M. Grubb et al.

/ Climate Policy 5 (2005) 000–000 129

Climate Policy 5 (2005) 000–000

COMMENTARY

Allowance allocation in the European emissions trading system: a

commentary
Michael Grubb1*, Christian Azar2, U. Martin Persson2
1
Carbon Trust; Imperial College, London, UK; Faculty of Economics, Cambridge University, Cambridge, UK
2
Chalmers University, Göteborg, Sweden

[Q2]Received [insert date]; received in revised form [insert date]; accepted [insert date]

1. Introduction
In any emissions trading system, probably the most difficult and important single step is the initial
allocation of allowances. It is the allocation that determines both the ultimate significance of the
system, in terms of the total emissions and the associated carbon price and incentive to change;
and which determines the distribution of costs and benefits amongst the participants.
In the European Union emissions trading scheme (EU ETS), allocation decisions are the
prerogative of Member States. This is probably unavoidable; EU governments would be unlikely
to tolerate EU institutions taking direct decisions about allocation of potentially valuable assets to
their companies, and EU institutions would anyway be more remote from the details of company
emissions and domestic political considerations that might determine reasonable or acceptable
allocations.
The European Commission has powers to challenge national allocation plans (NAPs) under
certain circumstances, and has indeed sought to exercise these powers, but the principal driver of
allocation decisions has unquestionably lain within the domestic politics of Member States. We
argue that this, combined with the specific approach to allocations taken by most Member States,
is beginning to look like the Achilles heel of the entire EU ETS. Based on the emerging experience
of first-phase allocations, we conclude that fundamental questions need to be addressed before
the EU ETS moves towards allocations for the Kyoto period.

2. Allocation: the picture as of 1 January 2005

When the trading system came into operation, the European Commission (EC) had approved 21
NAPs. At the time of writing, the four additional NAPs (Czech Republic, Greece, Italy and Poland)
are still being contested, as is a UK request for changes.1 In the 21 approved NAPs, total allocations
amount to just over 1.5 billion[Q5] tCO2/year in the period 2005–2007. This allocation, approved

[Q3]*Corresponding author:
E-mail address:
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by the EC, is only just over 1% lower than the numbers proposed by Member States in their
original NAPs.

2.1. ... Compared to recent emissions

Only Germany and Slovenia have not allocated more than they currently emit (see Figure 1); this
was also true for the UK under its originally agreed NAP of July 2004.1 Among those that have
been given the most generous allocations are Finland, Lithuania, Luxemburg and the Slovak
Republic, which have all allocated more than 25% above recent emissions. Italy’s proposed
allocations in its draft plan, contested by the EC, exceed its recent emissions by more than the
emissions of the entire trading sector in Sweden. Collectively, the allocations agreed as of October
2004 totalled about 3% above corresponding emissions during 1998–2002 for the countries where
historical emissions were reported.2 The UK revision combined with presently proposed Czech
and Italian plans would roughly double this (to about 6%), the proposed Polish plan could bring
the collective increase across EU countries to about 9% over recent historical levels.

2.2. ... Compared to Kyoto targets

The fact that hardly any Member States have allocated less than recent emissions in many cases
contrasts with their obligations under the Kyoto Protocol.3 Figure 1 also compares the allocations
with one that would be in line with uniform sectoral implementation of the Kyoto commitments, in
the sense of a linear trend in EU ETS sector emissions from 2000 to the Kyoto target reduction in
2010. Collectively this would imply a cut by 2006 of about 3%, in contrast to the 3–9% increase
allocated for 2005–2007. The real situation is worse: most of the present and projected emissions
growth in the EU overall comes from the transport and service sectors; the share of emissions from
the sectors covered by the EU ETS (and in some countries, absolute emissions from these sectors)
has been decreasing. Economic evaluations also indicate that it is cheaper to cut back in the EU
ETS sectors (including power generation) particularly compared to transport. Thus the implied gap
between actual EU ETS allocations and the total EU and national Kyoto targets is considerably
greater even than implied by Figure 1.

2.3. ... Compared to official ‘business-as-usual’ projections

Many allocations are in line with or almost as high as ‘business-as-usual’ (BAU) projections
(ECOFYS, 2004) for the trading sector, and some exceed it. Summed across all Member States, the
aggregate cutback from BAU projections in the NAPs agreed as of October 2004 was only 1%.
This is indeed much smaller than the forecasting error in such projections.

2.4. ... About which there is also legitimate concern

In addition, there is a substantial risk that the BAU numbers themselves are inflated. There has
been no general trend of increasing emissions from the EU ETS sectors (apart for some countries,
especially ‘cohesion countries’ like Spain), and for large emitters like Germany and the UK there
has been a marked decrease in emissions from the EU ETS sectors over the last decade. No
 M. Grubb et al. / Climate Policy 5 (2005) 000–000 131

Figure 1. This graph compares the 21 allocations approved by the European Commission so far and the four
NAPs still under consideration (denoted by an asterisk) with recent emissions in the trading sector (blue bars)
and the allocations needed to put the countries on track for their respective Kyoto commitments (orange bars)
(assuming a linear trend in total emissions between 2000 and 2010 and a constant share of emissions from the
trading sector). Missing bars for some countries are due to lack of data on recent emissions in the trading
sector in those countries’ NAP

satisfactory explanation has been given as to why this should suddenly reverse for the period
2005–2007.
Historical precedents regarding BAU ‘baseline’ projections are not encouraging. In terms of
binding, target-based sector CO2 emission regulations, the UK was a pioneer, with both the UK
ETS (under which companies ‘bid in’ emission reduction targets), and the climate change agreements
(under which companies committed to emission targets in return for rebates of the climate change
levy). Both have had to be substantially strengthened after it became apparent that emissions from
132 M. Grubb et al. / Climate Policy 5 (2005) 000–000

the companies involved were far lower than originally projected, leading to an embarrassing surplus
compared with the agreed targets.
This is not really surprising. Emission prospects are inherently uncertain and the process of
negotiating allocations in relation to future projections introduces a strong incentive for industry
to maximize projections of its activities and emissions; optimistic forecasting, and some ‘gaming’
and bias in the analytic input is almost unavoidable, even without the perverse emission incentives
noted below. Government is at a disadvantage in such negotiations; also, governments themselves
may consider that they face asymmetric risks, fearing the political consequences of ‘underallocation’
to specific sectors more than those of collective overallocation. It thus seems likely that the BAU
forecasts against which the modest cutbacks have been proposed are themselves significantly
too high.

2.5. Conclusions on Phase 1 allocations

Even if the BAU projections are taken at face value, the collective picture is one of weak allocations.
Even in Germany, one of the driving forces in climate change and almost the only one to have
allocated an absolute reduction, the outcome allocates 15 MtCO2 more than committed in industry’s
existing voluntary agreement, which many observers considered already weak (Michaelowa, 2004).
Collectively, the EU ETS allocations represent only a tiny cutback from BAU projections, and in
no way put EU industries on course for Kyoto targets. If the BAU projections do turn out to be
significantly inflated, there seems a risk of collapse of the trading system in Phase 1, as there may
be few, if any, buyers. A system without buyers is not a market; and very few small buyers in a
market deluged with potential sellers may generate little action. We now consider the implications
of this overallocation more closely.

3. Implications of weak allocations

There are a number of reasons why the overallocation in the EU ETS, described in the previous
section, is of serious concern.

3.1. Implications for emissions control and the cost of meeting Kyoto targets
First, weak allocations imply little emissions control in the first period. Since the trading directive
has the potential to lower the cost for the EU countries to meet their Kyoto targets, this is unfortunate.
Second, as illustrated above, the allocations seen are simply not consistent with a trajectory
towards domestic implementation of Kyoto targets even for the EU ETS sectors. Yet reducing
emissions in the trading sectors is far easier than in most of the rest of the European economy,
notably transport and the commercial sectors, where emissions are growing rapidly.
When challenged by the European Commission about consistency of NAPs with Kyoto targets,
the response of Member States has been that in the event of domestic shortfall, the Kyoto flexible
mechanisms would enable them to comply through wholesale international purchase of emission
allowances. This, however, not only dodges the core issue of achieving real emission reductions in
developed economies (with some possibility that allowances from former Soviet countries would
be ‘hot air’, i.e. from surplus Kyoto allocations); it also risks generating a sudden rush for
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international purchases as the Kyoto compliance date looms, which may be far more costly,
particularly for government treasuries.
The current allocations simply defer the difficult actions required to change the course of
emissions, whilst the problem itself accumulates. The existing Kyoto first period targets are only a
first small step on the path of successively more stringent emission reductions needed if we are to
avoid severe global climate change impacts, and the longer that action is delayed the more costly
and disruptive it is likely to be.

3.2. Implications for the stability of the EU ETS

Weak allocations may threaten the stability of the EU ETS. At the most general level, the legitimacy
of emissions trading remains disputed by some in the environmental community, many of whom
would prefer taxation or mandatory targets without flexibility. If the EU ETS is seen to be failing to
deliver the promised emission reductions, pressure for other approaches will grow.

3.3. Implications for the Kyoto system of weak allocations also in the second phase of EU ETS
Weak allocations in the Kyoto period would imply that emission reductions have to be achieved in
other sectors and that will increase the overall cost of meeting the target. In addition, weak allocations
will tend to undermine the market-based nature of the Kyoto Protocol and undermine the
international cohesion behind it. The original intent was that, spurred by domestic legislation such
as the EU ETS, private companies would make use of Kyoto’s project-based mechanisms (Joint
Implementation and the CDM) to generate emission credits internationally. Weak allocations remove
the incentive for this. Backloading the problem on to future government trading undermines the
use of international market-based mechanisms and undermines industry engagement.
With weak allocation, the EU’s willingness to allow companies to import emissions credits from
reduction projects in developing countries under the CDM will become irrelevant; in a surplus
market no company would have reason to import credits. It thus reduces the incentives for business
to engage directly with developing countries. Conversely, it makes the Kyoto mechanisms
intrinsically more political, with governments, not companies, becoming the major buyers (to the
extent that other sectors do not compensate for the generous allowances).

3.4. Implications for European energy and carbon intensive industry

Finally, weak allocation is not only a step in the wrong direction from the standpoint of the
environment and the international system; it may also do European energy intensive industries a
disservice. Industry argues that what it most needs is a stable, long-term policy environment against
which to plan investments; weak allocation, for the reasons set out above, achieves the reverse,
and gives no real incentive for innovation. Weak allocation does not do enough to prepare industries
for the stronger emission reductions that will be required. It exposes industries to the risk that EU
governments may either resort to other measures that may cost industry more, or will have to
tighten allocations more severely and rapidly. Additionally, an excessive allocation in some countries
threatens to distort competition between companies in different European countries. It amounts to
a free transfer from government to industry, in defiance of basic principles of European competition.
134 M. Grubb et al. / Climate Policy 5 (2005) 000–000

4. Allocation options going forward

Several factors in combination have led to the present overallocation: a logically flawed basis to
the allocation methodologies; corporate lobbying based upon competitiveness concerns; and the
ability for each country to allocate free allowances to its own firms. It is almost as if each country
were allowed to print its own Euros, without any reference to inflation risks, and then to give the
Commission a weak legal mandate just to check that the surplus Euros did not constitute an illegal
subsidy to specific sectors.
For the first period, 2005–2007, this situation has been worsened by the lack of any aggregate
target for national emissions, so countries did not need to make an explicit trade-off between
emissions in the trading and non-trading sectors. This will not be the case in the second period,
when the Kyoto target has to be met. Prospects for reasonable allocations in the second period
may thus seem brighter, but the fundamental problems will still need to be addressed.

4.1. Allocation methodologies

In Phase 1, most governments have allocated total emissions relative to ‘business-as-usual’
projections, and the more detailed distribution has typically been distributed in relation to past
emission distributions.
The reliance on BAU projections is an invitation to gaming around the projections. As indicated
above, the track record is not good: the UK government has twice got target-based negotiations
spectacularly wrong. Government–industry negotiations contingent upon industry forecasts
exacerbate the natural tendency of industry (and governments) to be optimistic about growth
prospects, by rewarding those that exaggerate the most. Since industry has all the real data, and
governments are likely to be risk-averse, the negotiations are inherently one-sided. It is a hopeless
approach to adopt in the face of genuine uncertainty and incomplete (and asymmetric)
information.
Even worse, the prospect of future allowance distribution being contingent upon recent emissions
(‘updating’) gives a direct incentive to industries to inflate actual emissions. Neuhoff et al. (2005)
recently estimated the value of inflated emissions in 2003–2004 to be about ¤4/tCO2, assuming a
50% probability that allocations for the Kyoto period (EU ETS Phase 2) are distributed according
to the same principles as Phase 1 allocations, but updated to 2003–2004 emissions. If companies
did factor this into their operations, this could have led UK power companies to increase their
emissions by several percent to reflect the expected value of the increased allocations that would
result in the Kyoto period. Such a BAU approach to allocation with updating could thus risk
materially increasing greenhouse gas emissions. This approach has to change, and decisions should
be made soon about the basis for company-level allocation in the next period.
Essentially, this leaves only two options. One is to auction the allowances. With full auctioning,
many of the allocation-related problems would vanish; indeed the potential for distortion of EU
markets may be much reduced. In addition, the societal cost of meeting the emission reduction
targets would drop, since auctioning generates government revenues that can be used to reduce
other distortive taxes (see, e.g., Goulder et al., 1999). However, full auctioning would exacerbate
concerns about international competitiveness impacts, and is not consistent with the current directive;
so a mixed allocation system is more realistic.
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For the non-auctioned part of the allowances, various principles on which to base allocations
can be explored other than the ‘grandfathering/BAU’ approach so far taken. The most obvious to
consider is benchmarking, in which allocations are defined with direct reference to industry best
practice. Benchmarking is not simple, nor is it a panacea, but greater emphasis on benchmarking
could well ease some of the problems of the Phase 1 allocations.

4.2. Addressing competitiveness concerns

The main reason why companies lobby hard for lenient allocations under the EU ETS is that, for
any individual company, greater allocation has a direct financial benefit. But the argument that
companies have used, and that governments fear, is that tougher allocations would put their
competitiveness at risk. Given the pervasiveness and impact of competitiveness claims, it is
remarkable how little real analysis has been carried out. However, the analyses that do exist suggest
that competitiveness concerns have been widely exaggerated; indeed many sectors may be neutral

Figure 2. Net value that could be at stake under the EU ETS for carbon prices of ¤10/tCO2 for
various sectors under different scenarios of allocation and different degrees of cost pass-
through in the power sector. The degree of import dependence of the sectors is also illustrated.
Aluminium (Al) production – ‘solid electricity’ – stands out as the most exposed, whilst the
iron and steel industry is also potentially vulnerable. All other sectors have less than 2% net
value at stake. The study from which this figure is drawn (Carbon Trust, 2004) concludes that
aluminium would indeed be threatened if EU producers bought power from the grid, whilst
iron and steel could cope plausibly with carbon prices up to about ¤10/tCO2 but would suffer
at higher prices. Most other sectors are barely affected and indeed a number might gain due to
the knock-on price effects and revenues from permit sales. Cement and construction, for
example, despite being one of the most energy-intensive industries, would only need to
increase prices by about 1.5% in the central scenario to maintain present profitability – not a
major threat to domestic producers – and its profitability increases marginally under all three
of the Carbon Trust price and allocation scenarios, due to the value of free allocations.
136 M. Grubb et al. / Climate Policy 5 (2005) 000–000

or have some potential to gain under the EU ETS (see Figure 2 and legend). A first requirement
going forward is that the competitiveness debate is grounded in serious economic analysis.
Under more stringent climate reduction targets, carbon- and energy-intensive industries that
face international competition may suffer losses. Governments will have to think in more targeted
and careful ways about how to protect such industries (partly to buy acceptance for climate policies,
partly to avoid losses of jobs in socially sensitive regions, and partly to avoid carbon emissions
merely moving elsewhere). At least for moderate allowance prices, one solution may be to continue
the present practice of granting free permits close to projected needs for internationally exposed
industries that cannot pass cost increases on to consumers, whilst cutting back more for those that
can plausibly pass costs on (including electricity generating companies). Electricity-intensive
consuming industries (such as aluminium), which would face electricity cost pass-through but
emit little direct carbon, may also need some kind of compensation (e.g. ‘downstream’ allocation).
Another approach may be to introduce border tax adjustments.

4.3. Political coordination

A major additional complication in first-round allocations was perceptions of differential allocation
between Member States, leading industries to voice concerns about unequal treatment within Europe
and a competitive ‘race to the bottom’ in allocation plans. To avoid a situation where the
overallocation of the first period is repeated and the Kyoto targets jeopardized, better coordination
between allocation methods across Member States is also required. For that reason, the following
should be considered:

• Methods for allocating allowances and the total amounts are negotiated and agreed at the EU
level (Council of Ministers). The burden-sharing agreement on emissions target can be seen as
a precedent for this.
• Basic principles for these decisions should be that the allocations are in line with the Kyoto
Protocol targets, adjusted for the amount that countries (governments) commit to buying through
Kyoto’s international mechanisms.
• The same principles are applied in all countries.
• A larger share is allocated through auctioning.

Procedurally, the need for stronger coordination at a European level need not only apply to Europe’s
political institutions. Since a major concern of companies is unequal allocation between different
countries, based in part on a patchy understanding of industrial realities by diverse governments,
European industry sector organizations could be invited to play a larger role in debates about
allocation distributions within their sector. If they were able to resolve differences between their
companies in different Member States, this could be a useful contribution – if they respect the
need for overall reductions in line with internationally agreed targets. European industry has played
a major role in weakening the Phase 1 allocations to a point that may undermine the credibility of
emissions trading as an effective instrument, and a political backlash is a real possibility. They
could make positive contributions, but the terms of their engagement must change if they want to
avoid more punitive systems in the future.
 M. Grubb et al. / Climate Policy 5 (2005) 000–000 137

The EU ETS is a bold venture, designed in principle to minimize the cost to European industries
and economies of achieving CO2 reductions. It is pivotal to the international response on climate
change, and European credibility is fundamentally at stake. But the devil, as they say, is in the
detail, and the Phase 1 allocations appear weak to a degree that may threaten the credibility of the
whole scheme. Negotiations on the next-period allocations have to start shortly. For success in
that, the crucial Kyoto first period, the lessons of Phase 1 must be learned – and learned fast.

Notes
1 In November 2005 the UK requested an increase in its total allocations in the light of revised emission projections, citing this
request as being consistent with the forewarned preliminary nature of its forecasts underpinning the original NAP. The
quantitative analysis in this Commentary uses the original UK data; the revision would turn the UK allocation from a small
decrease to an increase of ~3% in Figure 1.
2 These numbers are taken from the National Allocation Plans (NAPs). For some of the smaller countries, estimations were not
available at all (and are thus excluded in this calculation) and for others they were not available for all years in the 1998–2002
period.
3 The EU Kyoto target for total greenhouse gas emissions is 8% below 1990 levels during 2008–2012, differentiated between
Member States according to the 1998 Council agreement, under which Germany and the UK make the dominant larger
cutbacks to help offset growth particularly in the ‘cohesion countries’ (Spain, Portugal, Greece and Ireland). The EU target in
principle applies to the EU-15. The ‘accession countries’ shared the EUs –8% target, except for Hungary and Poland (6%) and
Malta and Cyprus (no target as not in Annex I). The EU-15 target can offset against reductions in the accession countries by
invoking the emissions trading clause (Article 17) under the Kyoto Protocol, but the accession countries would be free to sell
any surplus allowances ‘to the highest bidder’ internationally, and their first sales have been to Japan, not to the EU-15
countries. For simplicity, however, the collective data in this commentary refer to the EU-25.

References
Carbon Trust, 2004. The European Emissions Trading System: Implications for the Competitiveness of European Industry
[Q6][available at http://www.carbontrust.co.uk/].
ECOFYS, 2004. Analysis of the National Allocation Plans for the EU Emissions Trading System. Report to UK Department of
Trade and Industry and Department for environment, Food and Rural Affairs, London.
Goulder, L.H., Parry, I.W.H., Williams III, R.C., Burtraw, D., 1999. The cost effectiveness of alternative instruments for
environmental protection in a second best setting. Journal of Public Economics 72, 329–360.
Michaelowa, A., 2004. Der NAP: zu lax und Umverteilung zugunsten machtiger Interessengruppen. Presentation to Energiestiftung
Schleswig-Holstein meeting at Kiel, 19 April 2004.
Neuhoff, K., Grubb, M., Keats, K., 2005. Emission allowance allocation and the effects of updating. Mimeo, Faculty of
Economics, University of Cambridge, UK.

Data sources
All National Allocation Plans (NAPs) can be found on the European
Community website: http://europa.eu.int/comm/environment/climat/emission_plans.htm
The data on national allocations approved by the European Commission can be found in press releases from the European
Commission, available at: http://europa.eu.int/comm/press_room/index_en.htm
138 M. Grubb et al. / Climate Policy 5 (2005) 000–000

Queries

Allowance allocation in the European emissions trading system: a commentary

M. Grubb, C. Azar, U.M. Persson

Q1 Is the rubric “Commentary” needed here?

Q2 Please insert received, revised and accepted dates here (if required for a Commentary).
Q3 Please insert phone and/or fax numbers and email address here (if required for a Commentary).
Q4 No Abstract or Keywords. Are these needed for a Commentary?
Q5 I assume that ‘billion’ refers to a thousand million (US usage) rather than a million million (British
usage), but it may be better to avoid using ‘billion’ unless you are sure that its meaning will be
universally understood.
Q6 I have changed the URL for Carbon Trust to one that works. Please check.