenhouse gas permit could be issued through a single procedure in accordance with that for permits under the IPPC Directive. Any changes that take place to the installation must be reported and could trigger a change in the conditions of the permit.

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13. Allocation and issuance of allowances


It is proposed that in the period from 2005 to 2007 all Member States allocate allowances to participating installations for free. This common approach is to protect the internal market. Without such harmonisation, it is feared that if allowances were allocated on the basis of auctioning in one Member State but allocated free in another, competition may be distorted. Requiring participants to pay for their initial allocation will present particular difficulties in the first period because the price of allowances will still be unknown.

By 30 June 2006 the Commission will review the experience gained during the allocation of allowances for the period 2005-2007 with a view to ascertaining which harmonised method would be most appropriate in future. There may be too little time for the Commission to make a proposal on the method of allocation for the period 2008-2012 that could be adopted and transposed in time to allow operators sufficient prior notice of how allocations would be made in that period. It is therefore proposed that pending adoption of such a proposal, the Commission, assisted by the Regulatory Committee, should be able to decide on the method of allocation in the period 2008-2012.

The total quantity of allowances issued under the proposal would be left essentially to the Member States. However, in order to ensure that the sectors concerned by the emissions trading scheme contribute appropriately to the overall reduction of greenhouse gas emissions made necessary by the Community's international commitments, and to ensure a level playing-field between companies competing within the internal market, the allocation of allowances must comply with a set of criteria to be applied across the EU. These criteria are elaborated in Annex III of the proposal. This Annex can be further amended in the light of experience of the implementation of the Directive.

Also, the quantities allocated should ensure that the overall emissions of all the participating installations collectively would not be higher than if the emissions were to be regulated under the IPPC Directive, which should be the case if the criteria contained in Annex III are followed. Member States, in establishing their national allocation plan, should consider the technological potential of the installations concerned to reduce direct greenhouse gas emissions. Furthermore, all allocation decisions would have to comply with Community requirements concerning State aid. The proposal does not spell out what would be consistent or inconsistent forms of allocation with regards to State aid as each situation will have to be examined on its merits. Member States should also ensure that new entrants have adequate access to allowances, so as to be able to establish their operations within the Member State in accordance with Article 43 of the Treaty.

To ensure the transparency and fairness of allocations, Member States would be required to publish and to submit in advance to the Commission a national allocation plan that shall include objective and transparent criteria for allocation within that Member State. The national allocation plans would be examined within the framework of the Regulatory Committee. This proposal provides for the Commission to reject a plan that is inconsistent with the criteria within 3 months. However, when a national allocation plan contains State aid within the meaning of Article 87 of the EC Treaty, the plan has to be notified to the Commission in accordance with the provisions of Article 88.

It is to be noted that State aid scrutiny examines the possible distortions of competition arising from exceptions to a general rule of allocation within a single Member State, and, as a general rule, the method of allocation should apply to all installations, with exceptions having to be duly motivated.

There could also be a concern that once Member States have taken their decisions on initial allocation for the initial three-year or subsequent five-year periods, unforeseen circumstances might arise that would lead to sudden increases in the price of allowances. Such price spikes have not proven to be problematic in other emissions trading schemes elsewhere in the world, but this is subject to there being a sufficiently large and liquid market, allowing the participation of intermediaries able to develop options, derivatives and other risk-management tools. It is important, in this context, to allow unrestricted access to the market by intermediaries and other persons who may not have obligations arising from a greenhouse gas permit under this proposal, but whose inclusion will add liquidity to the market.

Regarding the issue of whether other persons, such as environmental NGOs, should be able to buy allowances and then cancel them - thereby increasing their scarcity - this entitlement is already foreseen in the draft rules on use of the Kyoto mechanisms and national registries in the context of the implementing rules of the Kyoto Protocol i. Such possibility would not only maintain consistency with the UN rules for international emissions trading under the Protocol, but also would provide for the meaningful participation of civil society and have no material impact on the price of allowances in such a large market as is foreseen.
[i.e. the function of cancellation of Assigned Amount Units or credits from the project mechanisms of the Kyoto Protocol].

15.

14. Validity of allowances and Banking


Allowances created under the scheme will be recognised across the EU without the need for Member States to enter into any further arrangements regarding mutual recognition as a result of this Directive.

It is proposed that allowances have a lifetime not extending beyond the end of the initial three or subsequent five-year period in which they are issued. This proposal therefore allows for the unrestricted banking of allowances from one year to the next during the initial three-year period or within each subsequent five-year period. Member States are free to decide whether to allow the banking of allowances between the period ending in 2007 and that starting in 2008. As from 2008, however, the proposal requires Member States to allow the banking of allowances from one five-year period to the next. Such banking does no harm to the environment while providing greater temporal flexibility. Banking will be ensured by the requirement that Member States issue to holders of surplus allowances at the end of each five-year period a corresponding number of 'new' allowances in the following period in addition to the allocation of allowances that would have normally been issued.

It should be noted that banking within the context of the Kyoto Protocol is conditional upon the relevant Party being in compliance with its obligations. These arrangements for banking are intended to ensure that, even if a Member State is not in compliance with its international commitments, holders of surplus allowances within its national registry would not lose the benefit of having obtained that surplus. At the end of a five-year period, businesses would effectively not be 'dispossessed' of any surplus allowances they might hold. If uncertainties were to remain, they may lead to a reluctance to hold allowances as a 'safety cushion' to cover unforeseen circumstances, and there would also be a risk that surplus allowances suddenly flow out of a Member State that looks unlikely to meet its commitments, thus worsening its predicament. In this way, Member States can legitimately claim to hold all the allowances held by account holders in their national registry at the end of a commitment period under the Kyoto Protocol.

16.

15. Tracking of allowances


It is envisaged that a wide variety of individuals and groups will participate in the EU emissions trading market even though the obligation to surrender allowances as a fulfilment of their obligations will only apply in respect of the activities listed in Annex I. Allowances will only exist in electronic form. Accordingly, any natural or legal person will be able to hold allowances and retire them provided they establish accounts in national registries in accordance with the envisaged Regulation to be adopted. Allowances will only be transferable by those holding accounts in national registries.

Integrity of the tracking system, by means of the system of national registries, is vital to the effective functioning of the emissions trading market. Discrepancies and fraud would damage the environmental integrity of the scheme as well as undermine its credibility. The elements contained in the proposal are based on experience of the allowance tracking system (ATS) under the US sulphur trading regime, elaboration of guidelines on national registries under the Kyoto Protocol, and the approach taken in the field of Community legislation concerning value added tax i. These have suggested the need for an independent transactions log. If irregularities are identified by automated checks, the registries concerned will not give effect to transactions relating to the allowances concerned until the underlying problem is resolved. Installations that have not had their emissions report verified as accurate would lose their right to transfer allowances until they are in compliance with the requirements of this Directive.

Because this component of the trading scheme will require a very high degree of consistency best achieved through harmonisation, it is suggested that detailed rules on the functioning of national registries should be undertaken by means of a separate Commission Regulation.

17.

16. Monitoring, reporting and verification


Emissions must be subject to common monitoring, verification and reporting obligations among sources covered by the scheme to ensure the environmental integrity of the scheme. The proposal contains basic principles for monitoring and reporting criteria in Annex IV and sets up a framework for the elaboration of guidelines based on these principles through a Regulatory Committee procedure. Monitoring and reporting criteria specific for the activities undertaken by an installation will be elaborated in the installation's permit.

The proposal also contains a list of binding verification criteria contained in Annex V. These leave it to the discretion of Member States to decide whether the verification is done by their competent authorities or through independent verifiers, and who should bear the cost of such verification. Failure to follow the monitoring and reporting requirements, or failure to have emissions reports verified in a timely and proper manner, should entail sanctions that would also include the suspension of further transfers of allowances by the operator until such a time as the deficiencies have been remedied.

18.

17. Compliance


Cases involving breaches of the obligation to surrender sufficient allowances to cover verified emissions are to be dealt with in a stringent and consistent manner throughout the European Community. This would be attained by the imposition of a financial penalty either at a rate of EUR 100 per excess tonne or twice the average market price during a predetermined period, whichever is the higher. In the period prior to the commitment period of the Kyoto Protocol, this penalty would be EUR 50 per excess tonne or twice the average market price during a predetermined period, whichever is the higher. Other than setting the level of penalty for each tonne over-emitted, Member States shall determine and apply sanctions for breaches of the Directive that are 'effective, proportionate and dissuasive'.

What is essential is that the penalties for non-compliance are sufficiently high to ensure that it makes no sense for an operator not to go out and buy from the market a sufficient number of allowances to cover the installation's actual emissions. The US sulphur trading scheme has an excellent compliance record in practice largely due to the high penalties applicable to cases of non-compliance.

Furthermore, the imposition of a financial penalty would not remove the obligation in the following year for the operator of the over-emitting installation to surrender allowances corresponding to the excess emissions, or the pre-determined environmental outcome of the scheme as a whole will be undermined.

It should be emphasised that the level of the penalties for non-compliance should be set having in mind that the vast majority of participants, if not all, should not incur them. Allowances are valid for the entirety of the period in which they are issued. Member States are required to issue a proportion of these allowances each year before the 28 February. The surrendering of the allowances in respect of the previous year's emissions by operators must take place by 31 March, by which time the allocations of the current year's allowances must have been made. As operators can use any of the allowances in their possession to fulfil their obligations, it is extremely unlikely that any operators acting in good faith will incur compliance penalties before the end of the period.

19.

18. Access to information and public participation


The public should have access to information concerning the results of the monitoring, reporting and verification obligations, information on holdings in national registries and any actions concerning breaches of the Directive, in accordance with Directive 90/313/EEC on the freedom of access to information on the environment.

It is necessary to ensure transparency in the allocation of allowances. National allocation plans give highly relevant information on how the Member States intend to meet their climate change commitments, just as they will also give information on the quantities to be allocated to individual installations. Allocation should be transparent and based on objective criteria. To this end, the proposal requires that Member States publish their national allocation plan, provide for comments to be made on it by the public and submit it to the Commission before taking any final decision, which must take due account of public comments.

The proposed provisions are consistent with the Aarhus Convention that the European Community is committed to ratify soon. Many activities covered by this proposal are listed in Annex I to that Convention and will, following adoption of the Commission's proposal for a Directive of the European Parliament and the Council providing for public participation in respect of certain plans and programmes relating to the environment and amending Council Directives 85/337/EEC and 96/61/EC i, be subject to public participation in respect of their emissions in accordance with Directive 96/61/EC.

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19. Reporting by Member States


This Section requires Member States to report to the Commission on issues relating to the operation of the trading scheme, including experience with allocation, the operation of national registries, monitoring, reporting, verification and enforcement.

It is suggested that the first report be submitted by June 2005, with reports annually thereafter. Thus there would be twelve months between the first and second reports. The Commission is required to report annually on the operation of this scheme, nine months after the end of each compliance period. The Commission is also mandated to organise an exchange of information between the competent authorities of Member States concerning developments related to implementation of the Directive. The collection of monitoring data for greenhouse gas emissions according to common rules will facilitate the task of Member States to report emissions to the European Pollutant Emissions Register i and also improve the quality of data in that register.

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20. Links with other emissions trading schemes and renewable certificates


The scheme has been designed to be compatible with the international emissions trading to be established amongst Parties included in Annex B of the Kyoto Protocol. It can also link up with domestic trading schemes established by particular countries, such as those that may be established in Accession Countries if those countries have not already joined the Union. Such a linking of schemes would require the conclusion of agreements with other States according to which governments agree to mutually recognise each scheme's allowances towards fulfilment of the domestic obligations of installations. Before concluding such an agreement, each government would want to satisfy itself that the environmental quality of allowances issued elsewhere is satisfactory and that monitoring, compliance and national registry provisions are as robust. These and other issues would have to be negotiated by the Community and Member States with the respective countries involved. This is true also for emissions trading under the Kyoto Protocol, where the tradeable unit ("assigned amount units") can be traded only if the respective governments involved agree that these will be recognised as counting towards domestic obligations, and corresponding adjustments are made to national registries.

Emissions trading under this proposal should also be compatible with another market-based instrument being developed within several Member States, namely 'Tradeable Renewable Certificates'. Moreover, provisions for the issuing of a 'guarantee of origin' of electricity produced from renewable sources are also contained in Community legislation on renewable energy i. These certificates or guarantees represent the additional benefits of electricity from renewable energy sources. As renewable sources do not emit greenhouse gases, they would not be covered by the obligations of this proposal. Indeed, power companies might wish to invest in renewable generation capacity so as to reduce their emissions of greenhouse gases, while at the same time fulfilling objectives for the increased use of renewable energy. However, so as not to create confusion, renewable certificates should not be integrated with the greenhouse gas allowances needed for compliance with the obligations of this Directive. Furthermore, Member States should take account of renewable energy targets when deciding on the quantities of allowances to be allocated under this proposal.

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21. Market organisation


The proposal does not stipulate how the market in emissions allowances is to be organised. This is because the Commission is convinced that market structures will arise once the obligations are clear, and the allowances for fulfilling the obligations are established. The Commission wishes the organisation of the market in allowances to be left open to solutions driven by the private sector. Brokers will enter the market to provide services as intermediaries and thereby enhance liquidity. Similarly, it is anticipated that exchanges will compete to provide a place for buyers and sellers to meet. Such market intermediaries will facilitate price discovery, and the installations with obligations under this Directive will be able to benefit from the greater liquidity and flexibility offered. This approach is wholly in line with emissions trading experiences elsewhere in the world.

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22. Links with project-based mechanisms


Adoption of this present proposal will establish an emissions trading scheme potentially covering the whole European Economic Area. The magnitude of this challenge is considerable. Consequently, this proposal does not foresee the inclusion of credits from national or international project-based mechanisms, in particular those under Articles 6 (Joint Implementation) and Article 12 (the Clean Development Mechanism) of the Kyoto Protocol. The Commission believes that the eventual inclusion of such credits is desirable, subject to the satisfactory resolution of outstanding issues regarding their environmental integrity. The Commission intends to subsequently make such a proposal in the form of a separate instrument on the implementation of project-based mechanisms in the EU. The content of that Directive cannot be anticipated at this stage, particularly as the rules and modalities of these international mechanisms have yet to be agreed.

The interaction between a Community-wide emission trading system and international project-based mechanisms should be carefully considered. If the rules agreed by the United Nations are insufficiently robust in terms of environmental value, it is possible that one or more Member State may want to not allow entities to use these credits to meet their obligations under the greenhouse gas permit for the purposes of emissions trading. If other Member States continued to allow the use of these credits, Member States trying to restrict their domestic use would find it practically difficult to do so, as entities who could use these credits would use these against their domestic obligations and sell 'allowances' into the market. This further instrument may also allow national offset-projects provided that the project meets acceptable environmental, verification and certification standards.

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23. Subsidiarity and proportionality


The present proposal for a framework directive takes account of the principle of subsidiarity. The real economic benefit of emissions trading will only be obtained if allowances are fully tradeable and accepted across the Community. For this to be achieved, the establishment of a common framework is necessary if this new instrument, already being developed in some Member States, is not to create further barriers within the internal market. However, where appropriate decisions on implementation have been left to the competent authorities of Member States. Regarding proportionality, only those elements that are necessary for the proper functioning of the instrument and the achievement of the objectives of the Treaty are regulated by the present proposal.

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24. Timing and review


The Community emissions trading scheme will commence in 2005. The scheme will initially run until 31 December 2007, at which point a new multi-year period will commence that coincides exactly with the Kyoto Protocol's commitment period (2008-2012). Thereafter, the scheme will operate in five-year phases. Each phase will enable Member States to consider how many allowances they are to allocate in aggregate to their trading sectors. In this way, Member States should, as appropriate, gradually reduce the number of allowances in the light of more ambitious future commitments. During the initial 3 or later five-year phases, however, businesses will have certainty as to the quantity of total allowances available.

By 31 December 2004, the Commission may make a proposal to include other activities and emissions of other greenhouse gases, once accurate monitoring guidelines for these gases can be elaborated.

A review may also be carried out by 30 June 2006 based on experience of the implementation of this proposal, and in the light of developments in the international context. This review shall be accompanied by proposals as appropriate.