Whose carbon price is it anyway?
Strengthening carbon markets in the European Union through Fit for 55
15 July, 2021
Carbon pricing has been the European Union’s cornerstone in the fight against climate change since the start of the Emissions Trading System (ETS) setup in 2005. The ETS functions by imposing a cap on the total emissions allowed in the EU and requiring polluters to submit emission allowances (EUAs) for each tonne of carbon produced during the span of a year. However, under the current design of the ETS, only 40% of the greenhouse gases (GHGs) emitted by the EU27 are actually included in the pricing mechanism; the Effort Sharing Regulation regulates the rest of the economy, giving more control to EU Member States.
Given the objective set by the European Commission (EC) of achieving net carbon neutrality by 2050, expanding the coverage of the ETS, as well as reducing the distribution of free EUAs became key priorities in Brussels. All discussions regarding the future of the EU ETS developed after the system started to become more effective and robust—and now that political support for a green transition and deep decarbonisation has become a certainty. In response, the price of EUAs (certificates which polluting installations must submit for each tonne of GHGs they are emitting) has increased rapidly and is currently trading at a record high of over 50 EUR. This steady growth of the price of EUAs has been a crucial step towards triggering record investments in clean technologies, making abatement in the sectors covered by the EU ETS more effective.
Under these auspices, the EC proposed a reform package on 14 July 2021 intended to align existent policy options with objectives agreed upon by all institutional stakeholders. This reform package comes shortly after both the European Council and the European Parliament adopted the European Climate Law in June 2021, which sets a binding EU climate target of reducing net GHGs emissions by at least 55% by 2030 compared to 1990. Symbolically, this reform package was named Fit for 55 by policymakers and the media.
Many policy initiatives in Fit for 55 do not address the EU ETS, but rather other regulations that serve the EU’s sustainability objectives, such as the renewable energy directive (RED) or the energy efficiency directive (EED). These measures will nevertheless be essential in building the necessary policy infrastructure, increasing the role played by renewables and phasing out unsustainable technologies. In this sense, the share of renewables in the final energy demand of EU Member States would need to grow from 32% to 40% in 2030, while CO2 would not be sold anymore after 2035. However, Fit for 55 goes further than pushing for individual reforms, as it targets the expansion and improvement of the entire carbon pricing framework in the EU.
Firstly, Fit for 55 pushes for a one-off cut of the total EUAs in the market, which should immediately increase the carbon price. This will be complementary to keeping the intake rate of the Market Stability Reserve at 24% until 2030; this implies that if the number of EUAs are excessively high at any point in time (above 833 million), 24% of the excess allowances will be taken out of the auction market and moved into a “reserve”. While both measures appear to be only incremental, they are fundamental in that they allow for new policies to function in an already more robust carbon pricing environment. Having a more stringent cap on emissions, imposed through the number of EUAs allowed in circulation, allows for other sectors to be introduced under the ETS without the price of carbon dropping. Additionally, strengthening the Market Stability Reserve at a point in time where the price of EUAs is on the rise sends a long-term message to the market that large fluctuations should not be expected—allowing companies to anticipate their demand for EUAs and ultimately facilitating an even more cost-effective abatement.
Secondly, the Commission intends to make the free allocation of EUAs conditional upon investments in energy efficiency and carbon reduction measures. This linkage is one of the more contentious points of the ETS, as many analysts believe free allocation should be phased out more rapidly, rather than being locked in through these types of policies. In Phase 4 of the ETS, around 43% of the EUAs are freely distributed to GHG-emitting installations to avoid potential carbon leakage. Carbon leakage refers to the phenomenon in which, to avoid stringent climate policies, companies move to other jurisdictions with no similar (or less) regulations, leading to an overall increase in GHG emissions. Nevertheless, carbon leakage remains a rather theoretical scenario, as studies showed the risk to be low due to other factors (and benefits) that keep companies within the EU. Linking free allocation to self-improvement measures is expected to reduce this form of distribution by anything in the range of 4-50%, implying an enormous amount of uncertainty. While it is understandable that many critics see this approach as too conservative, a potential long-term benefit is forcing GHG-emitting companies to enhance the existing overall funding for technological change to occur earlier than expected. Even if free allocation is to be phased out, the negative externality associated with undersupplying research remains intact. Indirectly, this reform might even solve it, while also not stepping back on the commitment towards full auctioning of EUAs in the future.
Thirdly, the maritime transport sector will be included in the EU ETS. Increasing the coverage of the carbon market to account for shipping will be done progressively: ship operators would have to surrender EUAs covering 20% of their GHG emissions in 2023, 45% in 2024, 70% in 2025 and 100% from 2026. Covering this sector would imply adding around 90 million tonnes of CO2 to the ETS, which could affect the stability of the price and thus distort signals sent to markets. During this stage is where reforms, such as the Market Stability Reserve and the one-off cut, will kick in to ensure the smooth inclusion of the new sector into the system. Nevertheless, opposition is expected from trade organisations such as the International Chamber of Shipping or the International Maritime Organisation, where both organisations have a role in coordinating current decarbonisation measures for maritime transport. The main warning sent by such organisations is that while carbon pricing might be efficient when enacted globally, regional prices might lead to overlapping taxation and distortions to trade. While true in essence, this comes after coordinated efforts of self-regulating shipping has failed in the past, forcing the EU to take a similar approach to what has been done previously with aviation.
Fourthly, the Fit for 55 package initiates discussion on a second carbon market that would cover buildings and road transport. This measure recognises that using alternative policy instruments, such as fuel standards, has proven to be insufficient. However, the vast majority of Member States have already stated their opposition to this new carbon market, fearing the distributional effects of the policy would make it politically dangerous. Nevertheless, in anticipation of these attacks, the EC has initiated a new funding facility: the Climate Action Social Facility. According to Vice-President of the EC Franz Timmermans, this fund will “protect vulnerable households against potential price increases for heating and transport fuels, especially in regions where clean options aren’t readily available”. While many politicians immediately appealed to the Yellow Vest movements as a dystopic framing of what is to come due to this policy, debates on how to design the carbon market will endure for years, making predictions on the form of backlash only pieces of fiction.
Lastly, this package introduces the carbon border adjustment mechanism (CBAM), one of the most anticipated, yet highly controversial, policies that have entered the political repertoire in the last years. This new legal mechanism would target to avoid carbon leakage by putting a carbon price on imports of certain goods from outside the EU. If implemented optimally, this measure would be, from the EU’s perspective, equivalent to a global expansion of its ETS. However, there are still many political and technical challenges facing the CBAM. Technically, this measure needs to respect the rules of international trade as codified through the WTO. Making the CBAM into a WTO-compatible arrangement is possible, but it requires alignment and support from Member States. In this sense, the main obstacle might be Germany, which fears international retaliation against the CBAM might affect its export-oriented economy, especially in car manufacturing.
What comes next?
It comes as no surprise that the EC is pushing to expand carbon pricing in the EU through the Fit for 55 package. At this stage, experts agree that without pricing emissions, it is impossible to comply with objectives of the Paris Agreement—and ultimately, to limit the effects of climate change. However, while carbon pricing is a mainstay of the policy agenda, few attempts were actually made at pricing sectors of the economy that would immediately impact the final consumer. While the rising price of electricity is often associated with the Brussels-directed carbon market, there was no sizeable backlash against the EU ETS. One reason is that due to external conditions, the price of carbon was too low for consumers to really feel it, even if polluting companies made sure to pass through most of their costs on to the end of the value chain.
The reforms under Fit for 55 will shift this narrative. Not only is it likely, but it is rather certain that when sectors such as transport and buildings are included under any form of carbon pricing system, bills will increase, and alongside them, concerns related to energy poverty. Instruments like the Climate Action Social Facility will be necessary for designing a complementary social policy that alleviates the distributional concerns of carbon pricing— especially in countries that lag in the energy transition, such as Central and Eastern European states. This dilemma emphasizes that if the EU wants to promote a green transition, they will also need to ensure a just transition.
However, climate change is no longer just an incoming threat, it’s a reality that we need to confront—and we need to confront it now. And during this confrontation, the probability that certain groups or sectors will indeed bear significant costs is a reality. But that is exactly the point—if nobody would bear any costs, there would be no tangible incentives for people to change their behaviour, for companies to change their methods across the production chains or for states to support research into alternative technologies. Still, it is unwise to avoid this discussion: if we want to decouple economic growth from unsustainable resource exploitation, behavioural changes are necessary alongside large-scale policy.
Furthermore, social policy will need to complement climate policy, but only insofar as it avoids disproportionately affecting disenfranchised groups from bearing the (major) costs of transitions. It is essential that climate policy avoids become a funding source for the European welfare states, but rather, measures taken to fight, for example, energy poverty are designed in a manner that promotes real technological change.
Fit for 55 needs to be framed as an opportunity for change. Subsequent debates on each policy might take up to several years, a time in which responsible politicians, think tanks and climate advocates must do whatever they can to push for changes across Member States. If the EU wants to succeed and avoid popular backlash, it must ensure that states act in concert moving swiftly towards deep decarbonisation. Avoiding that the European Green Deal is seen as a revolution from above might be as important as the investments that are to be made in the next decade.
If we want sustainability to be sustainable, we need to connect technical input with proper communication strategies—and Fit for 55 gives us the right materials to work with.