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Fit for the future? The next decade of the EU ETS

Governments are making a lot of net-zero commitments. So, how will carbon pricing instruments look like under a net-zero framework? The World Bank reported that currently there are 64 carbon taxes and Emissions Trading Systems (ETSs) in operation worldwide covering 21.5 per cent of global greenhouse gas (GHG) emissions. Among those, the European Union Emissions Trading System (EU ETS) – a cornerstone of the EU’s policy to combat climate change and a key tool for reducing GHG emissions from the regulated sectors – has been recognised as one of the most positive signs of the past years, together with all the changes that are included in the European Green Deal.

The EU ETS is about to change soon. The system covers about 40 per cent of the EU’s emissions, it’s the oldest and now second-largest ETS in force, which has set a precedent worldwide but a the same time it has also faced some criticisms.

The next reform of the ETS along with proposals for the revision of other key EU climate legislation will be proposed later in July by the European Commission as part of steeper emission reductions across the economy envisaged under the European Green Deal. Hungary’s Regional Centre for Energy Policy Research (REKK) brought together experts to discuss the future of carbon pricing and the impacts of a possible extension of the system.

“A 55 per cent emission reduction target by 2030 is very much a stepping up of ambitions, which also means that we need to reopen policies and strengthen our existing targets,” started Peter Vis, Senior Research Associate at the European University Institute. He emphasised that never before the targets have been incorporated in European law, which gives tremendous legitimacy to tightened emission reduction regulations and to introduce a more stringent ETS system.

The Commission’s Impact Assessment envisages a target of minus 65 per cent emissions reduction compared to 2005 by 2030 within the ETS.

“We are going from 43 per cent reduction by the ETS sectors in 2030 to 65 per cent which is a 22 per cent further reduction, it means the total allocation in the ETS will be reduced by half,” said Mr Vis. He explained that if the total issuance of allowances is reduced by half then the share of free allocation will become a much smaller slice of the cake than previously, so it’s going to hurt even in the industry sectors that get free allocations.

“In the end, that’s what it is designed to do and a high carbon price is also an opportunity to trigger investment in innovation,” he noted.

“Among all the different technologies required to deliver the net zero emissions target, almost 50 per cent does exist but at a very immature stage,” said Tom Howes, Head of Energy and Environment Division at the International Energy Agency speaking about hydrogen, carbon capture and storage (CCUS), synthetic fuels, bioenergy and so on.

“However, it is not clear if a carbon pricing tool will necessarily be the most effective one,” he continued. “More likely we will be using carbon pricing in terms of helping the uptake of current technologies in the short term. In the long term, no single instrument will deliver rather more instruments together.”

The new ETS will be also strengthened in terms of the sectors it covers. The maritime sector will be most probably brought in the main ETS system. But the critical sectors are buildings and transport.

“We must remember that household electricity and electric vehicles are already covered by the ETS system, the Commission can argue that as electricity is already covered and the economy is becoming more increasingly electrified we should put other fuels – natural gas, heating oil – in there as well,” said Mr Vis.

He underlined that there is a good case for keeping these sectors separate, under a different design of ETS until 2030 to test the mechanism. Mr Vis also emphasised that it should be the fuel suppliers who have to report emissions and surrender allowances on behalf of the carbon embedded in the products that they sell. The separate system could also ensure that the new policy does not affect the CO2 price in the current system as transport and buildings have much higher carbon abatement costs. Mr Vis also highlighted that if there’s going to be auctioning in these sectors there must be revenue recycling to address social fairness.

The European Commission is expected to present a proposal regarding the introduction of a carbon border adjustment mechanism (CBAM) to avoid carbon leakage by imposing a carbon price on imports of certain goods from less climate-ambitious countries. According to Peter Vis, it will take time to develop this policy but it’s coherent with our climate targets because it would be hypocritical if we would continue to import high-carbon intensity products from outside.

As the EU is set to raise ambitions, Hungary asks for a level playing field.

“One of the issues that concern the most Hungary is the introduction of any uniform carbon price for the building and road transport sector,” starts Barbara Botos, Hungary’s Deputy Secretary of State for Climate Policy. She explains that the yearly emission of an average Hungarian household, its is approximately 4 tCO2eq and the additional yearly costs in case of a uniform carbon price could be significantly higher.

“We are open to extending the scope of the ETS to maritime and to revise of existing rules on aviation, however, the rest should be untouched,” underlined Barbara Botos. She noted that in case the further extension of the scope is inevitable, certain flexibility can be demonstrated in terms of road transport, however not in the building sector based on the existing criteria.

Hungary also believes that the GDP/capita approach should be maintained when determining Effort Sharing Regulation (ESR) targets. ESR sets national emission reduction targets for sectors not covered by the EU ETS. Some Member States proposed that the ESR targets should be aligned based on convergence and cost-efficiency. As Barbara Botos underlined this is unacceptable for Hungary, as it would result in raising the targets for lower-income Member States with a higher rate compared to the high-income Member States. By climate convergence, Hungary means that those Member States that have not decreased their GHG emissions compared to 1990 should do their very best to follow suit. As she pointed out national emission reductions should ensure that the raised EU reduction target is reached, so all Member States must contribute, without free-riding.

Overall, what will drive carbon pricing in the future? Espen Andreassen, Head of the Long-term Reports at Volue Insight mentioned four drivers valid in 2020-2021: first, the 55 per cent GHG reduction target agreed in the EU, which could require the annual emissions of 2018 to be cut by 1,800 million tonnes. Combined with a general macroeconomic optimism, strong purchasing from speculators and rising hard coal/lignite to gas fuel switching prices.

“However, there is not much potential left for hard coal and lignite compared to a decade ago,” said Mr Andreassen, reflecting on which of these trends will be still valid in the future.

“Beyond 2021 we can count on policies promoting hydrogen, heat pumps and electric vehicles,” he said. “The most important aspect will be the cost of renewables and technology falling down.”

However, he warned that we really need to see the renewable electricity growth that is required, considering that so far it also includes hydropower which is something that cannot be expanded too much.

“Another threat is the skyrocketing metal prices which are quite crucial for renewables development as wind is very steel-dependent, both onshore and offshore,” he concluded.

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