Progress was made on the EU ETS, ETS 2 and CBAM in December, but many questions remain unanswered.
Carbon pricing has long been thought of as one of the most effective ways to migrate economies away from fossil fuel dependence to achieve net zero and limit global warming to 1.5°C.
In December, the European Commission, Council and Parliament reached consensus on the reform of its Emissions Trading System (ETS), the development of a separate system for other industries (ETS 2), and the introduction of the Carbon Border Adjustment Mechanism (CBAM), which has the potential to globalise Europe’s carbon pricing regime.
To encourage companies to adopt low-carbon business operations and products, the ETS was first introduced in 2005 to cover around 40% of EU emissions. It sets a cap on the amount of CO2 emissions that can be emitted by companies and issues a limited number of free allowances, which are distributed to prevent carbon leakage (an increase of emissions outside the EU as a result of EU climate policies). Any additional carbon credits must be purchased on the ETS trading market.
ETS 2 will operate as a separate market for the road transport and buildings sectors, with a more gradual phase-in and contingencies to protect the general public during periods of energy price volatility. Once operating in tandem, the ETS and ETS 2 will cover around 80% of EU emissions.
Introduced as part of the Fit for 55 raft of legislation, the CBAM will mirror the prices set by the ETS and implement a tax on certain carbon-intensive imports to prevent carbon-intensive producers from moving their operations outside of the EU to avoid ETS measures. The CBAM will gradually replace the ETS free allowances.
“The ETS, ETS 2 and the CBAM are the centrepieces of the EU decarbonisation agenda,” says Charles Boakye, Equity Analyst of ESG and Sustainable Finance at investment bank Jefferies.
“It’s almost like a house of cards, with the ETS at the bottom – if that’s not in place, then everything else will come crashing down.”
But building this house of cards has been a long, contentious road, hindered by pushback from carbon-intensive industries and some political groups. The three-pronged carbon pricing strategy is still far from finalised, however, with discussions over the fine print expected to continue over the course of this year.
“Everyone should acknowledge that this is progress and that none of it was certain ground before the very last minutes of the trilogue negotiations,” Hugo Bluet, Senior Carbon Markets Analyst at the London Stock Exchange Group (LSEG), tells ESG Investor.
Making a splash
Already a cornerstone of EU legislation, the EU ETS is now targeting a 62% reduction in emissions by 2030 compared to 2005 levels – a target that some view as lacking ambition.
The European Parliament’s Committee on Environment, Public Health and Food Safety (ENVI) originally proposed a 68% emissions reduction target, while the World Wide Fund for Nature (WWF) called for 70%. But at least it’s marginally more ambitious than the 61% originally proposed by the Commission.
“Whether it’s 62% or 65% is a purely academic question,” says Boakye. “The most important thing is that the ETS has been hugely successful in lowering the emissions of [carbon-intensive] industries so far and will continue to do its job.”
The EU further agreed that ETS free allowances will be almost halved by 2030 (48.5%) and entirely phased out by 2034, where it will be replaced by the CBAM.
Shipping companies can also expect to gradually fall under the ETS, with 40% of their emissions covered from 2024, 70% by 2025 and 100% by 2026.
ETS pricing during periods of economic volatility has been a point of concern for EU lawmakers. In early February, prices reached highs of around €97 per tonne of CO2, prompting policymakers to call on member states to agree to lower the threshold at which regulators are allowed to intervene in the ETS. Experts speaking to ESG Investor note that such moves would be ultimately counterproductive.
“Even at €80 per tonne, that price doesn’t account for the welfare losses from emitting that tonne of CO2,” says Bernhard Bartels, Executive Director of ESG Analysis at data provider Scope Group, adding that “increasing the CO2 price will lead to better economic outcomes in the long run.”
As the war between Russia (one of the EU’s largest sources of fossil fuels) and Ukraine (the so-called breadbasket of Europe) continues, Bluet says this will “set a peculiar context for the reviewed ETS framework to be rolled out”.
There is even greater controversy surrounding the introduction of ETS 2.
Serving the buildings and road transport sectors, by targeting distributors supplying fuels to these industries, ETS 2 will have a more direct impact on the general public.
The EU has therefore installed a number of contingencies, including a pledge to delay the launch of ETS 2 from 2027 to 2028 if energy prices are still deemed to be exceptionally high, and a commitment to release additional CO2 allowances onto the market if prices exceed €45 per tonne of CO2.
Between 2026-32, ETS 2 will also be supported by the €87 billion Social Climate Fund (SCF), which will be funded by the market from 2027 and will support vulnerable households, micro-enterprises and transport users following price changes caused by the new system.
“The EU has obviously tried to soften the blow for consumer-facing sectors, but the SCF is a bit of a blunt instrument,” says Boakye from Jefferies.
“I’d prefer to see something more targeted that perhaps focuses on household incomes to ensure funding is distributed to the poorest and most vulnerable in society. Right now, it’s not entirely clear how the fund will operate in practice.”
The mechanism will apply to imports from non-EU countries, including cement, electricity, fertilisers, iron and steel, aluminium and hydrogen, as well as some cathode active materials and downstream products, like screws and bolts.
“Further carbon market reforms need to ensure that all emissions are priced in, including supply chain emissions outside the EU, to avoid the EU’s regulatory and fiscal programme simply leading to the ‘export’ of emissions through the relocation of high-emitting activity outside the EU,” says Scope Group’s Bartels.
Camille Maury, Policy Officer at the WWF European Policy Office, adds that the EU should look to “extend the scope of the CBAM” to other sectors, to ensure it remains “suitably ambitious”.
A more simplified CBAM, which will only apply the reporting obligations in an effort to begin collating data, will begin operating from October 2023. This will be followed by the introduction of the tax system in parallel to the phasing out of the ETS free allowances, with the end goal of covering all goods falling under the ETS by 2030.
In addition, the Commission will conduct a complete review of the mechanism by the end of 2027, assessing progress made and the impact on imports from developing economies. Application for exclusions from the CBAM by developing economies will be allowed, provided they have an equivalent domestic carbon pricing mechanism in place.
However, Maury points out that co-legislators did not agree on using revenues generated through the sale of CBAM certificates to fund climate action outside the EU, particularly in emerging markets and developing economies (EMDEs) – a core priority identified both at COP27 and COP15.
“All of that revenue is instead being added back into the EU budget, as opposed to supporting poorer countries that will be taxed by this mechanism in their transition to net zero,” she says.
The slow phasing out of ETS free allocations further risks undermining the ambition of the CBAM, according to LSEG’s Bluet.
“A robust CBAM framework was designed for and will be reliant on the fact that free allowances will be cut down to zero. With still a large share of allowances being given for free until 2030 – and beyond – this very idea is put into question,” he warns.
The slow phase out could be attributed to concerns from targeted sectors about remaining competitive with the rest of the world, says Boakye from Jefferies.
Eurofer, the European steel association, said the phase out of free allocations “risks wiping out a large part of EU steel exports worth €45 billion if no concrete export solution is found before 2026”.
Pressure on carbon-intensive processes should “encourage industries to turn to low-carbon technologies and other solutions”, Boakye points out.
Sticks or carrots?
While the EU has chosen to wield the stick to pressure carbon-intensive industries to transition to low-carbon alternatives, other parts of the world have chosen to the dangle the carrot.
Earlier this year, US President Joe Biden signed the Inflation Reduction Act (IRA) into law, committing US$369 billion to investments in green technologies and domestic renewable energy sources through a series of tax incentives.
“The US has gone down a very different route, so far rejecting the idea of a nationwide carbon pricing scheme, instead upscaling green investment incentives through the IRA,” says Boakye from Jefferies.
“The jury’s out as to which is the best or most efficient way to ensure widescale decarbonisation.”
Another important question that is yet to be answered is whether the EU’s carbon pricing strategy is too little too late.
“Timing is one of the biggest issues,” says Bartels, noting that the CBAM won’t be properly phased in until 2026, and ETS 2 from 2027, cutting it close to the EU’s 2030 decarbonisation target and putting its net zero by 2050 ambitions under pressure.
Confidence will be somewhat restored once all pieces of legislation are formally adopted. The agreements reached in December now need to be confirmed and adopted by EU member states, the European Parliament and Council before they can be published in the EU’s Official Journal and enter into force. All parties have until October to do so, when the CBAM is slated to enter into force.
Although a global carbon market covering all sectors and jurisdictions would be the most “economically optimal” solution, according to Scope Group’s Bartels, the establishment and growth of the EU’s ETS and CBAM is the next best thing, “providing an incentive for other countries to price their emissions”.