Key messages from 2022 State of the EU ETS Report

The new State of the EU Emissions Trading System (EU ETS) Report looks at lessons learned from Phase 3 of the EU ETS and the first steps of Phase 4, and the impact of high carbon pricing and unprecedented increases in energy prices. EcoAct carbon market expert, Anouk Faure, reviews the report’s key messages.

The 2022 State of the EU ETS was published on 26 April 2022 in collaboration with the European Round on Climate and Sustainable Transition (ERCST), BloombergNEF, the Wegener Center at the University of Graz in Austria, and EcoAct. The seventh edition of this annual report aims to provide an independent contribution to the policy debate on the role and effectiveness of the EU carbon market. The report analyses Phase 3 and the first steps of Phase 4 of the EU ETS in the context of a new climate ambition to achieve net-zero by 2050 (Read the full report here).

2021 saw a number of significant events for the EU ETS. Firstly, it marked the start of the “Fit for 55” package negotiations between the European Parliament and the European Council which could lead to significant changes to the scope and parameters of the EU ETS from as early as 2023. Furthermore, Europe has been impacted by unprecedented increases in energy prices and ongoing uncertainties.

While negotiations are underway to align the EU ETS with the new climate ambition, this report addresses two questions: What lessons can be drawn from Phase 3 of the EU ETS (2013-2020)? How can we analyse the environmental and socio-economic effectiveness of the EU ETS over the past year?

What were the results of Phase 3 of the EU ETS?

• After a second Phase characterised by low carbon prices due to structural instabilities, the reforms carried out under Phase 3 (2013-2020) enabled the recovery of a price signal consistent with the EU’s decarbonisation objectives.
• The EU ETS reached its 2020 emissions reduction target in 2014. This reduction was largely thanks to the decarbonisation of electricity production (-38% compared to -9% for other industrial facilities). Beyond the contribution of the EU ETS, all the policies supporting the electricity sector’s transition, as well as historically low gas prices, facilitated this result.
• The pandemic had a considerable impact on CO₂. Between 2019 and 2020, emissions dropped by 11%, compared to an average of 5% over previous years. However, this reduction rate is still far off regulatory requirements.
• Beyond economic variations, several signals indicate the beginning of significant decarbonisation of European industry. The carbon intensity of combustion activities decreased by about 30% during Phase 3, and before the Covid-19 crisis. Elsewhere, progress has been slow over the same period.
• Phase 3 was also marked by a decline in the number of quotas accumulated since 2008. For the first time, all industrial installations had to buy the equivalent of 2 to 3% of their emissions at auction. This does not include combustion activities, which had to deal with a shortfall of permits equivalent to 85% of emissions.
• However, according to the market data, the possibility of banking allowances is an effective flexibility mechanism for levelling out future needs for quotas.
• The increase in the price of carbon has led to a significant increase in auctioning revenues for Member States: they were four times higher in Phase 3, and 75% of them were used for climate purposes. In 2020, the sectors regulated by the EU ETS benefited from 40% of these revenues via direct support measures for decarbonisation (e.g. adoption of low-carbon production technologies), with the rest mainly going to energy efficiency measures and support for the transport sector’s transition.
• Finally, the implementation of the market stability reserve coincided with a sharp increase in carbon prices, and these high prices were maintained during the Covid crisis. However, behavioural factors such as the anticipation of future scarcity of credits, or the demand for risk coverage from regulated companies, seem to be equally important as the actual decrease in supply.
• Amidst current energy and political tensions in Europe, stability reserve capacity will be challenged in Phase 4.

The EU carbon market’s environmental efficiency in 2021

• 2021 brought two major changes to the EU ETS: the revised framework for Phase 4 (2021-2030) and the European Commission’s “Fit for 55” legislative proposal, which is based on the 2050 carbon neutrality objective. Provided there is an agreement at EU level, the EU ETS reduction target will shift to -61% of emissions in 2030 compared to 2005 levels. Projected emissions based on GDP growth of between 0 and 2% per year could soon reach the stage 4 target path.
• By 2021, “revenge pollution” (the aggressive rebound in emissions during economic recovery) post-Covid almost fully eclipsed the emissions decline observed during the health crisis, returning them to 2019 levels. In total, emissions increased by 9.1% compared to 2020, mainly due to electricity generation.
• The electricity sector is decarbonising, thanks to the growing use of renewable energies, which now account for most power generation (excluding hydroelectricity), and to the substitution of coal by gas.
• Since 2013, the reduced share of nuclear power has resulted in a slower decline in emissions which has offset the emission reductions achieved by the substitution of coal with gas between 2018 and 2020.

Socio-economic efficiency in 2021

• In 2021, the EU ETS recorded the highest carbon prices since its creation, exceeding €95/tCO₂. This is a result of successive reforms to reduce quota supply, progress towards a deeper decarbonisation of industry, the announcement of reforms driven by the European Green Deal, as well as the unprecedented energy situation.
• However, in 2021. and for the first time since December 2018, this price level is no longer sufficient to substitute natural gas with coal for power generation. This was due to tensions related to Russian natural gas supplies as winter approached.
• While the potential of the ETS to trigger innovation in low-carbon technologies is recognised, confidence in its governance has decreased slightly since 2020.
• The direct costs of the EU ETS, together with their carbon pricing, have greatly increased since 2020, directly impacting consumers.
• A rough estimate of the indirect costs of the EU ETS shows that they have escalated in power-intensive industries, increasing the risk of carbon leakage despite state aids. Managing these costs will be a challenge in Phase 4 and will raise the question of the social impacts of the energy transition.

Market performance in 2021

• In 2021, the total volume traded increased by 13% compared to 2020, reaching almost 11 billion EUAs in 2021. This is due to the rebound in post-Covid emissions which has boosted the demand for credits, and the participation of financial investors.
• The number of non-EU ETS regulated actors rose by 67% between 2020 and 2021. Changes in European allowance prices have often been aligned with changes in the positions of investment funds.
• Carbon price volatility also increased between 2020 and 2021.
• Despite the fast-rising carbon prices, no cost containment measure was initiated in 2021, nor will it be in the first half of 2022. However, this has triggered a debate on the issue of speculative behaviour in the EU ETS. As a result, the European Securities and Markets Authority (ESMA) opened an investigation. Its findings, published in March 2022, do not indicate any abnormal operations in the EU carbon market, but call for further market monitoring.
• Analysts’ projections agree on an upward trend in the price of carbon by 2030, with prices possibly exceeding €100/tCO₂