The EU Emission Trading System (hereafter ETS) has been the subject of a lengthy four-phased strengthening process leading to the construction of the most developed system of the kind in the world. It currently covers 45% of EU total greenhouse gas (GHG) emissions and is thus a major tool for the fulfilment of the EU’s climate commitments.

It relies on a “cap and trade” model: a cap is set up at a level supposedly lower than the actual level of emissions for the whole zone concerned, and shall be progressively reduced. A certain number of allowances is defined, they are given a price and are allocated to the sectors concerned. Each allowance allows its owner to emit one ton of CO2 or the equivalent in CO2 of the other gases concerned. It relies on the principle of economic rationality: pro-environmental innovation must become gainful compared to business as usual. With a certain amount of allocations attributed to a firm, it will seek to avoid exceeding its quota and the fines associated with such a situation. In addition, a firm can increase its profits by selling unused surplus allowances. Such a mechanism can only produce its full effects if the prices are high enough to provide incentives. That condition was the central focal point of the successive reforms.

Building the EU ETS System

The EU ETS was put in place by Directive 2003/87/EC. The first phase from 2005 to 2007 was qualified as a “learning by doing” period. The goal was to introduce the mechanism to the industrial sector while limiting the constraints imposed on it. Its scope was limited to the greatest emitting sectors: power generators and energy-intensive industries (such as metals, paper, oil refineries and steel). The vast majority of allowances were allocated for free, with a low penalty for non-compliance. Each Member state defined a national allocation plan to share said allowances amongst the concerned industries, which by nature generated disparities.

The second phase, from 2008 to 2012 saw the reinforcement of the system with a reduction of the number of allowances, though still insufficient to provide any deterring effect. Yet one must note that for the first time, Member states could draft their national plans based on the data on emissions collected during the first phase, an information that had been lacking in the early days of the market. The second phase also saw an increase in the number of states concerned, with three non-EU states added (Iceland, Liechtenstein, and Norway), an inclusion of the aviation sector and the enlargement of the scope to new GHGs. The proportion of free allocations was also reduced.

The third phase was the one of reform. An EU-wide cap was introduced, planned to be reduced by 1,74% every year with a shift towards the generalization of auctioning of allowances as the default system. Another major innovation of this phase was the creation of the NER300 fund, aimed to favor innovation and low carbon technologies. Yet a major obstacle to the system’s efficiency remained: the fixed number of allowances. Due to lower industrial activities in the aftermath of the 2008 crisis, added to miscalculations of the level of allowances needed, a surplus continued building up which maintained the prices at non-deterring levels.

Consequently, EU decision-makers opted for the add-up of two limiting measures: a short-term one, creating a backload of allowances to postpone their entry into the market and a long-term one, through the establishment of a Market Stability Reserve (MSR). From January 2019, the reserve is used as a market regulator to avoid any surplus.

Persisting issues and relative successes: the path towards Phase 4

The three phases of the ETS have shown the development of three kinds of persisting issues:

• The surplus: Until the beginning of phase 3 and from the very start of the market, a surplus was built-up. It is a recurring feature of most, if not all, emission trading systems worldwide. It can be due to miscalculations of expected emission levels, but also and especially in the 2008-2012 period to the evolution of industrial activities after the economic and financial crisis. The efficiency of the MSR in that regards remains to be observed, but the rupture with the previous cap’s inflexibility surely is promising.
• Carbon leakage: another inherent issue in a globalized economy, companies seek to maximize their benefits. In order to do so, relocating to jurisdictions that apply less constraining and costly norms is a frequent response for some industries. To avoid that issue, a list of particularly sensitive industries was established and led to the auctioning of free allowances to the firms concerned.
• Boosting innovation: an ETS system aims to reach two environmental benefits: a lowering of GHG emissions, but also a promotion of innovation in order to render productions more efficient and less energy consuming. The efficiency of the EU ETS in that matter is hard to evaluate.

Despite these issues, the EU ETS’s first three phases have been considered a success. It appears indeed that the EU ETS “has contributed to small but real emissions reductions and had limited but positive impact on investment decisions and innovation” (https://www.europarl.europa.eu/thinktank/en/document.html?reference=EPRS_BRI(2018)621902). The emission target for 2020 was reached ahead of time and emissions from ETS covered structures have decreased by 24% compared to 2005.

Companies have made the system part of their decision-making, to the point that it is said it has even changed “corporate culture” (http://www.ceps-ech.eu/sites/default/files/State%20of%20EU%20ETS%20v16_0.pdf). Such markets are now worldly spread and become inherent to firms’ investment choices. From an image point of view, the generalization of emission trading systems has sent a strong message to the corporate world that it was built to last and be reinforced.

The changes brought with the fourth phase appear to go in that direction.

Phase 4: the maturity age of the EU ETS?

The fourth phase, running from 2021 until 2030 is a consolidation of the preexisting system. It pursues the reinforcement of its incentive effect with more ambitious reductions of the cap, from 1.74 % per year to 2.2% per year from 2021 so as to achieve 43% of emission reductions in the ETS sectors compared to 2005 levels.

The amount of free allowances will be defined for five years, while it used to be eight years in the previous phase and will be progressively limited. Their allocation shall be more targeted to reflect the reality of carbon leakage and take technological progresses into account.

On the funding side, the NER300 fund is replaced by two funds: an innovation fund designed to provide support for research projects related to renewable energies sources and carbon capture and storage; and a modernization fund directed towards the energy sector in 10 lower income Member States.

Finally, the MSR is strengthened with an increase in the percentage of allowances placed in it from 12% to 24%. Surplus allowances exceeding the previous year’s volume will be invalidated. That way, the MSR will reduce the existing stock twice as fast as it could before. Member States are also being given possibilities to cancel “an amount of allowances equivalent to the abatement driven by the implementation of national measures” (https://www.oxfordenergy.org/publications/eu-ets-phase-iv-reform-implications-system-functioning-carbon-price-signal/?v=920d0c66f3d2).

The Fourth phase is thus a maturity phase. It comforts a policy that finally seems to have found its stability and is ready to produce its maximal effect. It was made more dynamic, better able to react to changes in the economic or technological context.

The importance of the EU ETS in the years to come will become even greater as the EU’s climate objectives grow. The new Commissioner in charge of the Green Deal, Frans Timmermans has already advanced the idea of an extension of the system to the maritime sector, and an expansion within the aviation sector, which had previously tumbled. The system is thus bound to remain a major tool of the EU’s climate policies both internally and on the international stage, as a trendsetter.

Sources:

• Centre for European Policy Studies, “2016 State of the EU ETS Report”, February 2016.
• European Commission, “Factsheet: The EU Emissions Trading System”, 2016.
• European Parliament, “Briefing: Post-2020 reform of the EU Emissions Trading System”, November 2017.
• International Carbon Action Partnership, “ETS detailed information”, 23^rd December 2019.
• Lauren E. Mullen, « The European Union overstepping its bound and borders : the extraterritorial effect of the emission trading system and its call for multilateral action”, University of Pitsburg Law Review, Vol. 74, N°4, 2013, p. 783-802.
• Stefano De Clara, “The EU ETS phase IV reform: implications for system functioning and for the carbon price signal”, Oxford Energy Insight, N°38, September 2018.

 

Marie Escorneboueu is currently a trainee at the European Court of Justice, specializing in European environmental law and chemicals. Before that she graduated from the Master 2 Droit Economique de l’Union at the University Paris 1 Panthéon Sorbonne and from the College of Europe.