Europe needs to urgently prepare for carbon market ‘endgame’

In just 16 years from now, the CO2 cap under the EU’s emissions trading scheme goes down to zero. This is hard to ignore and means no one can indulge into procrastination, argues Claudia Günther, Michael Pahle, Sebastian Osorio and Simon Quemin.

Claudia Günther, Michael Pahle, Sebastian Osorio, and Simon Quemin are researchers at the Potsdam Institute for Climate Impact Research (PIK). 

The profound implications of the recent European Union Emissions Trading System (EU ETS) reform become apparent in a single number: 2039.

Extrapolating the revised linear reduction factor used to set the cap, this marks the year when no carbon allowances will be issued in the existing EU ETS anymore. In other words, in just 16 years from now, energy companies and energy-intensive industries will only be able to use carbon allowances they have previously banked or bought from other market participants.

The "ETS endgame", as we call it in a recent analysis, is thus clearly on its way. In this article, we argue that for regulators, policymakers and firms alike, immediate preparation for the endgame is of the essence. Waiting too long risks obfuscating the path to climate neutrality or being left behind in walking it.

What regulators need to urgently prepare for

The cap going straight down to zero raises important policy and market design questions. Can a market with fewer and fewer allowances still function at all? Might a carbon tax be necessary to complement or even replace the ETS? Will the market stability reserve tighten the cap beyond what is efficient? Could an extension of the ETS via linking to other systems or including negative emissions be the answer to dwindling supply and residual emissions?

Addressing these questions head-on is essential because leaving them unanswered implies regulatory uncertainty for companies regulated under the ETS – and would distort the carbon price signal necessary to ensure the massive investment decisions will be cost-efficient.

The EU Commission already initiated a study to investigate issues and options for the ETS post-2030, and new research to inform the above question is wanted. Surprisingly, economists have given this issue very little attention so far.

What policymakers need to urgently prepare for

European policymakers are already tirelessly implementing new policies and strategies, including the Net Zero Industry Act, the Carbon Removal Certification Framework, and the strengthening of the Innovation Fund.

But do they align well with the ETS in removing barriers that could impair the efficient functioning of the price signal? For that, well-designed and targeted complementary policies are necessary that remove investment barriers and cut red tape while supporting the development of new technologies around carbon capturing (CCS/ CCUS). All that can effectively amplify the financial incentives that carbon prices create.

One example where urgent reorientation is needed is the use of ETS auction revenues in EU member states. In 2021, member states re-invested only 24% of revenues specifically into climate and energy actions, whereas 51% went to national budgets (EU Climate Action Progress Report 2022).

This is bound to change with the reform: all revenues must go into energy and climate action. However, that does not necessarily mean that they will be put to best use. ETS revenues used for climate and energy action so far go into a plethora of actions and programs, from sustainable transport to energy efficiency in buildings. Instead, they should be targeted to help industry cope with structural changes, like supporting the rollout of green hydrogen.

What is more, ensuring the cost-effectiveness of these measures will be imperative. With the endgame on, every Euro must be well spent from now on.

What industry needs to urgently prepare for

In the same vein, industry needs to reorientate its business strategies urgently. The model results of our analysis show a substantially higher rate at which the adopted reform will accelerate the transformation: the phase-out of coal-fired power generation across the EU will already be nearly completed by 2030. Likewise, substantial emission reductions would be necessary in energy-intensive industries before 2030, such as the steel and cement sector.

While several companies have announced plans to produce their first ton of green steel in the next two years already, looking at EU-wide investment plans for the next decade reveals a large investment gap.

Italy, for example, is the second largest producer of crude steel in Europe, with a production share of 16 % in 2021. However, according to data from the European Steel Association, only five low-carbon projects of unknown scale have been announced so far across the 29 production sites.

Another example is cement production. Its creation leads to process emissions which cannot be completely avoided and must be offset by CCUS in the future. The abatement potential of CCUS projects in European cement industry tracked by the International Energy Agency is 10 Mt CO2 until 2030, less than 10 % of verified cement emissions in 2021.

Thus, even if all of these projects came to life, they could not deliver the necessary cut in emissions. To avoid losing its competitive advantages in the race for net zero, industry is well advised to immediately ready its strategies to keep up with or even lead the market.

Winning the ETS endgame means delivering the Green Deal

The ETS endgame confronts regulators, policymakers and industry with new challenges and an unprecedented urgency to cut down emissions. However, it is not the ETS itself that creates these challenges. Rather, it is the goal of climate neutrality by 2050 from which the cap is derived. The ETS just makes apparent that ambitious action must be taken now if the goal is to be achieved.

The ETS has proven to be an effective tool in reducing emissions and boosting low-carbon technologies, and its price signals have the potential to steer investments and speed up decarbonisation at the scale required for carbon neutrality. By winning the endgame, making the best use of this potential is the EU’s best chance to deliver the Green Deal.

This article is a summarised version of a scientific paper published on 7 March 2023 and available here.