Strengthening the EU ETS

Around the world, countries are putting forward their Intended Nationally Determined Contributions (INDCs) to a global agreement on climate change, to be reached in Paris in 2015. With new emissions reduction targets, these governments will pursue climate mitigation through a variety of policy tools. A prime example is the set of reforms that the European Commission has proposed to the Union’s pioneering cap and trade system, the Emissions Trading System (ETS) in an effort to align and adjust the tool to help meet the EU’s INDC.

The European Union’s ETS is the world’s largest carbon cap and trade system, covering more than 11,000 power stations and industrial plants in 31 countries, as well as airlines.[1] However, in recent years a surplus of EU Allowances (EUAs) in the system has driven the price down, hitting a low of €2.6/ton in 2012. Though the market has recovered somewhat, and EUAs are now trading at just under €8/ton,[2] this price is still too low to encourage mitigation actions in most sectors. Aiming to address this surplus, align to the EU’s 2030 emissions reduction target (40% below 1990 levels by 2030), and improve the overall operation of the system, in July 2015 the European Commission (EC) presented its “summer package” of reforms for the post-2020 period, and submitted them to the European Parliament, Council, and relevant committees.

Many of the EU’s approved and proposed reforms align with recommendations published in a 2013 CCAP report recommending seven reforms to the EU ETS to enhance price stability and spur innovation and investments required to create a thriving and low carbon industrial sector.These proposed changes include setting aside allowances in an industrial low-carbon transition fund, a price management mechanism, a structural adjustment of caps, and a comprehensive assessment of competitiveness.

Under the EC’s proposed reforms, the principal changes would entail accelerating the reduction in emission allowance volumes to align with the EU’s new target, updating and tightening sectoral benchmarks, and establishing a competitive innovation fund (open to companies across the EU) and a separate modernization fund for the ten poorest Member States. Under the new proposed rules:

• The linear reduction factor (currently 1.74%) will increase to 2.2%. In other words, the volume of emissions allowances made available each year will decrease at a rate of 2.2%, leading to an additional reduction of 556 MtCO2e by 2030.

• Benchmark values, the basis for allocation of free allowances to internationally competitive carbon intensive industries, will decrease by 0.5%-1.5% annually based on the degree of sectoral technological advance, with 1% as a default. Revisions of specific sectoral benchmarks will occur more frequently, with one before the 2021 allocations and another in 2026. Greater frequency of benchmark updates will ensure that allocations of free allowances more accurately reflect the reality of technological progress in sectors while reduction ceiling (1.5%) encourages continuous improvement, as particularly efficient industries (or firms within those industries) will profit from any reduction beyond that point.

• An Innovation Fund, modeled after the successful NER 300 program, will set aside EUAs to support first-of-its-kind investment in Renewable Energy, Carbon Capture and Storage (CCS), and low-carbon innovation in energy-intensive industries. Companies in all Member States are eligible to apply for this support.

• A Modernization Fund will provide support to the ten EU Member States with per capita GDP less than 60% of the EU average to help them meet their investment needs related to achieving energy efficiency and energy system modernization goals. Member states with less than 60% of the EU average GDP per capita will be eligible to submit a pipeline of projects for approval by a board including representatives from Member States, the European Investment Bank, and the European Commission. Each eligible member state will have a formula allocation for receipt of support.[3]

Additionally, member states with less than 60% of the EU per capita GDP average have the option to provide a “transitional free allocation” to the electricity sector for the purpose of modernization of the sector. These allowances are reduced from auction volumes, and can be no more than 40% of the country’s average allocation over the 2021-2030 period.

The proposed changes complement reforms already underway. As an effort to reduce the surplus of EUAs, the EC has postponed the auctioning of 900 million EUAs until 2019. This hasn’t itself had a significant impact on the price – investors in carbon-intensive industries tend to have long time horizons, and can plan for a temporary shortfall accordingly. However, holding back these allowances has permitted the Commission to establish a Market Stability Reserve (MSR), which will respond to excessive surplus or shortage of EUAs by adjusting auction volumes appropriately, either by adding allowances to the reserve, or releasing them in the next auction round. Working within strict, pre-determined guidelines for intervention, this regulation of EUA surplus is expected to enhance price stability, and thus encourage mitigation action. The MSR has been approved by the European Parliament and the European Council of Ministers, and will begin operation in 2019, with full implementation in 2022.

In addition to the volume-based MSR, the ETS has a price-based provision that allows relief in case of serious price spikes. According to a provision that came into force in 2013, if the average price for more than six consecutive months is greater than three times the average from the previous two years, the Commission and member states will meet, and under certain conditions may opt to release allowances that are held in reserve or bring forward future auction volumes.[4]

As next steps, the European Parliament and Council will consider the “summer package” (the linear reduction factor adjustment, changes to benchmarking policy, and creation of the innovation and modernization funds) for the post-2020 period, and may adopt, reject, or amend them. At the same time, the EC is developing a number of complementary proposals to reform the energy sector, including revisions to existing energy labeling programs, and a public consultation process for electricity market reforms. The latter will aim to create a more flexible market through real time electricity pricing, streamlining the flexible trading of electricity, eliminating regulated prices and inefficient support schemes, and coordinating EU member state renewable energy support schemes. Finally, the EC and member states will work to come to agreement on fair distribution of responsibility for mitigation among the states in the sectors not covered by the EU ETS (approximately 55% of EU emissions), known as an “Effort Sharing Decision.” The EU held a public consultation on such a decision earlier this year, and plans to put forward a legislative proposal in 2016.

Only months after the release of its INDC, the EC is demonstrating that it has begun to take the steps necessary to turn the reductions promised into reality. As we move toward and past Paris, we can expect other countries will start doing the same – identifying the policies and investments they will need to translate these numerical targets into on-the-ground actions that produce real emissions reductions. In this new phase, in which many, if not all, countries have emissions reduction targets that can be quantified, many will likely look to emissions trading as a cost-effective way to achieve reductions.

The EU’s experience and proposed reforms illustrate a number of the challenges faced in adopting such a system, and provides examples of potential efforts to solve them, as can be seen below.

ChallengeEU SolutionEncouraging ambition without losing industrial competitivenessBenchmarking System with free allocations for vulnerable industriesPromoting integration and consensus among economically and industrially heterogeneous regions or populationsEstablishment of a Modernization Fund for the least wealthy member statesOvercoming technological barriers and encouraging innovationEstablishment of an Innovation Fund to support the demonstration of cutting-edge technologyAddressing unanticipated surpluses or shortages that discourage mitigation or damage economic productivityCreation of a Market Stability Reserve to manage surpluses in the market

While the effects of these reforms will not be known for some time, the challenges they seek to overcome can inform other countries’ or regions’ design of their own carbon markets, and provide at least one model to overcome them.