- Status quo: ETS cap and its trajectory
- EU ETS renewal in the Fit for 55 climate package – deal from December 2022
- New trading system for transport and buildings sector: ETS II
- Past experiences and price developments
- Fixes to the EU ETS over time
With the EU ETS, the European Union has created a market mechanism that gives CO2 a price and creates incentives to reduce emissions in the most cost-effective manner. The objective is to bring down emissions in power generation and energy-intensive industries (such as the production of iron, aluminium, cement, glass, cardboard, acids, etc.) by a certain percentage each year. The system has helped reduce emissions from these sectors by about 35 percent between 2005 and 2021.
Under the scheme, companies have to buy or receive allowances corresponding to their CO2 emissions, making power production from burning coal and other fossil fuels more expensive, and clean power sources comparably more attractive.
The EU ETS follows a ‘cap-and-trade’ approach: the EU sets a cap on how much CO2 can be emitted – which decreases each year – and companies need to have a European Emission Allowance (EUA) for every tonne of CO2 they emit within one calendar year. They receive or buy these permits – and they can trade them. After each year, they surrender enough allowances to cover their full emissions.
The EU ETS covers CO2 emissions from power stations, energy-intensive heavy industry (e.g. oil refineries, steelworks, and producers of iron, aluminium, cement, paper, and glass) and civil aviation. Extra-EU flights are not included in the system’s scope; only those between and within countries in the European Economic Area must comply with the programme.
Heavy industry receives a certain amount of free emissions allowances to help stay competitive with businesses outside the EU who fall under less stringent climate legislation.
Companies face a fine if they emit more CO2 than they have covered by emission allowances. The fine is 100 euros per excess tonne. Companies are therefore incentivised to reduce emissions by investing in energy efficiency as they can then sell excess allowances. (For context: the world’s largest chemical company, Germany’s BASF, produced 20.2 million tonnes of CO2 equivalents in 2021 scope 1 and 2 emissions)
Status quo: ETS cap and its trajectory
The system covers more than 10,000 power plants and factories in the 27 EU member states plus Iceland, Liechtenstein, and Norway, encompassing around 40 percent of the EU’s total greenhouse gas emissions (2021).
The objective of the EU ETS is to reduce greenhouse gas emissions from power stations and other energy intensive industries by a certain percentage every year (linear reduction factor – LRF). As of 2013, the LRF was set at 1.74 percent to achieve an overall reduction in these sectors of 21 percent by 2020, compared to 2005 levels.
Between 2021 and 2030 the overall number of emission allowances declines at an annual rate of 2.2 percent. The reduction factor was set in 2018 to align with the previous EU targets of cutting all greenhouse gas emissions by at least 40 percent by 2030 compared with 1990 levels.
EU ETS renewal in the Fit for 55 climate package – deal from December 2022
In mid-2021, the European climate law came into force, which sets a binding target of a net greenhouse gas emissions reduction (emissions after deduction of removals) by at least 55 percent by 2030 compared to 1990. In order to achieve this new, more ambitious goal, the European Commission presented its “Fit for 55” package of new rules and legislative proposals in July 2021 – including a renewal of the EU ETS. After negotiations, the European Parliament, member state governments in the EU Council and the Commission reached a deal in December 2022 to reform the existing ETS and introduce a second system for transport and heating fuels.
While the final texts have not yet been released (leaks), the key changes according to press releases are:
- New 2030 target for ETS emissions is -62 percent (previously -43%) compared to 2005.
- New linear reduction factor: 4.3 percent from 2024 to 2027 and 4.4 percent from 2028 to 2030.
- Member States should spend the entirety of their emissions trading revenues on climate-related activities.
- Shipping emissions are to be included within the scope of the EU ETS. Council and Parliament agreed on a gradual introduction of obligations for shipping companies to surrender allowances: 40 percent for verified emissions from 2024, 70 percent for 2025 and 100 percent for 2026. Big offshore vessels of 5,000 gross tonnes and above will be included.
- Free allocation: The rules for companies receiving free emission allowances will change, phasing these out by 2034. (2026: 2.5%, 2027: 5%, 2028: 10%, 2029: 22.5%, 2030: 48.5%, 2031: 61%, 2032: 73.5%, 2033: 86%, 2034: 100%) Free allocations can be cut by 20 percent if companies do not introduce decarbonisation measures demanded by energy audits.
- Interaction with carbon border adjustment mechanism (CBAM): as of 2026, when the CBAM comes into effect for a number of sectors, free allocation to European emitters will be gradually reduced (see above). The CBAM will thus be fully phased in by 2034.
- Aviation: The EU ETS applies for intra-European flights: EU institutions agreed to phase-out free allocation to aircraft operators and to move to full auctioning of allowances by 2026 to create a stronger price signal (decrease of 25% by 2024 and 50% by 2025). To deal with extra-European flights to and from third countries, the global Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) will be integrated into the ETS.
- Emissions from burning waste are to be monitored from 2024, and included in the ETS from 2028 (member states can push this 2030).
- The Innovation Fund, will be increased from the current 450 to 575 million allowances.
- The Modernisation Fund will be increased by auctioning an additional 2.5 percent of allowances that will support EU countries with GDP per capita below 75 percent of the EU average.
- Market stability reserve reform: 24 percent of all ETS allowances will continue to be placed in the market stability reserve to address possible imbalances between the supply of and demand for allowances in the market due to external shocks such as those caused by COVID-19.
The European Roundtable on Climate Change and Sustainable Transition (ERCST) has also published a policy brief about the December agreement with some more details.
New trading system for transport and buildings sector: ETS II
For the first time, the EU decided on a new emissions trading system to cover fuel distribution for road transport and buildings, and additional industrial sectors. The system will run separately from the existing EU ETS.
Key details according to press releases:
- Implementation begins in 2027.
- Could be postponed until 2028 to protect citizens, if energy prices are exceptionally high.
- Will apply to distributors that supply fuels (not households or drivers).
- Linear reduction factor was set at 5.15 from 2024 and 5.43 from 2028.
- Member states can exempt suppliers until 2030 if there is a national CO2 price which is equivalent or higher than the new ETS II price.
- Part of revenues will be used for Social Climate Fund.
- Includes a price stability mechanism: if the price of an allowance in ETS II rises above 45 EUR, 20 million additional allowances will be released.
Past experiences and price developments
In the first two trading periods of the EU ETS (2005-2007 and 2008-2012) the majority of allowances were given out in large amounts for free, pushing the price for first-period allowances to zero in 2007.
In its third phase (2013-2020), 40 percent of allowances were auctioned, pushing electricity producers to buy all of their allowances (with exceptions in some member states like Poland, Bulgaria, Hungary, Lithuania, etc.).
Still, free allocation prevailed in manufacturing (80 percent) and aviation (85 percent), and sectors deemed to be at risk of ‘carbon leakage’ also received an extra amount of free allowances.
During the system’s latest reform, which came into force in 2018, a reduction in the number of permits distributed for free was agreed upon. As part of this reform, in the programme’s fourth phase (2021-2030), the number of economic sectors deemed to be at risk of carbon leakage, and thus entitled to free emissions allowances, were cut.
As a consequence of the generous distribution of free emissions allowances, prices for permits were never as high as envisaged. The surplus of permits grew even greater after the 2008 economic crisis caused emissions to fall faster than anticipated (production in the steel industry alone declined by 28 percent between 2008 and 2009). Critics also said that companies’ frequent use of cheap CDM credits pushed the carbon price down.
While the system has had some effect – it ultimately does put a cap on carbon emissions – for a long time the EU ETS didn’t produce the anticipated result of increasing the price of electricity generated from fossil sources like coal more expensive versus electricity generated from clean power sources such as renewables. In fact, low prices contributed to a revival of lignite as a cheap and competitive power source in Germany. Researchers at the German Institute for Economic Research (Deutsches Institut für Wirtschaftsforschung, DIW) calculated that only a price of more than 40 euros per emitted tonne of CO2 could meaningfully affect the price of power from coal to make other energy sources more competitive . Yet, CO2 allowances were as cheap as 2.81 euros in early 2014.
However, since the latest reforms for the programme’s fourth phase were agreed upon, permit prices have risen. The clearing price at the auction of 23 February 2018 stood at 9.68 euros; in August 2018, trading prices for EUAs rose to 18.50 euros per tonne. As of 2020 when a more ambitious EU climate target for 2030 became tangible and new climate policy initiatives were announced under the European Green Deal, EUA prices started to rise even more and reached an average of 25 euros per tonne in 2020.
In 2022, prices have been consistently above 60 euros, with records reaching almost 100 euros.
Fixes to the EU ETS over time
Some economists uphold an effective emissions trading scheme like the EU ETS as a panacea to the problem of greenhouse gas emissions – in all sectors, across all countries and without the need of national legislation and subsidies for renewables.
However, the scheme’s many challenges led several EU member states to push for a reform of the ETS, and the EU took some preliminary steps to doing so. In a first attempt to reduce the surplus of around 2 billion allowances (July 2014), the EU temporarily removed 900 million permits from auction in 2014-2016 – a policy instrument called backloading.
In 2015, a decision to create a Market Stability Reserve (MSR) was adopted, which came into operation in January 2019. This instrument allows authorities to increase or decrease the number of CO2-permits in the market, following clear rules, in order to regulate the price. If the total number of allowances in circulation surpasses 833 million, allowances will be added to the reserve and reinjected if the number of pollution permits falls below 400 million. Initially intended to be returned to the system in 2019-20, the 900 million back-loaded permits are to be added directly into the reserve.
The MSR also allows member states to close down fossil fuel power stations without the adverse effect of freeing up large amounts of CO2 allowances that could, in turn, be used by other emitters. To prevent this so-called ‘waterbed effect’, as of 2023, the MSR will allow for both the automatic deletion of surplus allowances and member states’ active removal of emission permits.
The problems plaguing the ETS since its entry into force in 2005 have led a number of countries to take unilateral steps. The UK (when still a member of the EU) introduced a price floor for carbon; Denmark, Sweden, Finland, France, Ireland, and the Netherlands have introduced a carbon tax. In Germany, the government launched a carbon price in the transport and buildings sectors as of January 2021.