CAN Europe position on the revision of the EU Emissions Trading System (ETS)

POSITION PAPER

Introduction

EU and Member State climate action remain off track with the international commitments to stop climate change and keep temperature increase to 1.5°C as agreed in the Paris Agreement. The EU Emissions Trading System (ETS) requires a thorough revision and a substantial increase in ambition in order to drive down emissions at a rate sufficiently fast to be in line with the objectives of the Paris Agreement.

The EU ETS, together with the Effort Sharing Regulation (ESR) and the LULUCF Regulation are the EU’s main climate instruments implementing the EU’s overall climate target. While the LULUCF Regulation mainly deals with net carbon removals from land-based sources, the EU’s overall emission reductions are divided into a contribution from the sectors covered by the ETS (mainly power, industry and aviation) and the ESR (mainly agriculture, transport, buildings and waste). Under the previous EU climate target of -40% emission reductions by 2030, ETS sectors were set to decrease emissions by 43% compared to 2005 levels while sectors covered by the ESR had to reduce their emissions by 30% compared to 2005 levels. The ESR target in turn is divided into 27 nationally binding targets.

Following the increase of the EU’s economy-wide climate target to achieve at least -55% net emission reductions by 2030, compared to 1990 levels, the European Commission is preparing a comprehensive overhaul of key EU energy and climate legislation, including the EU ETS. This offers the unique opportunity to ramp up climate action in all sectors and to fully align EU policy with its global commitments. In light of Europe’s historic responsibility and its capacity to act, CAN Europe is calling for the EU to reduce its domestic greenhouse gas emissions by at least 65% by 2030, as compared to 1990 levels.
While this position paper addresses key issues for the revision of the EU Emissions Trading System, please refer to our accompanying position papers with regards to our general demands on the overall EU climate policy architecture, the revision of the EU energy targets and carbon pricing.

In order for the EU Emissions Trading System to become fit for the Paris Agreement, it requires a thorough revision of its core features. The following document focuses on our Network’s topline demands with regards to i) increasing the system’s overall ambition level, ii) strengthening the resilience and responsiveness of the system, iii) respecting the Polluter Pays Principle and iv) funding climate action through the EU ETS.

1. INCREASING THE SYSTEM’S OVERALL AMBITION LEVEL

Ensure that the EU 2030 climate policy architecture is in line with the Paris Agreement

The overall EU climate framework is in urgent need of a substantial revision in order to contribute effectively to the EU’s achievement of the Paris Agreement objectives. A sharper increase in ambition is not only necessary to limit temperature increase to 1.5°C, but it can also send a strong market signal and provide necessary regulatory certainty to the market to stimulate and reinforce private investment. In order to reflect its capacity to act and its responsibilities as a major historic emitter, the EU should achieve at least 65% emission cuts by 2030. In turn, the EU’s implementing legislative framework needs to be upgraded and each policy piece needs to be brought in line with this higher level of ambition.

Rebasing – one-off reduction of the cap to bring ETS emissions closer to reality

The highest abatement potential in a robust ETS reform comes from a combination of rebasing the cap and substantially increasing the linear reduction factor (LRF). The cap, the overall limit of allowances in the system, continues to exceed real emissions, building up a structural surplus that the market stability reserve (MSR) alone cannot fully address. The European Commission estimates that this surplus amounted to around 250 million allowances in 2019, but the current pandemic will increase this surplus even further. In order to ensure that the cap better reflects real emission levels, it needs to be readjusted through a one-off reduction at the earliest date possible.

Substantially increase the Linear Reduction Factor

The linear reduction factor (LRF) is the annual rate at which the overall cap for emission allowance decreases. In the current ETS Directive, the LRF is set at 2.2% (up from 1.74% in the 2013-2020 period). The LRF needs to be further increased in order to drive down emissions sufficiently and achieve climate neutrality by 2040. Time is of the essence. The later a revised LRF is applied, the higher it has to be in order to meet the desired emission reduction levels in 2030. Therefore, the LRF should be applied as soon as possible and by 2023 at the latest and combined with a substantial rebasing effort. Given the timing of the legislative process, we assume that the earliest possible date for an increased LRF to apply is in 2023. Without rebasing or with the new factor applied later, the LRF would need to be considerably higher.

Eliminate the structural surplus of allowances

Over the years, a significant surplus of unused allowances has built up under the ETS, amounting to almost 1.6 billion allowances in 2020. Despite the latest revision of the EU ETS leading to a significant reduction in the surplus, it will continue to flood the market up until 2030. Unless addressed, this historic surplus which could further increase due to the consequences of the COVID-19 pandemic could lead to a situation in which real emissions in 2030 exceed the ETS target. In order to avoid such a situation, rebasing of the cap and the increase of the LRF need to be complemented through a thorough review of the market stability reserve (MSR). Our specific demands on the MSR are detailed in the following section.

2. STRENGTHENING THE RESILIENCE AND RESPONSIVENESS OF THE SYSTEM

The ETS remains alarmingly vulnerable to external shocks. After the 2008 economic crisis demand for emission allowances plummeted and created a giant surplus in the market which kept the carbon price extremely low for a decade. The current pandemic-induced economic downturn will further increase this surplus. In order to support the system’s resilience and adaptiveness, the following elements should be reinforced through the coming revision: strengthening the market stability reserve (MSR), introducing a steadily increasing carbon floor price and making unilateral national cancellations of allowances mandatory.

Strengthening the Market Stability Reserve (MSR)

The market stability reserve (MSR) which became operational in 2019 is a permanent mechanism to address the surplus of allowances in the EU ETS by absorbing unused allowances and keeping them off the market. It responds to imbalances in supply and demand and is activated when specific thresholds are met. Every year, if the surplus of allowances measured as the total number of allowances in circulation (TNAC) is greater than 833 million, a certain percentage of the TNAC, which is determined by the MSR intake rate, will be placed in the reserve. Between 2021 and 2023, the MSR intake rate is 24%. From 2024 onwards, a lower intake rate of 12% applies. In case the surplus in the system falls below 400 million, the MSR will release allowances back into the market.
The current rules of the MSR require further strengthening in order to fully address the systemic surplus, to ensure the EU carbon market can accommodate the need to phase out coal and lignite in the power sector by 2030, and to support the ETS in dealing appropriately with external demand shocks.

Establish an EU-wide and steadily increasing Carbon Floor Price

In order to prevent the EU carbon price from dropping to historic lows, a carbon price floor should be introduced within the EU ETS. It will offer all market participants planning security, predictability as well as maintained application of the Polluter Pays Principle. The price floor should start at 40 EUR/tCO2e and increase over time, aiming at reflecting the societal cost of carbon, estimated at 180 EUR/tCO2e. If such a price floor cannot be realised in the whole EU ETS within a reasonable amount of time, a group of EU member states should go ahead and introduce the instrument in the framework of a forerunner alliance. All revenues from a carbon floor price should serve to fund further climate action (see point 4 below).

Address waterbed effects through unilateral cancellation of allowances

The market stability reserve might not be responsive enough to address a possible surge of unused allowances stemming from increased climate action at member state level. National measures such as shutting down of coal power plants due to coal phase-out decisions can free up billions of allowances which can have a dampening effect on the EU-wide carbon price. In order to ensure that progressive measures in individual member states do not weaken the ETS price signal, it should be mandatory for member states to unilaterally delete an amount of allowances equivalent to the emissions saved by the national measure.

CAN Europe calls for unilateral cancellations of allowances to be made mandatory in response to national measures impacting the EU carbon market.

3. RESPECTING THE POLLUTER PAYS PRINCIPLE

Abolish free allowances and move towards 100% auctioning

Currently, 94% of industrial emissions under the ETS are still believed to face a significant risk of carbon leakage. Industry receives the bulk of its allowances for free, eliminating the urgently needed incentives for industry to transform towards climate neutrality and resource efficiency. Recently, the EU Court of Auditors has recommended reforming this system of free handouts. Given the lack of evidence of climate policy-induced carbon leakage, the current handout of free allowances to industry and aviation operators needs to stop. Polluting for free in times of a climate crisis is unacceptable. The ETS should shift towards 100% allowance auctioning across all covered sectors. If a carbon border adjustment mechanism (CBAM) were to be implemented, this must be developed as an alternative to free emission allowances and there should be no overlap between the two.

Ensure coherence with Carbon Border Adjustment Mechanism (CBAM)

The European Commission has proposed to introduce a CBAM to ensure international action on climate and to address a possible increased risk of carbon leakage due to the necessary revisions to the ETS to align it with the EU 2030 climate target. The European Commission has also been very clear from its first communication of its intention to develop a CBAM that it would be WTO compatible which means applying the environmental exception allowed in WTO Article XX. However, as carbon leakage remains theoretical, it does not justify an increase and possible protection of EU industry. . Given the long-standing weaknesses of having free emission allowances in the ETS, CAN Europe calls for several aspects to ensure coherence and a reinforcing relationship between the ETS and the CBAM:

Fully include emissions from international aviation and shipping

Today, emissions from international maritime and aviation are not sufficiently regulated. In theory, all flights from within the European Economic Area (EEA) are covered by the system in addition to extra-EEA flights with either departure or destination in the EEA. Since 2012 however, the EU ETS does not apply ‘temporarily’ to these extra-EEA flights, in light of attempts from the International Civil Aviation Organization (ICAO) to establish a global regime to reduce aviation emissions (the so-called stop-the-clock-derogation). In addition, the non-CO2 impacts of aviation have still not been addressed by the EU, despite increasing the climate impact of aviation by a factor of three compared to CO2 alone, according to EASA’s latest report published by the European Commission. Emissions from international maritime emissions have so far not been included in the EU ETS and remain largely unregulated. Emissions from both incoming and outgoing vessels to EU ports should be fully included in the EU ETS (so-called ‘full scope inclusion’).

Eligibility of biomass in the EU ETS and ESR

Biomass is treated as if it were a carbon-neutral energy carrier, but that is demonstrably not the case. While the emissions related to the decline in carbon sequestration from tree-cutting are accounted for in the land sector, this is done badly meaning that many emissions go unaccounted for. Furthermore, LULUCF accounting is not a good tool to measure emissions from biomass burning, and does nothing to calculate the carbon impact of the biomass burnt and whether it is better or worse than burning fossil fuels. Indeed, according to a recent JRC report, different types of biomass currently incentivised by EU policy increase emissions compared to fossil fuels, and create tension in the use of biomass as food, fibre or fuel, leading to habitat destruction, land-use change and biodiversity loss. It is therefore essential that the sustainability criteria for biomass in the EU Renewable Energy Directive be strengthened, and for biomass burnt for energy under the ETS and ESR only to be considered carbon-neutral if it complies with those criteria.

4. FUNDING CLIMATE ACTION THROUGH THE EU ETS

In order to accelerate the EU’s economic transformation and to achieve at least 65% overall emission reductions by 2030 and climate neutrality by 2040, national revenues from auctioning ETS permits as well as the various funds and investment instruments under the EU ETS must boost climate action, be dedicated to action in the EU, deliver on the EU’s international climate finance commitments and must not support technological lock-in that is incompatible with the EU’s long-term objectives.