UK: Glimpses Of Phase 4 Of The EU ETS - The 2030 Climate And Energy Policy framework

Summary On 24 October 2014, the European Council (the "Council") announced a package of measures1 (the "Conclusions") designed to further reduce the bloc's greenhouse gas emissions by 2030. The Conclusions reflect the Council's initial review of the European Commission's (the "Commission") January 2014 communication whereby it tabled a set of proposals necessary to bring strength and stability back to the EU ETS (the "Communication").2

While the Conclusions do not yet have the force of law, the unanimous backing of the Council sends a strong political signal to the market that the EU ETS remains the EU's primary greenhouse gas reduction mechanism. Furthermore, the Conclusions inform the Commission and Parliament of the key aspects which the Council will expect to see in any future legislative proposal regarding Phase 43 of the EU ETS; as such they are a glimpse into the shape of Phase 4 of the EU ETS.

Background Without any doubt, the EU ETS has struggled to find its feet over the past six years. It is a cap-and-trade scheme that has been tortured by a perpetual oversupply, partially caused by Europe's natural movement towards a services-led economy, and worsened by the impact of the global recession in recent years. The result is that prices have been continuously driven down, from a high of more than €30 per tonne in 2008 to a low of €2.63 per tonne in 2013.4

Some estimates suggest that the current surplus of EUAs amount to 1.5 billion – 2 billion tonnes of carbon, approximately equivalent to an entire year's requirement under the scheme. This surplus may worsen before the end of Phase 3.

The surplus prompted the implementation of the "backloading" plan last year. This temporary solution involves the removal of 900 million EUAs from the market in 2014-16, only for them to be reintroduced again in 2019-2020. It is hoped that market demand will be stronger near the end of Phase 35 of the EU ETS and therefore, allowance prices will be more resilient to their reintroduction. However, on current estimates, absent other measures, such resilience is unlikely.

The current EU ETS allowance price is itself a reflection of (a) anticipated future demand that may be supported by an expectation of Phase 3 allowances being 'carried-over' or 'banked' into Phase 4, and (b) scarcer post-2020 allocation of allowances though a combination of reduced free allocation and a higher carbon emission reduction target than the present 20%. The Conclusions setting out the 2030 Climate and Energy Policy framework are therefore likely to be seen as a key indicator to support Phase 3 EU ETS allowance prices.

The fight to reduce emissions within the EU is not just limited to sectors that are captured within the EU ETS but also to sectors that fall outside it. The overlap of other policy measures, such as renewable energy and energy efficiency within the EU, if not managed carefully, can also have a detrimental effect on allowance demand and price expectancy with the EU ETS.

In the first package of measures to combat climate change adopted in 2009, the ambition was to achieve a 20% reduction in greenhouse gas ("GHG") emissions relative to 1990 levels by 2020, a 20% increase in consumption of energy from renewable sources and a 20% improvement in energy efficiency.

According to the Commission's latest annual progress report on meeting Kyoto and EU 2020 related objectives,6 the EU's GHG emissions are estimated to have already decreased by 19% compared to 1990 levels as of 2013, and are projected to be 21% lower by 2020. Further, in its 2013 Renewable Energy Progress Report,7 the Commission reported an EU-wide renewable energy share of 12.7% as at the end of 2010. More recently, the Commission estimated in its 2014 Energy Efficiency Communication8 that the EU will achieve energy efficiency levels of approximately 18-19% in 2020. However, given that the ultimate goal is to prevent a 2ºC rise in average global temperature, long-term targets now need to seek to achieve an 80%-95% reduction of GHGs by 2050.

Key Points of Reform The Conclusions support a "well-functioning, reformed Emissions Trading System (ETS) with an instrument to stabilise the market". This implicit acknowledgement, of the current absence of a well-functioning EU ETS, is an important indicator that a fix is necessary and one for which a separate instrument will be required.

The Commission published a legislative proposal9 in January 2014 suggesting the introduction of precisely such an instrument into the EU ETS: the Market Stability Reserve (the "MSR"). The intention is that the MSR "render the auction supply of emission allowances more flexible and... make the ETS more resilient to any potential future large-scale event that may severely disturb the supply-demand balance". The significance of the MSR, in the context of the Council's new proposals for Phase 4, cannot therefore be understated.

The most compelling reform proposals decided upon by the Council in its Conclusions are as follows:

(a) Targets to be achieved by 2030:

(i) a binding EU-wide GHG reduction target of at least 40%, compared with 1990 levels;10

(ii) a target of at least 27% for EU-wide final energy consumption generated from renewables, albeit only binding at EU level;

(iii) an indicative energy-efficiency target of at least 27%; and

(b) Free allocation of allowances to sectors at risk of carbon leakage: this is to continue beyond 2020 with periodic review of the benchmarking methods of allocation in order to prevent carbon leakage,11 and a better adjustment of the system in accordance with varying levels of production in different sectors;

(c) Treatment of low-income Member States: Member States with a GDP per capita 60% below the EU average may continue to provide free allowances to installations operating in their energy sector (subject to a limitation on total numbers of free allocations after 2020);

(d) Investment funds: the current New Entrants' Reserve ("NER") of 300 million allowances will be bolstered by a further 100 million allowances. A new fund will also be created comprising 2% of the allowances set aside from total allocation to address any additional investment needs of low-income Member States;

(e) Non-ETS: a flexibility mechanism will be provided for Member States whose national reduction targets are significantly above both the EU average and their cost-effective reduction potential, along with Member States which did not provide free allocations in 2013 for their industrial installations; and

(f) Transport sector: the Commission was invited to examine possible measures to reduce emissions and promote energy efficiency in the transport sector.

The Council noted it will keep all elements of the above package under review, and will continue to give strategic orientations as appropriate, most notably with respect to the ETS, non-ETS, internal energy market and energy efficiency.

Comment on key features of the Conclusions

Emission Reduction Target As noted above, the Conclusions state that "The European Council endorsed a binding EU target of an at least 40% domestic reduction in greenhouse gas emissions by 2030 compared to 1990. [emphasis added]" The unanimous backing by the Council of such a target is widely seen as a signal of ambition to other nations ahead of the 21st Conference of the Parties to the UNFCCC ("COP21") next year in Paris. Further, with the Council agreed on a target of at least 40%, this could serve as a baseline that provides scope for the adoption of more ambitious targets at COP21.

This figure of at least a 40% reduction against 1990 levels is to be delivered through (i) reductions from emissions subject to the EU ETS (targeted as a 43% reduction) and (ii) from emissions outside of the EU ETS (targeted as a 30% reduction). However, both of these reduction elements are calculated against 2005 levels, which will make their precise impact on the 40% figure against 1990 levels more difficult to ascertain.

Renewables and Energy Efficiency The Conclusions also provide for additional targets to exist in parallel to the 40% emission reduction target. These are an "EU target of at least 27% ... for the share of renewable energy consumed in the EU in 2030" and an indicative "target at the EU level of at least 27% ... for improving energy efficiency in 2030".

To the disappointment of renewable energy advocates, the renewables-related figure of 27% sits at the lower end of the range of potential renewables targets previously considered by the Commission in its Impact Assessment earlier this year.13

The most notable feature of the targets for renewables and energy efficiency, apart from their alleged lack of ambition, is the fact that neither involves binding national targets. The targets are binding only at overarching EU level.

So how will these targets be achieved if not binding at Member State level? The answers are somewhat vague at present. However, what the Council has proposed in its Conclusions is a "reliable and transparent governance system", fully respective of Member States' freedom to determine their energy mix. It appears that the intention is to introduce a system of "national energy plans" based on upcoming guidance from the Commission. The language of the Conclusions puts a very positive spin on the absence of binding national targets, emphasising the "flexibility" this gives, and the fact that it leaves Member States free to set higher, more ambitious targets, but not addressing the obvious risk that there will in fact be a lack of ambition. However, according to the Communication, there will be "an iterative process between the Commission and Member States [that] will ensure the plans are sufficiently ambitious as well as their consistency and compliance over time". This suggests something akin to the former EU ETS practice of Member State allocation plans: a system that was ditched in Phase 2 of the EU ETS in favour of a more centralised approach. We will need to wait for further detail of this "governance" structure in order to form any view as to the likely effectiveness of these renewables and energy-efficiency targets.

The UK in particular sought to reduce these aims and refused to agree to binding renewables and energy-efficiency targets. There are concerns that by issuing multiple targets for renewable energy, energy efficiency and overall emissions, the Council has created the risk of an overlap in policy which has the potential to undermine the EU ETS' function as a reliable price signal upon which participants depend for market certainty. This is a polarising issue. On one hand, in recognition of the diversity of Member States' respective national energy markets, the UK maintains that countries should be able to determine the way in which they meet the overarching emission reduction target. On the other, industry players argue that Member States will not support investment in renewables without the incentive created by a renewables-related target that is binding at the Member State, as opposed to EU, level.

Flexibility in achieving targets The Conclusions provide for various flexibility mechanisms by which low-income Member States can more effectively meet the various targets described above. Prior to the meeting of the Council, certain Member States, largely led by coal-dependent Poland, argued that they would be disproportionately affected under the current system by increased energy prices and reduced industrial competitiveness if an emissions-reduction target of 40% were to be adopted. The Conclusions therefore acknowledge this concern by allowing free allocation to continue after 2020, the establishment of two funds to help finance industries in low-GDP Member States, and finally, the donation of 10% of all EUAs auctioned by Member States among those countries whose GDP per capita does not exceed 90% of the EU average in 2013.

This "10% fund" will operate by creating a supply and demand gradient, reducing the allocation of EUAs to Member States with a higher than average GDP per capita, and thereby theoretically forcing them to purchase EUAs from those Member States whose GDP does not exceed 90% of the EU average in 2013.

Compliance in non-ETS sectors The Conclusions also provide for flexible instruments to be used in achieving emission reduction targets in non-ETS sectors "for Member States with national reduction targets significantly above both the EU average and their cost effective reduction potential as well as for Member States that did not have free allocation for industrial installations in 2013 - ... through a limited, one-off, reduction of the ETS allowances". This can be interpreted as a nod to those wealthier Member States who have shown a previous desire to address the adverse impacts of climate change, and whose non-ETS sectors currently struggle to contribute to achieving emission-reduction targets (for instance, Germany and France). In other words, it is possible that the Council intends such Member States to have the option to use carbon allowances to cover emissions from industries now outside the ETS, such as transportation or agriculture, thus providing more flexibility in the way in which non-ETS-covered sectors help nations to meet targets. In practice, this may result in a Member State reducing the number of EUAs allocated to ETS-covered sectors (e.g. by way of cancelling national auction volume), and replacing that obligation with a higher non-ETS sector cap. There is speculation that the "one-off reduction" refers to a single decision before 2020 to forfeit auction volumes, or, beyond that, a permanent cancellation of allowances.

Next Steps The focus will now turn back to the Commission, which has the task of transposing the Council's Conclusions into draft legislation to be considered by the EU Parliament. A first draft of the proposed legislation is expected from the Commission in early 2015.

In the meantime, it is understood that the Council's Conclusions will form the basis of the EU's position paper for COP 21 in Paris.

Conclusion As with every announcement regarding climate policy, there have been those who have criticised the Council's Conclusions as a weak compromise. While it is undeniable that the decision does incorporate elements designed to accommodate Poland's heavy reliance on coal, or the UK's refusal to bind itself to energy-efficiency targets, it is equally true that the Council's paper endorses the EU ETS as its primary policy tool for reducing GHG emissions beyond 2020 and further endorses the need for an MSR to be introduced to help fix the existing oversupply problems.

However, the Council's proposals for Phase 4, if implemented in an environment where the EU ETS continues to be over supplied, will do little to restore confidence in the EU ETS as the right tool to achieve the necessary decarbonisation of the EU in order to reach 80-95% GHG reductions by 2050. Therefore, while much will be said in the coming weeks regarding the Council's headline 40% GHG reduction target, or the "trilemma" facing the EU's energy industry – namely on the issues of energy cost, renewability, and security; of perhaps more fundamental importance to the EU ETS is the Council's approval of the MSR.

Ultimately, the real benefit of the package for Phase 4 will turn on how successful the implementation of the MSR will be. As presently proposed by the Commission, the MSR will not be effective. However, we must recognise that the draft legislation put forward for the MSR is only in an early stage of the co-decision process and it will go through many rounds of deliberation and lobbying before it is finally agreed.

Footnotes

1.European Council (23 and 24 October 2014) Conclusions on 2030 Climate and Energy Policy Framework. Copy available at http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/145397.pdf.

2.Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, and the Committee of the Regions: A policy framework for climate and energy in the period from 2020 to 2030. Brussels, 22.1.2014. Copy available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52014DC0015&from=EN.

3.Phase 4 of the EU ETS will run from 1 January 2021 to 31 December 2030.

4.Monthly average prices for EUAs, source: World Bank State and Trends of the Carbon Market 2012.

5.The EU ETS's third phase commenced 1 January 2013, and will run until 31 December 2020.

6.Report from the Commission to the European Parliament and the Council – Progress Towards Achieving the Kyoto and EU 2020 Objectives (Brussels, 28.10.2014, COM(2014) 689 final). Copy available at http://ec.europa.eu/clima/policies/ggas/docs/com_2014_689_en.pdf.

7.Report from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions – Renewable energy progress report {SWD(2013) 102 final}. Copy available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52013DC0175&from=EN.

8.Communication from the Commission to the European Parliament and the Council – Energy Efficiency and its contribution to energy security and the 2030 Framework for climate and energy policy. Copy available at http://ec.europa.eu/energy/efficiency/events/doc/2014_eec_communication_adopted.pd 

9.European Commission: Proposal for a Decision of the European Parliament and of the Council concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC, COM(2014) 20/2, SWD(2014) 18 final (January 2014). Copy available at http://ec.europa.eu/clima/policies/ets/reform/docs/com_2014_20_en.pdf.

10.This translates into a 43% target versus 2005 levels for sectors covered by the ETS, and a change in the linear reduction factor after 2021 from 1.74% to 2.2%.

11.The movement of industries out of the European Union in order to avoid the impact of the EU ETS cap-and-trade mechanism.

12.This is in effect a continuation of the Article 10(c) exemption from Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003, establishing a scheme for greenhouse gas emission allowance trading within the Community (as amended). Based on recent figures, this would apply to Montenegro, Serbia and the Former Yugoslav Republic of Macedonia, Albania and Bosnia and Herzegovina, which are all at least 60% or below the EU-28 average GDP per capita.

13.Commission Staff Working Document – Impact Assessment: A policy framework for climate and energy in the period from 2020 up to 2030 {COM(2014) 15 final} (22/1/2014). Copy available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52014SC0015&from=EN.

14.An overview of the procedure for making law in the EU is available in our previous client alert, "The making of Emissions Trading laws – understanding the EU legislative process", which can be accessed http://www.reedsmith.com/the-making-of-emissions-trading-laws--understanding-the-eu-legislative-process-05-09-2013/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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