Two Steps Forward, One Step Back

The people of Argentina were not the only ones celebrating on the Sunday of the World Cup final. Negotiators from EU member-states, the European Parliament, and the European Commission were also popping corks, after the three institutions finally reached a deal on reforming European carbon pricing that Sunday morning through a process of discussion and negotiation known as a “trilogue”. After a year and a half of painstaking negotiations, an agreement on the future design of the EU Emissions Trading System, regarded by both Brussels as well as Berlin as the European Union’s most important climate protection instrument, had been reached.

But is the agreement also a boon to climate protection and climate justice? Only to a certain extent, it would seem. Although greenhouse gas reduction targets in the EU Emissions Trading System were tightened up considerably, the heavy industry lobby won its fight for some concessions on the original draft. This will dilute the effects of the reforms, particularly during the 2020s. Social equity was also been chipped away at, with the essential new Social Climate Fund set to receive less money than originally planned.

In July 2021, the European Commission proposed the Fit For 55 package as part of its Green Deal. The aim of the package is to support Europe in reducing greenhouse gas (GHG) emissions by at least 55 percent by 2030 compared to 1990 levels — 15 percent higher than before the reforms introduced by the June 2021 European Climate Protection Law, which was adopted in response to the Paris Climate Agreement.

A core element of the Fit For 55 package is the now-accomplished reform of the European Union Emissions Trading System (ETS), which is already in place for the European energy sector and industry as well as the aviation sector. A new instrument will be associated with the ETS in order to protect the EU from ecological dumping though imports. Starting in 2026, this will place a carbon tariff on imported goods at the border. In addition, the EU is introducing a Social Climate Fund to cushion the social impact of the new (and vigorously contested) emissions trading system for the transport and buildings sectors (ETS 2), which will take effect one year later.

Breaking Down the New Targets

EU emissions trading plays a pivotal role in the European climate protection strategy. The significantly tightened climate target in the EU’s Fit for 55 package — 55 percent greenhouse gas reductions by 2030 compared to 1990 levels — can be broken down into two parts.

First, reduction targets in the old ETS will become more stringent for the energy sector and heavy industry. Second, the package sets new, ambitious goals for all sectors that are subject not to the ETS (“non-ETS sectors”), but to the Effort Sharing Regulation (ESR). These sectors include the heating of buildings, transport (excluding shipping) and aviation, agriculture, waste management, and small energy and industrial installations.

Specifically, this means that by 2030, they must reduce greenhouse gas emissions to a significantly greater extent than previously agreed. Within the ETS sector, this amounts to a 62 percent target, rather than the previous 43 percent, and in the non-ETS sector, 40 percent, rather than 29 percent, both in comparison to the 2005 base-year level.

While the ETS target relates to Europe, in accordance with the EU emissions trading mechanism, the joint non-ETS target is broken down into individual nation-state targets. This system remains unchanged. For instance, by 2030 Germany must now reduce its non-ETS sector emissions by 50 percent compared to 2005 levels, rather than the previously agreed 38 percent, in accordance with an amendment passed last November.

The regulatory area of the new ETS 2, which the European Commission wants to introduce for road transport and buildings in 2027, and which has its own climate target of 43 percent GHG emission reductions compared to 2005 levels, therefore overlaps with the regulatory area of the Effort Sharing Regulation to a large extent.

Fortunately, conservative efforts to completely bury binding, country-specific non-ETS Effort Sharing Regulation reduction targets have been repelled. Had they succeeded, individual nation-states would be under even greater pressure to justify their efforts in the transport and buildings sectors to those who are putting the brakes on climate protection and would perhaps be confronted by the thought “What’s the point of implementing speed limits or ambitious building standards, when there’s a new emission trading system?”

All in all, 75 percent of EU greenhouse gas emissions will be regulated in future by the two emission trading systems, 40 percent of which will fall under the ETS.

A Reformed ETS

The EU Emissions Trading System in place since 2005 has had little to no positive impact on the amount of coal-fired energy generation or carbon emissions from industrial plants. There are several reasons for this.

Huge industry pressure resulted in a cap (the overall GHG cap for ETS sectors) that was too unambitious from a climate protection perspective. Industry received emission permits that were highly generous and mostly assigned free of cost, rather than by auction. Moreover, the ETS rules were relaxed in other respects.

Many companies seized the opportunity to utilize climate protection projects in the Global South or Eastern Europe to fulfil their ETS reduction commitments. There were often no real attempts at climate protection behind projects labelled CDM (Clean Development Mechanism) and JI (Joint Implementation), but cheap carbon reduction certificates from these mechanisms flooded the trading system in Europe.

The EU has subsequently reformed the ETS multiple times throughout its existence. Certificate surpluses at least have been and are being dismantled bit-by-bit, and new “lazy” reduction certificates from questionable overseas projects are now no longer permitted in the ETS. Carbon allowance prices have risen significantly due to these reforms in recent years (currently around 80 euro per tonne of carbon) and occasionally — at least before the energy crisis caused by the ongoing war — actually contributed to climate protection.

With the new targets, the energy sector and industry will be forced to adopt a much stricter course for achieving reductions from 2024 onwards, as the amount of emission allowances issued by the government decreases at a faster rate. In the six years between now and 2030, emission reductions will double previous targets (with an initial reduction factor of 4.3 percent that increases to 4.4 percent, instead of the 2.2 percent per year previously stipulated).

The European Parliament failed to make any headway with its demand for free allocation to end categorically by 2032.

As the European Parliament has requested on many occasions, this emissions trading system is being extended to maritime transport for the first time. Moreover, as environmental organizations in particular emphasize, all national revenues from auctioning ETS allowances across the EU are now to be distributed to climate protection initiatives.

Legislators also plan to continue dismantling unused allowance surpluses from previous periods. Rebasing the overall emissions ceiling in stages over two years starting in 2024 will cut a total of 117 million allowances from the system. However, this is less than half the volume demanded by environmental foundation WWF.

The Market Stability Reserve (MSR) is another existing mechanism that could ensure that old and any new surplus allowances are withdrawn from the market quicker. Should emissions permits become scarce, however, Brussels can grant additional permits from the MSR if certain thresholds are reached. This would mean additional emissions permits feeding rapid economic growth, at least to a certain extent. In light of the climate crisis, this is unacceptable.

Climate advocates also view the stated goal of 62 percent net emission reductions by 2030 compared to 1990 levels as insufficient. The World Wildlife Fund demanded at least 70 percent. The resulting target will not meet the 1.5-degree global warming ceiling set out by the Paris Agreement. Analysts nevertheless estimate that, as a result of the new legislation, fossil fuels will be phased out in Europe by around 2030 — driven solely by the market, which of course does not preclude ambitious regulatory coal phase-out resolutions.

The ostensible success story of the coalition between the Christian Democratic Union (CDU), the Free Democratic Party (FDP), and the Greens in the state of North Rhine-Westphalia puts this notion in perspective. The coalition sold its recent decision to boost lignite output for the next few years and sacrifice the embattled village of Lützerath as a supposed quid pro quo from energy firm RWE in order to move the state’s fossil fuel phase-out up to 2030.

The Commission’s draft proposal for ETS reform a year and a half ago made clear that a market-driven phase-out was to be expected between 2028 and 2030. Analysis of the proposal upon its release may also have ensured that the FDP and coal supporters in the Social Democratic Party (SPD) grudgingly agreed to the passage in the federal government’s coalition agreement that pledges to “ideally” phase out fossil fuels as early as 2030 (rather than 2038–2035, as stipulated in the current phase-out law).

The cost-free allocation of emissions permits to industry has been a controversial aspect of the ETS for years. These are distributed fully or pro rata according to defined benchmarks (due to the decreased cap, only the most efficient processes receive a full allocation). In contrast to the energy sector, industry only has to purchase a small proportion of allowances at auction. This free allocation of permits not only hampers climate protection investment, but also leads to idly acquired extra profits. Wherever they can, steel and chemical companies factor the commercial value of their free carbon allowances into the sale prices of their products.

While this is due to gradually change, the Commission’s proposal unfortunately slows things down. Starting in 2026, an annually increasing volume of allowances will be auctioned to sections of industry subject to the new border tax adjustment mechanism (see below). Cost-free allocation will decrease — by 2034, all emission permits will be auctioned.

The European Parliament failed to make any headway with its demand for free allocation to end categorically by 2032. Neither could environmental organizations that, like the German socialist party Die Linke, have been calling for an immediate end to any kind of free allowances for years. And while the Commission’s proposal discussed reducing free allocation by 10 percent per year in favour of auctioning, lower auction shares have now been agreed for the first few years and higher shares in later years. This constitutes a gift to industry that partly rolls back the effect of reform.

Environmental groups also criticized the Commission’s draft proposal for the fact that only 47 percent of the free allowances are allocated to industrial sectors that will be included in the introduction of the Carbon Border Adjustment Mechanism (CBAM) tariff, where the free allowances will dwindle to nothing. This in turn means that 53 percent of all allowances, such as for glass, chemicals, or refinery products, remain wholly unaffected by trade-offs. Under current laws, these free allowances will not expire until 2030.

At least the remaining free allowances will be allocated under stricter conditions in the future: without energy audits, companies will lose 20 percent of their allowances. The 20 percent of facilities that cause the most harm to the environment will also be penalized, which could mean the loss of an additional 20 percent of their allocation if they do not implement climate protection measures. The result of the trilogue between the institutions also increased the benchmark annually by 0.3 percent, reducing the volume of freely granted emission permits.

The New Border Tax Adjustment Mechanism

The main argument made by industry lobbyists for allocating free allowances to companies has always been international competition with non-European manufacturers, who are not subject to comparable climate protection instruments that affect costs.

The CBAM is a new instrument connected to the reduction of free allocation. This carbon tariff will be levied on goods imported from outside the EU to level out competitive differences between domestic producers and comparable foreign products that exist (or are purported to exist) as a result of different carbon pricing levels or even a lack of carbon pricing. The tariff will be levied simultaneously and reciprocally to the free allocation, meaning it will also be introduced gradually. It will only fully come into effect in 2034.

Initially, the CBAM will only affect sectors that the negotiators associated with a comparably high risk of carbon leakage and comparably high production levels. These sectors are cement, electricity production, fertilizer, iron and steel, aluminium, power, and hydrogen. Here too, an exception has been bargained for that works against climate protection: the steel industry is set to retain its current entitlement to free allowance allocation until 2030.

Moreover, the European Parliament’s requests for changes pertaining to including organic chemicals and plastics in the mechanism were not considered. This inclusion will now not be examined until 2030. Also postponed was the decision on whether exports from CBAM sectors to other EU countries should receive discounts (equivalent to the carbon tariff on imports) in order to remain competitive on third markets.

The New ETS 2

The ETS 2 for the building and transport sectors is also new, and takes an “upstream” approach for the time being. Those obliged to surrender auctioned-off emission allowances starting in 2027 are not greenhouse gas emitters, as in the case of the existing ETS, but rather fossil fuel distributors. Carbon costs will be reflected in bills for heating and fuel.

In both of these sectors, however, climate protection is significantly more expensive than in the electricity industry, for example, where (prior to disruptions resulting from the war in Ukraine) carbon prices ranging from 30 to 50 euro were enough to force the first old coal-fired power plants out of the market. Scientific studies point to costs of between 100 to 150 euro for each tonne of carbon the heating sector avoids producing, and approximately 150 for the transport sector.

According to reports from the negotiating table, German Chancellor Olaf Scholz applied the brakes and made negotiations more difficult.

Due to its comparably low steering effect, the majority of EU member-states share the scepticism of the European Parliament and environmental groups as to whether the ETS 2 will have a tangible social impact. Germany asserted its position on this issue in Brussels. In anticipation of the solution it wanted for the EU, the Merkel government, with support from the Greens and opposition from Die Linke, introduced a national pricing system for buildings and transport in 2021 with the Fuel Emission Trading Act.

A January 2022 study authored on behalf of the WWF pointed out the limited effectiveness and social volatility of the Commission draft of ETS 2. It also highlighted that a fair redistribution of revenues between all member states would require a high degree of political responsibility.

In turn, the EU Parliament called for oil and gas companies to bear half the costs to ease the burden on consumers — without success. An “emergency brake” on prices was agreed on as a compromise, which takes effect at carbon prices of 45 euro per tonne. Above this benchmark, additional allowances are designed to push the commercial value back down again, and the end user market is to be closely monitored for abuse.

The starting date for ETS 2 will also be postponed until 2028 if energy prices remain extremely high.

The New Social Climate Fund

The EU will establish a new instrument called the Social Climate Fund to help poorer households, micro-enterprises, and transport users cope with the price impact of the new ETS 2 for buildings and transport. That said, the fund is considerably smaller than originally planned.

It is part of the EU budget and is supposed to be replenished by ETS 2 auction revenue up to a maximum amount of 65 billion euro. The fund will run for the period 2026–2032, and will only be operational one year before the new carbon pricing system comes in. The European Parliament had demanded more preparation time in order to be able to mitigate the social effects of implementing the trading system early, for instance in terms of the transition to zero and low-emission transport and increasing the energy efficiency of buildings. In the end, their demands were unsuccessful.

Each member-state must now present the European Commission with a “social climate plan”. Such a plan could include measures providing direct income support “in a temporary and limited manner”, which must not exceed 37.5 percent of the estimated total costs of social climate plans. The Social Climate Fund is to be primarily used for “vulnerable households” and micro-enterprises as well as transport users most affected by energy and transport poverty. It could potentially be spent on investments that could help prevent social disadvantages.

Member-states are required to cover 25 percent of the Social Climate Fund. In the Commission’s original draft proposal, the amount was 50 percent. This may be the principal reason why the fund, including co-financing, now only totals 87 billion euro rather than the planned 144 billion.

Germany’s Responsibility

Although yet to receive formal approval, the three-way agreement on carbon pricing reform contains measures that substantially advance climate policy. That said, it does not go far enough in terms of fairly contributing to the Paris Agreement goals. Particularly the concessions made to heavy industry, which were not present in the Commission’s original draft, significantly erode social safeguards.

According to reports from the negotiating table, German Chancellor Olaf Scholz applied the brakes and made negotiations more difficult on at least two key issues: the reduction of free allocation of allowances to industry and the amount of the Social Climate Fund. These are precisely the issues of the package that came in for the most criticism from the climate protection movement.

As a supposed trailblazer for climate protection issues, Germany therefore bears the primary responsibility for the negotiations’ half-baked result.