EU agrees on reform of the European emissions trading system

Negotiators from the Commission, the Parliament and the Council of the European Union have reached a political agreement on the reform of the European Emissions Trading Scheme (EU ETS). The European Commission had presented a corresponding proposal in July 2021 as part of its Fit For 55 climate package. The reform is intended as a significant building block of the EU’s objective to reduce greenhouse gas emissions by 55% by 2030 compared to 1990 levels.

The energy sector, energy-intensive industries and aviation, among others, are covered by the EU ETS. Businesses that are part of the sectors covered by the EU ETS must hold an EU emission allowance for each tonne of greenhouse gases emitted. For a certain amount of emissions, they are allocated allowances free of charge. However, for emissions exceeding this amount, they have to buy additional allowances. This is intended to provide an incentive for the companies concerned to reduce their greenhouse gas emissions.

The agreement reached last weekend aims to reduce the cap on emissions from EU ETS sectors set for emission allowances by 62% by 2030 compared to 2005 levels, the year the EU ETS was introduced. Under the existing ETS, there would be only a reduction of 43%, the Commission said.

The previous system provided for an annual reduction of 2.2 % in the upper limit of greenhouse gas emissions. The new system now provides for an annual reduction of 4.3% in 2024, 2025, 2026 and 2027 and 4.4% in 2028, 2029 and 2030 by issuing correspondingly fewer allowances. In addition, the cap will be reduced by 90 million allowances in 2024 and 27 million allowances in 2026. Furthermore, the Market Stability Reserve (MSR) will remove up to 24% of surplus allowances from the market each year beyond 2023.

The MSR came into force in 2019 and is intended to reduce available allowances and cushion overly erratic price fluctuations. The upper threshold value defined for the total number of allowances in circulation (TNAC) is decisive for determining the corresponding surplus. This upper threshold is to remain unchanged at 833 million allowances for the time being, although in future allowances from air transport and later presumably also from maritime transport will factor into the calculation.

Parliamentarians involved in the negotiations of the agreement said they expect that, as a result of these measures, the carbon price will increase significantly. Christian Lütkehaus, ESG expert at Pinsent Masons, said: "Indeed, a reduction of allowances will very likely lead to an increase in the carbon price, probably also beyond the 100 Euro mark. In principle, this is a good thing; however, important details, for example in connection with the CBAM as well as pending or possible decisions at the national level, are still open and we are currently also seeing what influence geopolitical developments can have on decisive factors.“

For the EU ETS sectors that are also covered by the planned Carbon Border Adjustment Mechanism (CBAM) - including iron and steel, cement, fertilisers, aluminium, electricity and hydrogen - the agreement also provides for the allocation of free allowances to be phased out from 2026 until no more free allowances are issued in 2034. Parallel to the expiry of the free certificates, the CBAM is to be introduced in these sectors, whereby it is only to apply to the share of emissions not covered by the free certificates in the period from 2026 to 2034.

Only last week, a political agreement was reached on the CBAM. The CBAM provides for the EU to impose a CO2 levy on certain imported goods if they come from countries whose climate protection measures do not match the climate protection level in the EU. Businesses would then have to buy certificates for the import of these goods that reflect the amount of CO2 emitted in their production.

The CBAM is intended to compensate for competitive disadvantages that EU industry would otherwise face due to the rising costs of emission rights. Ultimately, the new system should also prevent production from shifting from the EU to other countries that do not have emissions trading and therefore enable cheaper production. This shift is called carbon leakage.

But for the time being, it remains unclear how the relocation of production of export goods to other EU countries can be avoided. The agreement does, however, provide for the Commission to assess the risk of this by 2025. If necessary, it shall also present a legislative proposal that minimises this risk and is in line with the rules of the World Trade Organisation.

The latest agreement on the EU-ETS Ialso provides for new measures for air and maritime transport.

In aviation, the allocation of free allowances is to be reduced initially from 2024 and then phased out completely in 2026. In addition, it will be possible at a later date to cover not only flights that take off in the European Economic Area (EU, Iceland, Norway and Liechtenstein) and land in the European Economic Area, Switzerland or the United Kingdom, but also all long-haul flights that take off or land in the EU.

In the shipping sector, shipping companies are to hold certificates for 40% of their CO2 emissions from 2024, for 70% in 2025 and for all emissions from 2026 onwards.

For fuels used in road transport or for heating, the agreement also provides for the creation of a separate emissions trading system (EU-ETS II). The independent emissions trading system is to be introduced in 2027, and the CO2 price will then be paid by the companies that supply the fuels. However, the German Ministry of Economics and Climate Protection expects that the prices will be passed on to end-consumers in order to achieve the necessary climate protection incentives. Germany already has a comparable system, which was introduced in 2021 with the Fuel Emissions Trading Act.

In contrast to ETS I, however, the price in ETS II is to be subject to a correction mechanism: if the costs are above 45 euros per tonne over a certain period of time, additional certificates are to be issued, which would cause the price to fall.

Before the new system can enter into force, the Parliament and the Council still have to formally adopt the corresponding legal acts.