Background Climate change is the most serious environmental issue facing the world. As a signatory to the Kyoto Protocol, the EU is committed to achieving an 8% reduction in greenhouse gas emissions by 2012 compared to 1990 levels. To that aim, the EU has adopted Directive 2003/87/EC establishing a scheme for greenhouse gas allowance trading within the Community. Since 2005, it enables some 12,000 large electricity generators and industrial plants in the EU to buy and sell permits to release carbon dioxide (CO2) into the atmosphere. Currently, the EU’s Greenhouse Gas Emissions Trading Scheme (ETS) covers approximately 50% of CO2 emissions across the EU. However, the threat of climate change and the perceived efficacy of economic instruments has led to proposals to extend the scope of the ETS to cover greater volumes of greenhouse gas emissions. Phase I of the ETS runs for three years from 2005. Phase II will run for five years from 2008. The Directive 2003/87/EC required the European Commission to review the scheme in 2006 and, where necessary, make recommendations for expanding or improving the scheme. Objectives The wider objective of the project was to assess the implementation and operation of the first phase of the EU ETS, to contribute to its update and to the achievement of the Kyoto target for reduction in GHGs emissions. LETS Update set out to provide: • an assessment of the implementation and operation of EU ETS phase I, including the level of harmonisation that has been achieved across MS; • recommendations on which gases and sectors should be included in 2008 and future phases based on the feasibility and importance of including them; • options for achieving greater harmonisation in 2008 and future phase; • a sustainability appraisal to assess the environmental, social and economic impacts of the current and future ETS. Results Each of the objectives has been reached by the project. A number of conclusions were achieved that could lead to environmental benefits. - The first relates to the expansion of the scheme to cover a wider set of emission sources. Having undertaken a comprehensive assessment of all sector contributions to EU total GHG emissions, the project found that it is feasible to include the aluminium, part of the chemicals and coal mining sectors in a future phase of the scheme. This would not require any significant modifications to the current design of the scheme and would not have unreasonable impacts on the EU economy. The environmental benefit of including these sectors in the scheme is that it would provide them with a financial incentive to reduce the combined 280 Mt of CO2 equivalent emissions currently released every year. The inclusion of all three of the recommended sectors would increase the CO2 equivalent coverage of the scheme by approximately 9%. - LETS Update also considered a possible expansion of the scheme to sectors not currently covered by the scheme using the introduction of a domestic offset programme. This would allow developers to gain allowances for achieving emission reductions in non-EU ETS sectors. A domestic offset programme would have limited direct effect on overall emissions, as allowances generated by the offset projects would be sold into the EU ETS and displace reductions that would have otherwise taken place. Only if a discounting mechanism is applied (i.e. not all emission reductions are converted into credits), would offset projects result in additional emission reductions. However, such a scheme would provide an opportunity to stimulate emission reduction activity in non-traditional and perhaps difficult to tackle sectors, which may be environmentally desirable in the longer term. - LETS Update also concluded that improvements in the transparency of National Allocation Plans would have a significant impact on improving the environmental benefits of the scheme. - Final conclusion of the project relates to the fact that the EU ETS is only one of a raft of EU policies and measures designed to reduce emissions of GHG. LETS Update identified the potential for overlap between existing and planned policies and measures and recommended careful assessment of these overlaps and their implementation to take advantage of synergies and minimise the potential for perverse incentives. This will be critical for achieving real and attributable environmental benefits. A number of the project’s findings were reflected in a communication setting out the agenda for the revision of the ETS adopted by the European Commission in mid-November 2006 (COM(2006)676 of 13/11/2006 – Communication from the Commission on Building a global carbon market – Report pursuant to Article 30 of Directive 2003/87/EC). The European Commission specifically referred to the recommendations of LETS Update as an important source of information, which is intended to further inform the proceeding review. A proposal for the review is to be published in the second half of 2007.