EU carbon market

The European Union’s Emissions Trading System (EU ETS), often referred to as Europe’s flagship tool to fight climate change is the largest carbon market in the world. It was established in 2005 and includes over 11.000 installations across the European Economic Area, covering around 40% of Europe’s greenhouse gas (GHG) emissions. The EU ETS is a “cap and trade” system, meaning that a cap determines the total amount of greenhouse gases that companies can emit. For most sectors, this cap shrinks annually. Under the cap, companies receive or buy emission allowances which they can trade as needed. One allowance gives the holder the right to emit one tonne of greenhouse gas.

Since the beginning, the EU ETS has suffered from a surplus of emission allowances which has led to a price too low to spur low-carbon transformation. The main causes for the insufficient price signal are an unambitious overall target, the economic crisis, and inflow of international credits.

Pollution profits under carbon leakage rules

Excessive handouts of free pollution permits to industries deemed at a risk of “carbon leakage” have led to a situation where the biggest polluters are able to make profits from the system. Carbon leakage refers to a hypothetical situation where companies move their production to countries with laxer environmental rules. When pollution permits are handed out for free, European taxpayers are required to shoulder the cost, while governments lose out on additional public revenue,  vital for investments in the climate-friendly transition of the EU economy.

Fossil fuel subsidies

A derogation in the EU ETS allows the low-income EU Member States to grant free pollution permits to their electricity providers, on the condition that they invest an equivalent amount of money into modernising their energy sector. However, contrary to its intended goal, the policy has led to long term investments in fossil fuel infrastructure, including coal. Strict selection criteria and proper public participation processes are needed to guarantee that the provision drives diversification of the energy mix in the eligible countries instead of locking in unsustainable, carbon intensive energy production.

Towards a global carbon market – linking

The EU ETS legislation provides for the possibility to link with other emissions trading systems around the world. It is expected to be linked with the carbon market of Switzerland from 2019. Linking carbon markets together is supposed to result in cost efficiency, but any linking must be designed carefully and with full transparency and public input in order not to undermine the overall climate mitigation impact.

Market Stability Reserve

To address the massive glut of emission permits on Europe’s carbon market, the EU has decided to set up a reserve to temporarily store its surplus allowances. The Market Stability Reserve (MSR) will be operational from 2019, at which point 900 million allowances that have been put aside as short term solution, as well as all unallocated allowances, will be placed in the reserve. Each year, a share of the surplus emission allowances will be taken from the market and placed in the reserve for as long as the market is oversupplied.

The EU is currently reviewing the rules of its carbon market for the period from 2021-2030. However, the EU ETS alone will not deliver the necessary emissions reductions, and it is crucial to take a broader look at the EU’s climate and energy policies, including the energy efficiency and renewables legislation and ensure that they complement and not undermine one another.

Carbon Market Watch advocates for more ambitious reduction targets, permanent cancellation of surplus allowances from the Market Stability Reserve, an auction floor price, and a phaseout of free allocation in combination with border tax adjustments to make the EU ETS a tool to drive industrial de-carbonisation. Auctioning revenues should be used to fund innovation and to support workers in carbon intensive sectors in the transition to a low-carbon economy.