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  • Writer's pictureAlessandro Vitelli

Europe's tangled climate to-do list

Given everything that’s been going on – in a political/regulatory sense – in Europe this past fortnight, I’m finding it a little difficult to keep track of the various proposals, plans and suggestions that have floated out of Brussels, and I thought by writing them down I might make a little sense of them.

What’s more, in the discussions I’ve been having with people lately, I’ve come away with the impression that it’s not always clear which file each of the EU ETS reforms beings to, or what the timeline is for each of these initiatives. The danger is that if you or I “cross the streams” like they did in “Ghostbusters”, things will get rather messy.

In brief, then, there are three separate “chapters” to the EU’s various climate proposals:

0. In the Background: The already-reformed EU ETS Phase 4

1. The review of the Market Stability Reserve

2. Updating the EU ETS 2030 (Phase 4) target

3. The EU Green Deal, including the Covid-19 recovery plan - this is where they’ve hidden the border carbon adjustment mechanism, among other things.

0. In the Background: The EU ETS Phase 4 reforms

The package of reforms for Phase 4 was formally completed in April 2018, but the guts of the reforms were already known back in late 2017 – this, including the late changes to the MSR (24% withdrawal rate) was the trigger for the immense rally that saw prices treble over 2018.

From 2021, the linear reduction factor goes from 1.7%/year to 2.2%/year, free allocation for trade-exposed industries starts to decline, and benchmarks for free allocation are tightened significantly.

That’s where we stand today.

1. The MSR Review – scheduled for 2021.

The MSR was conceived in 2014 and introduced in 2018. The regulation was amended before it even started to allow the MSR to absorb the 900 million EUAs that had been temporarily withheld from the market in the “backloading” episode in 2014-2016.

Additionally, as part of the Phase 4 reforms, the intake rate of the MSR was doubled from 12% to 24% between 2019 and 2023 to soak up more of the surplus supply.

In 2021 the EU will review the operations of the MSR to date, and the general consensus appears to be that it will need to be beefed up, to take more EUAs out of circulation simply because the LRF doesn’t appear to be able to keep up with the rate of decarbonisation.

The betting at the moment seems to favour an extension of the 24% withdrawal rate for several years, if not right through to 2030.

The timing of the MSR review, together with the Commission’s intention to table legislative proposals for the new 2030 target next year, suggests that the MSR review and 2030 target will be legislated pretty much at the same time; perhaps they will be merged.

Since the MSR’s 24% rate is fixed through to 2023, it seems logical that whatever reforms are enacted to the mechanism will only take effect from 2024.

2. Updating the EU ETS 2030 (Phase 4) target - Commission proposal by June 2021

Last week the Commission formally announced that it will propose an increase in the 2030 EU-wide target from the current 40% reduction from 1990 levels, to “55% at least”.

A 55% target for the EU as a whole implies a) a new EU ETS target, b) a new Effort-Sharing target for the non-trading sectors of the economy, and c) new 2030 goals for energy efficiency and renewable energy.

On the surface, this looks like the Commission wants to re-open the Phase 4 review that was formally agreed in 2018 and inject it with steroids.

However….. In her speech on the State of the EU last week, Commission President Ursula von der Leyen highlighted the Commission’s ambition to extend the EU ETS to not just maritime emissions, but also to road transport and buildings.

So this latest reform project isn’t just about tweaking the existing settings and tightening the 2030 cap, it could be about widening the scope of the market, massively.

This last proposal opens up a can of worms for me. So far, price discovery in the EU ETS has been all about decarbonising the power sector. The clean dark and clean spark spreads are pretty much running the show.

But by 2030, coal will have largely been shut down across most EU member states, and you have to wonder whether the generation spreads will remain the primary price discovery tool. What comes next?

Furthermore, do transport, maritime and buildings emissions have the same economics as power? Is there a zero-carbon brick or cement spread? What price is needed to shift vessels from running on heavy fuel oil to, say, LNG? And are they the same?

A recent paper from IETA suggests that because the decarbonisation of these sectors may not cost the same, separate emissions trading systems may be required. What fun!

But I digress. The Commission will come forward with legislative proposals for the 2030 target in June 2021.

When will these 2030 targets take effect? Using the Phase 4 reforms as a template, you can bet that the 2030 package will take all of two years, if not longer, to complete.

We already know that the EU ETS is going to be “adjusted” for the period 2026-2030: there’ll be a dynamic change to the allocations, and perhaps to other parameters like the LRF. It seems likely to me that the 2030 goal will only enter force in the middle of the phase, when the already-planned tweaks take place.

3. The Green Deal/Covid recovery

Oh boy. Where to start?

Legislating for a goal of net zero emissions by 2050 is one thing, but the Green Deal basically wants to remodel the entire EU economy: the way we travel, the way we build things, the way we consume, etc.

In addition to the 2050 programme, the emergence of the Covid-19 pandemic forced the Commission to tack on a recovery plan to the proposal: some of this is relevant to the EU ETS, since paying for the €750 billion Next Generation Europe recovery plan will involve taking some money from EU ETS revenues, perhaps the proposed border carbon adjustment.

What that means for the EU ETS is pretty vague right now; first we have to get the 2030 target out of the way. Not only that, but the European Parliament’s environment committee has said it would like to legislate a 2040 target as well!

We could assume though, that a net zero target would have significant impact on the cap, and would probably require the introduction of some sort of removal credit for CO2 emissions. Since EUAs represent actual emissions, and net zero will require some sort of removal/offsetting, there will have to be another form of carbon reduction unit.

Not only that, but we are going to have to seek out the next level of abatement. For the past 15 years the EU ETS has worked almost exclusively to force fossil fuels out of power generation. Everything has been about the power sector, while industrial emissions have been protected by free allocation, indirect compensation, etc.

As a result, we know very well what price of carbon is required to shift coal out of the merit order. But do we know what price is required to decarbonise cement? Steel? Chemicals? The Net Zero goal is going to bring totally new economics to the EU ETS.

The Commission has published a timeline for all the legislative elements of the Green Deal – it’s a long and pretty intimidating list, which you’ll find here. Suffice it to say that between now and the end of next year we should expect a positive blizzard of proposals from Brussels.

I'm sure there are some basic errors in here, but the above is all based on reading and on conversations with stakeholders and market participants. Please give me a shout if you spot any mistakes!

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