EU ETS Basics How a Market Can Help Reduce GHG Emissions

7 March 2022 18:24 RaboResearch

Urgent decarbonization requires significant investments. The EU’s carbon market, the EU ETS, was deployed in 2005 to enable them. This paper covers its story and basic principles, and how can it help trigger decarbonization investments.

Netherlands, Bruinisse, Mussels farming in Oosterschelde or Grevelingen estuary. Background Grevelingen Dam, part of Delta works and windmills

Pricing Carbon to Save the Climate

By now, the need to take urgent action to curb greenhouse gas (GHG) – mostly CO2– emissions is an accepted reality known worldwide. The first worldwide Conference of the Parties (COP) of the United Nations Framework Convention on Climate Change (UNFCCC) was organized back in 1995 with the aim to coordinate globally the fight against climate change. The signing of the first worldwide pledges to reduce GHG emissions followed in 1997 in Kyoto. The Kyoto Protocol set legally binding GHG reduction targets. Its first commitment period ranged from 2008 to 2012. The signing of the Kyoto Protocol triggered the still ongoing discussion on which policy instruments could be used to engage or encourage the private sector in achieving national emissions reduction targets.

Reducing emissions is far from being a straightforward task that can be achieved from one day to the next, especially in heavily oil-based economies. Within the Kyoto Protocol, three types of mechanisms were considered to articulate emissions reductions: the clean development mechanism (CDM), joint implementation (JI), and emissions trading (ET). The first two originated the so-called “flexibility mechanisms” or “voluntary carbon markets.” (Their role in emissions reduction is analyzed in this paper.) The mandatory mechanisms – or carbon pricing instruments (CPI) – can be divided among carbon taxes, which impose a levy on certain products based on their carbon content, and carbon markets, where the national amount of emissions available would be distributed according to mixed policy and market criteria. The main characteristics of key CPI instruments can be found in this report (in Dutch) from RaboResearch.

Box 1

Historically speaking, uncontrolled GHG emissions have been analyzed as a type of market failure, the result of an “environmental externality.”

The term was first recorded in the OECD dictionary in 1997 as an “economic concept of uncompensated environmental effects of production and consumption that affect consumer utility and enterprise cost outside the market mechanism.”

Some players may include in their decision-making process the consequences of deteriorating the environment when they do not feel a corresponding loss of value reported back to their balance sheet.

The Challenge Behind Emissions Reduction Investments

Confronted with the need to reduce emissions, governments, companies, and individuals face an equally complex task. To begin with, which actions and technologies can deliver the required reduction? And what investments do those technologies require?

For each stakeholder – a country, a city, or a company – there are different combinations of technologies that could deliver the sought emissions cuts. This menu of possible investments is often shown in the form of sectorial marginal abatement cost curves (MACC), popularized by McKinsey around 2007. Figure 1 shows one MACC example, representing the decarbonization technologies available for the city of Toronto and their cost effectiveness.

Figure 1. MACC curve for the city of Toronto, 2020

Source: Ibrahim, Nadine, and Christopher Kennedy, "A Methodology for Constructing Marginal Abatement Cost Curves for Climate Action in Cities,” 2016

In a MACC, the technologies available to reduce emissions in the considered context are displayed as squares. The height of the square shows the cost of the technology, in USD/metric ton of reduced CO2 emissions. The width of the square, along the horizontal axis, depicts the emissions reduction that the technology can achieve in megatons CO2 (MtCO2). The technologies are sorted along the horizontal axis in increasing cost order.

This layout clearly shows, for example, how many MtCO2 can be reduced with actual economic returns on the investments. Crossing the point of zero cost, the remaining options involve a cost.

The no-brainer, urgent investments are those that can deliver both an emissions reduction and an economic return. These are typically energy-efficiency related, like replacing light bulbs with LEDs or improving insulation by replacing wood-made windows with double glazing. The investment is rapidly repaid thanks to the energy savings.

Unfortunately, this “no-brainer” group of technologies can only deliver a certain amount of emissions reduction. If more reductions are needed, technologies with a negative return (a cost) have to be considered. If emitting CO2 is allowed for free, companies will not have any economic incentive to venture into such investments. They need to be persuaded in other ways.

Giving GHG emissions an economic value allows societies to achieve higher GHG emissions reduction than only sticking to the no-brainer group of technologies. It also enables more diverse choices with regard to when, how much, and where to invest in emissions reduction.

Trading Emissions Rights to Enable Investment Flexibility

Science tells us that only a limited amount of additional MtCO2 can be emitted before the climate may cross a point of no return. We are confronted with environmental, technological, economic, and also societal choices. These dilemmas are solved in different ways, depending on the degree of a central (governmental) authority’s intervention.

Central authority planners, especially in non-market economies, may set mandatory targets and assume or place the investments themselves, hoping to achieve the desired reduction.

In market-based economies, two families of CPI can be used. On one hand, indirect guiding tools such as taxation or levies can be set. They must be properly adjusted to discourage emitting activities (a full-fledged analysis of carbon taxes and their impact can be read in Dutch here). On the other hand, a market approach can be used. Emissions rights markets can help distribute the emissions reduction targets across agents in a more adaptable way. Their main working principles are depicted in Figure 2.

Figure 2. Basics of emissions rights trading

Source: European Union, “EU ETS Handbook,” 2015

A national authority determines how much GHG companies in the covered sectors can emit during a given period, typically on a yearly basis. This maximum or “cap” is sliced into “emissions permits” or “rights” distributed to companies. To facilitate a smoother transition to carbon pricing for participants, rights can be initially given to companies for free (“freely allocated”). As the market matures, fewer rights are freely allocated and a bigger share is auctioned. In this way, the pressure to address the required investments is gradually set on companies. The firms covered by the market have to ensure that, at the end of the period, they have acquired an amount of emissions rights matching their realized emissions. The rights have to be given back (“surrendered”) to the authority. If they can’t surrender enough rights to cover their actual emissions, they typically face prohibitive fines.

Trading emissions rights between companies and across sectors helps accommodate different decarbonization speeds. In the example in Figure 2, company A decides to invest in a more costly but less carbon-intensive technology sooner than their competitors. Therefore, company A needs fewer rights than those initially allocated to the companies in its sector, and it can trade its excess rights in the market. The resulting income can help them finance the investment. In this way, the market incentivises the laggards, like company B, to make decarbonization investments and lower emissions. The price signal of the emissions rights helps companies and other economic agents to freely design strategies to cut their emissions. However, the higher the price of emissions rights, the bigger the competitive advantage for leaders and the greater the economic push for laggards to start investing in decarbonization.

The flexibility to distribute the transition commitment for companies across different adaptation speeds is the main argument for those supporting market schemes over tax-based ones. It also helps to reduce the cost of decarbonization, as emissions will first be reduced by companies that can more easily adapt.

EU ETS Leads the Way, the World Is Catching Up

The role that carbon markets and other carbon pricing tools can play to help reduce emissions is recognized in Article 6 of the Paris Agreement. Building on this global recognition of their potential contribution, the World Bank identified 64 CPI being used worldwide in 2021. Combined, these instruments cover just above 20% of the world’s GHG emissions.

Of all the global CPI, 31 are emissions trading systems. Figure 3 shows the evolution of global GHG emissions coverage by the different ETS. The EU Emissions Trading System (EU ETS) is only behind China National ETS in terms of traded volume, and the EU market has shown the strongest price signal in recent years.

Figure 3. Share of global GHG emissions covered in regional, national, and subnational carbon pricing initiatives

Source: World Bank, 2022

The EU ETS kicked off in 2005, covering large GHG-emitting sectors, such as power production, and energy-intensive industries, like cement and glass. It currently covers the emissions of more than 11,000 companies across the EU.

During its initial phase, from 2005 to 2007, GHG emissions rights were freely given. During these years, IT and regulatory systems were being built to start measuring and understanding the emissions of covered sectors. From 2008 to 2012, the first binding national targets were set to meet the EU’s global commitments to the Kyoto Protocol. Ninety percent of EU ETS emissions rights were still provided for free.

Figure 4. Deployment phases of the EU ETS.

Source: EEA, October 2020

In the third phase, from 2013 to 2020, all of the EU national markets were connected at the EU level. During this phase, only 47% of the emissions were freely given. This period was also characterized by very low allowance prices. This was partly a result of an over-allocation of rights (the “cumulative surplus”) and partly a consequence of the reduced economic activity caused by the aftermath of the financial crisis.

During the first two phases, the priority of policymakers was to ensure that the required reductions were achieved without imposing a very heavy burden on industries. But, the third phase made clear that, in order to be fully functional and to significantly unlock the necessary decarbonization investments, the EU ETS also needed to provide a stable, strong price signal. In this way the Market Stability Reserve (MSR) rule was added in early 2019. The MSR is a predictable balancing mechanism designed to ensure that the EU ETS market doesn’t suddenly suffer from an oversupply or shortage of GHG emissions rights due to unexpected shocks to economic activity. The fourth and current phase, covering the 2021 to 2030 period, comes to further increase the emission reduction ambition of the EU ETS. Among other factors, this strengthened ambition pushed the market towards higher price levels over the past year.

A Consolidated ETS Still Faces Challenges Ahead

Having finally achieved, significant price levels, the EU ETS is attracting increasing interest from all the involved agents. The companies covered by the ETS are beginning to perceive a significant economic signal prompting them to consider GHG emissions reduction investments. At the same time, financial investors are turning to what they consider a liquid market. In parallel, taking note of the potential impact that a strong ETS can have in the competitiveness of the EU industry, the European Commission has proposed the Carbon Border Adjustment Mechanism (CBAM). CBAM is a levy-based mechanism aimed at protecting EU companies covered by the ETS from unfair competition from regions that do not have similar mechanisms. The fundamentals of the CBAM and its potential impacts are also discussed in another recent report by RaboResearch.

In a nutshell, the EU ETS has been the world-leading ETS since its inception. As a first of its kind, its deployment has proven the need for adjustments along the way to make it relevant and efficient. The need for adjustments is likely to persist until the market approaches its final phase. That would be reached when a very decarbonized economy no longer buys emissions permits to continue emitting.

In our follow-up publication, we dive into further analysis of the current market circumstances that are driving EU ETS prices to never-seen-before levels.