The Emissions Trading System 4.0: Europe doing its homework under Paris Agreement

On 8 November European negotiators struck a final deal on the revision of the Emissions Trading System (ETS) for the period 2021-2030, proposed by the European Commission in July 2015.

The agreement marks a major step forward in Europe’s efforts against climate change, as it is the main legislative act implementing the European Union’s target of reducing greenhouse gas emissions by 40% by 2030 on the 1990 levels, alongside the non-ETS sector target being delivered by the Effort Sharing Decision legislation.

The legislation affects about 11.000 installations (power plants & industry) in Europe, which account for 45% of EU greenhouse gas emissions and which will have to reduce them by 43% on the levels of 2005.

Over the last two years, European institutions have grappled with one the most highly technical pieces of European law to find the right balance and meet three main challenging policy objectives:

• reestablish a meaningful carbon price (the price of emission allowances) after the value loss due to the 2008 economic crisis and the impact of parallel European policy measures (energy efficiency and promotion of renewable energy);
• define an effective safeguard to shield European industries competing at global level from the direct and indirect costs of the ETS, while maintaining an ambitious environmental target and further incentivizing industrial technology efficiency;
• allocate financial resources deriving from the ETS (auctioning of emissions allowances) to promote industry innovation, facilitate the transition in society and industry and provide a signal for the long-term decarbonisation of the energy sector.

The tension between these challenges at European level and between the specific circumstances and needs of Members States (industrial base, energy mix, economic situation, financial resources etc.) has dominated climate policy across Europe and resulted in intense political discussions both in Brussels and in capitals.

1. What’s in for European industry

European industry subject to the ETS (chemicals, steel, aluminum, paper, glass, cement etc), has been under particular pressure over the tightening of the rules for the allocation of free allowances to industrial installations exposed at risk of carbon leakage as a consequence of asymmetric climate policies at global level. Ensuring a sufficient number of free allowances to the best performing installations (those using the most efficient technologies commercially available today), has been finally recognized by Member States as a key issue and therefore they have agreed to put 3% of their emission allowances at disposal of industry in case of need. Sectors which are not deemed to be exposed at the risk of carbon leakage, however, will see a phasing out of the number of free allowances received (30% today) starting from 2026 to zero in 2030.

A more dynamic system of allocation of free allowances has been introduced, thus allowing for an allocation closer to actual production rather than historic production, meaning that the allowances will be adapted to production increases but also that windfall profits will be avoided.

Regarding the indirect costs of the ETS (costs relating to greenhouse gas emissions passed on in electricity prices), the Council and the Parliament could not reach an agreement on a further harmonization of the compensation measures, which will remain dealt with through State Aid. However, the new Directive introduced a strengthened monitoring of national compensation measures and an assessment of their impact on the internal market, as well as the possibility to reopen the debate on further harmonization in case this proves necessary.

2. What’s in for the European carbon market

Rules for the functioning of the supply and demand of emission allowances have been reformed further, thus complementing the ad hoc interventions already introduced with the Backloading measure in 2012 and with the creation of a Market Stability Reserve in 2014. The new rules will further reduce the supply of allowances in the European market on a regular basis after 2020, so to avoid a surplus and therefore a fall of the carbon price.

Monitoring the full impact of these new mechanisms on the carbon price evolution after 2020 will be key to assess the costs of compliance and the competitiveness curve as well as to make investment decisions for European power and industrial plants.

3. Towards a faster decarbonisation of the energy sector in Eastern Europe

A long and painful debate also took place on the rules for the allocation of financial resources deriving from the sale of emissions allowances under the Modernisation Fund for the decarbonisation of the energy sector in Eastern Europe. Transitional free allocations to these countries for the modernization of their energy sector will expire by 2030 and no support from the Fund will be granted to energy generation facilities using fossil fuels under certain specific conditions.

4. Boosting financing for low carbon technologies

The Innovation Fund has been recognized as a key instrument for the transition to a decarbonized economy and Member States have finally agreed to allocate more resources than initially proposed to projects which will promote the research into breakthrough low carbon technologies (including Carbon Capture and Utilization) and lower costs of the transition for industrial sectors.

5. Next steps and the future ahead

In 2018 the European Commission is expected to adopt delegated and implementing acts on most of the issues concerning industry and the European Funds, as well as revise the Guidelines on the State Aid measure under the ETS. Delegated acts will be adopted also on monitoring, reporting and verification of emissions in the aviation sector, for the purpose of implementing the global market-based mechanism under the ICAO on all routes covered by it.

Given the many uncertainties at global level (unequal implementation of Paris Agreement by the other major economies) and the implications of European national measures and circumstances  (carbon taxes, climate and energy national measures, pace of decarbonisation of the energy sector), co-legislators agreed that the Emissions Trading System will need to be closely monitored and adapted to a dynamic scenario.

Such evolutions might take several directions, like a tightening of the emissions reduction target in the stocktaking of global efforts in 2023 under the Paris Agreement in the case of higher ambition in other economies. The measures for energy-intensive industries will also be kept under review and other options to address carbon leakage remain under consideration, such as the introduction of a Border Adjustment Measure to include importers of products in the ETS, lately called for by President Emmanuel Macron.

Therefore, the Governance of the Energy Union will be the key instrument not only to assess whether policies at EU and national level are on track but also whether they are consistent in the overall framework of objectives.

The Emissions Trading System is likely to keep causing sleepless nights for quite some time…