EU ETS reform must tighten screws on the number of pollution permits

While European policymakers are debating how the EU’s Emissions Trading System (EU ETS) should be revised in the wake of the Paris agreement, the fall in the carbon price to below €6 per tonne of pollution gives a stark warning that Europe’s (supposedly) main climate instrument is not yet up to the job. Without the removal of surplus pollution permits, the adoption of a steeper decarbonisation pathway and the smart use of auctioning revenues, Europe’s carbon market will be doomed to fail.

In the past weeks, the EU’s carbon price has plummeted to an all-year low, showing the need for a much more drastic reform of the EU’s carbon market than currently on the table. The revision of the EU ETS is currently in the hands of the European Parliament and the Council and an agreement between the two institutions on the file is expected to take place in the second half of 2017.

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Making the EU ETS fit for purpose

The European Parliament aims to finalize its position on the EU ETS revision early next year, after which negotiations with Member States can start. A key issue of debate in the Parliament is how the environmental integrity of the EU ETS can be improved in line with the Paris climate agreement (read more here). At the climate summit in Paris, countries for example agreed to pursue efforts to limit global warming to 1.5°C and the EU ETS needs ratcheting up to implement this 1.5°C goal.

The Linear Reduction Factor that sets the level of ambition in the EU ETS is at the moment not in line with pathway to stay below 2°C warming.  It is also by far not enough for the new 1.5°C goal, as emissions need to decline much faster than the proposed 2.2% annual reductions.

Decarbonisating the power and industry sectors by 2040 means that EU ETS emissions need to annually decrease by at least 4.2% for example.

Such a steeper decarbonisation pathway is important to ensure that the EU ETS becomes a driver for emission reductions post-2020. So far, the targets in Europe’s carbon market have been set above actual emissions, which means the EU ETS has been oversupplied with emission allowances ever since its existence ten years ago. Models by Sandbag show that emissions are required to decline by a mere 0.5% annually to meet the 2030 climate target from the projected 2020 starting point. Making the EU ETS fit for purpose will require much faster reductions than currently on the table and the permanent cancellation of surplus allowances (read more here).

The hypothetical threat of ‘carbon leakage’

Meanwhile, under the guidance of the Netherlands presidency, the Council working party has this week discussed the heavily contested issue of “carbon leakage”. Although no evidence has ever been detected for this phenomenon (e.g. production displacement due to carbon pricing), the current ETS proposal nevertheless suggests that subsidies equal to €160 billion are given to heavy industry in the form of free pollution permits.

One of the key issues of the debate this year is how to incentivize industrial innovation so that European industries do not fall behind global competitors in terms of carbon efficiency. The proposed untargeted free allocation of pollution permits reduces the incentives of heavy emitters to invest in low-carbon technologies or efficiency improvements. Consequently the European Environment Agency projects that the EU’s industry emissions will not decline in the coming 15 years, suggesting that the current policies are not working properly.

To turn the EU ETS into an effective instrument that incentives industrial decarbonisation and promotes low-carbon investments, policymakers would need to take steps to phase-out free pollution permits and use the resulting auctioning revenues smartly. By phasing-out free pollution permits Europe can generate more auctioning revenues and investments to support the frontrunners that want to invest in breakthrough technologies, while also reducing the risk of windfall profits for heavy industry (read more here).

In the coming weeks and months, Carbon Market Watch will again put the spotlights on the amount of windfall profits that heavy industry has made from the EU ETS up to now, to bust some of the myths surrounding the carbon leakage debate. On Tuesday 15 March, we will organize anWaterworks1 event in the European Parliament on the topic (see here for more information).

For more information:

  • See here a presentation on how the ambition of the EU ETS can be brought in line with the 2050 climate objective.
  • See here a presentation on ‘carbon leakage’.
  • See here European Parliament Event 15 March 2016:  “RE-PLUMBING THE EU ETS: low-carbon innovation and carbon leakage in a post-Paris world”

by Femke de Jong