Does the EU ETS have an environmental impact?

The combined set of policies of the European Union to make the bloc climate neutral by 2050 is the European Green Deal. Within it, the “Fit for 55” policy package aims at reducing emissions by 55% from 1990 levels by 2030. The achievement of both these goals rests on the success of the EU ETS.

The European Union Emissions Trading Scheme (EU ETS) is the cornerstone of the EU’s climate and energy strategy since 2005. It has proven to be a fair and efficient policy tool to curb greenhouse gases cost-effectively on a massive scale.  

Over the past two decades, the scheme has demonstrated its relevance, as it is credited with a 41% reduction in industrial emissions.

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• The EU ETS, the cornerstone of Europe’s strategy to fight climate change
• The mechanism of EU ETS to deliver impact
• Accelerating emissions reduction by investing in allowances

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The EU ETS, the cornerstone of Europe’s strategy to fight climate change

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A brief history of climate change legislation

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Background to the EU ETS

The root cause of global warming is the massive emission of greenhouse gases - mostly carbon dioxide (CO2) and methane - caused by human activity. This is what we call anthropogenic emissions. They come, in large part, from the combustion of fossil fuels (gas, coal, oil) but have also other sources like livestock, refrigerants, or fertilizers.

Releasing these gases with a greenhouse effect warms the planet, inducing massive damages to societies and ecosystems. These damages are negative externalities, because it is these damaged ecosystems and societies that bear the costs, not the one responsible We know since the early 20th century that negative externalities are best managed by shifting the costs - the economic value of the sum of damages aforementioned - back to the initial emitters. This was made evident by economist Arthur Pigou.

The first large scale, empirical evidence proving Pigou right was in the early 1990s in the United States.  At the time, there were very high levels of sulfur dioxide and nitrogen oxides, causing acid rain, due to emissions from electric power plants. The Environmental Protection Agency (EPA) launched an emissions trading scheme called the Acid Rain Program, a market-based program to curb these gases through price incentives. In less than a decade, lasting improvements in air quality were measured, as well as reduced mortality rates.

The 1990s was also the decade global governments recognized the need to thwart human interference with the climate system. In 1992, 154 states signed the United Nations Framework Convention on Climate Change (UNFCCC), whose ultimate objective was the “stabilization of greenhouse gas concentrations in the atmosphere” (UNFCCC Article 2). It is the UNFCCC that instituted the annual Conference of the Parties, or COP, which meets annually.

The implementation measures followed years after, when world governments signed the Kyoto Protocol in 1997. In order to achieve its goals, the European Union put in place a market for emissions allowances between industrial installations: the EU ETS. Over time, it became the largest, most mature, and most sophisticated carbon market globally, and an inspiration for other jurisdictions around the world.

The EU ETS has witnessed multiple reforms, improvements, and modifications in order to become the centerpiece of the EU’s climate policy.

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The EU ETS within Fit for 55

Mid 2021, the European Commission presented the Fit For 55 legislative package in order for the EU to reduce its net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels. The package covers all sectors of the Economy and has multiple measures, many of which are already adopted at time of writing. It conforts the EU ETS as the main tool in addressing emissions reductions. It is Europe’s collective response to the pressing need for a fast-paced yet socially conscious transition to a climate-neutral economy by 2050. Its provisions aim not only to ensure emissions reduction but also to strengthen innovation and competitiveness in EU industries.

The new policy package makes the EU ETS even more ambitious:

• Extension of the scope to maritime transport
• Faster reduction of allowances every year and phase-out of free allowances to certain sectors
• Increased funding to the Modernisation fund, Innovation Fund, and Social Climate Fund
• All revenues generated by the scheme must be spent on climate policies

In order for Europe as a whole to achieve 55% reduction, the industries covered by the EU ETS must reduce their emissions by 62%.

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A track record of emissions reduction in Europe

Having launched the EU ETS in 2005, there is a track record of close to twenty years on which we can evaluate the efficiency of the market-based policy, and its political support. From 1990 to 2021, the EU-27 achieved a 30% reduction in net GHG emissions, even as it faced a number of political, economic, and social challenges. Data for 2022 suggests an additional 1.9% reduction, contributing to the overall aim of a 48% decrease by 2030 compared to 1990 levels.

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The EU ETS has demonstrated its efficiency

Emissions from stationary installations under the ETS experienced a notable 41% decrease between 2005 and 2023. They were primarily influenced by the decarbonization of the power sector, where the cost of abatement technologies is the lowest. As the number of available allowances decrease and their unit price increase, other sectors will have a strong economic incentive to reduce emissions.

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A 2020 study investigates the effectiveness of EU ETS in reducing emissions, saving over 1.2 billion tons of CO2 between 2008 and 2016 compared to a scenario without the EU ETS. Since then, the EU ETS has continued to mature and evolve, especially since 2018: Over the past 6 years, the price of EU Allowances have been multiplied by 10. Higher prices mean that more low-carbon solutions and technologies become economically competitive. Therefore, The environmental impact of the EU ETS is directly linked to its price levels, and has still a lot of potential ahead.

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The mechanism of EU ETS to deliver impact

The EU ETS Cap: a definition

The EU ETS Cap is the upper the limit on the number of European Union Allowances (EUA) issued in a year by the EU Commission. It constitutes the supply-side of the EU ETS market. Each allowance represents one tonne of CO2. Companies must hold EUAs equivalent to the quantity of CO2 they emitted during the year, and surrender them back to the EU at the end of the year.

The cap gradually decreases over time to achieve a 62% net emissions reduction below 2005 levels by 2030. This reduction follows a rate, or “linear reduction factor” (LRF), currently at 4.3% per year, increasing to 4.4% (between 2028-2030).

In order to have a common unit, all covered greenhouse gases have been converted to an equivalent warming potential than CO2. The Global Warming Potential (GWP) of CO2 is 1. The GWP of methane for example is approximately 30. All these gases are measured in CO2-equivalence, so one tonne of methane would be 30 tonnes of CO2-eq.

Higher prices mean lower emissions

Why should we price carbon

Setting a price on carbon drives emissions reductions by assigning a monetary value to the damages caused by greenhouse gas emissions: Each tonne of greenhouse gas represents a cost.

It is only by associating a cost to each tonne of CO2 or equivalent that industrials will have a real incentive to lower their emissions. With a carbon price, there is a trade-off between pollution and decarbonation. As the carbon price increases, the trade-off becomes increasingly favorable to decarbonation. For that to happen however, there needs to be a clear mechanism of price appreciation, hence the progressive cap (i.e.: supply) reduction. Different industries will invest in decarbonation solutions at different price points, depending on the availability and cost of these solutions.

Carbon price in the EU ETS: market-driven approach

Carbon pricing can be implemented through tax-based systems, where the price is set, or through market-based systems, where the price is the equilibrium between supply and demand.

The market-driven approach is more complex to implement. However, it is more fair and efficient, as it allows emissions targets to be met in the most cost-effective way. The carbon price will reflect the value at which enough emissions can be reduced at a given level of supply.

Having a carbon price lets the market dynamically allocate the decarbonation effort where it is the cheapest and most effective, without excessively penalizing those for whom decarbonation solutions are too costly. It is more flexible and adaptable than the brute-force approach of a tax.

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The European Allowance Market

In order to hold the EUAs, companies under the scheme purchase them through daily auctions or trade them on the market on exchanges or over-the-counter. Some companies, in some sectors, receive a share of their required allowances for free. We call this the free allocation. These free allocations are being progressively phased out. It will increase the incentive to reduce emissions as free allowances approach zero by 2030 for most sectors. The cap mechanism encourages companies to invest in emission reduction strategies as it put pressure on the price of each individual allowance over time: Market participants expect future prices to be higher than current prices due to the increase in scarcity.

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Adjusting supply ex post

One of the initial challenges of the EU ETS Market design was that the supply is predetermined. Therefore, there can be a big gap between set supply and actual demand. This was notably the case after the 2007 financial and economic crisis. The gap between available supply and actual demand created a supply surplus, which deflated prices. That surplus accumulated over time, threatening the entire market.

To address this situation, the EU ETS has implemented an adjustment mechanism. This mechanism aims at maintaining a tension between the available supply and the actual demand. Called the Market Stability Reserve (MSR), it absorbs excess supply when there is a surplus. If there is too much tension in the market, it makes allowances from its reserve available. This measure not only helps prevent an oversupply of allowances but also contributes to a more balanced and effective carbon market.

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Accelerating emissions reduction by investing in allowances

The price effect

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Accelerating investments in decarbonation by industries

As more investors buy and hold carbon allowances, they decrease the available supply and “tighten” the market. This subsequently drives up the price of carbon. This rise in price serves as a powerful economic incentive for industries to reduce their emissions, encouraging the adoption of cleaner and more sustainable solutions. The higher the price, the more investment in decarbonation solutions by carbon-intensive companies.

In turn, this makes decarbonation companies more competitive and generates demand for their products and services. It helps create a transfer of wealth, from carbon-intensive companies to low-carbon companies.

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Generating fiscal revenue earmarked for climate spending

The EU ETS is a compliance scheme: European allowances are issued by the European Commission through a daily auction. The revenue generated by these auctions is then distributed back to Member States, which have the obligation to use this revenue for climate spending. The higher the prices of allowances, the greater the climate budget.

The withholding effect

Tied to the price effect is the withholding effect. Every allowance held by an individual investor is a allowance taken away from the market for the entire holding period, and therefore made unavailable for polluters.

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The cancellation effect

Within the adjustment mechanism of the EU ETS, the cancellation effect plays a crucial role in balancing the available supply. This involves canceling a portion of allowances each year, preventing the overaccumulation of permits and helping to stabilize carbon prices in the market. The portion of allowances cancelled depends on the number of allowances held in accounts of market participants. Therefore, the greater the number of allowances held, the more allowances are cancelled.

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The frontloading effect

By investing in allowances today and divesting in the future, we flatten the supply curve. This means that we accelerate the efforts now, while giving future generations more flexibility. This gives the market a greater chance of success, by spreading the effort more evenly over time and ensuring we have a head start.

We’re “loading” the effort now so that we can reap the benefits tomorrow and make sure we’re not pushing back keep decisions.

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