Approaching the ETS Endgame in Europe

The Emission Trading System (ETS) serves as the primary policy instrument driving the reduction of greenhouse gas emissions within the European Union. Established in 2005 as a cap-and-trade mechanism, ETS mandates that regulated installations surrender emission allowances corresponding to their greenhouse gas emissions. These allowances are distributed annually under a diminishing cap, which was decreasing to zero by 2058 before the reforms introduced by the EU Green Deal.

When the Cap Hits Zero

At the new pace of reduction of the cap introduced by the EU Green Deal, it is expected that there will be no allowances left in the system by 2039. The reform has moved the original end date of 2058 to 2039, which in terms of policymaking is around the corner. Regulated companies and traders may be pushed to bank allowances in view of that date, which would only remove more allowances away from the market and further decrease its liquidity. Policymakers should start thinking seriously about such a so-called ETS “endgame” situation.

Possible future evolutions

There are several solutions to the disappearance of ETS allowances, including revising the cap, rethinking the EU ETS’s role regarding traded products, changing the geographical scope of the emissions reductions, integrating with other carbon pricing mechanisms (e.g. the EU ETS 2, the market mechanism for buildings and road transport), or releasing new allowances corresponding to negative emissions obtained from several types of removal techniques. A mix of these solutions is, of course, possible.

A further revision of the parameters

The progression of the ETS, spanning phases 1 to 4, paints a historical narrative marked by political interventions driven by shifts in allowance prices. The Market Stability Reserve (MSR) is the best example of this as it is designed as an automatic mechanism to control prices without considering them but rather looking at volume parameters like the total number of allowances in circulation. Further evolutions of the MSR could involve more changes to parameters such as the thresholds above and below which allowances go in or out of the MSR but could also be more profound and modify the mechanism to base it directly on the price level itself, which it is supposed to stabilise.

Moreover, it is highly probable that in the event of prices persisting at this level deemed detrimental to the competitiveness of the EU industry, some form of political intervention would likely need to be enacted on either the ETS or the MSR. The first psychological barrier to break is the 100€ per ton level, not far away, and it will serve as a test for political interventionism.

Re-imagining the Scope of ETS to reach EU Ambitions

There is additional flexibility available in changing the scope of the ETS or in linking the ETS with parent mechanisms like the new ETS (sometimes called ETS2) put forward for heating and road transport fuels.

Further extensions of the scope of the ETS to more sectors or other actors (for instance, to smaller installations as up to now the ETS only applies to installations above 20MW thermal) can stabilise prices if they come with a corresponding additional number of allowances. Recent scope extensions were made to encompass aviation and maritime transport.

A more profound scope change could be achieved by “merging” the ETS with the ETS2. Both mechanisms are of a cap-and-trade nature, but with different parameters and price levels. It is not impossible to make them converge, and manage a common and greater pool of allowances, which would reach zero later than 2039.

Empowering the EU ETS with Carbon Removal Technology

The EU’s 2050 carbon neutrality objective aims to offset residual emissions by implementing carbon removal strategies, effectively extracting carbon dioxide from the Earth’s atmosphere using both natural and technological solutions.

The EU has initiated work on a certification framework to cover the different ways to remove and store carbon:

  • Nature-based solutions, like restoring forests, soils, and innovative farming practices;
  • Technology, like bioenergy with carbon capture and storage, or direct air carbon capture and storage;
  • Long-lasting products and materials, such as wood-based construction.

To receive certification, the carbon removals will have to be correctly quantified, deliver additional climate benefits, store carbon for a long time, prevent carbon leaks, and contribute to sustainability. The certification process will also need to include requirements for third-party verification to standardise it, ensuring its environmental integrity and building the necessary public trust.

When all these conditions are met, it will be possible to link this carbon removal certification scheme to the ETS and generate allowances corresponding to the quantities removed and stored in a certified manner. This would maintain a supply of allowances into the ETS after 2039 and equip the mechanism with the tools required to allow it to manage a net-zero economy.

Propelling ETS into the Modern Day

The European Union ETS is now in phase four since its inception in 2005 and is expected to continue until 2030. However, all signs point to a reform of the current structure. Presently, the framework does not align adequately with the ambitious net-zero objectives. It currently operates with a finite number of allowances, set to reach zero by 2039. Anticipated pricing trends also suggest a steep increase well before this deadline, potentially as early as 2030, should no adjustments be implemented.

To address this challenge and realign the EU ETS with the goals of comprehensive emission reduction, we propose a dynamic solution. By integrating the EU ETS with a forthcoming carbon removal certification scheme, certified removal activities can seamlessly generate allowances in proportion to their effective carbon removal. This transformative step would propel the system into a new era, establishing a Net Zero Emission Trading System (NZETS). This strategic initiative would help position Europe at the forefront of emissions trading, fostering sustainability and environmental stewardship, and ensuring a resilient future for our industry.

Authors: Prof Dr Pierre Dechamps is a Senior Advisor in our Energy & Natural Resources team in Brussels.

The views expressed in this article are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals.

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