EU Emission Trading System (EU ETS)
What is the EU ETS? What is the cap-and-trade mechanism? Which gases and sectors are covered by it? And how does it contribute to the EU Green Deal?
The EU Emission Trading System (ETS) is the cornerstone of the European climate policy covering about 45% of the EU’s greenhouse gas (GHG) emissions and about 5% of global emissions. It follows the ‘polluters-pay-principle’, whereby firms covered by the ETS need to purchase an emissions allowance for each tonne of CO2-eq they inject into the atmosphere. In this respect, the EU ETS is a carbon pricing mechanism, like a carbon tax.
Two main features distinguish an ETS from a carbon tax. Firstly, a carbon tax fixes the price for polluting but the amount of CO2-eq abated by the measure is uncertain. By contrast, the EU ETS follows the cap-and-trade approach: it sets an emissions cap, imposing an upper bound to emissions, but the price of allowances is determined by the market and is thus variable (at the time of writing, the price is hovering around €38). Secondly, firms covered by the EU ETS can trade allowances between themselves, so that ‘cleaner’ firms requiring fewer allowances can sell them to more carbon-intensive ones. As explained in more detail further below in this article, the firms participating in the EU ETS also receive some free allowances according to sectoral efficiency benchmarks which reward the most efficient installations.
The EU ETS was the first international emissions trading scheme and has been the largest one in operation since 2005 and will retain this lead until the Chinese ETS becomes operational in mid-2021. Indeed, many more ETSs currently exists and are being developed around the world, both in developed and in developing countries, enhancing ETS linkage possibilities[1]. The emissions cap of the EU ETS decreases at a yearly rate, currently set at 2.2% of the 2010 baseline. Relatively to its launch in 2005, the EU ETS achieved a 21% reduction of regulated emissions in 2020 and is set to enforce a 43% reduction by 2030. This is in line with the EU’s Paris Agreement commitment. This yearly rate is likely to be further strengthened in the perspective of the EU ambition to raise the greenhouse gas (GHG) reduction target to 55-60%, through an overarching policy, the European Green Deal.
Which gases and sectors are covered by the EU ETS?
The EU ETS covers carbon dioxide (CO2), nitrous oxide (N2O) and perfluorocarbon (PFC) emissions from about 11,000 heavy energy-using installations, including power stations and industrial plants (oil refineries, steelworks and production of iron, aluminum, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals). Air flights that both depart and land within the borders of the European Economic Area (that is, the EU plus Norway, Lichtenstein, Iceland) are also covered by the EU ETS.
In order both to limit administrative (Monitoring, Reporting, and Verification) costs and to avoid disproportionately burdening small firms, in most sectors only industrial installations above certain production capacity thresholds are subject to the EU ETS. A list of all the activities covered and the related threshold is provided in Annex I of the Directive 2003/87/EC (European Parliament and the Council), whose consolidated version is referenced at the end of this article.
How are the allowances allocated?
The EU ETS has undergone many substantial reforms since its implementation. One of the most relevant changes concerns allowance allocation, which in Phase I (2005-2007) and II (2008-2012) was decentralised and mainly relied on freely allocated allowances. Since Phase III (2013-2020), the total volume of emission allowances is determined at the EU level, a single set of rules governs their allocation, and auctioning is the default allocation mechanism.
Free allowances are still allocated according to the risk of carbon leakage for each sector, i.e. the risk of firms delocalising production in a country where environmental regulation is laxer, thus leading to an increase in their overall emissions. There exist two intuitive criteria to assess the risk of carbon leakage of sectors. The first criterion is the cost of allowance purchases as a share of total costs: sectors for which carbon costs are particularly burdensome suffer a higher risk of carbon leakage. The second criterion is the trade intensity of a sector, that is the share of trade with non-EU countries over total turnover. Sectors that are more exposed to commercial pressure face a higher risk of carbon leakage.
As for the power sector, generators have had to buy all their allowances since Phase III, with derogations for three lower-income Member States (Bulgaria, Hungary, and Romania). By contrast, installations in the industrial sector are given free allowances depending on their efficiency relative to the 52 product-specific benchmarks outlined by the European Commission. In addition, one of three fall-back approaches is applied whenever products from an installation are too heterogeneous or change frequently. These benchmarks are based on 1) process emissions; 2) heat consumption; or 3) fuel consumption. As a rule, the benchmark corresponds to the average performance of the 10% most efficient installations.
Industrial installations belonging to a sector deemed at risk of carbon leakage receive free allowances covering 100% of their benchmarked emissions; these are calculated by multiplying the relevant benchmark by the installation’s recent output level. By contrast, for installations that are not deemed at risk of carbon leakage, only a share of this amount is freely allocated. This share has been constantly reduced, going from 80% in 2013 to 30% in 2020.
Furthermore, as there exists a maximum number of allowances that can be freely allocated at the EU level, a uniform cross-sectoral correction factor is applied to all installations, so that the final allocation of free allowances does not fully cover all benchmarked emissions.
Finally, special allocation rules hold for the aviation sector, with 82% of allowances freely allocated, 15% auctioned, and 3% withheld for new entrants and fast-growing companies. It is estimated that, in Phase III, 43% of total allowances were freely allocated, the rest (57%) were auctioned by the Member States.
What is the role of offsets within the EU ETS?
At its inception, the EU ETS was designed to be part of the nascent international carbon market and thereby to contribute to its development. The EU ETS was directly connected to the Kyoto system and the owners of regulated installations were allowed to use Certified Emissions Reductions (CERs) and Emission Reduction Units (ERUs), respectively generated by the Clean Development Mechanism (CDM) and the Joint Implementation (JI), to meet their compliance obligations. CERs and ERUs certify the abatement of one tonne of CO2 in a sector or jurisdiction not covered by the EU ETS, thus granting firms who purchase them the right to emit an additional tonne of CO2 within their EU ETS-covered activities.
However, as the European carbon market was troubled by a large oversupply, restrictions to the use of international credits were put in place quite soon: quantitative restrictions were introduced in Phase II and later tightened and complemented by qualitative restrictions in Phase III. As of Phase IV (2021-2030), the use of “offsets” (credits for emissions reductions outside the EU ETS) is not allowed any longer. Besides the need to curb oversupply to preserve the cost-efficiency of the EU ETS, the use of offsets received much criticism by scholars and NGOs, due to the low environmental integrity of most offset projects. According to a report commissioned by DG Clima, only 7% of potential CER supply for the period 2013-2020 had a high likelihood of delivering real, measurable, and additional emission abatement.
Historical trend of allowance prices
The price of EU allowances (EUAs) has suffered major variations since its very first phases, as can be seen in the figure below. Firstly, in 2006, the first publication of verified emissions revealed that regulated installations had been overallocated, causing an abrupt fall in demand. Secondly, the 2008 Global Financial Crisis hit the EU ETS hard, with the shrunken aggregate demand carrying over the carbon market. Subsequently, EUA prices further declined and then stagnated for some years, due to the combined effect of the above-mentioned oversupply of offsets and effective companion policies. Indeed, national policies fostering the deployment of renewables and the increase in energy efficiency reduced the demand for allowances by polluting firms.
Because of all these effects, by the start of Phase III (2013), the EU ETS had accumulated a surplus of about two billion allowances (more than the total volume of annual emissions under the EU ETS). As expected, this large allowance surplus severely depressed EUA prices. In 2012, the European Commission started tackling the problem by postponing the auctioning of 900 million allowances from 2014-2015 to 2019-2020, a measure known as ‘backloading’. However, as further action proved necessary, the Market Stability Reserve (MSR) was established in 2015, in which the backloaded allowances were stashed as an initial reserve.
How does the Market Stability Reserve prevent allowance prices from getting too high or too low?
The MSR consists of a rule-based mechanism that adjusts the number of allowances to be auctioned to the market surplus (i.e., the difference between the cumulative amount of allowances available for compliance at the end of a given year, and the cumulative amount of allowances effectively used for compliance with the emissions up to that given year). The surplus, known as Total Number of Allowances in Circulation or TNAC, is published yearly and determines the response of the MSR:
- if the TNAC exceeds 833 million allowances, allowances equal to 12% (24% in the period 2019-2023) of the surplus are withheld from auctions and added to the reserve;
- if the TNAC is lower than 400 million, 100 million allowances are taken from the reserve and injected into the market through auction;
- if the TNAC is anywhere between 400 and 833 million allowances, no response from the MSR is triggered.
The thresholds triggering the adjustments to allowance supply delimit an interval of surplus values within which “experience shows that the market was able to operate in an orderly manner”, the European Commission affirms.
From 2023 onwards, the number of allowances held in the reserve will be capped to the auction volume of the previous year and allowances in excess will be cancelled, thus effectively reducing the total EU ETS cap. The MSR is reviewed every five years by the European Commission, with the first review scheduled for 2021.
Does the EU ETS lead to carbon leakage?
So far, no scientific evidence supports the hypothesis that the EU ETS is directly linked to carbon leakage, mainly due to the past low–to–moderate allowance prices. Furthermore, as already mentioned earlier, sectors that are most exposed to carbon leakage receive a higher share of free allowances, thus partly reducing their costs and reducing the risk of carbon leakage. However, as in the near future, the allowance price is expected to rise significantly and free allowance allocation to be curbed, the risk of carbon leakage could change accordingly.
Until Phase III (2013-2020), the identification of the sectors at risk of carbon leakage relied on two sectoral indicators computed at the EU level: Carbon Cost Intensity (CCI) and Trade Intensity (TI). The former measured the carbon costs relative to gross value added, whereas the latter measured the trade value relative to the size of the European market. To be classified as at risk of carbon leakage, firms needed to exceed 30% in either of the two or 5% in CCI and 10% in TI.
As of Phase IV (2021-2030), a less lenient rule is being applied to identify the sectors at risk of carbon leakage. Specifically, a sector is classified as being at risk of carbon leakage if the product of the Carbon Emissions Intensity indicator (CEI) (expressed in terms of kgCO2 per Euro of gross value added) and the TI indicator, CEI × TI, exceeds 20%. In addition, an adjustment to free allowances allocation is applied in cases of annual output variations exceeding +/-15%.
A first list of sectors at risk of carbon leakage – the ‘carbon leakage list’ – was defined in 2009 by the European Commission for the years 2013 and 2014. Out of 258 sectors, 165 were classified as being at risk. The second list was defined in 2014 for the years 2015–2019 and later extended to cover 2020. A third list was adopted in 2019 to cover all Phase IV, with only 63 sectors still being present (European Commission, 2019).
The EU ETS in the European Green Deal
The von der Leyen-Commission has made the European Green Deal (EGD) a top priority of its mandate. In the words of President Ursula von der Leyen: “The European Green Deal should become Europe’s hallmark. At the heart of it is our commitment to becoming the world’s first climate-neutral continent”.
The figure below shows the many elements that make up the European Green Deal as presented in the preliminary communication by the EC (European Commission, 2020). Those most closely relevant to the EU ETS are listed under the heading ‘Achieving climate neutrality’.
In the first 100 days of the @vonderleyen Commission we have a collective responsibility to frame this right for the next five years, and beyond. This will be a team effort. pic.twitter.com/uDH1KsujUZ
— Frans Timmermans (@TimmermansEU) October 8, 2019
Tweet by Frans Timmermans
While the exact features of the European Green Deal and thus its implications for the EU ETS are still to be defined, a few possible future directions were outlined in the EGD communication. First, a higher EU climate ambition will likely mean that the EU ETS cap will be further tightened by means of a higher linear reduction factor (at the time of writing at 2.2%).
A second potential amendment of the EU ETS could be its expansion to include other sectors, with the main candidate being the maritime sector, whereas road transport and housing dropped out from expansion talks after initial consideration.
A central dimension in an EGD-aligned ETS reform will be the free allocation of allowances. Especially if other, complementary, policies are introduced to mitigate the risk of carbon leakage, the number of free allowances allocated to sectors under the EU ETS could decrease. The proposal of Carbon Border Adjustment Mechanisms is especially relevant to this point. Furthermore, given the inconclusive actions taken by the International Civil Aviation Organization (ICAO), the European Commission is considering to proceed with focusing on the EU ETS as the main policy tool to decarbonize aviation by means of curbing or even eliminating free allowances in this sector.
Finally, it is worth underlining that all explicit and implicit climate policies would have an impact on allowance demand, so that if the overall climate policy framework is changed, the EU ETS might be altered accordingly.
Notes
[1] FSR Climate is currently investigating obstacles and pathways to ETS linkages in its Life DICET project, co-funded by the European Commission. More information on the project is available here.
If you still have questions or doubt about the topic, do not hesitate to contact one of our academic experts:
Giulio Galdi, Simone Borghesi, Stefano Verde
Relevant Links
FSR Climate Publications:
- Informing the Carbon Market Policy Dialogue: the emissions trading systems at a glance, Technical report. AUTHORS: Giulio Galdi, Stefano Verde, Isabella Alloisio, Simone Borghesi, Juerg Fuessler, Ted Jamieson, Emily Wimberger, Li Zhou.
- Emissions trading systems with different levels of environmental ambition: implications for linking, Research report. AUTHORS: Stefano Verde, Giulio Galdi, Simone Borghesi, Juerg Fuessler, Ted Jamieson, Emily Wimberger, Li Zho.
- Emissions trading systems with different price control mechanisms: implications for linking, Research report. AUTHORS: Galdi Giulio, Stefano Verde, Simone Borghesi, Juerg Fuessler, Ted Jamieson, Emily Wimberger, Li Zhou.
Training:
FSR Climate Project:
European Commission Resources:
- Consolidated version of the 2003/87/EC Directive.
- List of sectors deemed at high risk of carbon leakage.
