The EU ETS is the primary tool in the EU's fight against climate change, utilizing a cap-and-trade system to regulate and diminish greenhouse gas emissions across diverse sectors. 2024 presents a potential shifts in carbon price dynamics following a flat 2023.
The EU Emissions Trading Scheme (EU ETS) is the main policytool in the EU’s battle against climate change. The carbon pricing mechanism is designed to regulate and reduce greenhouse gas emissions. And it works. Over the past two decades, it has evolved into a formidable tool to reduce emissions at scale, and a sophisticated, liquid market.
How does the EU ETS work and what are the key concepts in 2024? The cap-and-trade system spans into various sectors, aiming to maximize its positive impact on the environment. The emissions trading system has been expanding - the EU ETS is (or will be after 2024) relevant for aviation, maritime shipping, road transportation and construction building. What about EU ETS prices? 2024 can see different carbon price dynamics after a flat 2023. New announcement from the EU commission can bring prices to the upside. We’ll walk you through all the details below.
The authorities regularly modify some features of the EU Emissions Trading Scheme to adapt to broader dynamics and enhance its effectiveness in combating climate change. These changes include efforts to encompass a wider range of emissions, for example. They also regularly adjust the rate of supply reduction within the system (it is 4.3% currently). In 2024, the EU ETS functions as a cap-and-trade system: the laws of demand and supply in the free market determines a carbon price at the outset of the year, starting at around EUR 65 per tonne of CO2.
Annually, the EU Commission strategically diminishes the supply of European Union Allowances (EUAs) with the intent of driving up prices, a practice guided by the Linear Reduction Factor (LRF). Between 2013 and 2020, the LRF was set at 1.74% per year, escalating to 2.2% from 2021 to 2023, and as of the start of 2024, it has surged to 4.3%, reflecting a more aggressive approach to reduce emissions and stimulate market dynamics. This reduction in the allocation of EUAs underscores the Commission's commitment to fostering a market environment that encourages sustainable practices and emission reduction strategies. The regular increase in the LRF illustrates Europe's continued support in the market, even in the context of a land war at the door or Europe, an energy crisis, and sustained inflation.
The EU Commission has outlined clear environmental goals for 2030 and 2050. Those include a 55% reduction in greenhouse gas emissions from 1990 levels by 2030. Also, it aims for climate neutrality by 2050 - the amount of greenhouse gasses emitted should be minimized, and any tonne of CO2 emitted should be removed or offset. To achieve these climate objectives, carbon prices are going to have to continue to increase. It is only when faced with high emission prices that industries have a clear incentive to lower emissions. There are currently no guidelines set for a 2040 horizon, and in the first quarter of 2024, anticipated news in this regard may influence the EU ETS mechanisms and regulations.
Until the end of 2023, the EU emissions trading scheme was covering emissions the following sectors:
Since 2012, CO2 emissions from aviation have been part of the EU ETS. All airlines, both European and non-European, operating in Europe have to monitor, report, and verify their emissions and surrender European Union Allowances (EUAs). Initially, the idea was for the coverage to be for all flights from, to and within the European Economic Area (EEA). However, the EU ETS scope was limited to intra-EEA flights following the 2016 ICAO Assembly on the global measure. With the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), the EU ETS for aviation may revert to its originally planned full scope after 2024.
From 2024, cargo and passenger ships of 5 000 gross tonnage or more will be included in the EU ETS. After 2027, offshore ships of the same size will become part of the program as well. Monitoring and reporting should be done by the shipowner or any other organization or person that has the responsibility for the operation of the ship. All of the emissions from trips between EU Member states need to be taken into consideration. When it comes to trips between EU states and other countries, 50% of the emissions will be under the EU ETS scope.
Emissions related to road transportation will be included in a separate system - the EU ETS 2. The environmental objective is to achieve a 43% reduction in emissions from the building and road transport sectors by 2030 compared to 2005 levels. The allocation of quotas for these sectors in 2027 will be determined based on observed emissions in 2024, with a subsequent annual reduction of 5.1% from 2027 to 2028, followed by a higher rate of 5.38% from 2028 onward.
In the original EU ETS, member states were mandated to allocate a minimum of 50% of EU ETS auction revenues for climate change-fighting infrastructure. However in reality, they ended up investing even more in green projects - 76% of auction revenues between 2013 and 2022. A notable change with EU ETS II is the requirement for 100% of the member state proceeds to be dedicated exclusively to green initiatives.
The EU Commission's objective in imposing a carbon price is to impose a financial burden on polluters, intending for them to perceive carbon-intensive production as economically unfavorable. The goal is to incentivize industries to decarbonize by making the production of carbon more costly. Therefore, regulators aim to elevate the carbon price, fostering a shift towards a more environmentally friendly industry. This is the purpose of the EUA annual supply reduction - by reducing the offer, authorities pressure up the market (from 2024 on, the annual reduction rate is 4.3% per year).
Academic research and discussion has been supporting institutional decisions in carbon pricing and ETS. "The most important single economic concept in the economics of climate change is the social cost of carbon (SCC)." according to Norhaus. Scholars concur that the current carbon price falls considerably short of what they argue is necessary to adequately reflect the environmental damage caused by human activities. They state that, in the following decade, levels should reach EUR 174 (Pindyck), EUR 185 (Rennert), EUR 220 (Moore and Diaz), EUR 3000 (Kikstra) for the scheme to be effective.
Emissions Trading Scheme experts anticipate annual increase of around 7 to 9% by 2026 in the price of European Union Allowances (EUAs). Despite a recent downward revision in their forecasts, these experts still project medium to long-term growth in EUA prices. On average, they predict prices of EUR 93.85 and EUR 109 for the years 2025 and 2026, respectively.
EUA prices were falling in the last months of 2023 due to factors like increased renewable generation, restored French nuclear capacity, and lower natural gas prices. Even if these trends can still be observable in 2024 (quite unlikely), the pace is expected to slow down. In 2024 and on, as the focus shifts to complete industrial decarbonization, substantially higher carbon prices will be needed than the current €70 per tonne.
Sources:
The European Environment Agency, 2023. Use of auctioning revenues generated under the EU Emissions Trading System.The European Commission, 2023. Reducing emissions from aviation
The European Commission, 2023. Scope of the EU Emissions Trading System
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