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the Homing Bird #6

What has the EU ETS achieved so far? How will it become even stronger and better? Read our opinion piece on the phasing out of free EUA accocations in the EU ETS, as well as an exclusive interview with a carbon markets expert analyst.

the Homing Bird #6
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The Homing Bird

March 2024

Climate finance made easy by Homaio.

In this edition :

🔥 The Story - Harder Better Faster Stronger: What's in store for the EU ETS

🎙️ Expert's thoughts - Why are about carbon markets one of the most powerful tools to fight climate change? An exclusive interview with Lidia Tamellini, Carbon Markets Watch's policy expert on EU industrial decarbonisation.

🤪Last days to invest - Currently trading around 55€, European Allowances are the investment opportunity of 2024. Our ongoing subscription is open for another few days - don't miss it out.

Harder Better Faster Stronger: What's in store for the EU ETS

Monopoly money is neither good nor bad. On the one hand, it gives children an initial understanding of the concept of money in a low-stakes environment. But on the other hand, it fails to convey the real-life challenges associated with earning money. Children need to know that monopoly money is not a permanent substitute for real currency.

It’s the same thing with the allocation of free allowances within the European Union Emissions Trading scheme (EU ETS). Initially, these allocations were indispensable. Compliance players needed time to familiarize themselves with the rules of the game (the complex legal compliance procedures). Also, regulators made sure not to scare industries by inducing a too sudden financial shock. It was important to keep their activity in the EU, and not make them flee to areas without carbon pricing mechanisms of their own. This initial stage with free European Union Allowances (EUAs) distribution, helped compliance players to smoothly transition into the carbon market would.

As a reminder, within the EU ETS, EUAs are issued by the European Commission. Then, they are either sold through auctions or allocated for free. Since 2013, the allocation of free allowances has constituted slightly less than half of the total supply of EUAs. In 2023, it accounted for 49%, and in 2024, it decreased to 43%.

Free allocations - thank you for your service, you can go home now. Your mission is now accomplished.

The EU ETS covers 40% of the bloc's emissions. However, within the scheme, there is a distinction between emissions from the industry, and emissions from the power sector. So, the allocation of free allowances to those groups has not followed the same trends. There was a faster reduction of free allocations for the power sector compared to the industry.

This differentiation intended safeguard the EU competitiveness.. Industries were offered a financial cushion - they were assured they wouldn't need to relocate to carry out their activities in regions without carbon costs. On the contrary, this risk does not exist for power producers - they cannot easily migrate. Also, decarbonizing their activities is easier and less costly most of the time, compared to the processes that industrials need to undertake to cut their emissions.

The phasing out of free allowances for the power sector has proven to be very effective. In fact, the power sector alone has accounted for 75% of the emissions reductions within the EU ETS since its inception.

industry, power emissions and phasing out of free allocations

The decarbonization efforts, the decreased economic activity and the energy markets disruptions after the start of the war in Ukraine brought the EU power sector emissions very low in 2023 compared to 2022. Here is a reminder of the data:

industry and power emisions in the EU

What about the industrial sector? Why is it still receiving a significant portion of free allocations? Certainly, now that the system has been in place since 2005, industrial players no longer need monopoly money. They are familiar with how the system operates. Also, the risk of them wanting to exit the EU and operate in an ETS-free region is almost nonexistent - the Carbon Border Adjustment Mechanism (CBAM) was introduced in 2023.

The CBAM makes importers pay for the carbon emissions associated with the production of goods manufactured outside of the EU. The aim is to maintain European competitiveness by imposing a carbon cost on goods coming from economies that do not yet have an ETS in place.

The good news? Now that all industrial installations understand how the ETS operates and that there is no longer a risk of them relocating outside the country, the EU has accelerated the rate at which free allocations are reduced for industrial sectors. This change was announced in 2023.

It is optimistic to hear that the industrial sector will now face similar conditions to those faced by the power sector in the past, encouraging them to accelerate their emissions reduction efforts. This is a key milestone because the industry sector accounts for a significant portion of EU emissions. In fact, 30 industrial companies are responsible for 50% of the emissions covered by the EU ETS, representing over 25% of the total carbon emissions released by the European economy.

Indeed, the system has not been perfect. There has been a historical issue of industries receiving too many free allowances. However, the European Commission is now taking steps to rectify this error.

The impact of this discrepancy was particularly evident in 2022. The benchmarks for free allocations are determined based on “typical” activity levels, however, between 2020 and 2022, anything going on in the world was far from being “typical” (remember when you had to sign a paper to leave your house?). The reduced economic activity (and lowered amounts of CO2 emissions) during the pandemic led to the paradoxical situation where industries faced minimal costs for carbon while still receiving large amounts of free allowances. In 2020, 2021, and 2022, heavy industries respectively received 104.5%, 89.5%, and 94.7% of their allowances for free.

difference between free allocations and used EUAs

The error will now be rectified. In 2023, the most recent reform of the EU ETS coming with the Fit for 55 package updated the rules regarding the free allocation of carbon allowances. The power sector is already showing decarbonization efforts. Industrials, it’s your turn to show us what you’ve got!

phraphshowing the phasing in of CBAM and phasing out of free EUAs

So, there will be a surge in financial demand for EUAs from installations who will no longer receive free allocations. Also, as previously discussed, the EU ETS is now covering more sectors than previously (notably with the inclusion of maritime shipping). And post-2025 and 2026, there will be a sharp decrease in supply is due to RepowerEU supply adjustments.

Medium to long-term projections all indicate an upward trajectory in carbon prices. So, just like many other carbon markets analysts, we beleive that 2024 is a great entry point for buying EUAs.

Expert's thoughts -  Why are about carbon markets one of the most powerful tools to fight climate change?

portrait of Lidia Tamelllini

We were stunned by the findings of the Emissions Aristocracy report. The document identifies who is still receiving too much of a free lunch within the "polluters pay principle" policy. It tells us about past achievements of the EU ETS, as well as the forthcoming efforts to be made to achieve its decarbonization goals.

We interviewed one of the report's authors, Carbon Markets Watch’s leading policy expert on EU industrial decarbonisation, Lidia Tamellini.

Homaio: Why is carbon pricing and the EU ETS important? What has the scheme achieved so far?
Lidia Tamellini:
The first impressive achievement of the EU ETS is that it has forced industries to track and monitor their emissions. This is a crucial building bloc to any decarbonization effort. The EU ETS has brought Europe ahead in the game - we currently have decent databases that allow us to analyze historical trends and see what is working well and what is not to reduce CO2 volumes.

Many countries do not have such CO2 tracking mechanisms and will need to catch up, especially now that the Carbon Border Adjustment Mechanism will enter into play. Prior to embarking on efforts to decrease emissions, it is important to grasp the scale of the problem that must be addressed.

The decarbonization effect of the EU ETS is of course also crucial to be highlighted - as discussed in the Emissions Aristocracy report, it has achieved a considerable total decrease in GHG emissions of 38% since its inception in 2005.

H: How has the EU ETS succeeded in reducing emissions?
LT:
The EU ETS is effective because it is a wealth redistribution system, a “polluter pays” system. It increases the effectiveness of the use of funds to combat climate change. One side of the story is the revenue redistribution - industries pay to purchase carbon allowances, and public actors redistribute this money for effective climate-related projects. On the other side, free allocations can be seen as an indirect form of state aid. Regulators give this aid to industrials and expect them to invest in decarbonization technologies, this is another form of financial redistribution.

H: Why is it important to raise awareness on carbon markets? On the climate emergency more broadly?
LT:
Politicians have to be clear in their communication: we need to spend money today. If we do not spare the appropriate funds to fight against climate change now, the economy will end up facing higher climate-related costs in the future. Those can become extremely high and jeopardize the overall functioning of the future economy. Every citizen needs to contribute, it is our common responsibility to change our lifestyles.

The role of politicians is to reassure citizens that they are not alone in this effort. Everyone pays for it. Big companies do. Industrials do. Manufacturers, too. Everyone invests to respond to the environmental emergency.

H: How can this democratization occur in practice?
LT:
Citizens will have trust in the EU ETS only if they are convinced that any public funds invested in fighting against climate change will actually be beneficial to society. People need to believe that any state aid eventually ends up delivering concrete positive impact. Otherwise they would never want to contribute to the climate cause themselves, nor trust public and corporate commitment to establish just policies. Citizens should see tangible positive impact.

H: Are the recently announced climate targets for 2040 ambitious enough? How can they impact the EU ETS?
LT:
My biggest criticism regarding the 2040 climate targets is that they have focused too much on carbon removals. Industrials and the economy more broadly should not think that the climate effort has been shifted towards absorbing and storing CO2. Compliance carbon markets and voluntary carbon markets are two different worlds. We should make sure that direct emission reduction progress is sustained to the maximum and that there are separate, independent targets for carbon removal strategies. Compliance and voluntary carbon markets should not be merged, otherwise the environmental integrity of the EU ETS can be threatened. We do not expect such risk in the foreseeable future, though I am strongly advocating for 2 separate targets for 2040: one for carbon emissions reduction, and one for carbon removal.

H: What is the main point of improvement of the current EU ETS engineering?
LT:
The volumes of freely allocated allowances are the main current blocker of the EU ETS effectiveness. Giving EUAs for free initially made sense - industries needed to get familiar with the system and prepare their operations for the incoming decarbonization efforts. However, phasing out free allowances is long overdue - the power and energy sector has been exposed to the EU ETS for more than 10 years now. They know by heart the rules of the game and need no free allowances to adapt. Market dysfunctionalities like the ones underlined in the Emissions Aristocracy Report should not be occurring 19 years after the introduction of the EU ETS. Regulators need to make the rules stricter and make every polluter pay for every tonne of CO2 released.

The good news is that the authorities have started working on it - the recent reforms will make free EUAs disappear faster from the market. Also, all revenues from carbon allowance allocations will now be invested in climate-related projects. Yet, we believe that the framework should be made more granular, targeting specific products and sub-sectors separately.

H: Where do you see the EU ETS market going in the foreseeable future?
LT:
The EUA price is bound to go up, it is a feature of the system.The levels will increase gradually: CO2 needs to become a commodity with a price level that the economy cannot support.  

In this edition, we saw how successful carbon pricing has been in certain areas, and that ongoing reforms are addressing the remaining challenges. Ambitious results need steady and hard work! To get there, let's do our part by raising awareness and participating in the carbon markets to strengthen them.

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