Anyone can buy an allowance, even non-operators, which has created a secondary market for investors to trade EUA's like any other commodity. Allowances initially enter the market through official auctions and free allowances which are allocated directly to Operators. The market, involving both end users and speculators, is designed to drive up the price of emitting carbon and by putting this price on the emission of carbon, it changes the cost-benefit analysis of alternative technologies and strategies creating an incentive for Operators to take steps to reduce emissions.
In the first year, 80% of the total allowances were given to Operators for free, but this percentage will be reduced as the scheme progresses, down to 30% by 2020 and no free allowances by 2027. 3% of the total available allowances will be set aside for new entrants and existing Operators whose traffic increases by over 18% (up to a maximum of 1,000,000 allowances per Operator), with the remainder being auctioned off by each Member State.
The number of free allowances awarded to each Operator is based on the tonnage of payload (cargo or passengers) multiplied by the distance in kilometres travelled, with no consideration for the amount of fuel actually used to do this. The reason for this is that a finite 'pot' of allowances must be divided between a set number of Operators, so the t-km data is used as a proxy for scale of operations in order to divide the 'pot'. The number of allowances which must be surrendered each reporting year, however, is based on the actual amount of CO2 emitted.
This system is designed to benefit those who operate in more efficient ways, so more allowances are awarded to those who fly larger volumes over greater distances. This encourages higher load factors, and discourages shorter flights, where more efficient alternatives may be available. Unfortunately, this will have a particularly negative impact on business aircraft Operators, as they operate with fewer people on board.
The tonne-kilometre data gathered during 2010 is used to allocate allowances until next ETS Phase in 2020, unless they can demonstrate a growth in annual tonne-km of 18% by the second calendar year of that period.
Aircraft Operators will be allowed to surrender allowances from any industry, however other industries cannot surrender aviation allowances. This increases the size of the pool from which aviation can purchase from, but decreases the number of potential buyers if an Operator has a surplus. Aviation is the only industry which has specific allowances (unofficially referred to as EUAA's), and this will effectively create a parallel commodity, with its own value and market influences, as well as a separate auction process.
Operators are also allowed to surrender a small proportion (15%) of their requirement as Certified Emissions Reductions (CER's) and Emission Reduction Units (ERU's). These are credits which are created by projects which reduce the emissions in developing countries under the Kyoto Protocol's Project Mechanisms. They tend to trade at lower values than EUA's, but are of limited supply, and Operators can only surrender 15% of the allowances as CER's or ERU's.
Allowances can be banked from one year to the next if an Operator has a surplus, or borrowed from future years if they have a deficit (unless there is a significant change in the rules between ETS Phases, in which case they are normally restricted).
The price of allowances have been very volatile since its launch, peaking at over €30, and falling to almost nothing at the end of Phase I, generally as a consequence of over-allocation by some Member States. The spot price is currently around €7, but it changes on a daily basis. A price of €20-25 or €100 per EUA is usually quoted as being the minimum required to drive emissions reductions; however as the current price is significantly lower than this, campaigners often cite this as a failure of the system to reduce emissions. There have been suggestions made for controls to be placed on the price, such as a price floor or the equivalent of a central bank, but such suggestions have faced stiff opposition.
Allowances are issued in February of the year for which they must be surrendered. This means that new allowances are issued before the previous year's have been surrendered; so for example, the allowances for 2013 will be issued in February 2013, which is before the 2012 emissions surrender date. As a result of this, unless an Operator has sold a large quantity of their free allowances already, they are likely to be in a long position when the time comes to surrender. This makes borrowing very attractive, as this allows you to satisfy compliance without affecting cash flow.
This was a trend seen in other industries during Phase I of the scheme. As borrowing between Phases 1 and 2 was not allowed because of the significant rules changes, this left many Operators in a situation where they had to satisfy several years worth of compliance in one year. Fortunately, due to an over allocation of allowances, the price of carbon fell to about €0.01 by the time of the surrender deadline, meaning this was not a significant problem for the affected Operators.
The timing of the allowance issue also allows for Operators to use allowances as a way to generate capital, by selling them as soon as they are received. This is one of the reasons why a cap and trade system has been chosen over a straight forward tax, as it can directly provide the capital required to invest in green initiatives and alternative technologies. (see my article in Airline Fleet Management for more details). This, of course, carries a risk if the prices rise sharply before the allowances are re-purchased for surrender; however if the capital has been invested to reduce emissions, then an Operator will need to purchase fewer allowances. This summary is obviously a gross oversimplification, but covers the general principal behind why free allowances are awarded.
Once you understand how the scheme works, the next step is to see how it applies to you.