EU lawmakers agreed on an overhaul of the EU ETS rules as negotiators reached a deal on 18 December 2022. A full text circulated on 24 January confirms the key elements that were communicated a month ago. The document will now be presented to the European Parliament and to the member states in the Council for final approval. Assuming no delays, it could enter into force in May 2023.
The EU has set itself an objective to reduce overall emissions by at least 55 percent by 2030. To achieve that target will require a huge abatement effort in all sectors, not least the ones that are covered by the EU ETS. In July 2021, the European Commission proposed a comprehensive rehaul of the EU ETS Directive. Partly this is about tightening the cap for the emitters already covered by the EU ETS, partly it is about extending the system to sectors such as international maritime transport that have so far been largely unexposed to carbon pricing.
The European Parliament and the Council started processing the legislative proposal in late 2021. After both lawmakers had arrived at their respective positions in June 2022, they started trilogue negotiations with the aim of reaching a compromise. They agreed on all main points on 18 December, under the Czech Council presidency, but no full text was yet available, as recitals and certain technical aspects still had to spelled out. On 24 January a full text, 129-page long, was circulated. Barring any surprise, that document will now be presented for final endorsement in the European Parliament and in the Council. If all goes well, it should be finally adopted and enter into force in May.
In this analysis we provide a recap of what is agreed in the ETS trilogue, how the changes are likely to impact the carbon market, and the timeline for the upcoming adoption. We focus on four key elements, namely cap adjustment, scope expansion, the Market Stability Reserve (MSR), and the Carbon Border Adjustment Mechanism (CBAM).
Tightening the future supply of EUAs is arguably the single most important element in the EU ETS revision. Under the current version of the ETS Directive (from April 2018), the cap trajectory is calibrated to achieve a 43% tightening by 2030, to contribute to an overall abatement target of 40% down from 1990-levels. The new headline target of 55% will require a much more aggressive reduction within ETS sectors, and the new text envisages that the ETS cap will be reduced by 62%.
This is to be achieved by ramping up the annual linear reduction factor (LRF) from 2.4% to 4.3% in 2024 and then to 4.4% in 2028, combined with two extra volume cuts in 2024 and 2026. As a result, we will see issuance of 847 Mt worth of EUAs in 2030, instead of the 1,200 Mt that would follow from the current parameters. See figure below.
The cap adjustments will already have an impact in the years up to 2030, as the overall volume of EUAs issued during the period 2021-2030 will shrink from 14,000 Mt to 12,500 Mt. Still, the more substantial impact will be felt in the subsequent trading period, when issuance will effectively stop in 2039, and overall issued volume in 2031-2040 will drop from 8,900 Mt to 3,500 Mt.
What is clear from the figures below is that the difference between the existing versus new trajectory becomes much wider out towards 2040.
For the European Commission it was important to extend the principle of carbon pricing (let the polluter pay) to new sectors. This stems from the recognition that ETS covered sectors – most notably fossil power generation – have achieved significant emission reductions since 2005, the same cannot be said of sectors such as road transport, which have so far been dealt with (or not) by member states’ various sets of climate policy measures.
The new ETS revision expands coverage to new sectors, most importantly to emissions from maritime transport. All vessels above 5,000 tonnes are already obliged to monitor and report emissions, and as of 2024 they will need to account for their emissions by surrendering EUAs. Emissions related to intra-EU voyages will be accounted for 100%, while journeys to and from Europe, e.g., between Yokohama and Rotterdam, will need to account for 50%. The ETS will first apply only to ships’ CO2 emissions, but eventually the scope will be expanded to methane and nitrous oxide.
This puts shipping in a different position compared to aviation, where only intra-EU flights are currently covered by the EU ETS. The EU originally wanted to include all flights to and from Europe, but stepped down due to strong protests from China, the US, and others. For the time being, the EU has decided to throw its weight behind the Carbon Offset and Reduction Scheme for International Aviation (CORSIA) that is operated by the International Civil Aviation Organization. The European Commission will assess the merits of CORSIA in 2026, and then determine whether emissions from flights to and from Europe should be covered under the EU ETS (instead of, or in addition to being subject to CORSIA).
Furthermore, the new ETS Directive envisages the possible inclusion of emissions from municipal waste incineration from 2028 (pending an impact assessment due in 2026).
Finally, the directive stipulates the creation of a new ETS for buildings and road transport, often referred to as ETS2. This is meant as a parallel system for emissions from the millions of houses and cars around Europe. The obligation will be on the fuel providers, not the individual households, but costs will be passed on to end users. ETS2 will have separate allowance units, the price of which will be capped at €45. The first surrender obligation will be in 2027, for 2026 emissions. If energy prices remain high, implementation may be delayed to 2028.
The creation of an ETS2 was one of the most controversial elements in the whole ETS review, and one that was only possible against fierce resistance of the Social-Democrats in the European Parliament.
The Market Stability Reserve, the supply balancing tool introduced in 2019, is set to remain a powerful instrument when the market is defined as being unbalanced. The thresholds for when the MSR will be active are unchanged from the current setup. The upper threshold will remain at 833 Mt EUAs in circulation, above which the MSR will be active and withhold some of the additional supply from EUA auctions. The 24% intake rate is kept, but when the market becomes more balanced a buffer intake rate will kick in. If the total number of allowances in circulation (TNAC) is below 1096 Mt (but about 833 Mt), MSR will inject the difference between TNAC and the upper threshold into the MSR and thus the intake rate will drop getting closer to a balanced market as shown in the figure below.
The lower threshold will remain at 400 Mt and if the TNAC drops below this level 100 Mt will be released from the reserve per year.
One important change relates to the way some of the surplus EUAs are cancelled (invalidated) from the MSR. In the current framework, the maximum number of EUAs allowed in the MSR is equal to the preceding year’s auction volume. Any volume above that level is cancelled. Going forward, the maximum allowed volume is simply set at 400 Mt. This means MSR will be able to supply the market with 100 Mt over four years when the market is tight.
Carbon leakage measures have been dramatically changed through this EU ETS revision. CBAM will gradually replace free allocation for cement, iron & steel, fertilisers, aluminium, electricity, hydrogen, and some downstream products, reaching full phase-out/in by 2034. For sectors not covered by CBAM, free allocation rules have been updated with a conditionality mechanism favouring best performing actors. Installations receiving free allocation are required to conduct energy audits. The 20% worst performing installations must establish a climate neutrality plan. Non-compliance with these measures results in a 20% cut to free allocation. Additionally, the cross-sectoral correction factor (CSCF) will no longer be applicable to best performers.
The broader impact of CBAM on the market can be broken down into three elements: changes to EU CBAM sector market behaviour, changes to activity levels (impacting demand for EUAs), and the possibility of proxy hedging by importers. This will be explored in-depth in a forthcoming analysis.
The large changes to EU ETS framework to reflect the new 2030 framework have been expected by market participants and the final texts showed few surprises when it comes to the larger elements. However, with all elements in place the policy risk is off the table for the time being. Looking further ahead we are likely to see new market dynamics developing over the next years, with the prospect of a considerably tighter cap, especially after 2030, as well as the introduction of new sectors and of CBAM.
The 129-page leaked document that was circulated on 24 January is awaiting greenlight from the European Commission’s legal service. Barring any last-minute surprises, we can assume this is the text that will be presented to the lawmakers for their final approval of the deal concluded by their representatives on 18 December 2022.
In the European Parliament, the text might be presented for an endorsement vote in the environment committee (ENVI) on 9 February, after which it will pass to plenary. The first opportunity for that would be during the sessions in mid-February or mid-March, but according to media reports on 24 January, the plan is to put it to a plenary vote at the session 17-20 April.
In the Council, member states’ ambassadors are set to endorse the text during the COREPER I meeting on 8 February. Following that, it will be officially approved by member states’ ministers during a Council meeting. It will be presented as an ‘A-item’ for vote without any further discussion. The final, formal approval might take place by the end of-April, assuming the Parliament finalises its processing by 20 April. Then, the text will be translated and published in the Official Journal, possibly in early May. Entry into force will be 20 days later.
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