The European Union’s expansion of the European Emissions Trading System, known as ETS2, will extend the “polluter pays” principle to buildings and road transport. This will make carbon pricing more tangible to EU citizens but can also help them decarbonise. 

Amid the unfolding climate crisis and economic challenges of high inflation and rising living costs, the planned expansion of the EU’s Emissions Trading System to cover buildings and road transport (ETS2) is a prime opportunity to highlight the co-benefits of society’s transition away from fossil fuels, rather than a trade off between enhancing quality of life and safeguarding the environment, as some political voices have argued. ETS2 should be regarded as one element within a broader policy framework designed to facilitate a just transition while simultaneously promoting access to zero-carbon transportation and fortifying the energy-performance of our homes. 

According to research by the European Environmental Agency (2022), the buildings sector currently accounts for 15% and transport 22% of the EU’s direct emissions. These are currently covered by the Effort Sharing Regulation, which sets legally binding reduction targets for all member state emissions not originally covered by the EU ETS. Following full implementation of ETS2, which will be launched in 2027, 75% of the EU’s carbon emissions will, by 2030, be subject to the EU ETS carbon pricing mechanism, which should accelerate the bloc’s decarbonisation.

How will ETS2 work?

The ETS2 is an “upstream” regulation, targeting fuel distributors who, based on the carbon intensity of the fuels they sell, will be required to purchase and use allowances. Without a price corridor, price increases would then be passed on to consumers, and the start date will be determined by the stable pricing of fuel in the previous year. This means the scheme will launch in 2027 or be postponed to 2028 if starting prices are deemed too high. 

Once launched, the objective is for a 42% reduction in emissions by 2030 compared with 2005 levels. Safeguards are in place until 2030 to prevent ‘excessively high’ carbon prices, with an additional 20 million allowances entering the market once the price reaches €45 per tonne. Regardless of how high the ETS2 carbon price will turn out to be in reality, consumers can expect an impact on the cost of the fossil fuels they use, underscoring the necessity of a well-considered policy mix that couples energy savings and renewable energy deployment with the protection of lower income and other vulnerable groups.

Splitting the revenue

Most of the revenue generated from auctioning within both ETS systems will now be spent on climate action. Three-quarters will be allocated directly to member states to finance spending on transitioning to a low-carbon economy. The remaining 25% of auctioning revenues (up to a €65 billion threshold) will be allocated to the Social Climate Fund (SCF). The SCF was established alongside ETS2, and will be distributed to member states to offset the social repercussions of increased carbon pricing. Payments can be used for direct assistance or for decarbonisation schemes.

The role of the Social Climate Fund 

To gain access to the fund, member states will need to engage with stakeholders (including civil society organisations) and submit their National Social Climate Plans (NSCPs) to the European Commission. They will also need to provide 25% co-funding. 

NSCPs should primarily focus on measures with a dual social and climate benefit, such as offering vital support for comprehensive energy retrofitting, improving the accessibility of public transportation and electric vehicles, and implementing regulatory changes to encourage consumers to lower their emissions.

As a starting point, member states should consider the revenue from the new Emissions Trading System (ETS) and the Social Climate Fund as initial resources for financing the decarbonisation efforts in the road transport and building sectors, and increase their ambition accordingly. It’s important to note that carbon pricing, if applied at a flat rate to all consumers, no matter their income, is likely to disproportionately hurt lower-income individuals without affecting the behaviour of those with higher incomes as lower income groups spend a higher proportion of their income on energy. 

At the member state level, governments must balance protecting lower-income households from energy poverty with not diluting the incentive to reduce emissions. Support measures, such as  Germany’s “climate dividend,” which entails a taxable lump-sum payment to all citizens and Switzerland’s use of carbon tax revenue to reduce healthcare and social security expenses and schemes to provide heat pumps to lower income households, must be considered both in terms of their ability to reach the economically vulnerable and their corresponding administrative burden.  

Enhancing climate ambition 

ETS2 has the potential to be a valuable tool within a well-crafted policy mix that can assist the EU in achieving its necessary climate goals. The incentive for member states to take ambitious climate action is clear as the more successful they are at reducing their emissions, the less pressure they will feel from the ETS2 price signal. 

Under the Effort Sharing Regulation, member states have emissions reduction targets ranging from 10 to 50% compared to 2005 levels, with higher income states facing more ambitious targets. As all member states are bound by the same ETS price, lower income member states will receive greater support from the Social Climate Fund, with allocation considering factors such as the percentage of the population at risk of energy poverty. 

A robust carbon pricing mechanism needs to complement and work hand in hand with other climate policies and measures. Within the context of a continent-wide increase in the cost of living, it will be vital that ETS2 demonstrates solutions for how climate action can align with social justice objectives, all while upholding the polluter pays principle.

Carbon Market Watch highlights several areas where more ambitious policymaking can clear the path for a just transition:

Regulatory standards to drive down the energy use of buildings, cars and appliances must be strengthened. The Energy Performance of Buildings Directive must be complemented with sufficient grants and financing schemes by member states to ensure implementation. Regarding transport pollution, stricter CO2 emission performance standards for new cars are welcome but do not go far enough. The EU should stick to its initial agreement to ban the production of internal combustion engines by 2035 or earlier and not capitulate to the false idea that supposedly ‘climate neutral’ fuels are viable for new combustion engines post 2035. Instead, efforts should be placed on building no-carbon public transport and rural links.  

Social support to protect lower income groups must be adequately provided. Increasing the current cap of the Social Climate Fund from €65 billion to at least the originally proposed figure of €72.2 billion would increase funding for energy retrofitting and improve access to renewable energy schemes for lower-income groups.

Access to renewable energy must be increased and no further investments in fossil fuel infrastructure made. Member states must ensure the expansion of renewable energy infrastructure to provide citizens with the means to power their homes and vehicles with renewable sources. Lower-income member states can benefit from the Modernisation Fund to finance these projects. However, it is vital that no more funding is used under this scheme to finance fossil fuel gas expansion.

The Effort Sharing Regulation and ETS must complement each other. An overarching carbon pricing structure must be complemented with ambitious legally binding national targets that are aligned with the EU’s emission reduction goals. Questions remain unanswered as to how the ESR will align with ETS2 and when a post-2030 framework for ESR will be delivered. It is vital that ESR targets remain binding at national level and are strengthened to address market failures and barriers to energy efficiency investments. 

Going forward, it is evident that the implications of ETS2, most potently the potential for higher fossil fuel prices at a time when many are experiencing economic hardship, will spark controversy. It is vital that this scrutiny does not open the door to a roll back of the polluter pays principle and the scrapping or weakening of ETS2. Rather, policymakers must complement the scheme with support measures to protect lower income groups while further incentivising the rapid phase out of fossil fuels and the emissions reduction necessary to safeguard a liveable planet.