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What is the EU ETS phase 2 ? A 2024 review of the new structure and impacts

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A new emissions trading scheme, the EU ETS 2, is set to be soon implemented to cover the building and road transport sectors. Explore the article to grasp its operational framework and the mechanisms for redistributing wealth that will follow.

What is the EU ETS phase 2 ? A 2024 review of the new structure and impacts
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Unlike the EU ETS 2, the original European Union Emissions Trading Scheme (EU ETS) does not include the heating, construction or road transportation sectors. Yet, they represent a large share of the European carbon emissions - 19% and 12.4% respectively. Should they remain out of the game, the European Union will most likely not be able to meet its carbon emissions reduction targets

So, a new emissions trading scheme, the EU ETS 2, will be introduced in 2027 or 2028. However, there may be a risk of a price increase for end-consumers - carbon pricing in the building and transportation sectors can affect the most vulnerable low-income households in the form of higher rent, heating costs, or fuel at the pump. This is why the EU ETS phase 2 will be engineered with unique mechanisms, different from the current EU ETS rules. Robust redistribution schemes such as the Social Climate Fund will help mitigate the potential socio-economic shocks.

What is the EU ETS phase 2?

Why do we need the EU ETS phase 2, adjacent to the EU ETS phase 1?

Up to this point, emissions from buildings construction and heating, and road transport have remained outside of the reach of the EU ETS. However, the national decarbonization schemes targeting these sectors (for example in France, the Bâtiments Bas Carbone (BBCA), Haute Qualité Environnementale (HQE), or in Germany, the DGNB, or the BREEAM DE) have been insufficient. The EU will not be able to reach its climate objectives, should those sectors not decarbonize faster. They collectively account for a large proportion of the bloc’s emissions: the building sector accounts for 12.4% of European GHG emissions and road transportation is responsible for nearly 19% (equivalent to roughly 0.75% of all transportation emissions). In France, the transport sector alone is responsible for 30% of carbon emissions.

The EU emission trading scheme phase 2: a new CO2 pricing system

To remain on track with its climate promises, the EU will create a separate emissions trading system, the EU ETS 2 to include emissions from buildings and road transport. This new system will have different rules and prices compared to the initial EU ETS. A simple expansion of the EU ETS was not foreseeable because of the specificities of the building and transportation sectors. They directly affect most European citizens. Academic and institutional studies show that the lower the income of the member state, the bigger the impact of rising costs due to the introduction of the EU ETS 2. This is because the cost of carbon is common to all the Union, while each country has different economies : rent in Paris isn’t the same as rent in Warsaw. 

For this reason, European regulators are being cautious when introducing carbon pricing mechanisms for the building and road transport sectors that can directly affect individual consumers. By creating a separate ETS, they can set specific rules to avoid brutal and disproportionate economic shocks for the most vulnerable households.

Who will have to buy carbon allowances in the EU ETS 2?

A significant difference from the functioning of the EU ETS 1 is that previously, the responsability to buy and surrender carbon allowances was that of the entity directly engaging in the combustion of polluting sources. In EU ETS 2, however, the responsibility shifts to energy distributors. For instance, in the context of household heating, neither the household nor the energy producer is tasked with purchasing EUAs. Instead, it falls upon the company overseeing the distribution of heating energy to households.

How will the EU ETS 2 work?

What are the carbon price levels in EU ETS 2?

The European Commission will prevent the EU ETS 2 prices from going too high too rapidly and negatively affect the economy. So, the new system is engineered in a way that if the EU ETS 2 prices go above €45 for a certain period of time, regulators will release more CO2 allowances in the economy. Hence, by increasing the supply, they will introduce a downward price pressure. 

The difference with the “classic” ETS is that the release of additional allowances is not triggered by a supply level but by a price level, which is a novelty in the scheme’s design.

The EU ETS 2 emissions targets and the EU ETS phase 2 cap 

Just like in the original EU ETS, there will be a cap, or a maximum amount of emissions allowed in the economy over a certain period of time. This EU ETS phase 2 cap will have the CO2 volumes from 2024 as a starting point. Those levels will be decreased by 5.15% every year to set the cap for 2027. From 2028 on, the yearly reduction rate will be set at 5.43%. The goal of setting this cap is to reduce emissions by 42% by 2030 compared to the levels in 2005 for road and buildings sectors. (As a reminder, the current reduction rate in the EU ETS supply is 4.3%.)

The ETS 2 in the EU timeline, from 2024 and beyond 

The new EU ETS phase 2 will not be in operation until at least 2027, and the start date might even be pushed back to 2028 if the then prevailing energy prices are considered to be too high. The stability mechanism described above, triggered by EU ETS 2 price levels, will prevail until 2030. In 2031, there will be a new directive to decide whether to remove this price trigger. 

What is the impact and the EU ETS 2 scope

The European Emissions Trading Scheme 2 and impact on low-income households

The new EU ETS 2 covers emissions from road transport and buildings. This could lead to higher prices for consumers, particularly affecting low-income households since they depend a lot on fossil fuels for heating and getting around. According to a study by the WWF, general consumption expenditures could go up on average by 0.4-0.8% due to the EU ETS phase 2, this figure going as high as 1.9% for Poland, 1.6% for the Czech Republic and 1.3% for Romania. 

A graph showing the relative burden of the EU ETS phase 2 for households as share of consumption expenditure by income quintiles

The EU ETS 2 and potential rise in energy expenses

The same study shows that, without the social welfare redistribution mechanisms that we will discuss below, there will be considerable increase in heating and energy spendings. For example, in Hungary and Latvia, the price of fossil gas heating could increase by 37%, the price of fuel by 32%. In Belgium and in Poland the price of coal could increase by up to 91%. 

A graph showing the relative burden of the EU ETS 2 for households as share of consumption expenditure

The EU ETS phase 2 and revenue use

EU ETS 2 revenues redistribution for social protection 

In response to the possible increase in energy costs and the corresponding impact on low-income households, regulators have come up with robust wealth redistribution methods. Proceeds from the sale of CO2 allowances under the EU ETS 2 will be "recycled" to aid the most adversely affected by carbon pricing. Essentially, revenue generated from ETS phase 2 auctions will be redistributed to compensate for cost increases for the poorest. The WWF states that ETS 2 revenues will be sufficient to offset the additional cost of the ETS 2 for the poorest 40% of all households across the EU.

This mechanism is similar to what exists in Canada, where households receive tax rebates from the proceeds of the local emissions trading scheme.

EU ETS 2 revenues allocation 

50% of the auction revenues generated from the EU ETS 2 will be allocated to the newly established social climate fund, which will be further discussed below. The remaining 50% will be distributed to individual member states, who are required to allocate all of their proceeds toward social climate initiatives in the building and transport sectors. Here are some of the initiatives that will be financed through proceeds from the EU ETS 2: 

The EU ETS phase 2 and the Social Climate Fund 

The funds from the social climate fund within the EU ETS 2

The aim of this fund is to improve the support for the poorest households by redistributing the proceeds from the EU ETS 2. It is projected to raise at least €86.7 billion between 2026 and 2032. In addition to the revenue generated from EU ETS 2 auctions, it will also gather funds from the sale of 50 million allowances from the current EU ETS.

Ensuring a level playing field - the Social Climate Fund, “fixing” the asymmetric economic shocks 

The fund is specifically designed to offset the uneven impact of the shock caused by rising prices due to the EU ETS 2. Low-income member states are expected to be hit hardest because they rely heavily on carbon-intensive transportation and building heating and construction activities.

A graph showing the distributional effects of the SCF

The graph below shows that, the lower the income of a member state, the higher the proceeds from the social climate fund (SCF). As we go to the right (horizontally), countries are wealthier. Vertically, the bars in green show that a member state receives more funds from the SCF than what it spends to finance the program.

Sources

BNP Paribas, 2023. Transport, France's main source of GHG emissions

The European Commission, 2023. ETS 2: buildings, road transport and additional sectors

European Environment Agency, 2023. Greenhouse gas emissions from transport in Europe

Energy Ville, 2023. Decarbonization of heating in the buildings sector: efficiency first vs low-carbon heating dilemma

WWF, 2022. DCF and ETS 2 impact studies

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