Ahead of the next trilogue between the EU institutions on the Emissions Trading System (EU ETS), scheduled to kick off next week, CMW’s Agnese Ruggiero and WWF’s Camille Maury tackle the misconceptions and bust the myths about the EU’s carbon market’s revision.

The current energy crunch and the burning hot summer Europe experienced this year  have set alarm bells ringing across the continent: we urgently need to speed up climate action and wean ourselves off of fossil fuels.

In this context, the opportunistic and unfounded calls by industry to halt or slow down the revision of the EU’s flagship climate policy, the Emissions Trading System (EU ETS),  would only worsen the impact on the climate and would significantly compromise the EU’s resilience to shocks in the future.

Priority should instead be given to ensuring that the EU ETS has a clear target, that it provides the right incentives to rapidly reduce emissions and is future-proofed.

In an attempt to use the current energy crunch to water down climate ambition, some industrial trade associations are calling on EU lawmakers to scrap certain key elements of the EU ETS reform.

Leaky ceiling

In the current EU ETS plans, a one-off reduction of the overall number of allowances under the cap to bring them more in line with the actual emissions is currently being negotiated. But industry has been lobbying hard against this, claiming that it would artificially raise the price of carbon and make climate action more expensive.

Reducing allowances is necessary to  control the chronic oversupply, and to make a more resilient carbon market. In fact, the one-off reduction on the negotiating table is not strong enough to effectively address the issue.

Not too much, but too little

The gap between the current cap on pollution permits and actual emissions amounts to around 450 million allowances. It is clear that neither a cut of 117 million allowances in 2024, as suggested by the European Commission, nor a two-step rebasing of 120 million allowances, as proposed by the European Parliament, would be sufficient to tackle the structural oversupply that continues to afflict the EU ETS. Neither measure would result in a “severe shortage of allowances” for industrial sectors, as has been claimed by lobbyists.

Moreover, this demand blatantly fails to consider the effect that the new REPowerEU proposal, which aims to stabilise the EU’s energy supply in the wake of the Russian invasion of Ukraine, would have on the EU carbon market and the carbon price. Raising the €20 billion for REPowerEU by taking allowances currently sitting in the EU ETS’ Market Stability Reserve (MSR) would increase the supply of allowances on the market and reduce the CO2 price, therefore rendering a one-off reduction of the cap even more necessary. 

The alternative option, agreed on this week by the European Parliament ENVI Committee and several member states, of raising the €20 billion by advancing auctions of allowances that were meant to happen in the second half of the decade will also reduce the carbon price and is likely to offset the price increase generated by the rebasing. It is clear that both scenarios do not warrant avoiding the one-off reduction of the cap.

Reserving judgement

Parallel demands from industry that the EU carbon market’s supply-demand balance should be left unaltered are equally short-sighted. Also in this case the functioning of the Market Stability Reserve as a tool created to tackle oversupply on the carbon market by absorbing excess allowances off the market is at stake. The revision of the MSR should send a meaningful price signal and ensure the stability and resilience of the EU carbon market. It should, therefore, be further strengthened, not weakened.

If the rate at which the MSR absorbs surplus allowances from the market was left at 12% after 2024, the ETS market would remain critically oversupplied and the price would potentially never recover enough to provide a meaningful signal to spur investments in decarbonisation.

The MSR: a crucial climate actor

The MSR is starting to play its crucial role for the stability and resilience of the carbon market. Introduced during the last revision of the EU ETS as a response to the oversupply of allowances from the 2008 financial crisis, it was in large part thanks to this mechanism that the carbon price did not crash when the Covid pandemic hit. It is also what keeps it relatively stable today.

This is why it is essential to maintain and strengthen the parameters of the MSR. In this respect, the position of the European Parliament that further increases the absorption power of the MSR should be supported by co-legislators.

Freebies and giveaways

Historically, the allocation of free pollution permits has always been the most contentious element of the EU ETS revision, and this trilogue is no exception.

With the inclusion of higher climate ambition and the introduction of the Carbon Border Adjustment Mechanism, the reformed ETS looks to include a progressive phase out of free pollution permits and – in the Commission’s and Parliament’s positions – more stringent pre-conditions for receiving these giveaways. 

Calls from pro-industry voices to drop the revision of the way free pollution permits are allocated  should be ignored. Such calls would prove  detrimental for both the future of our climate and the EU industry itself. These freebies have proven ineffective at cutting emissions in the industrial sectors, letting polluters off the hook with a huge cost for member states’ budgets: €98.5 billion was lost to free allocation between 2013 and 2021.

A dirty history

Established in 2005, free pollution permits were meant to be a temporary exemption from the ‘polluter pays’ principle in the EU treaties. Yet, 17 years later, they are still firmly in place and mostly serving to delay industry’s green transition and acting as a barrier to the market for climate-neutral frontrunners. 

Free pollution permits work in direct contradiction with the ETS, by creating a subsidy to pollute and undermining the ETS price signal for over half of all ETS emissions between 2013 and 2021. Almost 5 billion more free pollution permits are expected to be handed out to large polluting industries in the EU in the coming decade. This is a massive market failure and a hidden disgrace of EU climate policy making.

Allocating free permits to pollute based on conditionality requirements such as investments in energy efficiency measures and decarbonisation plans is not about micromanaging EU companies but rather ensuring a more targeted, fair and effective use of this system. This would in turn incentivise cleaner production and support the industries that invest in it.

Pressing benchmarks

Moreover, a revision of EU ETS benchmarks is needed to ensure that free pollution permits are assigned on the basis of robust and up-to-date values. Industry’s call to halt the revision of these values and leave the system untouched for another decade is  self-serving and disingenuous.

Benchmarks are used to determine how many free pollution permits each installation receives under the EU ETS and are designed to decrease over time to take into account technological development, investment and best practices that reduce the emission intensity of the associated products.

In the current legislation, the pace at which benchmarks improve each year is glacial and does not reflect the efficiency gains and improvements that happen in reality. The current system has instead allowed large polluters to continue receiving copious amounts of free allowances for the last 15 years and has put cleaner producers at a competitive disadvantage. Keeping the current improvement rate appears to be a way to subsidise large polluting installations and artificially muteg the carbon price signal.

A cleaner future

It is crucial that free pollution permits are phased out as soon as possible, ETS benchmarks are revised to reward best performers, and support is provided to clean producers through public and private funding.

Deleting or watering down key elements of the EU ETS provides no solutions, even in such times of energy crunch and raised costs. Policymakers should finalise the revision of the EU ETS that strives for the most ambitious outcome for the climate. Only this will help EU industry thrive in the green transition while weaning it off its dependence on fossil fuels.

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A version of this article was published by Euractiv on 6 October 2022.