EUROPEAN EMISSIONS TRADING: EU ETS

ENERGY BRAINBLOG - 27. May 2021 - By Lara Dombrowski

The CO2 price is becoming increasingly important for the electricity market. Therefore, we take a closer look at the CO2 market and the discussed changes in the European Emissions Trading Scheme (EU ETS). In this first article, we look at the current developments and the envisaged changes in the course of the new EU climate protection package “Fit for 55”.

In summary, the EU ETS is the EU’s central instrument for reducing greenhouse gas emissions in a cost-effective manner. In this context, the EU ETS represents one of the world’s largest CO2 markets. It caps emissions from about 10,000 power sector, industrial and aviation installations from all EU countries plus Iceland, Liechtenstein, Norway and Switzerland.

In doing so, it covers approximately 40 percent of these countries’ greenhouse gas emissions (source: European Commission). How verified CO2 emissions within the EU ETS have developed since 2005 is shown in Figure 1 (data source: European Environment Agency).

Overview of the EU Emissions Trading Scheme

The EU ETS is a trading system for CO2 allowances that operates according to the “cap and trade” principle. There is a fixed system-wide cap within which plant operators purchase or receive emissions allowances. The cap is reduced over time so that overall emissions decline.

Currently, the EU ETS is in its fourth phase (2021-2030). This phase focuses on reducing the total number of emission allowances, specifically by 2.2 percent annually instead of the current 1.74 percent (linear reduction factor). Furthermore, this phase also further expands the Market Stability Reserve (MSR), into which surplus allowances are moved to stabilize prices.

Impact of the Corona pandemic on the EU ETS

Due to the Corona pandemic in 2020, CO2 emissions fell by 10 percent compared to the previous year. The price of traded CO2 allowances did not follow from this drop in demand, but recently rose significantly.

One of the reasons for the price development was the announcement that the European climate target for 2030 would be raised. After the EU negotiations on a tightening of the CO2 reduction target started in October 2020, the prices for CO2 certificates rose sharply.

They then continued to do so accordingly in 2021. With phase 4 of the EU ETS, the prospect of the new climate target and also an improved medium-term economic situation and speculative market participants, prices continued to rise to a record high of over 56 EUR/ton CO2 by mid-May 2021. The price development is shown in Figure 2.

In April 2021, the EU announced the new EU climate target: Emissions to be reduced by 55 percent compared to 1990 instead of only 40 percent as previously agreed.

Along with this, stakeholders will inevitably have to adapt the EU ETS as well. The “Fit for 55” package, which the EU will present in July 2021, will contain a total of 13 proposals for changes to the EU ETS and other measures.

How the EU ETS is to be adapted

Among the proposals that could be discussed in July are “Deeper Cuts.”

These refer to reducing the number of emissions permits issued over the ten-year period to 2030. Specifically, this can be achieved through measures such as adjusted caps, the MSR, or the linear reduction factor (LRF).

• First, the cap sets the total number of emission allowances. It could be reduced or realigned in future years.
• Second, the rate at which the total emissions cap shrinks each year is determined by the LRF. Thus, increasing the LRF would be an option.
• Third, the MSR is a mechanism that automatically controls the supply of CO2 allowances. In doing so, the MSR responds to changing demand with flexible supply. And it does so by reducing surplus CO2 allowances. That means: Another measure for “Deeper Cuts” would be an expansion of the MSR.

Figure 3 shows the expected development of TNAC (Total Number of Allowances in Circulation), the cap, the allowances in the Market Stability Reserve (MSR) and the verified emissions until 2030 (source: European Environment Agency).

Further measures in detail

Likewise, policymakers need to discuss measures on “carbon leakage.” There are currently proposals to reduce the total number of free allowances for companies in sectors that tend to relocate their production outside Europe when CO2 prices are high.

Carbon Border Adjustment Mechanisms are also under discussion. These involve increased levies on imports of emission-intensive products. The specific aim here is to reduce the risk of carbon leakage. At the same time, they are intended to encourage EU partners to increase their climate targets by creating a level playing field.

Another proposal concerns the introduction of carbon contracts for difference. Here, the difference from a fixed carbon price for clean technologies would be paid to industries that decarbonize their processes as long as the ETS price is too low. The development of a framework for carbon removal credits, certificates for taking CO2 out of the atmosphere, is also being considered.

In addition, there are increasing discussions to extend the EU ETS sectorally, for example to sectors such as buildings, road transport and the maritime sector (source: EURAKTIV). Another important issue is the introduction of a minimum CO2 price. This can be used to maintain planning security for investments in climate-friendly technologies.

The “Fit for 55” package: what are the important issues?

On July 14, 2021, the European Commission will present the “Fit for 55” legislative package. This will include measures to reduce emissions by at least 55 percent by 2030 compared to 1990 levels (source: European Commission).

Of the possible measures discussed above to adjust the EU ETS, some options are already on the table and are part of the new more ambitious “Fit for 55” climate protection program. Table 1 shows the main topics of the “Fit for 55” legislative package (source: EU Parliament, Karlsruhe Chamber of Commerce and Industry).

Specifically, EU policymakers will negotiate how to revise the EU ETS and how to capture greenhouse gas emissions and removals that result from land use, land use change and forestry (LULUCF).

Also on the table is an amendment to the Renewable Energy Directive and the Energy Efficiency Directive to implement the ambition of the new 2030 climate target.

Other topics that the EU Parliament will discuss in July revolve around the topic of alternative and sustainable fuels. This involves the infrastructure for alternative fuels and, above all, the use of sustainable fuels in aviation and shipping. In addition, the regulation that sets CO2 emission standards for cars and vans is also due to be amended.

MSR likely to take effect later

However, some of the issues mentioned above regarding the adjustment of the EU ETS could, even if decided in July, only become effective later anyway. This relates to the MSR, for example. Since the 24 percent MSR withdrawal rate is locked in until 2023, any adjustment to the MSR could likely not take effect until after 2023.

The coming weeks should lead to exciting political discussions at the EU level. We will keep you updated on the discussion at EU level. In a second article, we will present the results on the EU ETS in due course.

You can get more details on the European emissions trading system in our live online training “The European CO2 Market: Insights and Outlooks”. It will take place in September this year.

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