The upcoming European Commission review of the European Union Emissions Trading System (EU ETS) in July marks the beginning of the process to establish additional Phase IV legislation. Considering this, Redshaw Advisors examines some of the potential reforms under debate prior to the release of the review, following the Florence 10-year anniversary conference organized by the Commission.
One significant point of the debate revolves around the carbon leakage list, which identifies industries most at risk of relocating to regions with lower carbon costs. With the near finalization of the Market Stability Reserve (MSR), expected to triple prices by the end of this phase, discussions around the list’s rules and protection levels have intensified. Calls for greater protection of European industries vulnerable to carbon leakage have emerged, suggesting the continuation of today’s free allowance allocation or the sale of additional allowances, with the revenue directly compensating the industry. The finite nature of free allocation means that companies qualifying for 100% free allocation will receive it at the expense of those that do not. Regulators are reportedly considering a new law that would provide free credits covering as little as 30% of companies’ emissions, depending on the likelihood of relocation abroad (according to Reuters).
Currently, member states determine industry protection from indirect carbon costs, leading to calls for a formal Europe-wide response to this issue, as opposed to the fragmented policies of individual member states.
The review will also address ETS linking, with proposals to connect the EU ETS with other emissions trading schemes worldwide, aiming to establish a global carbon price and create a level playing field for industries. China’s planned national scheme is a potential candidate for linking, although challenges abound due to varying political landscapes and ambitions among countries. The MSR may further complicate scheme linkages, as it acts as a price support mechanism, making ambition levels and prices difficult to compare. Extending the MSR beyond Europe would be extremely challenging given the complexities involved in achieving political agreement within Europe itself.
The fate of unallocated allowances, such as those in the New Entrants’ Reserve (NER) and other unused EUAs, will be decided by the European Commission as part of the MSR compromise. Analysts predict there may be anywhere between 300Mt to 600Mt of unallocated allowances in the system by the end of Phase III. While the current plan is to include them in the MSR, the European Commission’s review will determine their future use, potentially directing a significant number of allowances to support industries. This dual effect would not only provide assistance to recipient industries but also mitigate the impact of the MSR, designed to reduce the surplus of EUAs and increase prices.
Currently, member states auction the allowances not allocated for free within the cap set by the European Commission. These auctions, conducted on platforms like the European Energy Exchange (EEX) and ICE, generate substantial revenue for the member states. Some have called for legislation to ensure that auction revenues are spent on environmentally beneficial purposes. However, it is likely that a majority, if not all, member states would resist such constraints on the use of their revenue, particularly during a period of EU uncertainty and economic difficulty.
The European Commission review of the EU ETS will play a vital role in shaping the future of the system and addressing key areas of concern and potential reform.
