Monday 08 February 2021

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Decoding - The European Emissions Trading System, EU ETS

As part of the Paris Agreement, several countries or areas have announced that they set a carbon neutrality target for 2050 (European Union or Japan, for example) or 2060 (China). Among the mechanisms put in place, carbon markets or emissions trading system, and the carbon tax, both aim to reduce CO2 emissions by charging emitters to act in this direction. In carbon markets, the authorities put a cap on emissions and allocate rights to pollute, and then a trading market sets the price for carbon. Within the framework of a carbon tax, it is the public authorities which directly determine the price of carbon. In this text, we will focus on carbon markets.

The Emissions Trading System (ETS) was first established in the European Union in 20051. Other areas then followed: New Zealand (2008), Switzerland (2008), Kazakhstan (2013), South Korea (2015), Australia (2016), Canada (2019), Mexico (3 years experiment from of 2020). In addition, several local authorities have also launched this type of initiative in Canada, the United States, China and Japan.

Overall, ETS mechanisms have developed more quickly than “carbon” taxes. However, some countries have set up the two mechanisms as France with the Climate-Energy Contribution launched in 2014. Other countries like Germany have applied a national system for the exchange of rights in sectors that were not covered by the European system in order to accelerate the reduction of their emissions.

The World Bank indicated at the end of 2020 that the emission trading systems in operation covered 3.9% of total greenhouse gas (GHG) emissions. In Europe, the sectors covered by the EU ETS market represent just under half of EU emissions.

Since its creation in 2005, many adjustments have been made to make the European market more efficient. New measures are expected by summer 2021 to bring the market in line with the new climate targets of the European Union.

Without going into the technical detail of the European pollution rights exchange market, let us return to its main characteristics, its history and the challenges of future developments.

EU ETS has primarily targeted the energy sector and industry

The European carbon market includes all the countries of the European Union but also Iceland, Liechtenstein and Norway, which have chosen to participate. Since January 1, 2020, the European Union and Swiss systems have been linked by mutual recognition that allows companies to surrender allowances from either system.

The European market currently covers 11,000 installations in the energy, industrial and intra-European air transport sectors, which represents around 40% of the region's GHG emissions.

A system of emission caps and allowances trading ("Cap and trade")

In a carbon market, an overall cap on GHG emissions from system installations is set. This cap declines over time to bring down the total emissions. Within this cap, companies receive or buy emission allowances free of charge, which they can trade with each other as needed. A quota represents the right to emit one ton of CO2. The limit on the total number of allowances available guarantees their value. Under the European system, two limits exist, one for fixed installations and one for the aviation sector.

Each year, a company must surrender enough allowances to cover all of its emissions otherwise fines are imposed. If a company reduces its emissions, it can keep the excess allowances to cover its future needs or sell them to another company in lack of allowances. The aim is to encourage companies to make investments to reduce their emissions.

This system seeks to achieve an environmental result in terms of reducing GHG emissions while leaving companies the choice on where and how to achieve this reduction.

1 EU ETS directive - 2003

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Juliette Cohen

Strategist at CPR AM

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