Pricing Carbon to Put Europe on a Path to Climate Neutrality

The upcoming revision of the EU Emissions Trading System (EU ETS) is a crucial opportunity to strengthen the scheme and ensure that it contributes to the goals of the Paris Agreement. EU ETS covers the energy sector and many industry sectors, and means companies have to have carbon credits, or EU Allowances (EUAs), for the amount of greenhouse gases they emit. They can either buy these allowances at an auction, buy them from each other in a market system or get them for free (free allowances). To drive a switch to carbon neutrality, the amount of EUAs is decreased annually, currently at a pace of 2.2% a year. The EUA price is right now at an all time high – around 55 euro per tonne CO2. This price hike is driving change ever faster, with coal plants closing all over Europe.

The EU Commission will present its proposal to revise the EU ETS this summer, on the 14th of July, and it is crucial we get this revision right to put Europe on a path to climate neutrality by 2040. I have commissioned a report from Carbon Market Watch on how we ensure the revision leads to the best possible outcomes, and you can read it in full here.The three key recommendations of the report are:

  • Increase the pace of emissions reductions and the rate at which surplus is taken off the market;
  • Phase out the free allocation of allowances for energy-intensive industries and the aviation sector to incentivise climate action in these sectors;
  • Use 100% of the auctioning revenues in further climate action, industrial innovation, just transition and international climate finance.

For the EU to keep to its commitment under the Paris agreement, the EU should reduce its overall emissions by 65% in 2030 and reach climate neutrality by 2040, with a 70% reduction of emissions in the ETS sector by 2030. The Commission’s current, inadequate goal is a 55% reduction in emissions by 2030 and climate neutrality by 2050, which would require a 65% reduction of emissions in the ETS sector by 2030. In order to increase the pace of emission reductions in the sectors covered by the ETS, a combination of an increased linear reduction factor (LRF) and a one-off reduction of the cap of overall allowances will have to be adopted. These changes should be implemented as soon as the legislative process allows and no later than by 2023. The diagrams below show five possible scenarios  – emissions reductions if we stick with the current legislation, the LRF needed to reach zero emissions in 2040 if the LRF is revised 2023 and 2025, and two possible ways to combine a one-off reduction with an increased LRF to reach zero emissions by 2040. Only scenario 4 and 5 are in line with the Paris agreement, and they also have the added benefit of dealing with excess EUA in the market which keep prices lower than they should be.

 

There is a surplus of 1.39 billion allowances within the ETS. The number is decreasing thanks to the Market Stability Reserve (MSR) which absorbs and invalidates extra allowances under certain conditions. However, the surplus could grow in the future, as a result of the decarbonisation of the power sector and the ongoing coal phase-out in many EU member states. To limit or prevent this, the MSR should be strengthened in particular by lowering the upper threshold which triggers intakes, and increasing the intake rate. Compared to the planned intake rate of 12% from 2024, an intake rate of at least 24%, which is the current intake rate, is needed.

The risk of carbon leakage, where emissions move outside the EU rather than decrease, has been used to justify mechanisms such as free allocation. However, there is no empirical evidence of carbon leakage having happened in the EU ETS and studies show that carbon prices are highly unlikely to ever have significant impacts on international competitiveness. Given the sectors’ ability to pass through costs, free allocation has also led to windfall profits. Free allocation should thus be discontinued, as it undermines both the polluter pays principle and the carbon price signal for a large share of the energy-intensive industries and aviation sector.

It is essential that the EU shipping sector is included in the EU ETS in the revision, as it is a significant source of greenhouse gas emissions that are currently not addressed through any climate measures. This inclusion should cover both ingoing and outgoing vessels as well as vessels that stay within the EU, with a significant percentage of revenues recycled back into the sector to push the transition to zero-emissions.

The aviation sector has been the fastest growing under the EU ETS, and has been a net buyer of allowances. Key aspects of the upcoming EU ETS reform will be to remove free allocation to airlines, and cover international flights – currently excluded from the law’s scope. CORSIA, the global alternative to ETS for aviation, is significantly weaker in both price and scope, and thus it is significantly better to cover aviation’s emissions wholly under the ETS rather than implement CORSIA, which would mean a step back in terms of climate ambitions.

While carbon pricing can provide a strong incentive for industries to reduce emissions and switch to cleaner technologies, it will not be sufficient to drive the deep industrial transformation that is required for the European Union to reach climate neutrality by 2040. Thus, public investments in R&D, innovation and clean energy need to increase dramatically. The current ETS directive prescribes that at least 50% of the revenues from the ETS be used for climate and energy-related purposes. One simple and important revision to increase support for innovation is to ensure that 100% of ETS revenue is channeled toward these types of investments. The funds created by the EU ETS Directive, the Innovation Fund and the Modernisation Fund, are important tools here. The Innovation Fund needs a substantial increase in financial capabilities in order to effectively support the transition in the ETS sectors, where more revenue from the ETS would be a good solution. The Modernisation Fund, important for climate justice as it supports those member states who have the longest to go in transitioning away from fossil fuels, needs to increase its transparency and ensure projects lead to long-lasting climate benefits.