EU Emissions Trading Scheme Explained

The incentivising idea behind the ETS, which the Canadian economist John Dales formulated more than 50 years ago, is as simple as it is brilliant. Instead of prescribing to each individual plant how much gas it may emit, the states merely set a total annual quantity and sell it by auction to the plants in operation. To reach fewer emissions, the overall amount – the cap – is reduced year by year. Companies can either invest in new technologies that produce less gas and sell surplus licences for an additional profit, or purchase additional certificates to increase their ceiling. The owners of all installations are required to monitor and report their CO2 emissions.

A simplified explanation of how the EU’s ETS works

However, as it has turned out, in an incomplete political construction like the EU, the system is vulnerable to lobby influence and meddling by national governments.

The main beneficiaries of the ETS regime are the energy-intensive companies operating across Europe. Many are allocated allowances for free. These make up 43 per cent of all circulating allowances, with a value last year, measured against the average market value, of €17.8 billion. Of the free allocations, more than a third is accounted for by the top twenty companies. The biggest by far is the steel producer Arcelor Mittal, which in 2019 received free allowances for 67 million tonnes of CO2, with a market value of more than €1.6 billion.

Fossilised fixations

Today, the EU is looking to reform the ETS within the European Green Deal announced by EU Commission President Ursula von der Leyen in 2019. The burning question, though, is that by paying fossil fuel subsidies to many strategic industries, are national governments tempting them to stick with obsolete technologies and not innovate?

A row of yellow construction hats with the ArcelorMittal logoArcelorMittal
ArcelorMittal has been the largest receiver of the EU ETS’ free allowances

Matthias Buck, Head of European Energy Policy at the Agora Institute think tank, and a former official in DG Energy at the Commission, thinks so. “The system of free allocation is primarily protecting existing assets and creates little incentive to invest in green, new technologies,” he said.

He and the chairman of the European Parliament’s Environment Committee, Pascal Canfin, are calling for the replacement of these subsidies with transition contracts that directly promote investment in carbon-free technologies.

Corona contagion

Many experts predict the Covid crisis and its accompanying economic downtown will bring about the risk of more free allocations, as happened in 2008. There is also a danger that carbon prices will collapse again like they did during the first phases of the ETS.

One solution may lie with a new EU import tariff regime that could be introduced from 2023 called the Carbon Border Adjustment Mechanism, or CBAM (see Factbox 1 below). If the plan is approved, it would lift import prices of goods in certain key sectors like steel. Carbon leakage (see Factbox 2 below) would be limited and at the same time the free allocation of emission allowances would be cut, driving up emission trading prices. Ultimately, new, green technologies could become profitable. The CBAM could be the instrument to eradicate free emissions permits and make the ETS work as it should.

Jean-Christophe Verhaegen/EU
Ursula von der Leyen, President (L) and Frans Timmermans (R) after the adoption of the Green Deal in December 2019

However, it has never been tried before and will be complicated to set up, in particular for intricate products like cars or electronics. It has attracted serious doubts among trade bodies and analysts, responding earlier to a public impact assessment by the European Commission.

The EU think tank Bruegel warns that “significant logistical, legal and political challenges will arise. Choices would have to be made between more efficient, highly complex and politically risky approaches, and mainly symbolic but more easily implementable solutions.” Bruegel also believes CBAM may face considerable resistance from EU trading partners, in particular the USA.

Frans Timmermans, the Executive Vice-President of the Commission  responsible for the European Green Deal, says: “We will do everything we can with subsidies and research to create a market for green steel and to drive the industry in that direction.” He said he was having the same conversation with the chemical industry. 

Many actors are considering creative ways to work around the obstacles within the EU, such as action by national governments to set strict emissions standards, direct subsidies for clean production technologies and a redirection of public demand towards carbon-free products.

Whatever the options governments agree on, one thing is sure: energy subsidies might become cleaner, but they will not disappear. However, at least consumers and taxpayers would be paying for tomorrow’s technology, not yesterday’s.

Factbox 1: What is the CBAM (Carbon Border Adjustment Mechanism)?

The CBAM is a proposed carbon border tariff contained within the European Green Deal. In the first stage, it aims to shield Europe’s steel, cement and aluminium sectors from imported goods produced under less stringent targets for CO2 reduction.

It is called a tariff because importers would be forced to buy carbon allowances through the EU’s Emissions Trading Scheme, which they currently don’t have to do.

Analysts say this would increase the price of their imports and thereby the competitiveness of European producers. It would also limit “carbon leakage”.  

Some obstacles to the CBAM include securing the agreement of the 27 EU member states and navigating World Trade Organisation rules that demand equal import treatment of the same or similar products.

Factbox 2: What is carbon leakage?

This is where companies can decide — if their energy costs are too high due to EU climate policy — to relocate production out of the EU to countries with lower costs.

The EU says this is a major threat to its climate policy as relocating companies may increase their emissions. It is the main reason the EU gave free emission allowances to energy-intensive companies.

Edited by Paul Anderson