The State of the EU ETS in 2020

The fifth edition of the report into the European Emissions Trading Scheme (EU ETS) summarises the current developments in the European carbon market.

The latest edition of the State of the EU ETS report was recently released. Produced in collaboration with the ERCST (European Round on Climate Change and Sustainable Transition), BloombergNEF, the Wegener Research Center at the University of Graz, and EcoAct, this annual report aims to provide an independent contribution to the policy debate on the role and efficiency of the European carbon market.

In 2018 revisions for Phase 4 (2021- 2030) of the EU ETS were adopted in order to help the EU to achieve its targets under the Paris Agreement and over the course of 2019 the EU ETS has continued its mission to send a price signal to stimulate an economically efficient decarbonisation.

The scheme of course is impacted by the wider context. This context continues to shift significantly. In 2019, the EU committed to Net Zero emissions by 2050 and is laying the foundations for its ambitious European Green Deal (EGD), and in 2020 the global economy finds itself hostage to the COVID-19 pandemic. Ultimately, these factors will have a significant bearing on the future of EU ETS, but here we summarise the current state of the scheme and the success of the system so far in driving forward decarbonisation of the bloc.

Key findings from the 2020 report: An EU ETS fit for purpose?

The report sees three expected deliverables of the scheme, against which is assesses and reports on its performance.

1. The environmental efficiency of the EU ETS

• The EU ETS has reached its emission reduction target for 2020.
• CO₂ emissions decreased by 8.9% in 2019. More specifically, the power sector decreased by 13.9%, compared to only a 1.3% decrease in industrial emissions.
• This emissions decline is almost four times faster than the EU ETS emissions cap compared to twice as fast as 2018. It is also the highest decrease in emissions since 2009.
• The decrease can be attributed to the substitution of coal fuels by gas in the power sector, as a result of a higher carbon price combined with historically low gas prices; the continued growth of renewables in the energy mix; as well as warmer than average temperatures diminishing demand for energy for heating.
• Carbon intensity is also an important measure besides absolute emissions reductions to demonstrate that activities are decarbonising rather than just reducing themselves. Although there is limited data, what is available indicates that sectors like glass, metals, refining and paper & pulp are decreasing in carbon intensity, whereas other sectors across Phase 3 remained fairly flat.
• Official figures from the European Environment Agency (EEA) show that by the end of 2018, emissions from fixed installations have already decreased by 29% compared to 2005. Official data from the EEA is not yet available for 2019.
• There is still great uncertainty about future emissions due to COVID-19. It is speculated that EU ETS emissions could be reduced by as much as 20% in 2020, recovering to 95% in 2021.
• Beyond 2020, the EU ETS target, set at 43% reduction in CO₂ emissions by 2030, will not be sufficient for the EU to achieve its long-term climate ambition of Net Zero by 2050. Several revision scenarios are to be examined in 2020.

2. The economic efficiency of the EU ETS

The state goal of the EU ETS is to “promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner”.

• In 2018 the EU ETS observed a price of between €18 and €29 per tonne of CO₂ – a level not observed for almost a decade. Following this, CO₂ emissions from the EU ETS fell sharply by 8.9% in 2019, a decline not seen since 2009 (a year when economies were reeling from the 2008 financial crisis).
• A large share of the emission reductions in 2019 can be attributed to fuel switching, and the European Carbon Price (EUA) price played a significant role alongside low gas prices. While the EU ETS has played a role in the deployment of renewable energy sources, it is not sufficient on its own. However, with EUA prices rising in recent years, and prices of renewables continuing to drop, the EU ETS is becoming an increasingly important factor.
• For the third year, the report carried out a “Market Sentiment survey”. It showed increased confidence that the EU ETS provides a stable and predictable framework for an investment signal. However, 64% of respondents believe that current price patterns are not compatible with the 2050 net zero goal.
• In terms of protecting against the risk of carbon leakage (i.e when rising costs push industry to other countries to avoid regulations) 2019 was the third consecutive year in which all industrial sectors experienced direct costs. Free allowances covered 98.8% of emissions in 2017, 96.8% in 2018 and 97.5% in 2019. Therefore, they have until recently been fairly protected from costs, but as costs rise, the picture will start to change meaning the risk could rise.
• Total auction revenues amounted to €14.6 billion in 2019, compared to €14.2 billion euros in 2018. Member states declared that they have spent 80% of their auction revenue for climate and energy purposes for the period 2013-2018. This is another mechanism of the scheme helping to facilitate the low carbon transition.

3. Functioning of the European carbon market in 2019

• The report measures against eight KPIs to evaluate whether the EU ETS is functioning optimally. Most of the KPIs moved in a negative direction in 2019 but this is not a cause for concern. 2018 was exceptionally active year as new financial players entered the market and ramped up activity.
• Overall traded volumes remain fairly high despite low activities from utilities due to fuel-switching. The test will be next year, post COVID-19
• The volatility of CO₂ prices has reduced but remains high when compared to other raw materials. The drop is considered positive as it points to a more stable market.
• Open interest has dropped in 2019, again not cause for alarm against an exceptional 2018 and it suggests that the scheme is delivering environmentally. However, it is important the market remains active.
• CO₂ allowance transaction volumes increase by 6% despite lower emissions.
• A new headline target for 2030 will need to be agreed to bring the EU ETS in line with Net Zero commitments. The Linear Reduction Factor (LRF) will need to change but precisely how and when will need to be carefully considered.
• In the EGD the door is opened to exploring the possibility of extending the EU ETS to a number of new sectors, including maritime transport (shipping), road transport and buildings.

Political topics to watch in 2020

What happens over the course of this year could have profound impact on the scheme moving forward. The scheme sits within a complex and shifting political and socio-economic landscape.

The implications of the European Green Deal and the Net Zero objective as well as the proposed carbon border tax are among challenges to be examined in 2020.

COVID-19 is likely to push Europe into a deep recession. The major challenge for the European Commission will be to demonstrate the capacity of the EU market to weather the storm and manage its climate objectives to deliver a “green recovery”.

In addition to this, the continued implementation of the EU ETS or equivalent scheme in the UK (among the largest emitters and buyers of EUAs) following Brexit is yet to be set in stone. The scheme is still yet to be entirely reconciled with the aviation sector commitments under CORSIA and the Market Stability Reserve will need to be able to adapt to this changing context in order to ensure the efficiency and functionality of the scheme moving forward.

Positive progress certainly made, but lots of work still to do!

Download the full report here