Europe, Carbon Markets, and Climate Change

The deluge in the Rhine Basin offered a grim reminder last week that climate change transcends boundaries. The scale and intensity of extreme weather events are continuing to rise across the world and surprising many climate scientists.

Parts of Rhineland-Palatinate and North Rhine-Westphalia were inundated with 148 litres of rain per sq. metre within 48 hours in a part of Germany that usually sees about 80 litres in the whole of July

Climate Scientists shocked by scale of floods in Germany, The Guardian

A (rather bleak) silver lining is the acknowledgement by major economies of the imminence and catastrophic effect that human-induced climate disruption can cause and the urgency in response that is required. I wrote about China’s carbon markets that went live last week in my previous post. Despite questions about limited coverage or scaling, it is still the largest carbon market currently as things stand and is only going to get bigger.

Europe stepped it up a notch and unveiled 13 policies on Wednesday last week (a day before the devastating floods, for the curious) to ensure that the continent meets its goals of reducing emissions by 55% in 2030 and reaching net zero by 2050, compared to 1990 levels. It is a serious set of policies that will have a sweeping effect on business, trade, transportation, infrastructure, taxation, and tariffs. This comes with a generous side of bloc-level politics.

The EU has a long, long road ahead in convincing its members, industry bodies, and regulators, before it becomes a reality. What comes out at the end of this road might look very different from the version we have been made familiar with, but big, hairy problems warrant bold actions. What Europe has proposed is mighty bold, I’d say.

The proposed policies together include measures to improve the viability of the overall carbon market, faster introduction of low-carbon technologies, shared responsibilities among the member nations, and specific use of proceeds to finance the transition smoothly and without friction.

You can read a summary of all the proposed inclusions here.

The pièce de resistance, if I may, and the first part of this two-part post is the proposal to revamp the legacy Emission Trading System. Do give my previous post a read for a quick recap on emissions trading systems. Here is a short excerpt –

For carbon markets to function efficiently, the price of carbon must be high enough that participants do not exploit the availability. In other words, not to buy at wholesale prices. In other, other words, the incentives should rest with those selling the credits so that more companies are nudged to reduce their emissions.

Liberal allocation of allowances ensures uptake but keeps prices low, as was the case during the early days of the EU ETS. It has been over a decade and a half and there is enough efficiency within the market for that to change.

The legacy ETS includes around 11,000 installations in the power sector, manufacturing units, as well as airlines, operating in the EU countries plus Iceland, Liechtenstein, and Norway. This will now additionally include the shipping sector from 2023 and will be phased in gradually over a 3-year period. It is tricky to build consensus among stakeholders within the maritime sector, largely due to a lack of commercially viable alternatives that can reduce emissions. The ETS will also force a pass-over of costs to non-EU trading partners, something that will certainly not go down too well during negotiations. Noblest of intentions have a history of flying across the face of implementation constraints.

To EU’s credit, this is not the first time they have proactively introduced regulations to uphold the underlying tenets of an emissions trading system. Back in 2018, the EU included an annual linear reduction factor of 2.2% for its emission cap. That is, the overall volume of emissions allowed for each sector will reduce by that many percentages every year. Scarcity of allowances will incentivise reduction in emissions and will have a positive effect on the price of carbon.

In the new set of regulations, this linear reduction factor is set to increase to 4.2% from the year the policies are ratified. This will come with a one-off increase in overall emission allowances available on the market to account for the inclusion of the maritime sector.

Another whopper of an inclusion is a separate Emission Trading System for road transportation and buildings.

The emissions cap for the new emissions trading system will be set from 2026 based on data collected under the Effort Sharing Regulation and ambition level and decrease to reach emission reductions of 43 % in 2030 compared to 2005 for the sectors of buildings and road transport.

[…]

A corresponding linear reduction factor is defined.

Explanatory Memorandum, European Commission, pp. 20

The idea behind a new ETS is understandable, although to me, it seems a little perfunctory and unidimensional. Its single important focus appears to be to take all reasonable efforts to not distort the legacy ETS system. In other words, not to have a detrimental effect on its carbon prices, especially given that it has had a slow, painful climb to current historic highs.

I do not remotely imply inclusion of the new sectors into the legacy system. My point of contention is the inability on the part of smaller economies in Central and Eastern Europe to pull their weight, in the proposal’s current form. Heating and transportation in these economies largely rely on cheaper and dirtier fossil fuels. It has all the markers of one-way policymaking, and something that will not aid when negotiations get underway, without a guarantee of generous funding to support transition at a hyper local level (households, local administrations etc.)

The commission hopes to ward off a political revolt over the creation of a separate carbon market for cars and buildings by using part of the revenues to fund a €72bn facility to help governments alleviate energy poverty for households who may face higher fuel and heating bills.

Brussels unveils sweeping plan to reduce Europe’s Carbon footprint, Financial Times

The proposed policies around the revisions to the Emission Trading System sure has caused a lot of ‘flash and bang’. What stays and what is irretrievably lost in the proposal will become clear in the coming couple of years. Frans Timmermans, the commission’s executive vice-president in charge of green policy, phrased it aptly.

“Nothing we have presented today is going to be easy. It’s going to be bloody hard – I know that.”

Timmermans on Fit for 55 package, Enlit 365

He also added that the “existential threat which is the climate crisis” called for radical steps.

Touché, Mr. Timmermans.

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Part 2 of this series will cover the revolutionary, yet controversial, carbon border tax that has the large manufacturing nations outside the EU up in arms, and has caused a bit of a diplomatic storm.