What is ETS?

The European Union's Emissions Trading Scheme (ETS)  was established in January 2005 as an economically efficient way for EU countries to meet their commitments under the Kyoto Protocol. It provides a means for European companies to buy and sell the "right" to emit carbon dioxide, creating an economic incentive for them to reduce pollution.

How are emissions permits allocated?

The EU designated which industries would be affected, focusing on energy-intensive "installations," such as power plants and cement factories, which together comprise nearly half of Europe's total carbon dioxide emissions. Airlines, ships, and cars are not covered by the scheme.

Countries were then allowed to determine emissions caps -- for their country as a whole, as well as for individual industries -- so long as they followed 12 criteria that had been determined by the EU. This method of allocations resulted in widely varying limits. According to a report by the UK-based institute Open Europe,  only 4 of the 25 EU member countries set targets lower than current emissions levels.

Each of the 5,000 companies covered by ETS was allocated a certain number of allowances each worth a ton of CO ₂ emissions. The company could choose to reduce its emissions and sell off its unused permits or buy permits for additional emissions. In total, the EU approved 6.57 billion allowances.

The allocation of permits was "a very complicated process," says Barbara Helfferich, spokesperson for EU Environment Commissioner Stavros Dimas. Before ETS was implemented, there was not a harmonized system of measuring EU emissions, making it difficult to establish limits that would be consistent from country to country. But the Commission has now collected 2005 data from all member countries, which it will use to more precisely allocate permits once the next phase of ETS begins in 2008.

How well is ETS working?

Critics complain that the biggest polluters were given the largest number of permits, penalizing those firms that had already begun reducing emissions. The allocation system also awarded coal-fueled power plants more permits than those fueled by natural gas, which is cleaner, thus creating a disincentive for companies to switch over to using gas. And to make a true market, they add, the allowances should have been auctioned off and not given out for free.

The permits are bought and sold by brokers, and on emissions exchanges, with about 1.5 million tons being traded daily. The price per ton of CO ₂ emissions started out at around €7, rising to €30 before crashing to €11.5 in early May when initial reports showed that allocations had exceeded actual emissions for 2005. The excess was due in part to overestimations of companies' current emission levels, as well as company efforts to reduce emissions. Shares have since rebounded to the €15 to €20 range, but they are expected to drop again as the end of Phase One approaches in 2007 since the permits can't be carried over.

"Phase I is just the learning by doing phase,” says Phil Brown, UK director of ECX, which controls upwards of 75 percent of the European carbon exchange market. "It looks like it'll be a bit rubbish and by the end the (share prices) will tend toward zero.”

But Phase II is expected to run more smoothly, with lower emission targets and up to 10 percent of allowances being auctioned off rather than given out for free. In addition, fines for exceeding allowances will rise to €100 euros per ton from the current €40 per ton.

So far, only several EU countries have filed their National Allocation Plans (NAPs) for Phase II, which were due June 30.

"Theoretically it's a very good instrument, but of course it depends on implementation," says Hermann Ott, head of the Berlin office of the Wuppertal Institute for Climate, Environment and Energy. "What we see at the moment is not a very stringent policy regarding NAP II."

Has it changed industry practices?

"We see that there is really already a change in the mind-set of businesses, and that’s tremendous," says Delia Villagrasa of the World Wildlife Fund's European Policy Office in Brussles. "It’s discussed as a factor at the boardroom level, and that we’ve not seen before.”

Julia Scharlemann, spokesperson for RWE, Germany's largest power utility, says that although Germany's NAP II will mean a 15 percent drop in power plant emissions -- a change she says will be "a big burden" for RWE -- the company is supportive of the plan, saying it will enable Germany to meet its emissions caps.