Is the reform of the EU ETS sufficient to contribute to the Paris Agreement?

Published 23rd March 2018 by Lucy Haines

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On 27th February 2018, Member States (MS) formally approved the reform of the European Union Emissions Trading Scheme (EU ETS) for phase IV (2021-2030) at the EU Council. After more than two years of negotiations since the EU disclosed its initial proposal for reform, this approval by MS is the last political step before implementation.

Since spring 2017 and the political negotiations in the trilogue calling for more ambition, the EU ETS price of carbon has doubled from 5 to 10 / tCO2, its highest level in six years. Can this reform of the EU ETS support this upward trend in carbon prices by 2030? Will it be able to deliver a carbon price level compatible with the Paris Agreement? Perhaps, but only under three conditions.

A REFORM TO MAKE THE EU ETS EFFECTIVE BY 2030

The approved EU ETS reform is actually more ambitious than the initial proposal of the EU Commission in 2015. It aims to make the EU ETS more effective in achieving the reduction target of -43% of CO2 emissions in the industry and energy sectors by 2030. This revision of the EU ETS Directive has been the subject of political compromise and a delicate balance between climate ambition and the preservation of the competitiveness of EU industries.

In terms of strengthening climate ambition, the reform consists of introducing the following three measures:

  • The cap of CO2 emissions will be reduced each year by 2.2% with an annual withdrawal of 48 million allowances from 2021 (versus 38 million currently).
  • The number of allowances to be placed in the Market Stability Reserve (MSR), that will be operational in 2019, will be doubled until the end of 2023 (withdrawal rate at 24% instead of 12%) to absorb the allowance surplus at a quicker rate.
  • A new mechanism to limit the validity of allowances held in the MSR beyond a certain level (when the MSR volume exceeds the auction volume of the previous year) will become operational by 2023.

The revised EU ETS Directive also includes a number of provisions to protect the industry against the risk of carbon leakage.

  • The share of free allowances will be 43% of the CO2 cap (and 57% of auctioned allowances) with a conditional increase of 3%.
  • More dynamic free allocation rules will be based on actual production levels and updated carbon intensity benchmark values.
  • The sectors with the highest risk of carbon leakage will benefit from free allowances during Phase IV. For sectors less exposed to the risk of carbon leakage, the free allocation rate will be 30% of their benchmark value, and will gradually decrease after 2026, with the exception of the district heating sector.

CONTINUED REFORM OF THE EU ETS IS NEEDED

The EU ETS is on track to reach its 2020 target of -21% reduction and its current reform undeniably strengthens its ambition. However, this updated directive will not be sufficient to make the EU ETS the main driver of the decarbonisation of industry and energy by 2030, in line with the ambition of the Paris Agreement. Market analysts agree that the EU ETS price of carbon could range between €10 in 2020 up to €25 in 2030, while the High Level Commission on carbon prices led by economists Stern and Stiglitz advocated in May 2017 a price trajectory compatible with the ambition of the Paris Agreement, between 34 and 68 €/tCO2 for 2020, then between 43 and 85 /tCO2 for 2030.

To achieve this economic incentive by 2030, three conditions must be met by 2025:

CONDITION 1: Making the EU ETS governance operational by 2020.

 

The varying energy and climate policies of the Member States can impact the functioning of the EU ETS. To improve transparency and address overlaps, Europe must adopt the regulation on the Governance of the Energy Union, proposed by the EU Commission in November 2016 to ensure alignment of policies with EU goals and also allow the flexibility to adapt to local conditions and needs.

 

CONDITION 2: Strengthening the resilience of the EU ETS against effects of other policies that weaken its price-signal by 2021.

 

The emission reductions generated by renewable energy and energy efficiency policies should be sufficient to achieve the EU ETS target of -43% by 2030, limiting the role of the market. The objectives of these energy policies could be further increased by 2030. Finally, other measures, such as the introduction of CO2 floor prices or the gradual closure of coal-fired power plants by some Member States, could lead to further emission reductions. To manage interactions between the EU ETS and energy policies, the rate of withdrawal of the MSR should be increased after its first review scheduled in 2021.

CONDITION 3: Aligning the EU ETS with the long-term carbon neutral path of the EU consistent with the Paris Agreement by 2025. 

The increase in the linear emission reduction factor of the EU ETS – now at 2.2% – will be essential to ensure a coherent EU decarbonisation by 2050. This alignment will have to be realised by considering the EU 2050 roadmap, “Towards a low-carbon EU economy in 2050”, which will be published in mid-2018, but also the global stock-take on climate ambition, scheduled by the Paris Agreement in 2023. Finally, the question of the economic treatment of “negative emissions”, such as carbon offsetting in Europe, will also need to be addressed as soon as possible, in line with developments in the Paris Agreement.

If we do not fulfil these three conditions, the price of carbon delivered by the EU ETS will not be sufficient after 2025 to encourage a successful low-carbon transformation of the EU energy and industrial sectors and to respect the EU commitment to the Paris Agreement. The next policy steps taken by Europe are vital.

 

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