Usefulness of the article: This note provides a detailed overview of the European Commission’s carbon pricing strategy following the announcement of the « Fit for 55 » plan, which aims to enable the European Union to reduce its greenhouse gas (GHG) emissions by 55% by 2030.
Summary:
- The European Commission (EC) has unveiled a series of measures, known as « Fit for 55, » contributing to the European Union (EU) Green Deal’s goal of reducing greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels.
- Most of the proposals are based on carbon pricing. In this note, we explore the underlying mechanisms of the EU Emissions Trading System (ETS) and the Carbon Border Adjustment Mechanism (CBAM).
- Phase 4 of the ETS review (2021-2030) introduces more ambitious emission reduction targets, extends the current system to aviation and maritime transport, and creates a new ETS for fuels used in road transport and domestic heating.
- The EC has also proposed the gradual introduction of a CBAM from 2023 to 2026. This system would apply to sectors at high risk of carbon leakage—iron/steel, cement, fertilizers, aluminum, and electricity generation.
- Carbon pricing also generates additional revenue. We are examining the various initiatives proposed by the EC to increase its financing capacity and smooth the financial impact on the most vulnerable households.
The European Union (EU) remains a leader in the fight against climate change, both through its commitments and its actions. The European Green Deal was adopted in January 2020 and commits to reducing emissions by at least 55% by 2030 in the EU (compared to 1990 levels) and achieving carbon neutrality by 2050. This plan requires massive funding, which is partially covered by the latest recovery plan adopted in the midst of the COVID-19 crisis (Next Generation EU). Transfers between states and low-interest loans are intended to stimulate public action and encourage private initiatives to green our economic system, which is still very carbon-intensive. These initiatives are essential but insufficient. Carbon pricing is another important element.
Carbon pricing is a means of internalizing the negative externalities caused by greenhouse gases. In theory, the relative price of goods adjusts according to their carbon content, thereby changing the behavior of economic agents and encouraging investment in a lower-carbon economy.
On July 14, the European Commission unveiled a plan ( » Fit for 55 « ) containing several proposals to achieve the GHG reduction targets set out in the EU Green Deal. This plan includes, among other things, stricter regulations in certain sectors (particularly the automotive sector), more ambitious reduction targets by sector, and, above all, a revision of the Emissions Trading System (ETS) and a proposal for an EU Carbon Border Adjustment Mechanism (CBAM).
This note discusses the main tools available to the EU to enhance the effectiveness of carbon pricing. We will detail the mechanisms and proposals of the EC concerning the ETS and the CBAM, but also, and above all, the economic, political, and/or geopolitical challenges surrounding their implementation.
1. Why an emissions trading system?
The ETS was introduced in 2005 and covers around 10,000 sites in energy production, manufacturing, and airlines operating in the EU. It accounts for around 40% of GHG emissions produced in the EU.
The underlying theory of the ETS is simple. The EU sets a maximum amount of pollution permits for the sectors concerned. These companies must then purchase these permits through auctions and are free to use, sell, or hold them in stock. If a company does not have enough permits to cover its annual emissions, it incurs significant financial penalties. In order to meet its emission reduction targets, the EU adjusts the number of permits available for sale downwards each year. In other words, if demand remains constant while supply is restricted, the price of each permit is likely to rise sharply in the coming years. Companies are therefore encouraged to « green » their activities now.
Unfortunately, the reality is a little more complex. The EU distributes permits free of charge in order to protect certain sectors from international competition, but also to prevent certain companies from relocating their activities to countries that are less concerned about environmental issues (carbon leakage). At the start of Phase 3 (2013-2020) of the ETS, free permit allocations accounted for 80% of new permits placed on the market, but this has declined to 30% in 2020 (Figure 1). For example, airline emissions are still fully covered by these free permits.
Figure 1: In 2020, free allowances covered half of observed emissions
Source: European Environment Agency
The free distribution of pollution permits—which increased following the 2008-2009 crisis and imports of international credits[1] —has significantly distorted the price signal of carbon pricing. In response, the EC created the Market Stability Reserve ( MSR) in 2019. This system does not allow for discretionary intervention, but automatically places allowances in the reserve, or releases them, when predefined thresholds are exceeded.
2. Revision of the ETS
The revision of Phase 4 of the ETS (2021-2030) introduces even more ambitious GHG emission reduction targets. The total amount of allowances will decrease by 4.2% per year (compared to 2.2% previously), to which an additional one-off reduction will be added when Phase 4 is implemented. This revision is also intended to correct distortions related to the distribution of free allowances.
The number of free allowances is expected to decrease slightly before 2026 but then accelerate sharply (-10% per year for 10 years). The rules for allocating free allowances remain unchanged and will continue to be based on a benchmark representing the performance level of the best companies in each sector. Free allowances will continue to be subject to verification of companies’ decarbonization efforts, while companies using low-carbon means of production will continue to receive free allowances. Finally, the EC suggests making slight changes to the MSR rules in order to smooth the placement of allowances in the reserve in cases where market surpluses are close to the threshold.
The Commission also proposes adding new sectors to the ETS, in particular those with still very high GHG emissions: aviation and maritime transport. For the former, the EC proposes to phase out free allowances and thus migrate entirely to the auctioning system from 2027 onwards. For maritime transport, only large means of transport (cruise ships and cargo ships) are likely to be affected, as they account for around two-thirds of the sector’s emissions within the EU.
By 2026, the EU should also create a new ETS including fuels used in road transport and building heating. Suppliers will be responsible for monitoring and reporting the amount of fuel they sell on the market, multiplied by the respective carbon content of the fuels. It is interesting to note that this new ETS proposes a specific mechanism to contain excessive increases in the price of carbon, which is probably the main reason for the split with the « classic » ETS.
In conclusion, free allowances will remain abundant in the coming years, while conditions remain relatively lenient. The incentives are ultimately not as strong as hoped, especially since the EC is proposing to introduce a carbon border adjustment mechanism from 2026, providing a kind of double protection for a few highly polluting companies. Uncertainties surrounding the adoption of the MACF have probably forced the Commission to be very cautious about the planned end of free allowances so as not to compromise the EU’s competitiveness.
3. The carbon border adjustment mechanism: the quest for the Holy Grail?
The CBAM tackles the risk of carbon leakage by reintegrating the cost of the carbon content of products imported into the EU. It is an environmental policy measure that protects the EU’s climate policy, preserves the domestic economy from unfair competition, and encourages exporters to the EU to adopt cleaner production processes.
From a practical standpoint, the MACF mirrors the ETS. Within the EU, importers will purchase allowances corresponding to the carbon price that would have been paid if the goods had been produced in the EU under the national carbon pricing rule. Conversely, if a non-European producer can prove that they have already paid a carbon tax in another country, the corresponding cost can be fully deducted for the European importer.
Initiatives similar to the MACF are already in place in California, and countries such as Canada and Japan are seriously considering them. But as things stand, the MACF should be seen as a negotiating tool. A transition phase will run from 2023 to 2026, with the aim of improving data collection, smoothing its deployment to anticipate disputes, and above all facilitating dialogue with third countries and the World Trade Organization (WTO).
The debate on the MACF has intensified in recent years, and the new commitments made by various countries to achieve carbon neutrality are not insignificant. The sooner these countries act, the sooner the gap between the EU’s carbon price and that of other countries will narrow, and the less they will be affected from a commercial standpoint (or the more likely they will be to be exempted). For example, China has just launched its emissions trading system, covering more than 2,000 energy production facilities. Unfortunately, China is repeating the EU’s initial mistake. Due to an oversupply of permits, the Chinese carbon price is currently too low ($7 per ton), as was the case with the European carbon price in the early years (Figure 2). In the US, Democrats are also looking closely at the possibilities of a carbon border tax to help finance President Biden’s spending program. But for a variety of reasons, we do not believe that the US will adopt a carbon border tax in the near future, although this debate now has the merit of existing across the Atlantic.
Chart 2: After a slow start, carbon prices have risen sharply in recent months
Source: Datastream, July 16
Now let’s turn to the tactical point of the negotiations. The EU’s MACF will only apply to goods with a high risk of carbon leakage—iron and steel, cement, fertilizers, aluminum, and electricity production, which together account for around 5-10% of EU imports and around 30% of global CO₂ emissions[4]. This initial list probably reflects Europe’s ambition to bring others along with it—particularly major trading partners, including China and the US—rather than confront them. The EC is maintaining additional pressure by stating that it reserves the right to extend the system to other products and services at the end of the transition phase (e.g., electrical equipment and automobiles)..
Negotiations with Russia and Turkey, on the other hand, are likely to be more problematic, as neither country has announced climate targets and both are major exporters of high-carbon products (Figure 3). For developing economies, the EC has not disclosed any specific rules but stands ready to « work with them on decarbonizing their manufacturing industries and provide them with technical assistance. » It is unreasonable to expect companies in the poorest countries to pay the same carbon price as those in the richest countries, even if this is consistent with avoiding carbon leakage. A minimum threshold on imports could help some countries, provided that large exporters do not split their shipments to avoid taxes. Negotiations are likely to be lengthy, given the global implications and the many special cases involved.
Figure 3: The impact of the MACF varies among the EU’s trading partners
Source: Centre for European Reform, July 2021
4. How will the revenues be used?
One of the beneficial effects of carbon pricing instruments is the potential to generate revenue that can help finance the energy transition or redistribute wealth. Revenues from ETS auctions are mainly paid into Member States’ budgets (around €14-16 billion per year) and are mainly reinvested in climate and energy-related projects (70% on average so far). In addition, the ETS finances the Innovation Fund, which supports disruptive innovations in favor of climate neutrality, and the Modernization Fund, which aims to improve the origin of electricity production in low-income Member States.
The EC proposes to increase the revenues of these funds. The Innovation Fund, which currently has 450 million allowances for the period 2021-2030, would receive an additional 200 million, while the Modernization Fund, which currently has 2% of the total allowances, would receive an additional 2.5% of allowances for the period 2021-2030. Revenues will depend on the price of carbon, but the total budget, at the current price of €50, would be around €32.5 billion for the Innovation Fund and €14 billion for the Modernization Fund. These proposals are welcome, but they do not entirely resolve the problem of the climate « divide » between eastern and western Member States. If we add up the funding from the two funds, the countries of Central and Eastern Europe should receive proportionally more. But some countries, such as Poland, are still heavily dependent on fossil fuels (in 2018, 44% of the electricity produced in that country came from coal and 30% from oil). Funding needs remain extremely high, but some countries, such as Spain in the 2000s and Slovakia in the early 2010s, have shown that reducing coal at the same stage of development is possible.
With regard to the MACF, the EC has confirmed that it intends to use future revenues to repay part of the mutual debt incurred by the EU under the Next Generation EU plan adopted last summer.
5. A socially equitable transition?
The ETS, the MACF, and more generally all measures to combat climate change will inevitably put additional pressure on vulnerable households, among other things through an increase in the prices of certain everyday products related to energy use (transport, home insulation). Although the benefits of the EU’s current strategy in the medium and long term are likely to offset the real cost of the transition, the issue of social acceptability is important.
The EC is proposing a Social Climate Fund, with dedicated funding for Member States to help citizens finance investments in the energy efficiency of their homes and less carbon-intensive mobility. The revenue would come from the new ETS (fuels used in road transport and domestic heating oil) and is expected to represent around 25% of the latter’s revenue (€72 billion spread over 2025-2032). However, these transfers would not be « direct. » The EC suggests that countries design their own actions to mitigate the social impact and then seek financial support from the fund. Certain conditions with predefined targets for decarbonization efforts are likely to be included. To illustrate the scale of the fund’s allocation, if the transfers were concentrated on the bottom quintile of the income distribution, they would represent only €100 per year per capita. These amounts seem low in view of the price increases expected in certain sectors, hence the importance of national initiatives to complement the EU’s efforts.
6. For now, these are only proposals…
The revision of the ETS and the launch of the MACF send strong signals about the EU’s intention to transform industry at the domestic level, but also about its willingness to drive these changes at the international level. However, these initiatives are only proposals at this stage and it will take several years for them to be fully implemented, requiring the joint approval of the European Parliament and the Council.
From this perspective, the MACF proposal is quite striking. It is described in very diplomatic terms, applies to few sectors, is very gradual in its implementation, and does not provide for any explicit redistribution other than to the EU budget. As such, it currently appears to be more of a political tool designed to buy time and put pressure on international partners/competitors to establish concrete negotiations, rather than a policy designed to be fully implemented. Discussions over the next few years with sectoral lobbies, Member States, third countries, and the WTO will be difficult and will most likely change the initial proposal. In any case, the measures announced in July will form the basis for discussions.
Bibliography
European Commission (July 2021) « European Green Deal: Commission proposes transformation of EU economy and society to meet climate ambitions »
Directorate-General for the Treasury (March 2021) « A carbon border adjustment for the climate | Combating carbon leakage in the service of global climate action »
[1]High-income countries received permits when they invested in CO₂ reduction projects in developing countries. Between 2013 and 2020 (Phase 3), these products had to be traded under the ETS.
[2]In order to mitigate the potential risk of excessive price increases, the MSR would operate within this new ETS and could release allowances from the reserve under certain conditions. This would cap the rise in permit prices.
[3]Currently, only Switzerland has an EU-recognized ETS, but Norway and Iceland are likely to be integrated in the near future.
[4]Specifically, iron, steel, and aluminum account for 7.9% of total GHG emissions, cement for 3%, fertilizers for 4.1%, and electrical energy for 13.6% (taking into account emissions leakage from the use of coal, gas, and oil). Source: OurWorldinData
[5]The Modernization Fund supports 10 countries: Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania, Poland, the Czech Republic, Romania, and Slovakia.
