EU Parliamentarians, Ministers Debate Possible ETS Reforms

23 June 2016

Members of the European Parliament’s environment committee met this week to consider duelling visions of how best to reform the EU’s Emissions Trading System (EU ETS). As the world’s first major carbon market and its largest, the EU ETS has been the flagship project of the bloc’s climate response since launching in 2005.

Along with being raised under the European Parliament’s Environment, Public Health and Food Safety Committee (ENVI) on Tuesday, the subject was also discussed during a meeting of environment ministers under the Council of the EU held the day prior, particularly in the context of how the bloc can meet its commitments under the Paris climate accord.

The EU ETS caps the bloc’s total emissions and requires covered power plants, factories, and other companies to surrender emissions permits. These permits, obtained either through free allocation or auctioning, may then be traded between participants, resulting in cost-efficient emissions reductions. In theory, increasing scarcity of permits should drive up the cost of polluting, spurring investment in low-carbon technologies.

In recent years, the EU ETS has suffered from a surplus of carbon credits, leading to lower-than-expected trading prices. After at peaking around €30 per tonne of carbon, an allowance now sells for only €5, well below the price needed to spur investment in cleaner technology. Critics contend the carbon market needs major reforms to be effective in transitioning Europe’s economy from carbon reliance and be sustainable in the long term.

Key issues

In recent months, three key issues have dominated discussions in both the Parliament and the Council, which are part of the co-decision process for reforming the EU ETS for the 2021-2030 period.

The first is how to eliminate the carbon credit surplus, which has been persistently high in the wake of the 2008 financial crisis, along with an over-allocation of free allowances to industries. That surplus accumulated, and there are currently nearly two billion extra allowances deflating carbon’s trading price.

Another concern is how to calibrate the EU ETS’s ambition. Through the end of 2020, the number of allowances available will decrease each year by 1.74 percent from 2010 levels through a mechanism known as the Linear Reduction Factor (LRF). In absolute terms, that means about 38 million fewer allowances available each year.

Many analysts warn, however, that the current LRF will not shrink the surplus quickly enough to boost carbon prices. Legislators have already approved a Market Stability Reserve to automatically set aside credits if prices dip too low and re-inject them if prices are too high, with that reserve set to launch in 2019. The reserve gained approval by the Council in 2015. (See BioRes, 27 October 2015)

The year 2020 will mark the end of EU ETS’ Phase III and the beginning of Phase IV. In Phase IV, the LRF is slated to climb to 2.2 percent each year, but many business and environmental leaders argue that the Market Stability Reserve and an LRF of only 2.2 percent will be insufficient to deal with the existing credit surplus and increase permit trading prices.

As reported by the media outlet Carbon Pulse, France has pushed under the Council for a new LRF of 2.4 percent, the level the European Commission says is necessary to reach the EU’s 2050 emissions target of cutting emissions by 80-95 percent compared to 1990 levels. Still others argue that an LRF of at least 4.2 percent is needed to in order to decarbonise the power and industry sector by 2040 the latest. (See Bridges Weekly, 17 March 2016)

The third and arguably most contentious issue commanding attention is how to allocate carbon credits in Phase IV. In the current period, only 57 percent of carbon credits will be auctioned. The remainder will be allocated for free to certain industries such as aviation. The share of allowances to be auctioned in phase IV will be a key element in shaping the future of the bloc’s carbon market.

Representatives from the United Kingdom led several other countries in calling for a multi-tiered system for free allocation. Their plan calls for only giving free credits to businesses most vulnerable to the risk of carbon leakage, the process whereby businesses and hence emissions move from countries with strict emissions policies to countries with more lax laws.

Ministers representing several Eastern European countries, however, argue that their industries are susceptible to poaching from countries without such stringent carbon measures, and they have argued for continued free allocation.

Rapporteur’s report sparks debate

European Member of Parliament (MEP) Ian Duncan, who is spearheading the reform efforts in the legislative body, published his recommendations in late May. “Right now, the ETS is like a car without an engine. We need to ensure it is fit to do the job it should and drive emissions reductions in Europe,” he said.

His report calls for allowing member countries to retire extra allowances when power plants close. He also called for assigning industries one of four levels of carbon leakage risk and allocating a corresponding percent of free permits to each risk category. The report suggests reassessing the LRF after the first UN global stocktake on climate contributions in 2023, when countries will report their progress to one another, and for addressing overlapping EU energy policies when they work at cross-purposes.

“The Paris Agreement has set a test for all of us, and our legislation must be fit to adapt to the new targets that Paris will produce,” said Duncan, referring to the universal climate accord adopted in the French capital city late last year.

Many environmental leaders worry, however, that even the reforms under consideration will not be enough to achieve the EU’s pledged contribution to the Paris Agreement.

The European Commission predicts carbon prices will climb to €14 per tonne in the next decade. As reported by Climate Home, Thomson Reuters Point Carbon predicts Duncan’s reforms would only boost the carbon price by an additional €2 to €16 per tonne. Traders argue that carbon needs to hit €40 per tonne to achieve the goals outlined in the Paris Agreement.

Some critics argue that the reforms under ENVI’s consideration are weaker than those proposed by the European Parliament’s Industry, Research and Energy Committee (ITRE). In an op-ed published by the media outlet EurActiv, Duncan contends that his proposals are borne from hard-earned compromises and reflect political realities.

A vote in the ENVI committee is expected on 8 December, with plenary likely to consider it in February.

At the Council level, although ministers on Monday did not resolve all the issues facing EU ETS, they agreed that reforms are key, while the bloc’s competitiveness in economic terms must also be assured, as reported in Business Green.

ICTSD reporting; “EU carbon price forecast inches up on reform plans,” CLIMATE HOME, 31 May 2016; “France pushes for 2.4% annual ETS cap cut EU as ministers shift towards flexible target-setting,” CARBON PULSE, 20 June 2016; “Why the shrill posturing on my ETS reforms?” EURACTIV, 9 June 2016; “EU environment ministers urge Paris ratification and carbon trading reform,” BUSINESSGREEN, 21 June 2016.

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