Brussels sets out path for EU ETS reform: Now the big battle begins

The EU ETS – which puts a price per tonne of the CO2 polluters emit – has been credited for reducing emissions in the power sector, for example by incentivising fuel switching from coal to natural gas. But with prices currently hovering around EUR 80/tonne, the system has also come under criticism for driving up costs, including for industry which on average receive 75% of allowances for free.

On Friday, the European Commission proposed a set of changes to the ETS in a bid to ensure heavy industry receive free allowances for longer while at the same time making the system more immune to price spikes.

Among the key proposals is to reduce the Linear Reduction Factor (LRF) from the annual 4.4% rate currently to 3.7% for 2031-2035 and 1.7% for 2036-2040. This means that the supply of new allowances to the market would continue beyond 2039 when auctions were originally scheduled to end.

Moreover, free allocation of allowances for industry will continue beyond 2030 but on the condition that an amount equivalent to 100% of their value is invested into decarbonisation in the EU.

Although the EC’s proposal has been criticised for weakening the EU ETS, the jury is still out on how deep the reforms really cut. Prices for carbon allowances actually rose after the announcement, having softened earlier in the day. At the time of writing, carbon prices were still close to EUR 80/tonne, indicating that the proposed changes are not seen as overly radical by the market.

Another observation is that the response from heavy industry has been mixed, with the chemicals industry, for example, criticising the EC’s proposal to make the allocation of free allowances subject to investment obligations.

The real battle begins this autumn when co-legislators in the European Parliament and the Council of the EU will try to hammer out a final deal by March next year. Opinions on ETS reforms diverge substantially, with Italy previously having called for a suspension of the system altogether while other Member States, Spain and Sweden among them, have called for strengthening the ETS.

What now for the gas sector?

ETS reform was one of the main topics discussed at a Eurogas event in Brussels on 1 July and there was broad consensus that reforms were needed.

Giusi Squicciarini, General Manager for Regulatory Affairs at Shell, which has been trading ETS allowances since 2005, said the system should allow for integration of international carbon credits – generated by carbon abatement projects overseas – “as a way to achieve the 2040 targets in a more efficient way.”

Among other measures, she also said the Market Stability Reserve (MSR), which is designed to release allowances during market tightness, could be tweaked in order to react quicker to supply-demand imbalances and price spikes. To this end, the EC in its proposal from 17 July suggested international credits could be used from 2036 and that the intake rate of the MSR should be reduced from 24% to 12% for allowances to stay in the market for longer.

Others have flagged that the ETS reforms should not go too far and called for a targeted approach.

“From our perspective, the EU ETS has been a very important driver for emissions reductions in Europe,” Andreas Guth, Secretary General of Eurogas told Gas Outlook on the sidelines of the conference.

However, one sticking point, according to Eurogas, is that the proposed fallback benchmarks – which are based on how efficiently industrial companies use heat and fuel in the production process, and which are used to calculate how many free ETS allowances industrial companies receive – rely on a ‘one‑size‑fits‑all formula’ based on a handful of top performers. This does not reflect the reality of the thousands of very different industrial and heating installations that are covered by those benchmarks, according to Eurogas.

Guth added: “The review should focus on targeted changes that preserve a strong ETS, while addressing shortcomings in areas like benchmarks and ensuring companies that have already invested in reducing emissions are not penalised.”

Meanwhile, Jelmer Schut, Business Developer for CCS, Biomethane & Hydrogen at Tata Steel Nederland, told a panel debate at the Eurogas event that Member States’ revenues from auctioning ETS allowances should increasingly be channeled back to decarbonisation projects.

Schut said the easiest transition is switching from traditional blast-furnace, coal-based steel making through a Direct Reduction Plant and Electric Arc Furnace route to alternative fuels including hydrogen, biomethane and natural gas with Carbon Capture and Storage (CCS), but that this will not come cheaply.

“What you need is funds. The ETS was once thought of to actually give back to the industry to be able to decarbonise. We haven’t seen [auction revenues] coming back.”

On 17 July, the EC proposed that Member States will be required to spend 50% of their national ETS revenues on investments to decarbonise ETS sectors. It remains to be seen, however, if this proposal gets watered down during the final negotiations.

But others call for strengthening the EU ETS

Negotiations between the EU institutions are expected to commence this autumn under the stewardship of the Irish Presidency of the EU Council. There is a general expectation that the EU will ultimately decide to prolong free allocation of allowances to industry.

Still, many take the view that the EU ETS needs to be strengthened, not compromised.

Lidia Tamellini, Policy Officer at Carbon Market Watch, told a recent webinar hosted by the Florence School of Regulation that decreasing the LRF would lead to a massive oversupply of allowances and depress the ETS price.

“Decreasing the Linear Reduction Factor to 3.4% will release 1 billion metric tons of CO2 into the atmosphere by early 2040, from now to the early 2040s. This is massive. Decreasing it to 2.4% will release 3 additional billion of metric tonnes of CO2,” she said.

Tamellini also noted that in the period 2021 to 2024, net carbon costs for heavy industry has been around EUR 3.1bn, according to figures from E3G, while financial support including from the EU Innovation Fund and national support from Member States has been EUR 14 billion.

“So, the support industrial operators receive is much more than the costs they are subject to under the ETS.”