Background

The European Union Emissions Trading System (EU ETS) is a carbon market that reduces greenhouse gas emissions across the European Union. It is the world’s first and largest carbon market and operates on the cap-and-trade principle. The system limits the total amount of greenhouse gas emissions allowed by regulated installations such as power plants and industrial facilities within the EU. The EU ETS covers around 45% of the EU's greenhouse gas emissions.

Under this system, allowances to emit a specific amount of greenhouse gases are distributed or auctioned to these installations. If an installation emits more than the allocated allowances, it must purchase additional allowances or face penalties. On the other hand, if an installation emits less, it can sell its surplus allowances to others.

Understanding the Cap-and-Trade Principle

A cap is a limit placed on the total amount of greenhouse gases that installations and aircraft operators can emit, and it is covered by the system. The cap is reduced yearly based on the EU's climate target, ensuring that emissions decrease over time The cap is emission allowances, where each allowance corresponds to one tonne of CO2eq (carbon dioxide equivalent) or an equivalent amount of nitrous oxide (N2O) and perfluorocarbons (PFCs).

1. The cap has been set for the whole of the European Union for stationary installations since 2021.
2. In the current phase 4 of EU ETS (2021-2030), the cap on emissions continues to decrease annually at an increased annual linear reduction factor of 2.2.
3. In the current phase 4 of EU ETS, 57% of the allowances are auctioned, and the rest are free allowances.
4. Free allowances in phase 4 are based on:

• Prioritizing sectors that have the highest risk of relocating production outside the EU and will receive 100% of free allocation.
• Benchmark values of the performance of the 10 best installations
• Risk of Carbon Leakage
• Activity level in the installation

For the current status of the emission allowances in EU member states, please visit here.

EU ETS objectives by 2030

The EU ETS aims to incentivize industries to invest in cleaner technologies, reduce emissions, and contribute to meeting the EU's climate targets by promoting a market-based approach to emission reduction.

• Reduce net emissions by at least 55% by 2030 compared to 1990.
• Lower cap to reduce emissions by 62% by 2030 compared to 2005.
• Free emission allocation allowance rules to help specific sectors move towards decarbonization.
• Phase out free emission allocation allowance rules in the aviation sector.
• Expansion of the current scope to include the maritime sector.
• Starting October 2023, the Carbon Border Adjustment Mechanism (CBAM) implementation across sectors such as cement, aluminum, fertilizers, electric energy production, hydrogen, iron, steel, and some downstream products will feel phase-out free emission allocation allowance from 2026-2034.
• Cost-effective emission reductions for buildings, road transport, and small industries through ETS 2 intended to regulate fuel suppliers.
• Social Climate Fund set up in 2026 to address social impacts using a portion of the revenues from the auctioning of ETS 2 shares.
• Innovation and Modernization Fund to support green transition and finance energy in the EU states.

ETS 2 Overview

The European Union (EU) introduced a new system called Emissions Trading System 2 (ETS 2) in 2023. This system is designed to address emissions from buildings, road transport, and other sectors that are not covered by the existing EU ETS. ETS 2 is a strategic addition that aims to complement the overarching goals of the European Green Deal and usher in a new era of sustainability.

1. Scope and Focus:

ETS 2 takes a different approach than its predecessor. Rather than targeting households and drivers, it focuses on regulating fuel suppliers. This strategy change is in line with the EU's goal of achieving a cost-effective reduction in emissions and facilitating a fair transition to decarbonization in the specified sectors.

2. Implementation Phases:

The implementation of ETS 2 will be carried out in a series of carefully planned stages. The first stage involves monitoring and reporting greenhouse gas emissions, which will commence in 2025. The Social Climate Fund will be launched in 2026, followed by the full implementation of ETS 2 in 2027. The goal is to achieve a 42% reduction in emissions compared to 2005 by 2030.

3. Market Stability Measures:

To ensure stability in the market, a reserve will be in place to maintain allowance prices. Additionally, if there are exceptionally high oil or gas prices in 2027, there is a provision to delay the launch of ETS 2 to 2028, indicating a commitment to flexibility and adaptation.

Social Climate Fund and Revenue Allocation

• Contribution to Social Climate Fund: Revenues generated from auctioning emission allowances in ETS 2 will fund the Social Climate Fund, which supports vulnerable groups during the green transition beginning in 2026.
• Financial Mobilization and Allocation: The Social Climate Fund is a financing initiative that aims to mobilize a total of EUR 86.7 billion from 2026 to 2032. The fund will receive contributions from member states and will primarily be used to invest in climate and social projects. Additionally, the remaining revenues from ETS 2 will also be allocated to member states to further support these initiatives. Overall, this comprehensive financial framework aims to create a sustainable and equitable future for all.

Reinforcements in the EU ETS Framework

Strategic Amendments

In the ETS 2 introduction, the EU Emissions Trading System has significantly strengthened. Maritime transport is now included, and the emissions cap has been tightened by 62% by 2030 compared to 2005.

Sectoral Decarbonization and Adaptations

The rules for free allocation have been updated to encourage the reduction of carbon emissions in various industries, which are aligned with the EU ETS objectives for 2030. Under these new rules, industries will have to meet certain conditions to qualify for free allocation. The aviation sector will gradually phase out its carbon emissions in line with the Carbon Border Adjustment Mechanism (CBAM) to prevent carbon leakage.

As the European Union moves towards achieving climate neutrality by 2050, the implementation of ETS 2, along with strategic enhancements in the existing EU ETS framework, demonstrates a proactive and adaptable approach. These measures indicate a commitment to environmental responsibility and establish a solid foundation for a fair transition, technological advancement, and sustained financial support for a green transition. The combined efforts of ETS 2 and the updated EU ETS lay the groundwork for a transformative journey towards a more sustainable and resilient future.