A new deal to reform the EU’s carbon market, struck late at night on 14 June between the centre-right European People’s Party (EPP), Socialists and Democrats (S&D) and Renew Europe (liberals) aims to tighten the EU Emissions Trading System (ETS) and phase out free allocation of EU carbon allowances to energy-intensive industries by 2032.

However, last week’s vote proves that this agreement between the ‘big three’ political parties still needs to overcome some hurdles.

The EU’s carbon market reform faced a major setback on 8 June when right-wing MEPs approved last-minute amendments ahead of a plenary vote in the European Parliament in Strasbourg, France, that weakened the proposal. As a result, the EU ETS reform, a key pillar of the EU’s ‘Fit for 55’ package to get on track to net zero by 2050, was rejected.

An unlikely alliance between the S&D, Greens, The Left, and conservative and far-right political groups sent the file back to the environment committee with 340 votes to 265, and 34 abstentions.

Pascal Canfin, chair of the European Parliament’s environment committee, at a press conference on ‘Fit for 55’ on 8 June 2022. (Photo by Eric Vidal; copyright © European Union 2022 – Source : EP)

It has been nearly a year since the European Commission proposed its ‘Fit for 55’ package, which adjusts the EU’s energy and climate legislation target to at least a 55% reduction in greenhouse gas emissions below 1990 levels by 2030.

Throughout these past months, many ‘hot’ topics have marked the EU ETS negotiations in the European Parliament and in the EU Council (member states): the expansion of the EU carbon market to road transport and buildings; a one-off rebasing of the emissions cap paired with a steeper linear reduction factor (the degree by which the emissions cap tightens every year); and the prospect of a phase-out of free EU carbon allowances to energy-intensive industries coupled with the introduction of a carbon border adjustment mechanism (CBAM).

These debates have taken place against the backdrop of an energy price crisis and Russia’s war on Ukraine, which have put fresh pressure on the EU’s climate ambitions.

Free allowance phase-out fight

After months of debate and internal horse-trading, MEPs in the Parliament’s environment committee agreed in mid-May on a widespread EU carbon market reform, which included the phase-out of free ETS allowances between 2026 and 2032. However, in a surprise manoeuvre, the centre-right European People’s Party (EPP) and liberal Renew groups agreed to a last-minute plenary amendment that delayed the phase-out to 2028 and prolonged it to 2034.

Several MEPs said they were “flooded” by emails sent by energy-intensive industry representatives ahead of the plenary vote, lobbying for last-minute amendments to ease the free allowance phase-out provisions.

"We will need to go back to the ENVI [environment] committee and solve this issue, which is related to one vote and two dates," said the committee's chair, French liberal MEP Pascal Canfin.

This is not the first time business-friendly lawmakers have tried to water down EU ETS ambition through last-minute amendments, says Suzana Carp, an independent EU climate and energy expert. In the EU carbon market’s preceding reform, agreed in 2017, several amendments introduced by the environment committee that significantly tightened the market were overturned in last-minute plenary votes.

The difference is that this time, the S&D, Greens and the left could trigger the rejection of the full text altogether – with the help of conservative and far-right forces, even if for the exact opposite reasons.

“From a purely political point of view, it makes sense to send [the report] back to the environment committee, given that last-minute amendments undermined the compromise [it had reached],” Carp tells Energy Monitor.

“What is really important is that it shows this Parliament – unlike the previous one – is extremely committed to the integrity of the [final] legislation,” she adds.

The deal struck between the three main political groups would see the handout of free EU emissions allowances end between 2027 and 2032. By 2030, energy-intensive industries would only receive half of the volume of free EU carbon allowances compared with today.

MEPs will need to vote on this and other amendments that might further strengthen or weaken the EU ETS – the Greens, for instance, are proposing changes to tighten the performance benchmarks by which industries are given free EU allowances – on 22 June.

Last chance to raise ambition

Free allocation was not the only reason the plenary vote last week failed. One of the last-minute amendments slipped in proposed that sectors covered by the current EU ETS – electricity, energy-intensive industries, aviation and now maritime – should reduce their emissions by 63% below 2005 levels by 2030. The deal agreed last night maintains that same level of ambition.

That is lower than the 67% the environment committee had originally agreed upon, even if still slightly above the Commission’s 61% proposal. NGOs such as Climate Action Network Europe have maintained that the target proposed for ETS-covered sectors should be at least 70%.

This could be the last chance for the European Parliament to strengthen the current reform of the EU carbon market ahead of the start of inter-institutional ‘trilogue’ negotiations with the EU Council. "This [latest development] is actually a chance for the Parliament to have a strong stance in trilogues,” Carp argues. In negotiations with member states, it is typically the Parliament that fights for greater climate ambition.

At the same time, there is a risk that the Parliament’s negotiating position is weakened as a result of the bickering among political groups about who is to blame for last week’s failure to get these files voted through.

EU Council takes charge

Back in 2017, the EU Council actually emerged as instrumental at brokering a deal that raised the bar of the plan, says Leon de Graaf, a senior consultant at Brussels-based company #SustainablePublicAffairs.

“The only reason we got an ambitious compromise [in 2017] was because the Council managed to get many ambitious things through, such as the cancellation mechanism in the Market Stability Reserve [which cancels part of the surplus of EU allowances held in the MSR so that they never return to the market],” he explains.

This move – driven at the time by more progressive EU nations such as Sweden and the Netherlands – was unusual, as the Council tends to congregate around the lowest common denominator for action among EU capitals. In practice, the EU Council usually weakens and the Parliament strengthens what the Commission proposes.

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Negotiations among member states are taking place in parallel to those among MEPs, with hopes for a compromise among national diplomats at a meeting of EU environment ministers on 28 June.

Despite a call by ten member states not to water down the current reform's ambition, there is no indication of a push to increase the ambition of the EU ETS, says de Graaf. “At the moment, the EU Council presidency [France] tries to stick to the European Commission’s proposal as much as possible.”

The most ambitious member states are likely to support France on this because delaying the file further would drag negotiations into the start of the Czech EU presidency – the Czech Republic takes over the six-month rotating EU presidency from France on 1 July – and could result in even lower ambition.

Enter CBAM

EU energy-intensive industries receive free allowances under the EU ETS to prevent carbon leakage or companies relocating to third countries with weaker climate and environmental standards.

However, civil society groups have repeatedly argued that free allowances do not incentivise decarbonisation; many industries have for years received more allowances than their actual emissions. According to a report by Brussels-based think tank the European Roundtable on Climate Change and Sustainable Transition, metals industries had a 26% EU allowance surplus in 2020; other sectors such as chemicals and cement had deficits of just 1% and 2%, respectively.

The EU carbon border tax or CBAM is meant to gradually replace free allocation, by making importers pay for the embedded emissions in electricity, iron and steel, aluminium, fertilisers and cement from third countries without equivalent climate legislation.

However, industry representatives argue that phasing out free allocation without knowing that CBAM will work could deal a major blow to the competitiveness of energy-intensive industries.

In a letter sent to EU lawmakers ahead of last week's plenary vote, representatives from Europe’s main industry groups called for “predictable measures and realistic timelines”. “Higher climate ambition needs to be achieved cost effectively and be accompanied by strengthened carbon leakage protection on EU and export markets against both direct and indirect carbon costs,” they wrote.

Tight timing

The plenary’s rejection of the EU ETS reform also postponed votes on CBAM – this hinges on an end to free allocation – and a new social climate fund that aims to raise revenues from an expanded EU carbon market to help the bloc’s poorest households. Votes on these two files will resume at next week’s plenary, together with that of the EU ETS.

There is a significant risk to the Commission’s plan to roll out the carbon border tax in particular, given that CBAM’s transitional phase would kick off in 2023, as per the Commission’s current proposal.

The Parliament’s leading CBAM lawmaker, Dutch S&D MEP Mohammed Chahim, said in a tweet that phasing out free EU carbon allowances by 2034 was worse than the Commission’s original proposal to end them by 2035. While the Commission foresees a gradual start to the phase-out in 2026, he explained, the Parliament’s rejected text voted to delay that to 2028.

This means industries would receive more EU emissions permits in total over the next decade, putting downward pressure on the carbon price. That prompted a dip of the price of EU allowances to just under €80 per tonne, even though prices stabilised and saw some gains in the days to follow. More free allowances would also lower the volume available for auction to raise revenues for the EU’s Innovation Fund, which is meant to finance low-carbon industrial innovation, noted Carbon Market Watch’s Agnese Ruggiero in a tweet.

Last week’s vote plenary indicates there is now a will to phase out free allowances sooner rather than later, says Carp.

“The way it [free allowances allocation] was always extended – and it was about to be extended again – was through such last-minute votes," she explains. The rejection of another such extension by MEPs last week brings the end to free allowances closer, and opens the door to an EU ETS that speeds up the industrial transformation to net zero.

Editor's note: This article was updated after publication on 15 June to reflect the deal to reform the EU ETS reached by the EPP, S&D and Renew Europe late at night on 14 June.