It took a while to see the concept & mechanisms of Carbon Trade emerging in Europe. Contested by industrials for being detrimental to their competitiveness and seen by environmentalists not ambitious enough, the EU ETS has now found its place within the carbon reduction arsenal.
Let review what is inside EU ETS gears and how it can efficiently support decarbonization of the economy.
What is EU ETS & how does it work?
Back in 2005, the European Union created the first market dedicated to Carbon trade and giving a price to one ton of CO2 emissions. The mechanism is based on CAP & TRADE. Each year, the EU defines a Not To Exceed amount of Green House Gases and any firm under the ETS scope must hold European Union Allowances for every ton of CO2 they release. Those companies receive, can buy or even trade those “rights to emit”
Power stations, energy-intensive industries (e.g. oil refineries, steelworks, and producers of iron, aluminium, cement, paper, glass) and civil aviation are part of the EU ETS. Flights out of EU remain excluded in the system’s scope until end of 2023.
The value of the allowance is guaranteed by their limited volume and heavy fines (100€ per excessive ton) are charged to delinquents. On the contrary, firms can sell their emissions permits on the market or decide to keep them for future needs. The mechanism relies on inducement to increase energy efficiency and, of course, reduces the volume of allowances over years. (excepting in 2008 to temper economical crisis)
Does ETS enforcement correlate with a reduction of EU GHG emissions?
Some may see in the EU carbon emissions reduction (-15% between 2005 & 2018), the positive effect of the ETS enforcement but a closer look is required.
Considering that over the same period of time, carbon price stagnated to a low & painless 10€ per ton, some can doubt about it!
Even if precautions shall be taken with direct correlations, it is interesting to report that the portion of industrial production within the European GDP fell by 16% within the same period.
It is not unrealistic to believe that the decline of the industrial sector in Europe – to the benefits of the expansion of the services- has played a real role in the reduction of the carbon emissions in the last 20 years.
Sluggish beginnings for the EU ETS.
First arrived on the Carbon Trade market, the EU has been widely contested at its starts. Heavy industries lobbyists were denouncing an attack to their competitiveness, so difficult to maintain in a globalized world. Threats on industries relocations were emerging.
On the other side, environmental activists were claiming a too low carbon price to be efficient and relocation threats being rather motivated by cheaper labor rates.
All would concede that the early stages of the ETS (up to 2018) were shy & modest along with a dragging learning cuve. Manufacturing industries were given 80% of their allowances for free (85% for commercial aviation). The consequence of massive free permits translated into a low carbon price and weak decarbonation incentive. Set at 16€ in May 2005, the value of one ton of CO2 has been staying under 10€ for years before inflating in 2018.
Experts from the DIW estimated that Electricity made out from fossil power plants was remaining competitive (compared to low carbon sources) until the price of one Carbon ton exceeds 40€. The low flat 5€ per ton, in 2012-2017 favored the expansion of lignite made electricity in German grid which was not the original intent…
A revamped ETS to support FIT for 55
On July 14th 2021, EU shifted gears with FIT 55 program (55% reduction in greenhouse gas emissions by 2030 relative to 1990s levels – previous objective was 40%-) and decided to bulk up its Carbon Trading system (for details see https://ec.europa.eu/commission/presscorner/detail/en/IP_21_3541)
In a nutshell, below main features were introduced:
- Permits caps get shrinked with a yearly decline starting at 5,15% and subject to adjustment depending on results.
- Extension of EU carbon trading scope to building and road transport. Permits will be auctioning and the revenues will help vulnerable household and will have to be invested in climate measures.
- Free allowances will stop for commercial aviation within EU by 2026.
- ETS is extending 100% of maritime transport within EU and 50% of extra EU legs (total 2/3 of EU maritime emissions are concerned). Free allowances will decline from 80% in 2013 to 0 % in 2026.
But the strongest measure concerns the deployment of a High Carbon import tax.
Taxing Carbon crossing borders…
The concept of imposing taxes to products manufactured from high carbon sources started to materialize in 2019 . In the absence of such a tool, firms subject to “carbon leakage risks” are given free allowance. Not a good signal to invest in low carbon production but at least a mitigation to sustain competitiveness.
FIT for 55 is targeting to implement Carbon taxes at EU borders (name being CBAM) in 2023 including 3 years transition phase.
EU importers will have to buy carbon certificates amounting to the carbon price which would have been paid if the goods were produced in Europe. If the non EU exporter was charged for a domestic carbon tax, the importer can deduct its amount.
This mechanism has the advantage to both bring a fair flavor within the international trade and appeals others to decarbonize their production. It overall gives a price to remain competitive on the European market.
Why a 60€ record in 2021 and which effects?
EU ETS price has been beating records after records during 2021 summer. That reflects the febrility of EU industrials acknowledging the soon arrival of lower carbon allowance volume, higher prices and broader scope.
In the context of European recovery from COVID-19, firms urged to buy allowances with direct effect on ETS price. Speculators trading high volume of allowances plaid a role as well.
The most visible consequence may be the Spot electricity price in Europe. As it is designed for, high allowance price raises price of the electricity made out from fossil fuels powerplants. Since, Gas power plants become more competitive than Coal ones for a carbon ton over 55€, demand on gas -already high- inflated. By consequence Gas price kept increasing, reinforcing price of EU electricity spot. 1 MHh reached the unprecedent level of 200€ on Sept 16th at peak hours (19h00). Same day in 2020, Spot price was about 70€.
EU took an ambitious environmental stance launching FIT for 55 with quick effect on ETS value and direct market signals such as price of SPOT electricity.
In such a context and more than ever, the implementation of Carbon taxes at EU borders become a priority to preserve European competitiveness. Implementation of such a process will be complex and likely subject to claims from WTO. EU shall stay firm and focus on a pragmatic implementation.
Also, there is a risk that prices for ETS allowances get volatile which would be detrimental to investments into low carbon solutions. Those are taking time and visibility on ETS pricing is a prerequisite to avoid postponing the efforts. Setting up a floor price at a levelpromoting investments in low carbon technologies could be one of the solutions.