EU emissions trading: Fewer allowances, more climate action

In order to keep the increase in global mean temperature below 2˚C and avert the harmful consequences of climate change, industrialised countries must reduce their greenhouse gas (GHG) emissions to close to zero by 2050. Emissions trading is an instrument used to meet these long-term climate targets and was introduced in the European Union for all member states on 1 January 2005.

The “cap and trade” principle

Energy sector companies and industrial installations must submit sufficient emission allowances to cover their greenhouse gas emissions. One European Union Allowance (EUA) gives the holder the right to emit one tonne of carbon dioxide (CO2), or the equivalent amount of other greenhouse gases. The total number of allocated emission allowances is limited (cap) and decreases every year.

The fundamental premise is that CO2 emissions should be reduced wherever this can be achieved most cost-effectively. For example, operators can technically improve their plants so that greenhouse gas emissions fall. If they fail to do so, they may have to purchase additional allowances. The allowances are freely tradable (trade) and are placed on the market at public auctions.

Since 2013, energy industry companies have been required to purchase all the allowances needed to cover emissions associated with power generation, whereas the majority of industrial installations continue to receive a free allocation of allowances for a proportion of their emissions. This is due to concerns that companies may otherwise be tempted to move their energy-intensive production out of the EU if costs rise too high. Aviation has been included in emissions trading since 2012.

Surplus of allowances pushes down prices

In the first trading period (2009-2012), the supply of allowances on the market substantially exceeded the demand, which resulted in lower prices for emission allowances and limited the commercial incentive to invest in efficient, low-carbon technologies. This increased the risk of a “carbon lock-in”, with firms investing in carbon-intensive technologies that remain in operation for many years.

In response to the surplus, a number of allowances (corresponding to 900 million tonnes of CO2 in total) were held back during the 2014-2016 period. This “backloading” measure proved effective: since 2017, prices have risen as the surplus of allowances has declined. The unallocated certificates are placed in a Market Stability Reserve (MSR), which will start operation in 2019 and is intended to make the EU ETS more resilient to future shocks.

In 2018, European law-makers decided to delete a proportion of the surplus held in the Market Stability Reserve. They also agreed that national measures implemented by member states may count towards auctioned amounts. After this decision, the price of emission allowances rose sharply again, reaching 20 euros per tonne CO2 eq. in September 2018.

Since the European Union’s Emissions Trading System (EU ETS) came into being, the Oeko-Institut has advised the German Government, the European Commission, businesses and environmental associations on how it can be improved and developed further. Oeko-Institut experts have thus played a key role in the introduction and evolution of the EU ETS.

Monitoring ETS emissions and market conditions

Within the European Topic Centre framework, Oeko-Institut researchers analyse the ETS data for the EEA ETS data viewer on behalf of the European Environment Agency (EEA). They also prepare the annual report “Trends and projections in the EU ETS”, which presents the development of emissions trends in the Emissions Trading System.

Besides tracking general trends, the report focuses particularly on monitoring developments in individual sectors and also analyses the balance between supply and demand of allowances in the market. National greenhouse gas projections are presented and their impacts on the EU ETS considered.

Study: “Trends and projections in the EU ETS in 2018” for the European Environment Agency

Aviation in emissions trading

Greenhouse gas emissions from aviation have been rising unchecked for many years. The EU therefore decided to include aviation in emissions trading in an effort to curb this growth. As the free allocation of emission allowances does not cover all the greenhouse gas emissions produced, most aircraft operators are required to purchase allowances at auction or acquire them from stationary installations under the Emissions Trading System.

With the decrease in supply and the increase in demand for allowances resulting from economic growth, the inclusion of this sector is reducing the surplus of allowances. The Oeko-Institut provides advice on many aspects of aviation, including all issues relating to emissions trading and the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), i.e. the global system to limit and offset emissions from the aviation sector, which was approved by all the UN member states in 2016.

Study: Weiterentwicklung des EU-ETS im Luftverkehr vor dem Hintergrund der Einführung einer globalen marktbasierten Maßnahme durch die ICAO (Further development of the EU ETS in aviation in the context of the ICAO’s introduction of a global market-based measure)

Studies on carbon leakage

On behalf of the European Commission, the Oeko-Institut, in collaboration with Trinomics and Cambridge Econometrics, has investigated sectors where there is a high risk that emissions-intensive businesses will transfer production to other countries with lower environmental standards (this is known as “carbon leakage”). Instead of purchasing allowances and investing in efficiency increases, the businesses shift their production to non-EU states.

This undermines the objective of emissions trading, which is to cut global CO2 emissions. Only worldwide efforts to reduce greenhouse gas emissions will limit global warming. In addition, the out-migration of industry has an adverse effect on the European economy.

The Carbon Leakage List

Businesses with a high carbon leakage risk are placed on an official EU list and benefit from special arrangements, including a higher free allocation of emission allowances.

In order to determine which energy-intensive businesses are most at risk and should therefore be included on the list, the carbon leakage indicator is applied according to a precisely defined methodology. The carbon leakage indicator is defined as the product of a company’s intensity of trade and its direct and indirect emission intensity. Further methodological controls compare the resulting data with those set out in the previous Carbon Leakage List. Only then is a decision taken on whether a business should be placed on the list for subsequent years.

Study: “Carbon Leakage List – Methodology for the Quantitative Assessment” on behalf of the European Commission