Designing a sound EU carbon market for buildings and transport

Two brothers cycling. Cycling happens year-round in Amsterdam, which has good infrastructure and relationships between cyclists and motorists.
Two brothers cycling. Cycling happens year-round in Amsterdam, which has good infrastructure and relationships between cyclists and motorists. Image: Marc van Woudenberg

We can draw vital lessons from the functioning of the EU’s current Emissions Trading System to expand it to the building and transport sectors in a way that serves the climate and advances social justice.

In its current shape, the EU’s Emissions Trading System (EU ETS) is far from perfect. It falls short on overall ambition and proper application of the ‘polluter pays’ principle. In its 16 years of existence, it was revised several times with economic sectors being added and countries entering or leaving the system. It has gone through three three trading phases aligning the system with new EU climate targets over time. The fourth phase started in 2021. In parallel, the European Commission unveiled reforms to the EU ETS as part of its ‘Fit for 55’ package.

Now that the proposal for a new ETS targeting the transport and building sector (aka EU ETS II) is on the table and negotiations at the European Parliament have started, what are the lessons we should bear in mind when designing this new ETS? 

The highest bidder

Free pollution permits must be scrapped and, instead, emission allowances must be sold via auctioning. If we look at the performance of the ETS to date, total emissions have fallen considerably in the electricity sector since auctioning became the default method of allocating emission allowances there. Thus, auctions, rather than free allocations, must be the guiding mechanism for EU ETS II from its inception.

The revenue that would be generated from these auctions represent a huge opportunity to finance climate action and support vulnerable people through the climate transition. Between 2013 and 2020, the EU ETS raised €68 billion in revenue for the member states. Scrapping free allowances from ETS I would raise hundreds of billions in additional revenue.

The annual revenues generated by the ETS II could be significant, even higher than in the existing ETS,  as the allowances in the new ETS would be auctioned. The European Commission’s impact assessment (see Annex 13) estimates an annual average (between 2026-2030) of €47 billion from ETS II auctions. 

This can partly be used to ensure that ETS II does not burden lower-income households. For the buildings sector, the availability of finance for renovations is an issue. Vulnerable consumers spend a large proportion of their income on energy and transport, and may lack alternative options in terms of green mobility. 

Therefore, all the revenue generated from the inclusion of these new sectors in the EU ETS should be spent on socially fair financial compensation schemes for people investing in improving energy efficiency, as well as on promoting renewable energy in buildings and/or road transport. Well-directed revenue recycling, combined with complementary policy measures,  can boost the impact of ETS II while ensuring a just transition, as highlighted in a recent study by the Institute for European Environmental Policy (IEEP). It can serve as a tool to fight both inequality and the climate crisis.

Beyond markets

Carbon pricing alone is not enough. Although the EU ETS played a role in spurring the transition towards renewable energy, it was definitely not the only driver. The price of allowances has not always been sufficient to spur a switch to renewables or less polluting fossil fuels, nor to make coal power plants durably unprofitable.

Since 2019, rising carbon prices have had a marked impact on the profitability of coal power plants across the EU. This highlights the fact that carbon prices on their own are not sufficient and that complementary policies and measures (like renewable energy targets and energy savings obligations) are necessary to truly incentivise the decarbonisation the power sector.

In addition, the EU ETS Market Stability Reserve (MSR) has proven effective in removing surplus allowances from the markets since it started operating in 2018. It represents a good example on how regulations and markets can work alongside. For example, the MSR can address the surplus of allowances due to the introduction of renewable energy sources  and achievement of deeper emissions reductions.

However, it can also improve the system’s resilience in case the scarcity of allowances increases. When that happens, the MSR cushions the impact of high carbon prices, by increasing the supply of allowances to be auctioned. The Commission has indicated in its ETS II proposal that a similar MSR to the existing one should be introduced – 600 million allowances will be frontloaded into the MSR for transport and buildings sectors in order to mitigate the risk of supply and demand imbalances associated with the start of ETS II. 

This means that we cannot think of ETS II as the sole mechanism for achieving Effort Sharing Regulation targets. Implementing carbon pricing for transport and building sectors must go hand in hand with strengthening the regulatory framework, in particular for vehicle emission standards and the energy performance of buildings. In addition, governments must establish measures and financial instruments to support the rollout of affordable public transport, affordable electric mobility and deep renovations.