BlogEmissions Trading System (ETS)

EU ETS reform extends carbon markets

Written by

Ulf Narloch

Published on

18. December 2022

On 18 December 2022, the European Parliament and the Council agreed the strengthening and expansion of emissions trading. The agreement aims to increase the use of carbon prices as an economic instrument for decarbonization. Two separate systems will cover the industry, energy, transport and building sectors in the future. 

Market instruments for climate protection 

The EU’s Emission Trading System (ETS) is already one of the largest carbon markets in the world. Like carbon taxes, such market instruments price emissions to address climate change. 

ETS was introduced in 2005 and since then, it has been progressively developed. With the tightening of the regulations for the fourth trading period (2021-2030), carbon prices rose to EUR 90 per ton of CO2 very recently.   

The reform of ETS is a crucial measure to reduce greenhouse gas emissions in the EU by at least 55% by 2030 compared to 1990 levels. The first proposal for an amendment of the  ETS directive was presented as part of the Fit for 55 package in July 2021. In June 2022, the Council agreed on the general approach for the reform.  

In addition to tightening the existing emissions trading system and expanding it to include the road transport and the building sector, a social climate fund is intended to cushion social impacts. Furthermore, the reform is going to be supplemented by the creation of a carbon border adjustment mechanism (CBAM), as a carbon levy on EU imports.

How EU ETS works 

In contrast to carbon taxes, which set a price per ton of CO2, emissions trading systems set an emissions cap. The price is then determined via emissions trading (a so-called Cap-and-Trade system).  

In accordance with the defined cap, the EU issues CO2 certificates as emission allowances (EUAs), which are distributed either via a free allocation or via an auction in a unit price procedure. This distribution represents the primary carbon market in ETS.  

The CO2 allowances distributed in this way can then be traded in the secondary market directly between seller and buyer or via exchanges and intermediaries. 

Emitters of CO2 emissions must surrender a CO2 certificate for each ton of CO2 emitted, which is thus withdrawn from the carbon market.

Two emissions trading systems  

In addition to the expansion of the existing emissions trading system (ETS-I) for energy, industrial installations, as well as aviation and maritime transport, a new, separate system for fuels (ETS-2) is to be created.  

Coverage 

This is to be achieved by expanding ETS-I to maritime transport. This would create the world’s first carbon price on emissions from shipping. 

Larger ships will be required to purchase CO2 certificates as early as 2024. This obligation is to be gradually increased in stages: 40% of verified emissions in 2024, 70% in 2025 and 100% in 2026. Non-carbon emissions (i.e., methane and nitrous oxide) are also to be covered from 2026. 

By expanding ETS-I to maritime transport, the emissions cap is to be increased once by 78.4 million CO2 certificates.

Emission cap 

The emission reduction target for 2030, which sets the upper limit of tradable emission allowances, is to be increased from 43% to 62% – measured by emissions from the sectors covered in 2005.  

This ceiling is to be adjusted by: 

  1. One-off reduction of the total amount of allowances by 90 million in 2024 and 27 million in 2026 (“rebasing”) 
  2. Increase in the annual reduction of issued CO2 allowances from current 2.2% to 4.3% in 2024-2027 and 4.4% from 2028 (“linear reduction factor”) 
  3. Continuation of the annual inclusion of 24% of CO2 allowances in market stability reserve (MSR), which are thus withdrawn from the market.  

In the event of excessive carbon price increases in ETS, MRS is to automatically add allowances into ETS in order to reduce price pressure 

Free allocation 

The allocation rules for energy and industrial installations are to be revised, so that the free allocation of CO2 certificates can be better targeted from 2026 onwards: 

  1. Greater reduction in benchmarks used to determine the quantities of CO2 allowances allocated free of charge; these should also take into account technological progress  
  2. Alignment of free allocation with measures to increase energy efficiency and reduce emissions (‘conditionality rules’) 
  3. Gradual phase-out of free allocation in step with the ramp up of CBAM from 2026 in sectors with a high risk of relocating production to non-EU countries; so far, these sectors have been exempted from the reduction of free allocation  

Free emission allowances for the aviation sector are also to be phased out by 2026.  

New ETS-II 

For fuels used in road transport, buildings and other sectors, ETS-II is intended to establish a new, stand-alone emissions trading system in order to reduce emissions in these sectors as well. 

From 2027, fuel suppliers and traders will need CO2 allowances for the fuels put into circulation. In the event of exceptionally high energy prices, the launch may be postponed by one year. 

ETS-II includes the following regulations:

  1. Setting an emissions cap in 2030, as 42% of all emissions in the sectors covered by ETS-I in 2005; the total amount of CO2 allowances should be set for the first time in 2027  
  2. Annual reduction of CO2 allowances by 5.10% by 2027 and 5.38% from 2028 on a reduction path starting in 2024  
  3. Auction of all CO2 allowances from 2027; there is no provision for free allocation as in ETS-I 
  4. Exceeding the auction volume by 30% in the first year above the specified allowance quantity to allow companies to mitigate price and liquidity risks (“frontloading”) 
  5. Stabilization of prices at EUR 45 per ton of CO2 by 2029 through the release of CO2 allowances from MSR if the carbon price rises above this mark 

It is envisaged that fuel suppliers who are already covered by a national scheme will be exempt from ETS-II until the end of 2030. In Germany, a National Emissions Trading Scheme (nEHS)  is being implemented.  

Formal decision in spring 2023 

Following this preliminary agreement in the trialogue, the formal decision on ETS reform is now pending in the Parliament and the Council before the new rules enter into force.  

For ETS-I, among other things, the extension to maritime transport and the reduction of free CO2 allowances in aviation will come into force as early as 2024. The majority of the changes – especially to the free allocation – will take effect from 2026. 

Companies covered by ETS-II will already have to report their emissions as early as 2024, before CO2 allowance trading starts in 2027 (or 2028).  

Sources and further information: 

Photo by Paul Einerhand on Unsplash 

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