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Is it time to open up the EU ETS again?

As the new year gets going, the EU is facing much higher energy prices than it has had to contend with in the recent past, topped off with an escalating carbon price driven both by the energy price and the ambitious decarbonisation plans of the EU Commission. Starting in late 2020 at a price of around €20, the purchase of an EU allowance (EUA) in the EU Emissions Trading System (ETS) now costs between €80 and €90 per tonne of CO2.

The current allowance price in the EU ETS provides a significant incentive to reduce emissions, including investment in substantial mitigation technologies such as carbon capture and storage (CCS). As such, this is a welcome and critically important change from over a decade of prices below  €20 and a low of €3 where the system did little to encourage the energy transition. For much of the 2010s the ETS was awash in allowances, with the surplus brought about by the financial crisis and subsequent EU recession, the influx of units from the Clean Development Mechanism (CDM) of the Kyoto Protocol and the overlaying of other policies in the ETS sector, a practice that erodes the need for a specific carbon price and will undermine its impact.

We are now in a world where the EU ETS is driving substantial mitigation action, which is exactly what it is supposed to do. The question that arises is what comes next? One way of answering that question is to look at a scenario analysis of the EU net-zero emissions goal, such as in the Shell EU Sketch released by the Shell Scenario team a bit over a year ago.

A deeper look at the Shell EU Sketch highlights the ambition of the Fit for 55 (FF55) goal. Even in the scenario, the reduction planned under FF55 for the EU ETS sector isn’t fully met in 2030, but instead requires another five years of effort. In addition the energy transformation in the EU is not yet fully matching that of the Sketch. Take for example the build rate of CCS facilities in the Sketch versus the real world. At the rate of change in the Sketch, some 40 major (~ 1 mtpa each) CCS facilities need to be operating by 2030 and over 100 by 2035. The EU has finally started developing CCS clusters, but not yet fast enough to meet these goals. This implies that during the 2020s the EU ETS could see further price escalation if project activity does not fully match the reduction goals of the system.

The Fit for 55 package of measures and targets is extraordinary ambitious, contributing to the global reductions required to avoid passing 1.5°C of warming and setting up the EU for a landing at net-zero emissions in 2050. It does need a meaningful carbon price to usher in the transition, but in the Shell EU Sketch it rises to around €60 by 2030 and €200 by 2050 (but on a much smaller level of emissions than today). The current price of an EU allowance should usher in real change for industry and industrial processes, which is needed, but a continuing steep up-trend may also be a sign of a system that is becoming overly constrained by the rate of reduction required compared to the rate at which projects can be implemented.

When the EU ETS first started the Kyoto Protocol was coming into force and we all imagined a world of interconnected cap-and-trade systems, ambitious clean energy projects in developing countries and a resultant liquid global carbon market. With substantial demand coming from the Kyoto signatory countries with targets and good supply from clean energy projects, the resultant carbon market would be of sufficient size to deliver cost savings to all participants. Importantly, major price spikes could be managed. Almost none of this happened.

In the process, the EU ETS was designed with external hooks to make use of the mechanisms of the Kyoto Protocol (CDM and Joint Implementation or JI) and to connect with other systems. With the prospect of an Australian ETS about a decade ago the EU began early negotiations with the Australian Government to link the systems, but a change of government in Australia put an end to the Australian efforts. With the US leaving Kyoto and other countries making little use of the mechanisms, the EU ETS was left as the only real buyer of emission reduction units (CER) from the CDM. So it was flooded with them, contributing to the 2008 price collapse. The EU rightly closed the doors and it wasn’t until 2020 when they were partly reopened with a link to the Switzerland ETS.

Industry will be feeling the competitive pressure and rising fuel bills for citizens opens the door to voter anger when it comes to elections if the EU ETS price continues to rise without adequate relief valve mechanisms. The Market Stability Reserve (MSR) would offer some reprieve as it starts releasing banked allowances, but a longer term solution could also be found through Article 6 of the Paris Agreement. The EU ETS could open itself to projects executed under the 6.4 mechanism and transferred into the EU ETS via 6.2, along with the necessary corresponding adjustments to the counterparty country nationally determined contribution (NDC). I discussed the corresponding adjustment mechanism in my last post of 2021. The transfer provision under 6.2 also provides an opportunity to link with other trading systems, such as the recently created UK ETS.

Making use of Article 6 will be a very different experience to that with the CDM. This is a mechanism that operates between two nationally determined contributions (NDC), each with its own plan to reduce emissions, but each plan must be converted to a carbon budget for the period of the NDC in order to use Article 6. The rules for doing this were thrashed out in Glasgow and can be found in III.B of the decision. When the transfer between NDCs is executed, a corresponding adjustment must be made to the respective carbon budgets. This means that the selling country must make up the amount of the sale through additional actions within their NDC, which ensures that the overall reduction goals of the respective NDCs are maintained. Under the CDM, no such provision existed.

With robust Article 6 accounting standards, the EU can have confidence that environmental integrity is preserved and that real reductions are delivered through the ETS. This was always a concern with the CDM. However, there is a fine balance to be achieved when creating a relief valve in that a sharp fall in the carbon price is not helpful for investment. As such, the EU might initially look to trade with a very limited number of countries, such as those with similar ETS structures. The UK, New Zealand and South Korea could all fall into this category.

By opening up the ETS the EU will promote confidence in international carbon trading, which will become an increasingly important part of the mitigation toolkit as the world gets closer to net-zero emissions. This is because remaining emissions and the availability of sinks to balance won’t always be in the same jurisdiction. But most importantly, a larger trading system will lower overall costs for the same reduction goals or alternatively may promote greater ambition, which is certainly needed and was called for in the Glasgow Climate Pact. This will benefit everyone.

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