Political debate continues on EU emissions trading reforms to help meet the bloc’s emissions reduction targets. Thibaud Clisson summarises the recent developments and looks to the future.
The future of the European Union’s Emissions Trading System (ETS) – the bloc’s flagship emissions-reduction mechanism that governs roughly 40% of the EU’s emissions – has been the topic of talks that seek to balance the ambitions of its ‘Fit for 55’ climate package with the urgent need for greater energy security after Russia’s invasion of Ukraine and related sanctions on Russian oil and gas.
These conflicting forces delayed a decision on the future of the ETS in June, but under a compromise deal, emissions from businesses using the ETS are now to be cut by 63% by 2030. This is up from the European Commission’s proposal of a 61% cut. The European Parliament also voted to end free EU emissions allowances (EUAs) for industries by 2032 with phase-outs starting in 2027.
There was also support for the planned carbon border tax (or Carbon Border Adjustment Mechanism) and for extending the ETS to international shipping – covering all shipping emissions to and from the EU by 2027.
Tougher rules and the price of carbon
Anticipation of these tighter rules on the ETS, including a squeeze on the supply of EUAs, caused the price of EUAs to increase to near EUR 100 already earlier this year. They are currently hovering around EUR 85. Prices could slide further amid an economic slowdown and the EU’s Save Gas for a Safer Winter package of measures. Both could cut gas demand until next spring
In the long term, however, carbon prices are expected to continue their upward trend, with recent projections based on potential linear reduction factors indicating a price of EUR 150 in 2023.
Concern about the role of investors outside of the ETS holding EUAs has led some market participants to call on the EU to curb speculative activity by these ‘non-compliance’ actors. Poland, for example, has called for measures to keep financial speculators out of the scheme. A clampdown might affect trading volumes and market liquidity.
However, in a recent report, the European Securities and Markets Authority (ESMA) said speculative activity amounts to just 4% of the market. Additionally, the European Central Bank has concluded that speculation has a limited impact on prices. Despite this, the European Parliament wants investor participation in EUA trading to be limited.
A price on imported emissions
The proposed tax on cross border emissions requires overseas firms to pay a carbon price on imported goods. They will have to buy CBAM certificates related to the emissions of their imports, with the price based on the average trading price of ETS allowances in the week before the import. The initial list of goods affected includes cement, electricity, fertiliser, iron and steel, and aluminium products.
The European Parliament wants to extend CBAM’s scope, so that organic chemicals, plastics, hydrogen and ammonia are also included.
While a carbon border tax may not by itself affect the price of EUAs, domestic firms will receive fewer allowances. That alongside CBAM implementation may raise prices.
CBAM could also encourage other jurisdictions to draft climate policies to standards similar to those of the EU. Kazakhstan, for instance, has developed its own carbon tax to avoid full payment of the CBAM – exports to the EU account for 40% of its total exports.
We believe early investment in transitionary technologies, for example in different pathways to produce steel using green hydrogen, will increasingly make economic sense as free allowances are phased out and the border tax kicks in. This also applies to other industrial sectors.
Currently, European steelmakers are at a disadvantage to non-European rivals who do not have to pay for emissions under the EU ETS. The border tax should remove this hurdle and boost a global effort among steelmakers – and in other industries – to decarbonise.
Tackling emissions from other sectors
The European Commission has also proposed that a separate ETS covering road transport and buildings emissions be launched in January 2024.
Tackling emissions from these sectors will be key to realising Fit for 55. While EU emissions related to energy use have been falling, residential and commercial emissions have been relatively flat, while transport emissions have actually increased.
Using an ETS to tackle EU transport and building emissions rather than employing standards is, however, divisive. The European Climate Foundation found it would increase living costs without reducing emissions meaningfully. Others are more positive. The Commission’s aim is for the ETS to cut combined road and transport emissions by 43% by 2030.
Members of the European Parliament have agreed that the new ETS should only apply to commercial buildings and transport – and not citizens – until 2029. The price of allowances is to be capped at EUR 50 – with the ETS’s Market Stability Reserve used to add allowances into the market if the price exceeds this level by 2030.
A proportion of income generated from the sale of these ETS II allowances would go to the bloc’s Social Climate Fund to support low-income families.
For investors looking at retrofitting buildings or at on-site renewables, we note the European Commission states that pricing carbon in the buildings sector will not by itself address barriers to such measures. Member state regulations on the energy performance of buildings under the EU’s Effort Sharing Regulation will play a large supporting role here. These should be watched.
Overall, the mechanics of the ETS promise to accelerate decarbonisation. A higher price should create opportunities for sellers of EUAs. As sellers, companies that can decarbonise sooner than peers will be able to capture a competitive advantage.