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A chance to nail down industry emissions
For over a decade, the European emissions trading scheme (ETS), which regulates greenhouse gas emissions from power stations and industrial plants, has been mired by a persistent surplus of emission permits, low prices and perverse incentives which did not reward emission reductions where they were supposed to happen. As a result, industry emissions failed to decrease.
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In July this year, the European Commission proposed a package of sweeping reforms to its climate policy, aiming to reach at least 55% emissions reduction in Europe by 2030, compared to 1990 levels. Within the ‘Fit-for-55 package’ (FF55), some measures affect the ETS, and more specifically industry. The carbon market welcomed the package in euphoria, the price of emission allowances (EUA) shooting up to levels never seen before, with a peak at €65.6 on 28 September 2021.
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So is this all a sign that we’re going in the right direction? We looked into the different legislative texts with high expectations, but unfortunately had to scale back our appreciation of the Commission’s willingness to tackle industrial emissions.
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More surplus than before
Some aspects of the package are mildly disappointing, such as the 2030 target for the sectors covered by the ETS: only 61% emissions reduction compared to 2005 levels, against the Commission’s own assessment that those sectors need -65% to reach the overall FF55 goal.
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Other aspects are much more worrying. First of all, despite having battled against the EUA surplus for so many years, the ETS amendment makes it possible for more surplus to accumulate than is currently possible. The reason is that the Market Stability Reserve (MSR), created to wipe away EUAs in excess of a threshold, would see that threshold increased under Commission’s proposal. The MSR threshold adds to various reserves of allowances totalling 1.8 billion kept in the system, ‘just in case’, in excess of the cap. As ETS emissions are soon to fall below the 1 billion tonnes mark, leaving this many excess permits available could be like not having a cap at all.
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The carbon price not driving down emissions
Also worrying is that the ETS has created perverse incentives which are well known and documented in the EC’s own impact assessment, yet the proposed reform will do almost nothing to correct them. Industrial plants covered by the ETS are awarded free EUAs in proportion to their output, so it only costs them the difference (if any) between the permits they get for free and those corresponding to their actual emissions. This mechanism, which is aimed at protecting those plants against ‘carbon leakage’, also has the defect of keeping polluting products competitive even in times of spiralling carbon prices.
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Free allocation raises many questions, not least on the effectiveness of Member States foregoing €30bn annually in lost sales of EUAs. A bit less talked of is its bullish effect on the carbon price: not only permits keep flowing to (industry) plants that already have too many of them while remaining scarce to the (power) plants needing them, but by protecting polluting processes from competition, it keeps industry emissions high and the demand for EUAs with them, boosting carbon prices further.
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Given the many negative effects of free allocation, everything should be done to put an end to it. We found that a carbon border adjustment mechanism, which is one possible way out of free allocation, is less controversial internationally than often said, so the proposed 15-year timeline to full implementation is hard to justify.
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Gambling on innovation
As the free allocation budget is lost to protect the ‘old’ industry, an instrument is given a boost in the FF55 proposal to develop a ‘new’ one. Doted with about €50 billion over the decade from the sale of EUAs, the Innovation Fund (IF) aims at financing projects with innovation contents ‘beyond incremental’, i.e. using technologies not commercially available.
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And here comes our third worry. The need for innovation on low-carbon technologies may be real, and the EU’s ambition of technological leadership is understandable, but giving the lion’s share of the EUA budget to tomorrow’s technologies is quite a gamble. Between ‘old’ industries and potential innovation, there are also a host of well known emission reduction measures that are not particularly innovative yet not price-competitive, possibly as a result of the other two support mechanisms, and do not benefit from any incentives. Circularity is one example. Substitutions between products (e.g. plastic to paper, concrete to wood etc.) is another. These measures disserve economic incentives too.
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Hydrogen: a risky solution
As most incentives on the table (including free allocation) reward production output, hydrogen is a likely winner. With the proposed reforms, all types of hydrogen production could become eligible to free allocation, and the majority of projects applying for IF funding revolve around hydrogen. This should help switching to greener hydrogen production for uses where it is currently produced from fossil fuels. But it might also support new uses with much less certain environmental benefits, e.g. producing hydrogen through electrolysis using grid electricity around the clock, some of it from natural gas or coal, to then produce… grid electricity (and a lot of conversion losses). This kind of use would actually result in more, not less, CO2 emissions.
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Surely, one would think that if a solution is absurd it will get caught up by economic reality? Well, maybe not if all incentive schemes point to the wrong direction. While grid electricity is expensive, it is subsidised in most Member States for industry uses (such as hydrogen production) through state aid compensation for indirect carbon costs. When the electricity used costs less than the one produced pays, and an intermediate fuel (hydrogen) is subsidised too, everything becomes possible.
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The wrong price at the wrong time
But with a carbon price around €60, can’t we say the ETS is working? Actually, one shouldn’t claim victory just because the price is high this year, as many of its bullish drivers are only temporary, as shown by our research. But also, the goal of the ETS is not to achieve a high carbon price but to reduce emissions at the lowest possible cost. By setting the wrong incentives, it could push the carbon price up while preventing emission reduction in industrial sectors, at the expense of the power sector and its end users and at a high overall cost for the society. In some cases, a high price could actually be a bad sign.
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Sandbag’s response to the Commission’s ETS reform proposal can be found here.
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- a surplus of about 1bn EUAs still there in 2030;
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- uncertainty related to the way free allocation will work;
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- bulls turning bears once the FF55 reform is finalised.
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The CBAM is the EC’s main initiative to curb free allocation, and the CBAM scope proposed by the Commission would cover as much as 47% of EU industry emissions. Despite that, and despite the geopolitical turmoil about it, we find that its financial impact on importers would be very small. It makes the very long proposed implementation timeline (15 years) hard to justify.
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As the EU has pledged to produce 10 million tonnes of green hydrogen annually by 2030, billions have started piling up in support for hydrogen projects with low technological readiness, and doubtful environmental benefit. We found that, instead, with a few simple targeted policies it could cost next to nothing to switch to renewable hydrogen in mature sectors already using hydrogen (so-called ‘no-regret’ uses). Potential and cost can be visualised in our abatement cost tool.
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The workspace giving platform Deed selected Sandbag as one of the top non-profit organisations fighting climate change.
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Are you an expert in Hydrogen, Steel or Recycling? We’re looking to test and deepen our analyses in those areas and would be very grateful for some insightful input.
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