The EU ETS review – current state of play

This blog post was written by Marcus Ferdinand. 

The review process of the European carbon market (EU ETS) is in full swing. Right in time before Christmas, the members of the Environment committee (ENVI) of the European Parliament voted in favour of a more ambitious post-2020 market set-up as compared to the European Commission’s proposal published in July 2015.

Most notable elements of the ENVI proposals are the higher linear reduction factor, effectively strengthening the EU ETS cap towards 2030, and a doubling of the rate at which the market surplus will be reduced by filling the market stability reserve. Overall, the ENVI proposal would tighten the market significantly compared to the Commission proposal. If adopted in this form, it could result in significant price increases for carbon allowances already in the near to medium term.   

Members of different political groups wrangled hard over the past weeks to narrow down the several hundred amendments tabled by Parliamentarians to the original Commission report into a manageable number of compromise amendments.

My six key take-aways:

  1. No cut in free allocation for best performers at risk of carbon leakage    
  2. Import inclusion scheme for heavy-weight construction sectors and benchmark updates based on real data
  3. Indirect cost compensation via auctioning allowances
  4. A strengthened MSR and a tighter overall cap
  5. No changes to modernisation fund recipients but solution included for Greece
  6. Inclusion of the maritime sector

No cut in free allocation for best performers at risk of carbon leakage

The ENVI proposal tries to address one of the key issues that has kept policymakers and industry lobby busy over the past months: how can a reduction to free allowances to the best performers at risk of carbon leakage be prevented? One important element is an optional transfer of up to five percent from the overall allowances intended for auctions and transfer these to the free allocation pot. These allowances would be transferred from auctioning to free allocation to support carbon leakage-exposed industry in case the demand for free allowances is higher than the defined supply. This could result in a maximum shift from the currently foreseen 57% auctioning to then 52% in case the entire 5% transfer is applied. Should the free allocation pot not run short, up to 200 million EUAs from the auction share might be cancelled towards the end of phase 4. These rules thus increase the certainty for industry to receive enough free allowances but also include the possibility for a tightened cap in case not all of these allowances are eventually required. A further strengthening of the market framework is envisaged by creating the New Entrant Reserve (NER) of 400 million allowances entirely with phase 4 allowances.

Import inclusion scheme for heavy-weight construction sectors and benchmark updates based on real data

Interesting for industry participants are the proposed benchmark rules as well as the foreseen set-up of an import inclusion scheme. Such a scheme would target sectors with a low trade intensity and high emissions intensity. Importers in sectors not having a trade intensity above 10% in the years 2009 to 2013 covered by the EU ETS would need to acquire and surrender allowances for imported products. The sectors concerned would not receive any free allocation even if they are part of the carbon leakage list. This de facto targets mainly the cement and lime sectors as also mentioned by the ENVI justification to the legislative wording. The Commission would still need to work out the exact modalities of such scheme until mid-2019. Interesting to note is the fact that it only addresses the loss of competitiveness in the EU market. A fact that would not be addressed by this mechanism is the loss of competitiveness in the non-EU market. Other industry sectors not affected by the import inclusion scheme would continue to receive their free allocation as proposed by the Commission on the basis of a binary carbon leakage list. For those sectors on the list, 100% of allowances up to the benchmark would be handed out for free while sectors not on the list would receive no free allocation with an exception for district heating that would receive 30 percent.

On the determination of benchmark updates relevant for each industry sector’s free allocation, the ENVI proposal foresees to use 2016 and 2017 production and emissions data for each sector to calculate the annual reduction in the benchmark values for the 2021 to 2025 time period. More recent data would be used for the 2026 to 2030 period. These calculations for annual benchmark reductions are limited by a minimum and maximum value for the annual reduction of the benchmark value of 0.25% and 1.75%. This is basically a rejection of the Commission’s proposal to use a flat-rate benchmark approach of 0.5, 1 and 1.5 percent per year starting from 2007-08 production and emissions data. The proposed method involves more freely calculated values to more accurately reflect recent emission intensity improvements.

Indirect cost compensation via auctioning allowances

The ENVI proposal foresees to auction three percent of the total phase 4 cap in order to compensate sectors for indirect carbon costs. This amounts to 465 million allowances. An Ecofys study showed that this amount would cover approximately 21% of the allowances the electro-intensive industry requires to be fully compensated for indirect carbon emissions up to the current EU ETS benchmark.

A strengthened MSR and a tighter overall cap

Parliamentarians in ENVI opted to double the withdrawal rate of the market stability reserve (MSR) from 12% to 24% for the first four years of its operation. Further, ENVI adopted to cancel 800 million EUAs from the MSR by 2021. The MSR is a mechanism to reduce the oversupply in the EU ETS by withholding a pre-defined percentage of allowances in circulation from the auction volume foreseen for this year until a threshold of 833 million allowances is reached. Therefore, the doubling of the withdrawal rate is an interesting move as it would decrease the oversupply much faster compared to the currently foreseen set-up. However, a doubled outtake rate can have unintended consequences given the definition in the MSR Decision. The MSR rules define a minimum annual withdrawal of 100 million allowances, which in combination with the originally foreseen withdrawal rate of 12% leads to an upper threshold of the mechanism of 833 million, a threshold where the MSR would stop reducing supply. The doubling to 24% adopted by the ENVI committee means that with a minimum of 100 million allowances minimum withdrawal the MSR will not stop taking out allowances until the surplus drops below 417 million instead. This is likely not the intention of policy makers and will likely be changed by an amendment to the MSR Decision. Should the strengthened MSR survive the upcoming political process, it would rapidly reduce the oversupply and likely lead to an increase in allowance prices already before the start of the mechanism in 2019. In combination with a proposed linear reduction factor of 2.4% per year and a cancellation of 800 million allowances placed in the stability reserve by 2021, the ENVI proposal provides ground for a significantly tighter market balance.

No changes to modernisation fund recipients but solution included for Greece

According to the original Commission proposal, access to the modernisation fund and making use of the derogation from full auctioning for the power sector (Article 10c) is restricted to countries with a GDP per capita below 60% of the EU average in 2013. The ENVI proposal foresees no change to the start year for an inclusion of member states in the modernisation fund and the 10c mechanism, but it allows member states fulfilling the criterion in 2014 to revert up to 40% of their auction volume to use it for the same purpose as laid out for the modernisation fund without participating directly. This criterion is only fulfilled by Greece and would allow the country to use around 120 million allowances for modernising its energy sector. However, this is just a relabeling of Greek allowances, hence every EUA that is used in this context is avoided auctioning revenue for the country.

Inclusion of the maritime sector

On international transport, the adopted ENVI position foresees an EU ETS inclusion of the maritime sector from 2023 for ships using EU ports if no comparable global measure is in place for the sector. It translates that the maritime sector is not doing enough at the moment and increases pressure on the maritime sector to take more climate action. This is a similar approach compared to the aviation sector that was included in the EU ETS in 2012. For the aviation sector, the ENVI proposal foresees a decreasing emissions cap for domestic flights and calls on the Commission to propose including international flights in the EU ETS, adjusting for any measures agreed at ICAO in 2019.

What’s next?

After the vote in the Parliament’s ENVI committee, the file will be put for a vote in the Plenary, a tentative date is scheduled for February 2017. Meanwhile member states in Council haven’t reached consensus yet. While the Slovak Presidency prepares for the Environment Council on 19 December, the incoming Maltese Presidency will likely have quite some work ahead to align the 28 different positions to one Council position which will then serve as basis for negotiations with a Parliament delegation under the lead of ENVI rapporteur Ian Duncan and representatives from the European Commission.

Should the Parliament’s Plenary adopt the ambitious ENVI position, I have my doubts that the trilogue negotiations will be easy as several member states will have huge objections against a significantly strengthened EU ETS framework. Therefore, my best guess at the moment is that we will not see a final adoption of the file before the second half of 2017. The ENVI position has to be seen in this regard as a negotiation position that will be tweaked during the further process to allow for a compromise with member states and the European Commission.

Posted 16-12-2016 Category: Energy & Climate Policy Tags: eu ets , ets , eu , carbon market , carbon cap and trade , emissions

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