A coming vote in the European Parliament will help decide whether the EU Emissions Trading Scheme will drive necessary low-carbon investment in Europe’s industry over the next decade, write Karsten Neuhoff and Oliver Sartor.
Karsten Neuhoff is Professor for Energy and Climate Policy at TU-Berlin and DIW Berlin. Oliver Sartor is Researcher Fellow Climate and Energy Policies at the Institute for Sustainable Development and International Relations (IDDRI).
On 15 February, the European Parliament will hold a crucial vote on the reform of the Europe’s flagship climate policy instrument – the European Emission Trading System (EU ETS).
The outcome of this vote for EU climate policy cannot be overemphasised. It will help to decide whether the EU ETS will drive necessary low-carbon innovation and investment in Europe’s industry over the coming decade, as long promised.
If not, a realistic scenario is that the EU ETS will slowly sink into oblivion as a “failed policy experiment”, leaving European industry nowhere closer to decarbonisation in a fast-changing world.
Saving the EU ETS requires that two things happen in the current round of reform. First, as the Parliament’s ENVI committee has rightly agreed on a set of compromise amendments drafted in December, adjustments are needed to better manage the supply of allowances in the system. This can be done via the proposed changes so-called the Market Stability Reserve.
But this by itself is not enough. In addition, a new approach is desperately needed to create appropriate incentives for decarbonising carbon-intensive materials sectors in the ETS, like steel, cement, and aluminium.
This approach must protect them from carbon leakage (i.e. offshoring production to places with weaker regulation). However, it must also provide the necessary conditions for these sectors to innovate and invest in low carbon alternatives. For this reason, it is essential that the reformed ETS reflects the principle that the full carbon price can be passed along the value chain to incentivise innovation and efficiency in the use of carbon-intensive materials.
Full carbon price pass-through is crucial for decarbonisation of the material sectors like steel, cement, and aluminium. Without it, there is simply no reason for economic actors along the value chain to support the uptake of innovative, low-carbon materials.
For example, there is no incentive for new developers of low-carbon cement to enter the market and compete with traditional cement unless it bears the full carbon price. There is also less incentive for the construction industry to invest resources in ways to use carbon-intensive materials more efficiently unless the materials prices justify the savings. For the steel industry, it is hard to see companies investing in capital intensive low-carbon technologies if they are not confident about the stability of the overall carbon leakage protection framework or if they cannot pass on their increment costs of decarbonisation in their product prices.
If the EU fails to protect the principle of carbon price pass-through in the current round of ETS reform, it risks condemning European industry to another decade of inaction on decarbonisation, regardless of the carbon price.
Fortunately, the principle of full carbon price pass-through is currently reflected in compromise amendment 84 on carbon leakage, reached by the Parliaments ENVI committee, in December 2016. This amendment proposes to do so for just a small number of sectors, by proposing to remove free allocations for these sectors and include imports of these products from outside the EU into the ETS. It is essential the principle of full carbon leakage that is contained in this amendment is protected and supported by the Parliament at the vote on February 15th.
At the same time, two aspects of the amendment could arguably be improved. Firstly, the amendment focuses on too few sectors: essentially cement clinker, lime and some industrial gases. As a minimum, the measure should be extended to include steel and aluminium. Otherwise there is a danger of creating distortions between sectors that are in competition for some applications.
Secondly, the amendment proposes to deliver the principle of full carbon price pass-through by including imports of selected materials into the EU ETS. For the sectors under consideration, in particular cement, such a border related measure can be implemented in full compliance with WTO. Expansion towards a broader set of sectors may however be challenging in the short to medium term, in particular in the present context of heightened tensions about international trade protectionism. It therefore makes sense to explore alternative options.
The principle of full carbon price pass-through could be achieved for a wider set of materials in a less contentious and more effective way by “inclusion of consumption” of carbon-intensive materials in the EU ETS. This mechanism is already used in carbon markets in China and Korea.
Under this system, producers have an incentive to reduce emissions because their free allocation is still based on an ambitious emissions benchmark. But, in addition, carbon-intensive materials would now also have a weight-based “carbon charge”, based on the ETS carbon price multiplied by the same emissions benchmark, placed on them once they leave the factory gate and are released for consumption in Europe.
The charge would be incurred by the intermediate purchaser (usually another manufacturing company) and either paid directly to the state or deferred and passed on along the value chain by the purchaser. It thus restores a carbon price signal for all purchasers of carbon-intensive materials along the value chain in Europe and thus helps to restore incentives for materials innovation and greater efficiency in use.
Like other consumption charges on fossil fuels or tobacco, the charge is due on materials irrespective of domestically and internationally and production process. As such trade of products is not impacted, and a level playing field across the value chain is ensured.
The text up for vote in the European Parliament comprises a key principle, namely to ensure the full carbon price pass-through along the value chain. The Parliament must defend the principle of full carbon price pass-through in the EU ETS or the EU risks a lost decade for the decarbonisation of carbon-intensive materials sectors. The two areas of improvement of the technical implementation mentioned earlier could for example be advanced in the subsequent trilogue negotiations between EU Parliament, member states and EU Commission.