The EU ETS is evolving to accelerate the decarbonisation of companies: what is at stake?

This week, after months of talks, EU negotiators finally agreed to implement a Carbon Border Adjustment Mechanism (CBAM), which taxes imports of carbon-intensive products from countries that do not adequately price greenhouse gas (GHG) emissions. The initial proposal was made by the European Commission in July 2021 as part of the Fit for 55 climate legislation package. The CBAM is an important aspect of the effort to align the European Union Emissions Trading Scheme (EU ETS) with the EU’s enhanced ambition to reduce GHG emissions by 57% by 2030, compared to 1990.

While the decarbonisation of the electricity sector has so far been sufficient to achieve the EU ETS emission reduction targets, future success will require the mobilisation of all industrial sectors. Critically, price signals must trigger technological shifts beyond the phase-out of only the most polluting fuels. What are the obstacles to the energy transition progressing at the scale and speed required by the Paris Agreement, and how can the reform of the EU ETS tackle them?

While the EU ETS contributes to the low carbon transition, the reform cannot guarantee Europe’s exit from coal

During Phase 3 (2013-2020) of the EU ETS, emission reductions were largely driven by combustion plants, which account for most of the power sector. Emissions linked to the combustion of fossil fuels decreased by 38% over the period, compared with 9% for other so-called “process” emissions, i.e.: those relating to industrial production processes.[1] This is due to the increase in renewable capacities and the switch to less carbon-intensive fossil fuels. Between 2018 and the end of 2021, the carbon price in the EU ETS made the use of natural gas more cost-effective than coal, allowing a 30% reduction in the sector’s carbon intensity. This indicator is essential, as only the increasing separation of emissions and production will help achieve net-zero emissions while maintaining the level of industrial production.

While the EU ETS has fulfilled its guiding role in the combustion sector, the challenge of using the carbon price signal to accelerate decarbonisation remains. Indeed, the current dynamics of energy markets and the increase in gas prices due to the war in Ukraine limit the incentive of the carbon price – even at €80/CO2e – to substitute coal for gas. While renewables used to replace coal-fired power plants, since 2019 they have been crowding out gas-fired power plants, slowing down emissions reductions from fossil fuel combustion.[2] This is unprecedented, as despite upward pressure on carbon prices, coal could retain its advantage over gas until December 2023, according to some analysts.[3]

How can the reform of the EU ETS fix this situation? As a market mechanism, the EU ETS is, by definition, permeable to external economic shocks and cannot impose one energy source over another. Only the acceleration of the GHG emission reduction trajectory imposed on installations will be able to act as a reminder, as the number of quotas available on the market – and the price of carbon – will at some point become incompatible with the use of coal as a fuel. The more ambitious the trajectory, the sooner this will happen: the proposal to move from a -43% emissions target to -63% by 2030, compared to 2005, should help.

The reform of the EU ETS only partially contributes to securing investments in low-carbon technologies

Furthermore, for other industrial installations, the reduction in carbon intensity remains more difficult to achieve, particularly in the steel, petrochemical, aluminium, and cement sectors, in which process emissions have been stable overall since 2013. The decarbonisation of these sectors, also known as hard-to-abate, is based on technological innovations that require significant R&D and investment.

In this respect, the current reform of the EU ETS involves an increase in the innovation fund of 200 million quotas (i.e.: 16 billion euros at the current carbon price) which should make it possible to meet part of the financing requirement. However, the EU ETS may not be able to provide installations with the visibility on future carbon prices needed to secure investments. While the Market Stability Reserve (MSR) helps to support the carbon price, the nature of the EU ETS – based on quantities and not prices – makes the carbon price uncertain, despite the planned adjustments to the reserve’s parameters. Supplementing the innovation fund with contracts for carbon difference, which consist in covering the difference between the market price of carbon and a predefined floor price, would help secure the return on investment in low-carbon technologies. These contracts are favoured by many industrial players, but their contours have yet to be defined at EU ETS level.

For European industry to have a competitive advantage, the Carbon Border Adjustment Mechanism is essential

While the EU ETS influences businesses through the carbon price it generates, the engine of business transformation lies first and foremost in value creation. This comes from the energy savings made possible by decarbonisation, and from the discovery of new markets for low-carbon products. In this respect, the Carbon Border Adjustment Mechanism (CBAM) measure, which consists of taxing imports of certain products to the extent of their carbon content and at a carbon price level equivalent to that of the EU ETS, is key to preserving the competitiveness of business in the European market, as well as limiting the risk of “carbon leakage” to regions of the world where the price of carbon is lower.

On December 13, 2022, the EU reached a provisional agreement on the CBAM to green its industrial imports and give a competitive advantage to European industry. A test period is set to begin on October 1, 2023.

Two important elements of the CBAM remain under negotiation. First, whether the end of free allocations for the sectors covered will be brought forward to 2032. Abolishing free allocations is a sine qua non condition for the compatibility of the CBAM with the rules of the World Trade Organisation (WTO). The end of free allocations should also help accelerate the decarbonisation of industry, since companies would then be required to buy all of their emission allowances.

Second, to ensure that EU companies are not disadvantaged for pricing carbon in their products in countries where local competitors do not, another proposal would provide rebates for exports. The idea is attractive in theory but may be complex to implement in practice. On what basis should these rebates be calculated? How can we ensure that they do not jeopardise the urgent need for climate action?

A final word: confidence and competitive advantage versus complexity

Most stakeholders agree that in the context of accelerating global commitments to net-zero emissions, the EU ETS provides a competitive advantage to regulated companies.[4] Keeping a share of free quotas goes against this statement, as it means that benefiting companies will be downgrading the signal sent by the EU ETS. Moreover, this agreement calls into question the initial role of the EU ETS, namely, to provide a robust price signal. By trying to do too much, the EU ETS, which has already reached a significant level of complexity with the reforms, risks losing the confidence of market players.

 

[1] 2022 State of the EU ETS report, https://ercst.org/state-of-the-eu-ets-report-2022/

[2] https://ember-climate.org/insights/research/european-electricity-review-2022/

[3] https://www.clearbluemarkets.com/post/goda-aglinskaite-market-analyst-at-clearblue-quoted-in-reuters-article-1

[4] Market sentiment survey, 2022 State of the EU ETS report