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Leaked information on the “Fit for 55” reform: What does it mean for European carbon allowances?

Executive Summary

Later this week the European Commission will issue its formal proposal to reform the EU Emissions Trading System. The revamp is intended to bring the market into line with the new EU-wide emissions target for 2030, which aims to cut greenhouse gases by 55% compared to 1990 levels.

In the last month, most of the proposal has been leaked in a draft document, giving the market an insight into what to expect on July 14.1

So what are the main changes being put forward?

Supply reduction

The purpose of the Fit for 55 package is to reduce the supply of emission allowances going forward in order to drive down emissions faster.

The main aspect of the reforms is likely to be a one-off “re-basing” of the cap on emissions. This adjustment to the limit on emissions each year will mean a step-change lower in the number of permits either auctioned or handed out free of charge to industrial companies.

The current emissions cap, which went into effect on 1 January 2021, is based on the previous EU 2030 target of a 40% cut from 1990 levels. The Commission proposal would “backdate” the cut by working backwards from the new 2030 emissions goal to generate a new theoretical cap in 2020, and then adjusting the overall cap to start at some point in the next three to four years.

(The European Commission has yet to calculate the precise 2030 emissions target for both the entire economy and for the sectors that are covered by the EU ETS.)

Hand-in-hand with the re-basing will be an adjustment to the rate at which the cap shrinks each year, known as the Linear Reduction Factor or LRF. The LRF will establish the trajectory from the date on which the reforms take effect to reach the 2030 goal.

A smaller re-basing of the overall cap would mean a deeper annual reduction, while a larger cut would allow a gentler LRF.

The overall impact of any reduction in the cap is likely to be bullish for carbon prices, since almost any combination of a reduction in the cap and a steeper annual cut would result in fewer carbon allowances being made available to the market. Since the supply adjustment is widely expected in the market it is already reflected in current prices to some extent.

Market Stability Reserve

The Market Stability Reserve will also be slightly adjusted. The MSR withdraws a portion of the calculated oversupply in the market each year; currently its withdrawal rate is 24%. According to the leaked Commission documents the MSR would remain at 24% for the remainder of the decade, instead of reverting to a 12% rate in 2024. This could mean that the current surplus of emissions is cleared sooner than previously expected.

The MSR should therefore work – together with the re-basing – to create a shortage of permits earlier in the current trading phase. However, last year’s Covid-induced drop in emissions reversed the recent trend and caused the surplus to balloon to nearly 1.6bn tonnes.2

Scope expansion

The Commission also proposes to extend the coverage of the EU ETS to the maritime transport sector. The draft suggests that emissions from all journeys between EU ports or that end in EU ports would be covered.

Shipping is estimated to contribute around 90m tonnes of CO2 equivalent to the EU’s greenhouse gas emissions annually; thus the inclusion of shipping in the carbon market would require the cap to be expanded by a small amount. The sector’s impact on the overall market will therefore be modest at first but will grow over time.

Road transport and heating of buildings will not be included in the EU ETS, but the EU Commission proposes to create a separate ETS for these sectors.

Carbon Border Adjustment Mechanism

There will also be a separate proposal to implement a carbon border adjustment mechanism (CBAM). This will act as a tariff on the carbon content of imported goods and raw materials from selected sectors.

To ensure that European industry does not gain a competitive advantage over importers that must pay the CBAM, free allocation of EU allowances to EU manufacturers will be phased out, although it is still unclear how long this transition may take.

The introduction of the CBAM will therefore mean more companies will need to buy EUAs in the market at a time when supply is being constrained even further by the reforms to the EU ETS. At current prices and volumes, this suggests additional cost for industry of around €30bn per year.

Next steps

The legislative process will involve the European Parliament at first, as its Environment Committee considers the draft rules and proposes its own amendments. These will be voted on and adopted by the full Parliament which will then enter into negotiations with the Commission and the Council over the final content of the legislation; a process known as comitology.

The entire process can take as long as three years, although it is worth noting that the Commission has proposed that some elements of the reforms should become effective as soon as 2023.

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