EU ETS reform: How to tackle climate change and avoid carbon leakage

With MEPs currently considering the reform of the European Union Emissions Trading System (EU ETS) for Phase 4 (2021-2030), Misato Sato makes the case for revised free allocation of emissions permits.

EU ETS Phase 4 reform offers a unique opportunity for Europe to get free allocation rules right. It is a chance to establish credible long-term protection against carbon leakage and to re-establish a viable carbon price to drive forward investment in our low-carbon future.

The need for reform is all the more urgent when you consider the crippling lack of credibility of the EU ETS. In a recent piece of research, interviews with company executives revealed the persistent problems with low carbon prices, windfall profits and the inflexibility of the system to macroeconomic cycles had further damaging consequences. Since the prices plummeted in phase 1 and 2 the EU ETS has not been taken seriously and is failing to influence critical investment decisions made at board level.

A strong carbon price

One of the greatest challenges in designing any ETS is deciding which sectors should be granted free allowances and how many they should receive. The idea is to allocate free emissions allowances to sectors where the carbon price could trigger the relocation of production. But the experience in the last decade has proved how tricky it is to balance free allocation to vulnerable sectors and uphold a strong carbon price. The fine line between the risk of carbon leakage and the need to steer Europe along the decarbonisation pathway is not easily trodden.

A strong carbon price does two things:

  1. Supply-side: A strong carbon price can incentivise industry to invest in making use of existing energy efficient technologies and to invest in developing new ones.
  2. Demand-side: It also encourages consumers to shift away from carbon intensive goods, which in turn encourages industry to shift to meet demand.

The potential for industry to improve energy efficiency is important but it has its limits. Industry roadmaps for key carbon intensive sectors project that without breakthrough technologies such as carbon capture and storage (CCS), expected technological advancements can only reduce supply-side emissions by 10-20% in the coming decades. Consumer demand for alternative, low-carbon goods will therefore need to play a greater role if industry is to meet its 2050 targets to reduce emissions.

3 changes needed

In an economist’s ideal world, the EU ETS would abandon the free allocation of permits to tackle carbon leakage, allocate all allowances by auction and introduce Border Carbon Adjustments; a trade measure to level the playing field between European producers and foreign producers in countries with less stringent environmental regulations. In reality, the chances of this happening by 2020 appear slim.

In light of this, the EU ETS should be reformed in three ways:

1. Output-based allocation

Emissions permits should be allocated to companies based on their actual or recent output. This would avoid the allocation of excess permits, which could otherwise force the carbon price too low to be effective.

It would also avoid many other distortions that arise with the existing free allocation rules.  For example, we found evidence that cement companies in regions suffering from severe economic recession are now perversely incentivised to over-produce if they want to avoid cutbacks in the amount of free emissions permits they are granted in future.

We have also found that output-based allocation, if designed well, can provide more robust protection against carbon leakage and effectively dampen the incentives to offshore production.

Output-based allocation can be combined with the benchmarking of emissions to help drive energy efficiency improvements by companies. My recent work has explored in detail how these benchmarks should be set to bring about the correct incentives. We found that in the case of cement production, a combination of two benchmarks – one on clinker production as is currently done, and one on the amount of clinker used in cement production – into a hybrid benchmark can encourage producers to switch inputs towards lower-carbon constituents of cement and to use carbon saving production technologies, whist at the same time discourage offshoring.

Output based allocation will also remove the distortions and administrative costs arising from complexities in current free allocation rules (such as the new entrant, closure and partial cessation rules). The additional monitoring, reporting and verification costs are negligible for industry but higher for policy makers. But they would be largely outweighed by the benefits of improved leakage protection and flexibility to economic fluctuations.

2. Prioritise free allocation to key sectors

To strengthen the EU ETS, free allocation of permits should also be reduced significantly and targeted only at those sectors at genuine risk of carbon leakage.  This is even more important under output-based allocation rules to prevent price fluctuations in the market.

A key concern with moving to output-based allocation is that the number of free allowances would not be capped, but will fluctuate with economic activity. This could make the price of allowances volatile.  To overcome this problem the share of uncapped free allocations across the entire system should be minimised by only giving them to carbon-intensive sectors whose margins are severely hit by carbon pricing and are unable to pass the cost of emissions on to consumers due to competition from producers in other markets. My work has identified that this only applies to a small number of sectors (e.g. steel and cement).

3. Demand-side factors

The EU ETS should also take account for demand-side factors, so that consumers are incentivised to shift away from carbon intensive goods.

With an output-based allocation, the true cost of emissions will not be passed onto consumers in certain sectors. Consumers will therefore have little economic incentive to curb consumption of carbon intensive products or switch to low-carbon alternatives. An artificially weak carbon price will also limit incentives for companies to develop new low-carbon technologies.

The option to combine output-based allocation with a consumption charge at the point of sale is therefore an attractive approach. The idea here is that a consumption charge is levied on carbon intensive materials such as clinker, steel or aluminium to restore incentives for consumers to buy the lowest carbon product. The charge is calculated based on the carbon content of the product, the carbon price and a benchmark. The charge triggers changes to consumer choices and incentives are then channelled up the supply chain to encourage producers to supply lower carbon goods to meet demand.  The legal and administrative barriers are lower than moving towards border carbon adjustments, as it is not a trade measure.

Next steps

Given there is still some time for reform, Europe’s free allocation debate should be ratcheting up ambition a notch towards implementing these three steps. Similar debates are happening elsewhere including California, Quebec, New Zealand, China and South Korea. Drawing from international experience and seeking international coordination could be a positive way forward.