The EU carbon price maintained its more than €50 ($59.19) a tonne level on the back of proposals to revise the underlying EU Emission Trading System (ETS) issued by the European Commission on 14 July 2021 as part of its ‘Fit for 55’ package.

These prices were unthinkable even a few years ago, when they were stuck at one-tenth that. 

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“Our current fossil fuel economy has reached its limits,” said Commission President Ursula von der Leyen. The plan to get Europe on track to net zero is to put a price on carbon and a premium on decarbonisation, added first vice-president Frans Timmermans.

European Commission President Ursula von der Leyen gives a press conference on the new ‘Fit for 55’ energy and climate package to deliver the European Green Deal, Brussels, July 14, 2021. (Photo by JOHN THYS/AFP via Getty Images)

Emissions trading is at the heart of ‘Fit for 55’, a package of about a dozen legislative proposals to enable the EU to reach to its legally agreed goal of greenhouse gas (GHG) emissions cuts of 55% by 2030. That goal, in turn, lies at the heart of the European Green Deal and EU plans for a sustainable recovery from Covid-19.

The EU ETS was the world’s first, and remains its largest, carbon market, covering around 41% of total EU GHG emissions. It sets an emissions cap for more than 10,000 industrial and energy installations, plus intra-EU flights. Each year, each entity must surrender one carbon allowance for every tonne of carbon emitted.

Power plants must buy allowances via auctions, but heavy industries, such as cement, steel and chemicals, have, so far, received most of them for free. The rationale behind the free allowances is to protect companies from the potential risks of carbon leakage and stop them leaving the EU for regions with weaker carbon constraints. NGO Sandbag estimates free allowances add up to €20bn a year.

The latest reform brings about five main changes.

1. Doubling the rate of cap decline

First, the Commission proposal nearly doubles the rate at which the EU ETS emissions cap declines year by year. The so-called linear reduction factor is currently 2.2%. This figure was intended to get the EU ETS to reduce emissions by 43% by 2030, relative to 2005, in line with a previous target to reduce economy-wide emissions by 40% by 2030, relative to 1990 levels.

In practice, the EU ETS has over-delivered. It has already led to a 42.8% emissions reduction, relative to 2005, the Commission said on 14 July.

The EU executive now estimates that without reform, the system would deliver a 51% emissions reduction by 2030, relative to 2005 levels. However, an economy-wide reduction target of 55%, relative to 1990, requires a lot more. To that end, the Commission proposes to nearly double the linear reduction factor to 4.2%, to enable the EU ETS to deliver a 61% emissions reduction by 2030, relative to 2005.

The Commission also proposes a one-off cancellation of carbon allowances to make it seem like the new linear reduction factor kicked in in 2021 rather than only after the EU ETS reform is agreed (probably two years from now).

2. Free allowances for longer

Second, free allowances for industry will continue for longer. Under the last EU ETS reform in 2018, free allowances were prolonged out to 2030 to protect energy-intensive industries from the risk of carbon leakage. The new reform foresees them continuing for even longer, albeit in smaller quantities, out to 2036.

The sectors eligible for free allowances out to 2036 are those that will in future be protected by a carbon border adjustment mechanism (CBAM). In practice, this means fertilisers, aluminium, cement, and iron and steel (electricity too, but power plants already pay for their allowances). Together, these sectors account for nearly half (45%) of emissions from sectors at potential risk of carbon leakage.

Free allowances for these sectors will be phased out by 10% a year from 2026, when the CBAM takes effect. The Commission has not set a date for the CBAM’s expansion to other sectors, but plans a review before 2026.

The CBAM is not expected to affect EU ETS prices because importers will not enter the EU ETS. Rather, CBAM allowances will be traded in a parallel market.

Free allowances have been heavily criticised by climate campaigners, who argue they have not incentivised European industry to decarbonise. Industrial emissions have remained essentially flat – contrary to von der Leyen’s claim at the 'Fit for 55' launch that the EU ETS “has already significantly reduced industry and power generation emissions”.

The Commission proposes to backload the reduction in free allowances necessitated by a smaller emissions cap to the second half of this decade. Free allowance distribution will also become more targeted and conditional on decarbonisation. Installations not implementing recommendations made in energy audits required under the EU’s energy efficiency directive will have their free allowances reduced by up to 25%. 

3. Tougher on shipping and aviation

Third, half of international shipping will be brought into the EU ETS and free allowances for intra-EU flights will be phased out. For more than a decade, the EU has sought to bring international aviation and shipping into its ETS. It has faced strong resistance, with many arguing for a global approach via the UN's International Civil Aviation Organization (ICAO) and the International Maritime Organization.

Under the new proposals, international aviation would stay outside the EU ETS and continue to be regulated by CORSIA, the ICAO’s fledgling offset market. However, half of all international shipping trips to and from EU ports – as well as intra-EU maritime travel – would be fully covered by the EU ETS from 2026, after a phase-in starting in 2023. “One cruise ship emits as much CO2 [carbon dioxide] per day as 80,000 cars,” said von der Leyen.

One cruise ship emits as much CO2 per day as 80,000 cars. Ursula von der Leyen, European Commission

In practice, the EU ETS will cover around two-thirds of EU maritime emissions, which remain above 1990 levels. Officials expect no major impact on the overall EU ETS price because the changes will add a relatively low 90 million tonnes of CO2 to the system, which covers more than 1.5 billion tonnes of emissions in total.

The Commission is proposing to regulate half, rather than all, international maritime trips because “we do not have the pretence of being able to regulate the entire world”, said a senior EU official. It already tried, and failed, with international aviation.

For intra-EU aviation, the Commission proposes to phase out free allowances. This decision means airlines will have to pay for every tonne of carbon they emit from 2027. Emissions from intra-EU aviation increased by 5% year-on-year on average from 2013–18, despite the sector's inclusion in the EU ETS.

4. Emissions trading for road transport and buildings

Fourth, road transport and buildings will get their own parallel EU ETS. There is “huge potential” to reduce emissions in these sectors that policies have failed to tap, the Commission says. The new ETS will target distributors of heating and transport fuels, rather than individual car drivers or building owners. It will launch alongside the existing EU ETS on 1 January 2026 and target a 43% emissions reduction by 2030, relative to 2005 – in other words the pre-‘Fit for 55’ target of the regular EU ETS.

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This approach mirrors what is happening in Germany. Unlike the German scheme, launched in 2021, however, the second EU ETS will not fix prices in its early years.

"We will make sure the market starts with sufficient liquidity,” a senior EU official said. “That should ensure a relatively low level of initial prices.” In practice, 30% more allowances will be sold in its first year of operation in 2026, the Commission says. It also foresees “several mechanisms to enable us to control any unwanted price spikes”, including a market stability reserve like that in the regular EU ETS.

5. Doubling the money

Finally, money for innovation and the modernisation of energy systems will be doubled. An existing EU Innovation Fund to support new low-carbon technologies would almost double to more than €50bn over ten years. An existing Modernisation Fund would more than double to help member states with lower GDP upgrade their energy systems to make them fit for net zero.

The scope of the Innovation Fund would also be extended to support projects through competitive tendering mechanisms such as carbon contracts for difference (CCDs). The revised Modernisation Fund will no longer support any fossil fuels; until now only support for solid fossil fuels, namely coal, was ruled out.

In addition, the Commission wants to set up a Social Climate Fund fed by the new buildings and transport ETS. The goal is to counteract any disproportionate effects of the new system on the less well-off, if and when fuel suppliers pass on CO2 costs to customers. The fund will make about €10bn a year available from 2025–32. Member states are expected to match any cash they receive. It is not an EU cash machine”, a senior EU official said.

The fund should be spent on measures like temporary income support, renovation support and facilitating access to cleaner vehicles. Cash will be distributed based on criteria such as share of rural population and energy poverty indicators.

Overall, the biggest chunk of revenues from both trading schemes is still expected to flow directly to member states. In 2018–20, revenues amounted to €14–16bn a year and member states on average spent 70% on climate and energy measures. The Commission would like to see this increase to 100%, although such a mandate is unlikely to be politically palatable with national governments.