Giant Steps for Carbon Trading in Europe

With allowances expected to reach $58 per ton of CO2 by 2020, companies could reap big rewards by embracing eco-friendly business practices

by Mark Scott

A STEAG Group power station beside the River Rhine at twilight on April 19, 2007 in Dinslaken, Germany Lars Baron/Getty Images

It's not every day the European Commission (EC) is compared to a magician. Yet like a conjurer pulling a rabbit out of a hat, Brussels has created a multi-billion dollar industry almost out of thin air since the European Union Emission Trading Scheme (EU ETS) started charging companies for emitting carbon dioxide back in 2005.

Europe's ongoing effort to combat climate change took a big step forward this Jan. 23 when the EC announced the third phase of the ETS, which extends the program to 2020 and sets more stringent reduction targets for the EU's energy and manufacturing sectors. For the first time industries such as aluminum and chemicals were added to the ETS, which will now cover almost half of Europe's total emissions.

The goal is by 2020 to lower carbon output 20% from its 1990 level through a market-based mechanism that fixes the problems of earlier schemes and creates a more realistic price for carbon credits. One way Europe intends to do this is by requiring some companies, beginning in 2013, to purchase carbon emission rights via auction, rather than by receiving them as grants. Among other changes announced Jan. 23 by the EC: a commitment to improve energy efficiency 20% by 2020 and a plan to produce 20% of the EU's energy from renewable sources over the same period.

Consumers Left Holding the Bag

The radical idea underlying Europe's ETS system is known as "cap and trade." The European Commission assigns a set amount of CO2 companies can emit each year—the cap. If companies produce less than that, they earn carbon credits they can sell to others who are overshooting their carbon targets. The more a company cuts emissions, the more it stands to earn from trading carbon credits.

That goal has taken a while to work itself out, though, after earlier phases of the ETS saw too many free allowances given to companies. That led to the price of carbon credits plunging to almost nothing by the end of 2007. Without the financial incentive to cut CO2 emissions, companies simply pocketed the credits, while passing on any extra costs to the end consumer. London consultancy Europe Economics reckons large energy firms in the EU have earned between $8.7 billion and $11.6 billion since 2005 by charging customers for carbon allowances the firms were given for free.

To fix that problem, Brussels will finally start charging companies for CO2 credits. Under the Jan. 23 proposals, electricity companies will have to buy 100% of their allowances at auction starting in 2013. Other industries, such as oil refineries and airlines, will be required to gradually purchase more credits during the EU ETS's third phase, starting with 20% of their total allowances in 2013 and scaling up to 100% of credits by 2020.

Million Dollar Payouts?

The Commission estimates revenue from auctioning could reach up to $80 billion by 2020, which will be split among member states. "Auctioning is fundamentally a good idea," says Mark Spelman, global head of strategy at consultant Accenture (ACN) in London. "A high cost for carbon makes firms re-evaluate their business models."

Despite a heavier burden to be shouldered by some of Europe's most emitting industries (BusinessWeek.com, 1/11/08), the implications for business from the Jan. 23 proposal remain largely benign. Companies that manage to reduce their carbon output, for instance, can still sell excess credits, thus pocketing a bonus from helping the environment. Power companies, such as Germany's E.ON (EONG.DE) and France's EDF (EDF.PA), could reap million-dollar payouts from trading carbon allowances over the next 12 years.

Even big polluters who can't clean up—and thus have to buy credits on the open market—stand to gain business benefit.