Free allowances in the EU ETS have several purposes - educating stakeholders on “the rules of the game” in the initial stages of the scheme, safeguarding against threats to industrial competitiveness, and preventing inflationary pressures induced by high carbon prices. The 2024 State of the EU ETS report sees the introduction of the Carbon Border Adjustment Mechanism (CBAM) and the forthcoming phase-out of free allocation as successes. Those mechanisms are aimed at protecting against carbon leakage and increasing EU ETS revenues. However, some organizations who were present at the launch event of the report in Brussels, like Carbon Markets Watch, advocate for a more ambitious phase-out to maximize the financial incentive for decarbonization efforts. As free allowances are gradually phased out after 2024, upward pressure on prices can be introduced in the market, leading to increased demand for EUAs and tightening the market, ultimately driving more investments in emission reduction measures from industries.
The primary market in the EU ETS is where EU regulators issue carbon allowances either through auctions or free allocation. This have several purposes:
In its “Key Takeaways” section, the 2024 State of the EU ETS report states that:
Researchers illustrate that since 2013, free allowances have primarily been channeled towards the industrial sector to uphold its competitiveness and curb excessive inflationary pressure. Indeed, in the combustion sector, nearly 90% of emissions are not covered by free allocations - the freebies have been rapidly phased out for the power sectors.
In the 2023 recap of the main regulatory developments of the report, reforms concerning free allowances are around an improved phasing-out schedule. The purpose is to gradually reduce them (but at a faster pace, still) and to eventually eliminate these allowances. There will be no more free allocations for most sectors by the end of 2034.
Some organizations actively advocate for an even more ambitious phasing-out of free allowances in the EU ETS. A representative from Carbon Markets Watch, present at the 2024 State of the EU ETS launch event, emphasized that while the market is already being improved, there is still room for enhancement. They suggested that the significant difference between supply and demand in 2023 (RepowerEU volumes) and the continuation of free allowance allocation are not maximizing the EU ETS incentive for decarbonization efforts.
As the phase-out of free allowances becomes more ambitious and some stakeholders push for a faster pace, upward pressure on prices can be introduced in the market. With fewer free allowances available, there will be increased demand for EUAs. Additionally, the end of additional supply volumes after the RepowerEU intervention will further reduce supply. This combination of reduced supply and increased demand due to fewer free allocations will strengthen the market, resulting in upward price pressure.
Stakeholders like Carbon Markets Watch advocate for an even more ambitious phase-out of free allocation to adhere to the "polluter pays" principle. The aim is to maximize the financial incentive for industries and power plants to decarbonize, without jeopardizing the EU economy. With fewer free allocations and higher prices, installations are expected to invest more in emission reduction measures, aligning with the overarching goal of incentivizing decarbonization efforts.
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