The European Union’s plan to turn its 27 member states into a low-carbon economy all hinges on one number: 20. The aim is simple: cut greenhouse gases by 20 percent; increase energy efficiency by 20 percent; and increase renewable energy use to 20 percent of total energy consumption. When does it all have to be done by? The answer should be obvious by now: 2020.

In January, the European Commission – the EU’s executive arm – put forward a climate action package to achieve these targets. Its goal is a big one: to ensure the sustainability of the planet, provide new business opportunities for European companies, and to improve the security of energy supply by bringing about a shift towards renewable energy.

Central to the package of measures is an updated version of its existing Emissions Trading System (ETS). With the ETS, launched in January 2005, the Commission has succeeded where the alchemists of history failed; it has taken a worthless element – carbon – and turned it into gold. The scheme gives companies a right to emit a certain amount of carbon and then sell any unused rights on the open market to other companies that have used up all theirs. The value of carbon traded on the ETS is already worth $59bn annually. If the price of carbon continues to rise as expected, the ETS could trade $115bn by 2020. (The Commission estimates revenue from auctioning could reach up to $80bn by 2020)

The new version of the ETS extends its scope to 2020 and sets more stringent reduction targets for the EU’s energy and manufacturing sectors. For the first time, industries such as aluminium and chemicals were added to the ETS, which will now cover almost half of Europe's total emissions. That will further increase the value of the emissions traded through the scheme.

The ETS is the cornerstone of the EU's strategy for fighting climate change. It is the first international trading system for CO2 emissions in the world. It applies not only to the 27 EU Member States but also to the other three members of the European Economic Area – Norway, Iceland and Liechtenstein. It currently covers over 10,000 installations in the energy and industrial sectors, which are collectively responsible for close to half of the EU's emissions of CO2 and 40 percent of its total greenhouse gas emissions.

The ETS is a “cap and trade” system – it caps the overall level of emissions allowed but, within that limit, allows participants in the system to buy and sell allowances as they require. These allowances are the common trading currency at the heart of the system. One allowance gives the holder the right to emit one tonne of CO2. The cap on the total number of allowances is what creates scarcity in the market.

For each trading period under the scheme, member states draw up national allocation plans that determine their total level of ETS emissions and how many emission allowances each installation in their country receives. At the end of each year, installations must surrender allowances equivalent to their emissions.

Companies that keep their emissions below the level of their allowances can sell their excess allowances. Those facing difficulty in keeping their emissions in line with their allowances have a choice between taking measures to reduce their own emissions – such as investing in more efficient technology or using less carbon-intensive energy sources – or buying the extra allowances they need on the market, or a combination of the two. Such choices are likely to be determined by relative costs, so emissions are reduced wherever it is most cost-effective to do so.

The first trading period on the ETS ran from January 2005 to the end of 2007 and was a “learning by doing” phase. The crucial second trading period began on 1 January 2008 and runs for five years until the end of 2012. The importance of the second trading period stems from the fact that it coincides with the first commitment period of the Kyoto Protocol, during which the EU and other industrialised countries must meet their targets to limit or reduce greenhouse gas emissions.

For the second trading period the Commission has capped national emissions from ETS sectors at an average of around 6.5 percent below 2005 levels to help ensure that the EU as a whole, and member states individually, deliver on their Kyoto commitments.

So far, the ETS has been a success, according to the Commission. The first trading period established the free trading of emission allowances across the EU, put in place the necessary infrastructure and developed a dynamic carbon market, it says. However, the environmental benefit of the first phase has been limited because the Commission gave out too many allowances – a point it readily admits. These were allocated on the basis of emission projections before verified data became available.

However, there have also been widely different national methods for allocating allowances, and this has threatened fair competition in the market. Under the revised scheme, these national allocation plans will be scrapped. They generated significant differences in allocation rules, creating an incentive for each member state to favour its own industry, and led to great complexity, the Commission says.

It also wants to introduce greater harmonisation, clarification and refinement about the scope of the system, access to credits from emission-reduction projects outside the EU, the conditions for linking to emissions trading systems elsewhere and better monitoring, verification and reporting requirements.

Other improvements to the scheme involve making better links with the global carbon market. The Commission wants the ETS to be an important building block for the development of a global network of emission trading systems. Linking other national or regional cap-and-trade emissions trading systems to the ETS can create a bigger market, potentially lowering the aggregate cost of reducing greenhouse gas emissions, it believes. “The increased liquidity and reduced price volatility that this would entail would improve the functioning of markets for emission allowances. This may lead to a global network of trading systems in which participants, including legal entities, can buy emission allowances to fulfil their respective reduction commitments,” says a Commission briefing paper on the topic.

The current Directive allows the ETS to be linked with other industrialised countries that have ratified the Kyoto Protocol, but the Commission is proposing to extend this to include any country or administrative entity – such as a state or group of states under a federal system – that has established a compatible cap-and-trade system. “Where such systems cap absolute emissions, there would be mutual recognition of allowances issued by them,” it said.

This global market is growing rapidly. According to a study released by the World Bank last year, the global carbon market tripled in 2006 – to $30bn from $10bn in 2005. The European ETS dominated the market with a share of $25bn, but projects-based markets in developing countries and in countries with economies in transition grew sharply to US$5 billion in 2006, more than doubling over the previous year. The report estimates that direct carbon purchases have leveraged an additional $16bn in associated investments supporting clean energy in developing countries since 2002.

“These numbers are relevant because they demonstrate that the carbon market has become a valuable catalyst for leveraging substantial financial flows for clean energy in developing countries,” said Warren Evans, World Bank Director of Environment.

The report shows that the developing world has contracted one billion tons of greenhouse gas emission reductions and is on track to bring an additional billion tons to the market by 2012. “These figures show the important contribution of the developing world to climate change mitigation. The additional billion tons from developing countries amounts to half of what Japan and the European Union together need to reduce, from now until the end of the Kyoto Protocol commitment period,” said Karan Capoor, World Bank financial specialist and co-author of the market report.

The voluntary market – for actions by individuals and companies not required by the Kyoto Protocol or other regimes – is also taking off with more than 50 companies offering offsets. Some estimates presented in the report put the volume of the voluntary market by 2010 at 400 million tonnes a year. But those predictions come with a strong caveat. The report warns that “this high-potential voluntary segment lacks a generally acceptable standard, which remains a significant reputation risk not only to its own prospects, but also to the rest of the market, including the segments of regulated emissions trading and project offsets.” There are efforts underway in the market to create acceptable, voluntary standards for offset projects.

As much as the market has grown, the report pointed out that “the enormity of the climate challenge will require a profound transformation, including in those sectors that cap-and-trade markets cannot easily reach. These include making public and private investments in research and development for new technology development and diffusion, economic and fiscal policy changes, programmatic approaches to decouple economic growth from emissions development as well as the removal of distortionary subsidies for high-carbon fuels and technologies.”

Meanwhile, the risks of investing in global carbon markets are soaring, as the trade in emissions rights between rich and poor countries becomes a pawn in talks to agree a new global climate change deal by 2009. The UK’s Guardian newspaper reported recently that the European Commission was thinking of using carbon offsets as a political tool to encourage developing countries to do more to fight global warming. “Developing countries will need to contribute, we are handing them a carrot,” it quoted the Commission's head of emissions trading Yvon Slingenberg as saying.

Slingenberg was speaking at a Copenhagen conference on the Kyoto Protocol's Clean Development Mechanism (CDM) offset scheme, worth around €12bn last year. Some carbon market participants warned the conference that the EC approach is too heavy-handed. “Unless the European Commission changes direction the existing CDM...market will weaken with potential collapse of some (carbon) funds and developers,” Odin Knudsen, managing director of environmental products at JP Morgan Chase, told the conference. “It's a tremendous injection of uncertainty, instability into the market.”

The Commission, however, says its latest move is designed to encourage developing countries, the main beneficiaries of trade in offsets, to engage in the talks. The concern is that in developing a successful carbon trading scheme for its member states, it will undermine other initiatives to cut emissions. Saving the planet is a big goal, and not one that Europe can achieve on its own.