EU ETS Reform: What’s to come for the mandatory carbon market

EU ETS reform

In a Decarb Connect Webinar held online on May 25th, ClimateTrade CEO Francisco Benedito and NWorld Partner Gregorio Gonzalo discussed upcoming changes in the EU ETS, and how companies can prepare for them.

The webinar, which you can watch here, couldn’t have been more timely: on May 17th, the EU Parliament voted in favor of a comprehensive reform of the EU ETS, in line with the Fit for 55 package. Among the changes included in the reform, Gonzalo pointed to seven key aspects:

  • Accelerating emissions reduction: cutting emissions by 60% by 2030 compared to 2005 baseline
  • New sectors covered by the EU ETS: maritime, road transportation and buildings
  • Increased coverage around aviation: all flights operated by EU-based aircraft
  • Carbon capture and storage: emissions captured could be deducted
  • Reinforcement of market stability: upper limit for number of allowances permitted to be in circulation, but also lower limit to ensure there are enough allowances in the market, ensuring supply and demand balance
  • All revenues from EU ETS should be destined to climate-related purposes, a boon for low-carbon technologies
  • Gradual phase-out of free allowances by 2030

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EU ETS price and demand impact of the reform

Speaking about the expected impact of this reform on EUA demand and prices, Benedito laid out some of the key pricing drivers: as global production and CO2 emissions decreased during the pandemic, there was a significant surplus of EUAs accumulated, which lowered the price of EUAs to about 36€ per unit. However, the war between Ukraine and Russia and the uncertainty around gas supply led to an increase in coal use for electricity production, which is highly polluting. As a result, the EUA surplus is fading away, and this reform will reduce EUA supply even more. 

In February 2022, the price of EUAs reached a record 98€ per unit, before the new reform was even adopted. Companies that need to buy EUAs to comply with emissions regulations are facing a declining supply of allowances in the coming eight years as free allocations are set to be phased out. In fact, the number of EUAs issued into the market each year is set to decline at 2.2% a year from 2021 through 2030. 

“Most analysts believe this will lead to a much smaller supply of EUAs. This month, EUAs are priced around 90€ and some analysts believe this price will reach 150€ in 2023,” he said. 

One thing that’s becoming clear with this new reform is that eventually, all sectors of the economy will be forced to offset their emissions. The package even talks about including citizens in the EU ETS around the end of this decade.

EU ETS WP banner

New sectors, new measures

Gonzalo then dove into some of the new sectors to be included in the EU ETS and what specific measures will apply to them.

When it comes to maritime transport, all emissions coming from intra-EU voyages will be included, as well as up to 50% of emissions from travel outside the EU. “There will be a transition period between 2023 and 2025 when maritime companies are going to have to gradually buy allowances up to 100% of their verified emissions, which should all be compensated between 2026 and 2027. Implications of not complying are quite severe,” he noted. Maritime companies now need to submit a monitoring plan for each of their ships and hand it to authorities in the next three months.

Road transportation and buildings will have special treatment, as they will operate within a separate ETS system commonly referred to as ETS II, which should be functional from 2025. From 2025 to 2029, only commercial fleets and buildings will have to comply, but the scheme will be extended to private cars and buildings after 2029. 

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EU ETS cost burden

Gonzalo and Benedito agreed that there is very little public information around transaction costs for purchasing, selling or cancelling carbon credits in the EU ETS. But a June 2020 working paper published by the London School of Economics and quoted in ClimateTrade’s white paper on the EU ETS offers a quantitative approach to understanding EUA transaction costs. The paper found that costs of around €10,000 per year plus €1 per permit traded allowed the most accurate predictions.

These transaction costs include exchange membership fees, the resources invested in operating a trading desk, monitoring the market and defining a trading strategy, as well as search, information, brokerage, intermediation and consultancy costs, and they are a barrier to entry from the EUA market. “The new reform, as well as the implementation of the Carbon Border Adjustment Mechanism (CBAM) will most likely increase this cost burden,” said Benedito.

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Carbon Border Adjustment Mechanism

The Carbon Border Adjustment Mechanism (CBAM) is the EU’s solution to prevent carbon leakage, considered one of the key elements of the Fit for 55 package. “Let’s try not to favour EU industries moving to countries with less stringent requirements on carbon, and let’s try not to replace European products with more polluting but cheaper products from outside the EU,” explained Gonzalo. 

CBAM also aims to incentivize non-EU countries to promote cleaner industries: while the price of the CBAM certificates to be purchased by EU importers will be based on the weekly average auction price of EU ETS allowances (EUAs), if goods are imported from a country with a carbon scheme, that price will be deducted from the cost of CBAM certificates.

The EU has now begun a transitional phase to gather data until 2025, and CBAM is expected to be fully in place in 2026, initially applying to industries like cement, aluminium, steel, fertilizers and electricity, but later to be extended to all sectors within the EU ETS. EU importers will have to declare the quantity of goods they imported every year at the end of May, and show corresponding CBAM certificates for the GHG emissions related to those products.

“With CBAM, the EU Parliament has been much more aggressive than the EU Commission proposed, phasing out free allowances by 2030 instead of 2035 as initially proposed,” said Gonzalo.

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The role of blockchain

“As CBAM comes into force, the focus will be on carbon offset traceability: as their products reach the EU, companies will be required to prove how and where they offset their carbon footprint, particularly if it was outside of Europe,” added Benedito.

As a result, blockchain technology is expected to become the infrastructure of choice for the EU ETS, since all transactions recorded on a distributed ledger are immutable, reducing fraud risks, and fully traceable.

Already, several players offer blockchain-based carbon offsetting products in the voluntary market. ClimateTrade was the first to do so in 2017, connecting the developers of mitigation and adaptation projects that want to sell their carbon credits to companies that need to offset their footprint without intermediaries and reducing transaction costs. The added benefit of the platform is that it avoids double-accounting, since certificates are cancelled in the registry before sellers can get paid. It also allows the immediacy of peer-to-peer transactions, for the benefit of those who work on the field every day to preserve the planet.

You can watch the full Decarb Webinar for free and on demand here.

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