20 Jul 2021, 13:05

Understanding the European Union’s Emissions Trading System (EU ETS)

The European Union’s Emissions Trading System (EU ETS) for the energy and industry sectors has long been considered a bit of a lame duck in climate action, with low prices for CO2 emissions not succeeding in triggering any move away from the use of fossil fuels. But fixing some structural deficiencies of oversupply in the past years, as well as the EU’s Green Deal and moves to toughen emission goals, have led to prices rising to over 50 euros per tonne CO2 in 2021. In the European Commission’s 2021 Fit for 55 package – a large policy proposal to achieve the bloc’s new climate target of minus 55 percent emissions by 2030 – CO2 reduction by the sectors under the EU ETS is assigned an even more important role. This factsheet explains the ETS' purpose and rules, its initial struggles, past reforms, and the latest changes proposed in the Fit for 55 package.

Overview

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. It has successfully brought down emissions from power generation and energy-intensive industries by 42.8 percent in the past 16 years. Under the system, companies have to hold allowances corresponding to their CO2 emissions, making power production from burning coal and other fossil fuels more expensive and clean power sources more attractive. At the same time, firms are incentivised to become more energy efficient because they can then sell their emissions permits on the market.

The EU ETS follows a “cap-and-trade” approach: the EU sets a cap on how much greenhouse gas pollution can be emitted each year, and companies need to hold 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.

The EU ETS is for CO2 emissions from power stations, energy-intensive industries (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 EU and European Economic Area must comply with the programme.

Companies face a fine if they emit more CO2 than they have covered by emission allowances. The fine is 100 euros per excess tonne. For context: the world’s largest chemical company, BASF, produced 23 million tonnes of CO2 equivalents in 2017. Companies have an incentive to reduce emissions by investing in energy efficiency because they can then sell excess allowances. Instead of EU ETS allowances, companies can buy credits from emission-saving projects under the Kyoto Protocol’s Clean Development Mechanism (CDM) in developing countries.

Current status and cap trajectory

The system includes more than 11,000 power plants and factories in the 27 EU member states plus Iceland, Liechtenstein, and Norway, and covers around 41 percent of the EU’s greenhouse gas emissions. Installations covered by the ETS reduced emissions by about 35 percent between 2005 and 2019.

The objective of the EU ETS is to reduce greenhouse gas emissions from power stations and other energy intensive industries (such as the production of iron, aluminium, cement, glass, cardboard, acids, etc.) 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 will decline at an annual rate of 2.2 percent. The reduction factor was set in 2018 to align with the EU targets of cutting all greenhouse gas emissions by 20 percent by 2020 and by at least 40 percent by 2030 compared to 1990 levels. In its Fit for 55 proposal of summer 2021, the EU Commission suggests a new LRF as of 2024 to reach the new, more ambitious overall climate target for 2030.

EU ETS renewal in the Fit for 55 climate package

In June 2021, EU member states adopted a new climate law which sets a binding Union target of a net greenhouse gas 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. The key changes that the Commission proposes to be made to the carbon trading system are:

  •  New 2030 target for ETS emissions is -61% (previously -43%) compared to 2005
  •  New linear reduction factor: 4.2% cut to ETS emissions cap every year, (if started in 2024)
  • Member States should spend the entirety of their emissions trading revenues on climate and energy-related projects
  • Shipping emissions will be included in the ETS for the first time to cover CO2 emissions from large ships (above 5000 gross tonnage), regardless of the flag they fly. The extension will include all emissions from ships calling at an EU port for voyages within the EU (intra-EU) as well as 50% of the emissions from voyages starting or ending outside of the EU (extra-EU voyages), and emissions that occur when ships are at berth in EU ports. The EU ETS would cover around two thirds of maritime transport emissions (90 million tonnes CO2); shipping owners will have to purchase and surrender ETS emission allowances for each tonne of reported CO2.
  • Free allocation: The rules for companies receiving free emission allowances will change slightly. Free allocation will continue to be based on benchmarks representing the level of performance of the best installations but they will be updated to include new actors using low-carbon or zero-carbon technologies (e.g. green hydrogen use in steelmaking). Also, free allocation will be made conditional on decarbonisation efforts: installations not implementing measures recommended in energy audits will have their free allowances cut by up to 25%
  • Interaction with carbon border adjustment mechanism (CBAM): as of 2026, when the CBAM is coming into effect for a number of sectors, free allocation to European emitters will be gradually reduced by 10% per year. “The CBAM is an alternative to free allocation, and as such the two measures should not overlap,” the Commission stated. The CBAM is a separate mechanism from the EU ETS which is proposed in a separate piece of legislation.
  • Aviation: The total number of aviation allowances in the ETS will be capped at current levels, and be reduced annually by 4.2%. The Commission proposes to phase-out free allocation to aircraft operators and to move to full auctioning of allowances by 2027 to create a stronger price signal; and align with the global Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)
  • New trading system for transport and buildings sector: For the first time, the EU Commission proposes in its Fit for 55 package a new emissions trading system for fuels distribution for road transport and buildings. The system will run separately from the EU ETS and is supposed to start in 2025, with a cap on emissions set from 2026. This new upstream system will regulate fuel suppliers. The cap in the new ETS will be reduced annually to yield emissions reductions of 43% in 2030 compared to 2005. 25% of the revenue from the new trading system will go to the Social Climate Fund where it is to be invested in energy efficiency of buildings, new cars and can also be used to directly help households who are struggling with higher petrol or heating fuel costs.
  • Market stability reserve reform: In a separate proposal which the Commission wants to see passed quicker than the rest of the ETS renewal, the EU executive initiates a small number of changes to the market stability reserve (MSR). The MSR is rules-based mechanism in the EU ETS (see below under “fixes”) which ensures that the number of allowances is adjusted in case of severe over supply due to unforeseen events such as economic crisis. Surplus allowances are automatically placed in the reserve according to fixed rules and released again in case pre-defined thresholds are crossed. The Commission wants to maintain the currently increased annual intake rate of allowances into the reserve.

Past experiences and price developments

The EU ETS has existed since 2005. In the first two trading periods (2005-2007 and 2008-2012) the majority of allowances were given out for free and in generous amounts, so the price for first-period allowances fell to zero in 2007.

In its third phase (2013-2020), 40 percent of allowances are being auctioned and power generators have to buy all of their allowances (with exceptions in some member states like Poland, Bulgaria, Hungary, Lithuania, etc.).

Still, free allocation prevailed in the manufacturing industry (80 per cent) and the aviation sector (85 per cent), and sectors deemed as exposed to “carbon leakage” also receive an extra amount of free allowances.

During the system’s latest reform which entered 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 does after all put a cap on carbon emissions – the EU ETS for a long time didn’t produce the anticipated result of making electricity generation from fossil sources like coal more expensive compared to energy 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. Scientists 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 affect the price of power from coal in a way that would make other energy sources more competitive. But 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 anounced under the European Green Deal, EUA prices started to rise even more and reached an average of 25 euros per tonne in 2020. In May 2021, prices soared to over 50 euros per tonne CO2.

Fixes made to the EU ETS over time

Purists among economists consider an effective emissions trading scheme like the EU ETS the panacea to cut 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 – this instrument is called backloading.

In 2015, a decision to create a market stability reserve (MSR) was adopted. The MSR started 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 will also allow 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.

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