Free allowances in the EU ETS were provided during the early stages of the system's operation to ease the transition for compliance entities and preserve European industrial competitiveness. These allowances are allocated based on benchmarks tailored to specific sectors and products, ensuring uniformity across various installations. With the introduction of Phase 4 in 2021, the EU ETS became more flexible, allowing for annual adjustments in allocation to account for production fluctuations. There will be a phasing out of free allocations by 2034 for sectors not exposed to carbon leakage - a more ambitious rate of reduction was proposed in the 2023 regulatory revisions. Also, the Carbon Border Adjustment Mechanism (CBAM) introduced in 2023 and in operation after 2026, will be complementary to the phasing out schedule of free allowances. The EU ETS is meeting the European Climate targets through a “polluters pay” principle, holding CO2 emitters accountable for every tonne of carbon corresponding to their activities.
The EU ETS (European Union Emissions Trading System) began operating in 2005, and it has undergone several phases of development since then. We are currently in the 4th stage of operation, spanning from 2021 to 2030. In its early stages, the allocation of free allowances was a crucial component. Compliance entities were entering a new system with significant administrative and compliance burdens. The allocation of free allowances provided them with an opportunity to understand the workings of the cap-and-trade system without being overly burdened by immediate costs. It was a learning period, allowing participants to grasp the rules of the market. This approach ensured a smoother transition into a fully operational market-based system.
EU regulators also had to ensure that their efforts to reduce carbon emissions didn't harm European competitiveness. Introducing a carbon cost too abruptly, which would rapidly increase operational expenses for industries, risked inflating prices of EU products. This could potentially make Europe less competitive against countries where carbon costs aren't a concern. This showed the necessity of providing free allowances as a means to prevent such economic disruptions, especially in the first stages of the EU ETS.
Free allowances are distributed according to benchmarks tailored to specific sectors and products. These benchmarks are determined based on the carbon intensity of each product, using data from the top 10% performing installations. With 54 benchmarks corresponding to specific products, this methodology creates uniformity across different technological variations, fuel types, installation sizes, and geographical locations.
After the beginning of Phase 4 in 2021, the EU ETS became more flexible. It now enables annual adjustments in allocation to individual installations. These adjustments account for fluctuations in production levels, using a two-year rolling average. Other updates from the Phase 4 allocation of free allowances focuses more on sectors that are vulnerable to relocating production outside the EU to avoid carbon pricing expenses. These high-risk sectors will still receive free allocations in the years to come, but the CBAM is changing the picture for the rest (see below for more details). Less exposed sectors will see a more ambitious reduction in free allocation, diminishing to zero by the end of 2034. An updated list of sectors prone to carbon leakage was established in 2019 and remains valid until 2030.
The CBAM, or Carbon Border Adjustment Mechanism, is a proposed policy within the EU ETS (European Union Emissions Trading System) designed to address carbon leakage and ensure fair competition for EU industries subject to carbon pricing. It imposes tariffs on imported goods based on their carbon content, extending the carbon pricing mechanism beyond the EU borders. The CBAM aims to prevent the relocation of industries to regions with less stringent climate policies, protect the competitiveness of EU businesses, and maintain environmental integrity by aligning international trade with climate objectives and ensuring that imported products face similar carbon costs as those produced within the EU.
As the CBAM imposes charges on imported products to compensate for their carbon emissions, it reduces the need for free allowances, which are currently allocated to EU industries to mitigate the impact of carbon pricing. The CBAM will be introduced progressively, only covering a proportion of the emissions for the production of a certain product at first. Below is the detail of the phasing in rate of the CBAM, corresponding to a respective phasing out of free allocations:
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