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Even before its adoption, the EU ETS was subject to years of fraught debate , lobbying and negotiation. After it started operating in , it quickly ran into trouble, facing volatile carbon prices that crashed in the wake of the financial crisis, while industry pocketed windfall profits. Prices have remained stubbornly low ever since, undermining the supposed role of the ETS as the cornerstone of EU climate policy.
The Brexit question is also covered. In a cap-and-trade scheme, industries covered by the market buy and sell allowances to emit greenhouse gases, within a cap that shrinks over time. In more extreme versions of this view, no other policies should be needed, as the shrinking cap is all that is needed to meet carbon targets more on this, below. The directive had been adopted after failed attempts to introduce a carbon energy tax, first proposed in It also marked a change of heart.
See this detailed history for more. Carbon pricing schemes around the world, including their nature ETS or carbon tax , sectoral coverage and share of national or regional emissions. This includes CO2 from industry, the power sector and aviation, plus nitrous oxide and perfluorocarbons from industry. This handy European Commission primer has more background. Greenhouse gases can be expressed in terms of carbon dioxide equivalent, or CO 2 eq.
For a given amount, different greenhouse gases trap different amounts of heat in the atmosphere, a quantity known as the global warming potential. Carbon dioxide equivalent is a way of comparing emissions from all greenhouse gases, not just carbon dioxide. Only flights between EU member states are covered, with flights outside the bloc still exempted , pending a review of the international aviation emissions trading scheme known as CORSIA.
Meanwhile, the EU and Switzerland recently agreed to link their schemes — following seven years of talks — meaning emissions credits can be traded between the two. In the initial phases, however, most emissions credits were handed out for free, first to familiarise participants with the system and create a functioning market, then later to protect industry from overseas competition not facing a carbon price.
Avoiding carbon leakage is a justification to temporarily postpone full auctioning, and targeted free allocation of allowances to industry is justified in order to address genuine risks of increases in greenhouse gas emissions in third countries where industry is not subject to comparable carbon constraints as long as comparable climate policy measures are not undertaken by other major economies. During phase 3, which runs until , the free share fell dramatically because power stations stopped receiving allowances for free.
Phase 4 runs from to and was the subject of the latest reforms, which will have an uncertain impact on the share of carbon credits handed out for free. This assumes three elements of the reforms kick in. Second, poorer member states can hand their power sectors some free allowances. Third, some allowances are likely to be removed from the market because of the market stability reserve MSR, see below.
These removals come out of the auction share, which effectively raises the share of allowances entering the market that are given out for free, even as it tightens the market overall. Note that this analysis excludes aviation emissions.
This share is to be maintained through phase 4. The EU ETS has also been plagued by persistently low carbon prices — for those that do have to pay for their pollution. Prices fell after the financial crisis because free allocation continued at levels based on pre-crisis economic activity, whereas industrial output contracted. Meanwhile, the spread of more efficient appliances and renewable sources of electricity cut demand for permits.
This left a flooded market. Opinion is divided on whether the latest reforms will resolve these problems and raise prices see below. The reforms agreed in November were meant to codify the rules of market operation during phase 4 of the ETS from to They ended up also aiming to correct persistently low prices, while continuing to shield industry from overseas competitors facing no carbon price and keeping eastern European states on board.
They update the rules on free allocation of allowances. They attempt to squeeze the market surplus, raising prices. And they extend and expand the support for energy system upgrades in eastern European countries, which has been the quid pro quo for their support of the ETS. This uneasy balancing act saw a series of stand-offs — most prominently over support for coal power — inevitably settled by compromise.
More on this later. The percent refers to a proportion of the average annual cap during The other key element of the reforms is the market stability reserve MSR , which will hold excess allowances outside the market starting from This is effectively a central bank for the carbon market , designed to stabilise supply and demand for credits, which will kick in from January The MSR was agreed in , but has been strengthened in two ways.
Lawmakers agreed to significantly tighten its parameters, so that it takes more credits out of circulation each year, while it will also now cancel credits if the surplus becomes large enough. If the surplus falls below Mt, m credits will be released from the reserve into the market. Second, if the number of credits in the reserve exceeds the volume auctioned in the previous year, then the excess will be automatically and permanently removed from the market.
The automatic cancellation will remove an estimated 2. Another element of the reforms allows ETS member states to voluntarily cancel allowances from their auction share, in response to the closure of electricity generating capacity that will no longer bid into the market. Cancellations are limited to the emissions of the closing capacity. Worker with steel forge.
Countries could use voluntary cancellation to demonstrate greater climate ambition, says Rachel Solomon Williams , managing director of carbon market NGO Sandbag. If governments decide to voluntarily cancel carbon credits, however, they would have to forego the revenue from auctioning those allowances.
This is the idea that climate action outside the ETS not only undermines the market, by weakening demand, but also achieves no extra emissions savings because the annual market cap is fixed. Yet disagreement remains over the appropriate balance between relying on the ETS and implementing additional EU or national climate policies. See below for more details. Carbon leakage is the idea that emissions-intensive industry could relocate production to another jurisdiction, to avoid paying the same level of carbon prices.
Emissions would fall in the country where CO2 is priced but might not change on a global level, or might even increase, if overseas industry is less efficient, more coal-powered or further away, necessitating extra transport of goods. A study for the UK government says: Their free allocation had been due to stop in A new consultation on revising the list of sectors deemed at risk runs until 2 February The power sector is not given free allowances, though phase 4 extends a partial exception to this for the 10 poorest EU member states in eastern Europe, including the likes of Poland, Romania and Hungary see below.
Under the phase 4 reforms, up to 3 percentage points of the auction volume can be transferred into extra free allowances, in order to avoid triggering the CSCF. These schemes, designed to support innovation across Europe and energy sector modernisation in poorer states, come with rules attached — though the strictness of the rules is unclear.
These funds were also used to leverage political support, both for ETS reforms and the wider EU climate and energy targets. Fiat Panda and Fiat production line in factory, Tychy, Poland.
The innovation fund, managed at EU level and funded via m allowances, will continue to be used to finance research and development of: For eastern Europe, two ETS schemes are supposed to assist energy system upgrades, under articles 10c and 10d of the directive.
These countries must submit national plans explaining what the money was going towards. Specifically, the plans should address: The national plan shall also provide for the diversification of their energy mix and sources of supply. While the revised legal text includes a series of new conditions, these leave considerable wiggle room. The European Parliament had called for a gCO2 per kilowatt hour threshold for support, effectively an outright ban on support for coal power.
This derogation shall end on 31 December The revised text says: The net impact of the reforms to these two support schemes for eastern Europe is uncertain.
In terms of future carbon prices, the strengthened MSR is the most important aspect of the reforms, says Ferdinand. He tells Carbon Brief: Ferdinand thinks the MSR will cut the volume of allowances available for auction roughly in half from , a cut of around MtCO2e. The phase 4 reforms tackle only one side of the supply-demand balance, by attempting to reduce the number of surplus allowances on the market.
Yet the other half of this equation — demand for emissions credits — is also affected by related climate policy, as well as unrelated market forces. Reflecting this uncertainty, analysts set out a wide range of ETS price predictions at a September conference organised by specialist newswire Carbon Pulse. Emissions — and, therefore, market demand under the EU ETS — have been falling rapidly, according to analysis from Sandbag. It says emissions fell by 2. If emissions reductions continue at a similar rate through the s, Sandbag analysis suggests, then the size of the ETS market surplus — currently around 1.
We still think there will be a relatively low price by , simply because there will be no scarcity [of allowances]. Yet these other actions are, by their very nature, decided by a wide range of actors and so hard to control.
The Netherlands has pledged to join the UK in setting its own carbon price floor from next year. It will also join Sweden in buying and cancelling allowances. Meanwhile Belgium is also looking at setting a minimum carbon price. Such a price floor should start at an economically significant level and rise over time…Many observers argue that it is misguided to focus on the EU ETS allowance EUA price, since the emissions cap determines environmental effectiveness and the allowance market works well in technical terms.
The magnitude and direction of its impact on the EUA price is highly uncertain. More fundamental change will be required to reaffirm the role of the EU ETS as the central pillar of European decarbonisation efforts. Arguments over the strength of the EU ETS will continue to play out over the years ahead, with the phase 4 reforms making explicit provision for the rules to be regularly reviewed.
The reviews are aligned to the five-yearly timetable of global stocktakes under the Paris deal. Where do we want to go?
How do we get there? Further changes are more likely around the Paris Agreement stocktake, he suggests. The parameters of the MSR will also be subject to review, in The ETS reform text also says: