In July, the European Commission unveiled the first part of its Fit for 55 package. The centrepiece of this package is a proposal for a revision of the EU Emissions Trading Scheme (ETS), accompanied by a proposal for the establishment of a Social Climate Fund (SCF). The ETS proposal sets an emissions reduction target for 2030 of 61% compared to 2005, in the sectors covered by the scheme, up from a target of 43% set in 2018. It aims to extend a carbon price signal to over two thirds of EU greenhouse gas (GHG) emissions by 2030. The proposal contains significant and controversial changes, and the road ahead for the Commission will be a bumpy one.

Background

The EU ETS was set up in 2005, as the first emissions trading scheme operating at the international level. It is a cap-and-trade system, in which an overall cap of the amount of certain GHGs that can be emitted by industrial and energy installations subject to the ETS – which covers only certain sectors and installations – is set and reduced over time. Within this cap, installations can buy emissions allowances and trade them between each other. Each year, installations have to surrender allowances (one for every tonne of carbon emitted) corresponding fully to their emissions in the previous year. If they fail to do so, significant fines could be imposed on them. By putting a price on emissions, the reduction of emissions and investment in low-carbon technologies is encouraged.

Allowances should, in principle, be allocated through auctioning. However, currently only a certain amount of allowances are auctioned and the rest are allocated for free. That is, although there is an overall limit to allowances, installations do not actually have to pay for some of their emissions. The reason for free allocation is primarily the protection of certain industries from carbon leakage. The share of free allowances has been reduced over time, but in the 2013-2020 trading period still only 57% of the total amount of allowances were auctioned.

The ETS has undergone several evolutionary phases, to address particular issues and align the scheme with EU climate targets. A significant issue in the initial phases was the large surplus of allowances leading to a lower price of emissions – related in part to a high overall emissions cap, a large share of free allowances, and the economic crisis which resulted in reduced industrial activity – overall creating weaker incentives to reduce emissions. To correct this, a Market Stability Reserve was put into operation in 2019 to address supply-demand imbalances in allowances and ensure a stability in the carbon markets.  

Aside from this, one of the key concerns regarding the ETS has been its potentially regressive effects, particularly on lower-income households, affecting some Member States more than others. There are also concerns over impacts of carbon pricing on workers in particularly affected sectors.

Main proposed changes

The overall cap in emission allowances is reduced each year by a certain percentage, the so-called linear reduction factor. The Commission proposes an increase of the linear reduction factor from 2.2 to 4.2% from 2024, the foreseen entry into force of the revised legislation. That is, the cap will be reduced by a greater amount each year than previously. This will be accompanied by a one-off reduction of the cap, which will have the same effect as if the 4.2 % factor had applied from 2021. After the expansion of the ETS to aviation in 2012, the Commission is now also proposing to extend its scope to maritime transport. This would apply to all emissions of intra-EU voyages and half of the emissions of extra-EU voyages, to be phased in by 2026. The scheme will not, however, be extended to extra-EU flights.

Free allocations will be phased out within 15 years, with a reduction of 10 percentage points per year from 2026. This is to happen alongside the entry into force of the proposed Carbon Border Adjustment Mechanism (CBAM), intended to address carbon leakage concerns. From 2026, free allocations will also be conditional on decarbonisation efforts, with a potential reduction of up to 25% where conditions are not met. All revenues from auctioned allowances – where they are not attributed to the EU budget – must be used for climate-related purposes, including support for low-income households.

The Commission also proposes a separate ETS for buildings and road transport. These sectors are and will continue to be covered by the Effort Sharing Regulation, which is also subject to revision. This scheme will apply to the release for consumption of fuels used for combustion in the sectors of buildings and road transport, that is, to fuel suppliers. However, this will also result in price increases for consumers, with regressive effects and differing impacts across Member States, exposing vulnerable households to a risk of energy poverty. While there is no common European definition on it, several indicators illustrate energy poverty, which has been a serious problem in many Member States. For example, more than 7% of the population of the EU27 – ranging from less than 1% in Austria to more than 30% in Bulgaria – had financial difficulties to keep their homes adequately warm in 2018. For this reason, the Commission proposes that 25% of revenues generated by this scheme are allocated to the SCF and used to support financially vulnerable households, micro-enterprises and transport users, as well as to promote emission-reducing investments.

The revised and newly added sectors to the ETS will be incorporated into the calculation of total allowances within the Market Stability Reserve to better reflect the supply and demand in allowances and reduce potential surpluses in the overall system. The proposed package is also supposed to improve resilience to major shocks in the markets by providing long-term predictability of the mechanism via stronger carbon price signals and lower price volatility. 

Furthermore, nearly €20 million for the Innovation Fund over the 2020–2030 period is proposed to support innovative commercial projects in promoting low-carbon technologies or processes (e.g. carbon capture, energy storage, innovative renewable energy generation) as part of the green transition. Additionally, the Modernisation Fund will support 10 Member States with relatively lower income by contributing to investments in modernisation of their energy systems (e.g. generation of renewable energy sources, energy storage, modernisation of energy networks) and improving energy efficiency. Similar to the SCF, part of the revenues generated from the auctioning of ETS allowances will be earmarked to these funds.    

Challenges ahead

The new ETS for buildings and road transport is one of the most hotly contested aspects of the proposal. It faces opposition from many sides, not only from within the Commission but also from the ETUC and organisations such as the European Environmental Bureau or Carbon Market Watch, because of the effects it is likely to have on consumers, particularly on low-income households.  

Despite its main objectives, the ability of the SCF to mitigate the social impact of this new scheme has been questioned. The share of revenue designated for the fund – €72.2 billion between 2025 and 2032 – seems far from sufficient to address the challenges that the scheme is likely to pose. Furthermore, the lengthy process of funds deployment, as seen from the experience of Recovery and Resilience Facility disbursements to Member States, raises questions about the rapidity and efficiency of timely support to citizens, who will be subject to increasing prices in heating and transport sectors sooner than later.  

Critics of the proposal have also highlighted the insufficient implementation of the ‘polluter pays’ principle, with continuing free allowances to heavy industry. It is claimed that taxpayers will have to pay for pollution, rather than industry, thus leading to fears that the proposal will cause backlash  citizens. Particularly given the separate ETS for buildings and transport – which does not foresee free allowances – the continuation of free allowances over as much as 15 years might lead to resentment of the fact that citizens are treated differently from companies, which have been benefiting from free allowances over the last decades. 

From the workers’ side, the ETUC argues that the revised ETS needs to be accompanied by efforts to address the social consequences, including the impact on workers in affected industries and regions to avoid job losses. It is, overall, not in favour of extending the EU ETS to road transport and buildings due to concerns about distributional effects. It draws attention to the sector-specific considerations during decarbonisation pathways and highlights the need to use complementary tools rather than solely focusing on carbon pricing mechanisms.    

Finally, there are diverse reactions from industry. While it welcomes the overall ambition of the Commission towards a net-zero future, BusinessEurope remains cautious about the full details of the package and possible inconsistencies between different legislative measures. The European Automobile Manufacturers’ Association (ACEA) appreciates the extension of the ETS to road transport fuels, as it will increase the visibility of carbon pricing, but it also points to challenges in reaching the proposed targets within tight deadlines, stating that these targets are not viable without significant additional efforts by all stakeholders, including Member States and relevant sectors. 

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