The EU Emission Trading System – carbon pricing as an important tool to achieve the objectives of the Green Deal

First published in ECA Journal 02/2020: Climate Change and Audit

By Sabine Frank, Executive Director, Carbon Market Watch

In a world that is increasingly feeling the consequences of climate change, the idea of polluters paying for their pollution makes more and more sense. The EU’s Emission Trading System (ETS) reflects exactly that thought and is the world’s largest carbon pricing system. The ECA has already looked into the EU ETS in the past (special report 6/2015) and will publish another report on EU ETS later this year, focusing in particular on how free allowances are provided for and allocated. These are also some of the aspects discussed below by Sabine Frank, who, since early 2019, has been the Executive Director of Carbon Market Watch, an NGO working on climate-related issues and carbon pricing. While critical on implementation aspects she also sees many opportunities for the ETS to contribute to achieving the EU’s Green Deal.

World’s largest carbon pricing mechanism under review

The EU Emissions Trading System (ETS) started operating in 2005 and is the world’s largest carbon pricing policy. It covers about 45% of the EUs greenhouse gas pollution coming from approximately 12 000 installations, across power generation, industry and aviation. It works through a ‘cap-and-trade’ approach by putting a limit on overall emissions from the installations covered. Within this limit, companies can buy and sell emission allowances as needed.

Its functioning and impact have been the focus of ardent discussions ever since its inception. However, like all public policies, it could benefit from an in-depth audit in the run-up to its expected review in 2021. A review of the EU ETS should answer the following key questions, among others:

  • Is the EU ETS compatible with the EU’s international climate commitments, and especially the 1.5°C target enshrined in Article 2 of the Paris Agreement?
  • Is it setting a price on pollution, and upholding the ‘polluter pays principle’ as laid down in Article 191 of the Treaty on the Functioning of the EU?
  • Has the EU ETS decreased emissions of greenhouse gasses (GHG) in the EU in the past, and can we expect it to do so in the coming decades?
  • How have the revenues raised by the EU ETS been used?

 Is the EU ETS in line with the Paris Agreement?

The Paris Agreement – to which the EU and its Member States are signatories -includes a clear target to hold ’the increase in the global average temperature to well below 2°C above pre-industrial levels and pursue efforts to limit the temperature increase to 1.5°C.’

Developed countries and regions are to do their fair share by decarbonising earlier than developing countries. For the EU that would mean reaching net-zero emissions (i.e. a balance between what is emitted and what is absorbed in carbon sinks) by 2040.

The EU ETS sectors, therefore, have a clear deadline, and should ideally decarbonise around that time – however, the total annual emissions permissible under the ETS (the cap) is not decreasing fast enough annually. Without changes, the emissions covered by the EU ETS would reach zero by 2058 – nearly 20 years late. The EU ETS, as currently set up, can therefore not be considered in line with the Paris Agreement or the EU’s international commitments.

Note that the EU ETS review for the 2021-2030 period started before the EU ratified the Paris Agreement in October 2016 – and an opportunity to align the EU ETS with a 1.5°C target was missed. We cannot afford to pass over the next opportunity to bring a major climate policy instrument in line with our international commitments, which will be in 2021. 

Is the EU ETS upholding the polluter pays principle?

For the EU ETS to uphold the polluter pays principle, it needs to result in an effective price on emissions. Auctioning is the default method of allocating emission allowances within the EU ETS. In that context, it’s a market-based mechanism and leaves the setting of the EU emission allowance (EUA) price to market forces.

However, application of the polluter pays principle by auctioning emission allowances is severely undermined by a policy-induced market failure: over 43% of all available emission allowances are to be allocated for free, at least until 2030 under current EU ETS rules. This pollution subsidy blocks the internalisation of the cost of pollution externalities for industry and airlines – most of the power sector no longer receives free allocations.

Over the 2008-2030 period, the EU manufacturing industries, such as steel, chemicals and cement, will have received free allocations worth approximately €383 billion. During the next trading period (2021-2030) alone, 6,3 billion allowances will be handed out for free – valued at about €165 billion.

As a result of this free allocation, more than 90% of industrial carbon pollution does not carry any cost for the polluting companies. It is no surprise then that industrial emissions have been nearly stagnant since 2012 – dropping a paltry 1% between 2012 and 2018. Emissions from the aviation sector even increased at an average rate of 4,7% per year between 2013 and 2017. In contrast, emissions from the power sector – where no free allocation is given – dropped by 22% between 2012 and 2018.

Figure 1: EU carbon emissions and free allocation – power sector vs industry 2012-2018 (based on 2019 Sandbag data, GHG emissions are relative to 2012)

 

Free allocation is granted to limit risks of so-called carbon leakage – industrial activity relocating to jurisdictions with no or less stringent climate measures. However, there is no hard evidence that carbon leakage has existed, or could become an issue in the near future.

Free allocation is a very costly mechanism to protect against a non-existent risk, and even worse, it has led to large windfall profits for companies. Many companies received more free pollution permits than their actual emissions – allowing them to sell their surplus permits and pocketing more than €25 billion over 2008-2015.

Because of the prevalence of free allocation, the EU ETS is undermining, instead of upholding, the polluter pays principle. Since allowances that have been allocated for free cannot be auctioned, they represent foregone revenues for EU member states. In this context, we can see a role for the European Court of Auditors to review the EU ETS and, in particular, the likelihood of carbon leakage happening and the prevalence of windfall profits to industrial sectors, and how this relates to the potential for generating auctioning revenues.

Is the EU ETS reducing emissions?

If the EU ETS is to reach its goal and help fulfil the EU’s climate targets, the sectors it covers must emit zero carbon pollution by around 2040. The good news is that carbon emissions from sectors covered by the EU ETS (excluding aviation) have decreased by 21% since 2008. However, the drop in total emissions hides the immense differences between industrial sectors and the power sector. The latter has seen rapidly falling emissions – a 12% drop in 2019 alone. However, this reduction should not be fully attributed to the EU ETS – other decarbonisation policies, such as coal phase-outs, renewable energy deployment or energy efficiency investments, have also played a major role. At the same time, industrial pollution from the production of steel, cement and chemicals has stagnated.

Every sector of the economy will need to make deep and sustained cuts in its emissions – and the EU ETS could contribute significantly if the polluter pays principle was extended to all the sectors it covers. In line with this, free allocation should, therefore, be abolished and replaced by auctioning of all emission allowances.

What happens with EU ETS revenues?

The EU ETS creates significant revenue streams through the auctioning of emission permits. The number of permits that are auctioned has increased steadily since 2012 – from 90 million in 2012 (worth €620 million) to over 920 million in 2018 (raising €14 billion).

These revenues have gone to Member State coffers – separate smaller streams go to EU-level funding instruments, such as the Innovation Fund. According to Article 10(3) of the EU ETS Directive, Member States are supposed to use at least 50% of these revenues for further climate action (such as deploying renewable energy, energy efficiency, innovation and research, avoiding deforestation and supporting reforestation) and report on this to the European Commission.

While over 2013-2015 Member States used over 85% of ETS revenues to finance climate action, this share had decreased to just 67% by 2018. In addition, we do not know whether these revenues have been used to fund additional climate action, or instead have freed up budgetary space, so funds earmarked for climate action could be shifted elsewhere. For example, some Member States currently hand out ETS revenues to the electro-intensive industry through unnecessary and costly state aid schemes – potentially up to €462 million in 2018.

In addition, according to estimates by the World Wide Fund for Nature (WWF), a minimum of 5% of revenues is actually used to finance climate-harming activities. And this is probably an underestimate, as non-transparent and inconsistent reporting means these numbers cannot be independently verified and checked.

Over the 2021-2030 period, about 57% of total permits will be auctioned. The remaining 43% will be handed out for free. This represents a significant revenue loss for the Member States and climate finance – approximately €11 billion in 2018 alone. Over 2021-2030 another approximately €165 billion worth of allowances will be handed out for free.

For the EU ETS to have maximum climate impact, all auctioning revenues need to go in full to support climate action. This includes renewable energy and energy saving, clean industrial decarbonisation and support for a just transition, in Europe and in the Global South. Furthermore, there needs to be thorough and critical monitoring of Member State reporting.

Again, the European Court of Auditors could play an important role in reviewing how Member States use EU ETS revenues. Such an audit could trigger pressure and measures to increase the consistency of reporting between Member States, ensuring complete data is publicly available and that the methodologies used to determine which revenues are used for climate action are transparent.

What should the future look like – a broad range of opportunities to be grasped

The implications of the European Green Deal and the European Climate Law are clear: every sector will need to reduce greenhouse emissions more rapidly. Moreover, the EU ETS still needs to be brought in line with the Paris Agreement, and this will have significant implications for future EU ETS targets. Higher climate targets imply a need for a stronger carbon price signal under the ETS – which in turn can lead to higher revenues to be used for financing the transition.

For that to be feasible, the EU carbon market itself needs to become a more effective and fairer climate policy instrument – and there is plenty of scope for improvement. Two opportunities have already been mentioned: first, ending the handouts of free pollution permits; and second, using all revenues to finance climate action.

But there are other tools related to the EU ETS that could raise public resources to fund further climate action. These include recycling more revenues back to the EU ETS sectors to bring breakthrough industrial technologies to market – the ETS Innovation Fund is meant to do this, but will only have €9-16 billion. The Maritime Decarbonisation Fund – currently being discussed by the Environment Committee of the European Parliament – is another good example. It would recycle part of the price that shipping polluters pay to assist these same polluters to decarbonise further through investing in research, development and deployment.

The EU ETS has a mechanism to take permits out of the market when the oversupply is deemed too high. The ETS Market Stability Reserve should be reinforced to not only take historic oversupply out of the market faster but also to protect the EU ETS and its price signal against future sources of oversupply. For example, announced coal phase outs alone could reduce demand for EU emission allowances by 2,2 billion between 2021 and 2030 – this is significantly more than the total number of permits that will be issued in 2020 (approximately 1,7 billion). Moreover, the ETS will have to take account of the impacts of the COVID-19 crisis on emissions due to the lockdown in many countries and any potential subsequent economic downturn.

In addition, expanding the EU ETS to sectors currently not covered by carbon pricing would bring in more revenues. Potential sectors include shipping and waste incineration. Note that the EU ETS will not be able to drive decarbonisation of these sectors on its own – other sector-specific policies will remain necessary. A major reallocation of resources is urgently needed to address the climate crisis; the European Commission estimates the current funding gap between what is available and what will be necessary at between €175 billion and €290 billion annually.

The EU ETS can also play an important role in helping the EU citizens’ and communities’ transition to a zero-carbon society. Some regions might be hard hit by the rapid decarbonisation that is needed – not only coal mining regions, but also regions dependent on currently emission-intensive industrial sectors. EU ETS revenues could be used to fund just transition initiatives to ensure no-one is left behind by climate transition.

To conclude, for the EU ETS to become an effective and fair climate policy instrument, the EU carbon market should price all carbon pollution from the sectors it covers, with all revenues earmarked to fund climate solutions (both in the EU and in the global south) and just transition. We are not there yet, but the revision of the rules, planned for 2021, is an opportunity to improve the system so that it can contribute to the clean transition of our societies. In all these areas the European Court of Auditors could play a critical role in ensuring public accountability and transparency.