A year ago, as Europe went into lockdown and economic activity cratered, the price of allowances in the EU Emissions Trading System (EU ETS) was languishing at €14.3 ($17) a tonne (t) of carbon dioxide. A year later, it had trebled to almost €43/t. Some analysts are forecasting its imminent rise to €100/t, as speculators and emitters alike look ahead to a hike in the EU’s 2030 emissions target and its 2050 net-zero goal.

The volatility in the carbon price and its potential to skyrocket is bringing this crucial – but complex and often overlooked – element of the EU’s climate policy framework into focus. It is raising difficult questions over international competitiveness, burden sharing and industry lobbying, as well as the effectiveness of a variable market signal in driving long-term investment decisions.

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The recent rise in the carbon price is, some analysts believe, a foreshadowing of that future. “If I was to put my money somewhere, I would go to the carbon market,” says Aje Singh Rihel, senior carbon market analyst at market data and infrastructure company Refinitiv. “It is practically given the market will go up over the longer term.”

A garbage incineration plant pours smoke into the sky above Amsterdam, 31 May 2005, on the eve of the EU Constitution referendum. (Photo by JOHN D MCHUGH/AFP via Getty Images)

The EU ETS was introduced in 2005. It imposes targets on 11,000 power stations and industrial plants (as well as intra-EU aviation), covering around 40% of EU greenhouse gas emissions. It requires emitters to surrender allowances equal to their annual emissions. Most allowances are auctioned by EU governments, raising €7.9bn in the first half of 2020.

However, while power plants must purchase all the allowances they need to surrender against their emissions, most industrial emitters still receive for free a substantial proportion of their allowances. This free handout is worth €20bn a year, says Sandbag, a climate policy think tank. These allowances are allocated using a complicated benchmarking process, based on the most efficient 10% of plants in a particular industry sector.

A carbon market handout

Free allocations, which include extra allowances for companies vulnerable to competition from outside the EU, are designed to avoid ‘carbon leakage’ – the displacement of carbon-intensive economic activity to jurisdictions that do not control carbon emissions.

This situation means that, to date, the impact of the EU ETS has been largely restricted to the power sector. The cost of allowances to balance emissions from a particular form of generation helps tip the scales from coal to gas, and from gas towards renewables, making the carbon price a constant consideration. For most industrial emitters, by contrast, engagement with the EU ETS has been a once-yearly job for a compliance officer, to ensure the company has surrendered sufficient allowances to match emissions.

Environmental groups are clear this state of affairs must end. “Free allocation doesn’t drive decarbonisation,” says Camille Maury, a policy officer at conservation group the WWF in Brussels. “We need to apply the polluter pays principle – it is the goal of the ETS directive.”

This point is made by raw data from the European Environment Agency. From the launch of the system in 2005 to 2019 (the last year for which data is available), emissions from fuel combustion (mostly in the power sector) fell by 34%. However, emissions from industrial installations (considered on a like-for-like basis) have been essentially flat.

There are signs higher prices are changing the dynamic. Simon Watson is a senior consultant at Redshaw Advisors, a London-based firm that helps companies with carbon risk management. Rising costs mean carbon emissions have become a “strategic issue” for industrial emitters, he says, with companies beginning to actively plan and manage their carbon position, and consider more carefully how to reduce fossil fuel consumption.

Reductions in power sector emissions have been sufficient for the EU to reach its 2020 greenhouse gas targets, but incremental improvements by industrial emitters will be nowhere near enough to get the bloc to its target of reducing emissions by 55% by 2030.

An end to incrementalism

“The sense I get from industrials is that they are close to reaching the maximum they can achieve in decarbonisation through efficiency savings rather than more substantive changes to their industrial processes,” says Adam Berman, head of EU policy at the International Emissions Trading Association (IETA).

Prices will have to rise to deliver additional abatement. Mark Lewis, chief sustainability strategist at BNP Paribas Asset Management in Paris, believes that to deliver industrial decarbonisation the carbon price will have to rise high enough to incentivise green hydrogen (hydrogen produced by electrolysers using renewable energy).

Through its use, initially as an industrial feedstock, and later as an energy source, green hydrogen will become “the marginal abatement option that will deliver the EU’s 2050 net-zero target”, he writes in a recent research note.

Lewis pegs the necessary carbon price at somewhere between €79/t and €103/t by 2030. The final figure will depend on the price of natural gas, the alternative hydrogen feedstock, and the ability to bring green hydrogen production costs down to €2–2.5/kg from around €4–5/kg today. Similarly, a carbon price of around €80–90/t would be needed to make carbon capture and storage (CCS) viable in Europe.

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Such analysis has increased interest in the EU ETS from speculators, helping to push prices up and increase volatility. Market watchers like Marcus Ferdinand, head of European power and carbon analytics at market intelligence company ICIS, believe the absolute price is less of a concern to regulators. More important is the speed of price moves, he says – the European Commission sees a carbon price of up to €90/t as necessary to support the hydrogen economy.

“As an industrial, you want some sort of predictability and stability to consider the carbon price as a viable element when you make decisions to invest in abatement technologies,” says Ferdinand. “High volatility is poison for these decisions.” However, the near impossibility of distinguishing between speculative trading and ‘real-economy’ hedging of carbon exposures makes intervention by regulators unlikely.

“At the end of the day, if you don’t like volatility, if you don’t like the price moving… you need to go for a different policy instrument,” says Ferdinand.

‘Decade-long’ decarbonisation

Nonetheless, switching to the technologies needed to deliver deep carbonisation is a “decade-long process” requiring massive investment, says Phil MacDonald, chief operating officer at Ember, a climate and energy think tank. Getting from here to there, while companies continue to have to pay for their ongoing emissions at high and potentially volatile carbon prices, “is going to be quite difficult”, he says.

It also risks being self-defeating, argues Liv Rathe, a director at Norwegian aluminium producer Norsk Hydro. “If we don’t have a [decarbonisation] technology with a cost level we can face, then we can’t remain in Europe anymore, and countries like China, with a considerably higher carbon footprint per tonne of aluminium produced, will export more aluminium to Europe. Is that the solution?”

This is where a carbon levy could come in, with imports into the EU from jurisdictions that do not impose a carbon price on their emitters subject to a border tax. The European Commission is exploring the potential for what it calls a Carbon Price Border Adjustment (CBAM). This measure is one of a number of possible changes to the market the Commission is expected to unveil in June.

Other changes are likely to include bringing ETS targets in line with a new 2030 EU emissions goal, extending the ETS to the maritime, land transport and heat sectors, and a review of the Market Stability Reserve, which the Commission uses to control excess supply or demand.

However, a carbon border tax poses a host of practical and political problems. Calculating the ‘embedded carbon’ – the amount of carbon emissions created for a particular product – becomes highly complex beyond the simplest goods, and the EU’s trading partners are anxious. US climate envoy John Kerry said in March that such a border tax should be a “last resort”, while Chinese diplomats have called for further discussions.

“If there is international cooperation on this, it could be one of the pieces of the puzzle that unblocks global attempts to reduce emissions,” says Ferdinand at ICIS. It would go a long way towards taking competitive tensions out of the decarbonisation debate, he believes. However, “if the EU’s international trade partners want to block it, there is a good basis for it fuelling some sort of trade crisis”, he adds.

Carbon costs at the border

Industrial emitters, meanwhile, want a CBAM to exist in parallel with free allocations. Industry watchers were surprised to see the European Parliament vote for such an approach in March – it would amount to a double subsidy and fall foul of World Trade Organisation rules, experts believe.

Indeed, some emitters believe the complexity of the mechanism means it is likely to be of limited use. Rathe at Norsk Hydro argues that, because most of the effect of carbon pricing in the EU is felt through the power price, a CBAM would likely fail to properly reflect the carbon costs faced by importers.

As well as continued free allocation, Rathe would like to see governments step up with the investment needed to commercialise the new, innovative technologies required to reduce emissions, as well as CCS and hydrogen – investments European industry cannot carry alone.

This view is shared by others. Singh Rihel at Refinitiv points to the Northern Lights project, a large-scale CCS infrastructure project developed by a range of industrial partners and backed by the Norwegian government.

“They are putting the whole infrastructure in place” to enable a number of projects to capture, transport and store their carbon emissions, with a substantial government subsidy, says Refinitiv.  “That is a game changer. The financial costs and technological and operational risks are too high” for companies to carry out such investments without government intervention, he says. “Once you have a few of these projects that start to work, that is going to open the door.”

Berman at the IETA believes the free allocation of allowances is only going in one direction, driven by EU climate objectives and the need for member states to earn additional auction revenue. It is likely, Brussels-watchers believe, that lobbying will shift from trying to defend free allocation to ensuring industry gets as much funding as possible for decarbonisation from EU Innovation and Modernisation funds.

The shift in the debate perhaps illustrates the limits of a carbon price. A variable and often volatile price signal can make the difference for a power plant operator choosing between running a gas or coal-fired plant. However, it is unlikely to tip the balance in favour of long-term investments worth hundreds of millions of euros. Once those investments in the underlying green infrastructure are made, though, a carbon price can tip the economics in their favour.

Indeed, this story played out in the EU renewables sector. Direct government subsidies in the form of feed-in tariffs, and later contracts for difference and auctions, got much of Europe’s clean energy capacity built, while the carbon price now helps support its economics.

“I have somewhat lost faith the carbon price will be the major driver in industry,” says MacDonald at Ember. “Instead, it will be about targeted government intervention in specific technologies. Once they can be commercialised, then the carbon price comes into play.”