Why was the emissions trading system introduced?

The EU Emissions Trading System (EU-ETS) was introduced in 2005[1]. It was designed to prepare the EU for implementing of the Kyoto Protocol, an international agreement that required developed countries to reduce their carbon dioxide emissions by 5% by 2012 compared to 1990[2]. Behind the ETS stands a decades-long record of international cooperation and scientific development on climate change.

In Poland, which participates in the EU-ETS, the mechanism tends to be criticized. The main axis of this criticism relates to frequent regulatory changes, which affect the price of emission allowances – this is perceived as interference with the market nature of the system. In addition, the EU ETS covers only about 40%[3] of CO2 emissions - those from power generation, heating, industry and aviation, which is seen as unfair from the perspective of these sectors.

The EU is not the only place where a carbon trading system exists. Globally, 24 similar mechanisms operate at regional or national levels – including China and some US states[4]. The challenge is that the systems, although similar in concept, differ in how they work. This creates an uneven playing field in global competition: products which include a lower CO2 price than that in the EU-ETS are cheaper.

Operating principles of the EU ETS

The goal of the EU-ETS is to bring greenhouse gas emission reductions by including the cost of CO2 in the production of energy and industrial products.

The EU-ETS requires emitters to acquire and surrender CO2 emission allowances (EUAs). In principle, allowances are purchased on the market from an available pool, known to all market participants. However, there are exceptions to this rule: the heating sector as well as industry and aviation, which are exposed to carbon leakage[5], receive a portion of allowances for free.

As the ETS is primarily designed to reduce CO2 emissions into the atmosphere, the pool of allowances available on the market is decreasing year on year in line with EU reduction targets. The limited supply raises allowance prices.

Allocation of allowances and their value

The rules for allocating allowances among EU-ETS participants are set out in the ETS Directive[6]. According to these rules, the European Commission assigns EUAs to:

- the pool of free allowances, which are distributed mainly to installations exposed to carbon leakage (43% of total allowances with the possibility to increase it to 46%);

- the auctioning pool, sold by:

• Member States (base pool + solidarity mechanism allocation),
• dedicated funds (Modernization Fund and Innovation Fund) through the European Investment Bank.

The money raised from the sale of allowances by states is their budgets’ revenue. The ETS Directive indicates that at least 50% of the revenue from the base pool and 100% from the solidarity pool should go towards climate objectives.

Several countries have decided to earmark their ETS revenue (as mentioned in a previous Forum Energy report[7]). In Poland, discussions on a comprehensive regulation on earmarking these funds for climate purposes are still in progress[8]. The sums involved are substantial - the value of allowances sold by the government, after taking the solidarity mechanism into account, may amount to EUR 46 billion in the years 2021-2030.

Support schemes in the ETS

Due to different circumstances of member states, support mechanisms are built into the EU-ETS to facilitate mitigation efforts. These include:

• A solidarity mechanism: under the current EU-ETS period (2021-2030), ten per cent of auctioning allowances have been set aside "in the interest of solidarity and growth in the Union to reduce emissions and adapt to the effects of climate change" (the so-called solidarity mechanism). In practice, this pool is redistributed among 16 countries in need of support. Poland is its biggest beneficiary, increasing the number of allowances the government can auction by 39%.
   
• The Modernization Fund: this is 2% of all allowances in the EU, or around 275 million EUAs[9] . The funds obtained from the sale of these allowances are earmarked for climate projects in the least wealthy Member States. As in the solidarity mechanism, Poland is the Modernisation Fund’s main beneficiary. 43% of the Fund’s resources (about EUR 6 billion) are assigned to Poland.
   
• The Innovation Fund: 450 million allowances to be monetized to support innovation projects across the EU. Institutions from all Member States can apply for funding from the Innovation Fund[10].

Fit for 55 - what to expect

Climate policy in the EU is moving forward. In July, the European Commission will present the "Fit for 55" legislative package. Its aim will be to prepare mechanisms for the implementation of the increased 2030 EU emissions target. As the EU-ETS plays a key role in reducing emissions in member states, its reform will be included in the package. The discussion on fluctuating CO2 prices will be an important element of the negotiations, but other threads will be more significant. Following are the topics of reform, which will affect the operation of the ETS:

• Reduction in the volume of available allowances in the ETS.
  A higher reduction target in the sectors covered by the ETS will mean that emission allowances in circulation will be reduced more quickly. Currently, the Linear Reduction Factor (LRF) is 2.2%. According to KOBIZE analyses, a higher GHG reduction target could translate into an average LRF of 3.7% and the allowance price could rise to EUR 76/EUA[11].
  The reduction target in ETS sectors will, however, depend on the emission reduction commitments in non-ETS sectors (e.g. transport, buildings, agriculture). Mitigation efforts in both ETS and non-ETS sectors should cumulatively reduce EU GHG emissions by 55% by 2030.

• Review of the functioning of the MSR (Market Stability Reserve).
  Since the beginning of the EU-ETS a surplus of about 1.5 billion allowances has accumulated in the system[12]. The surplus has contributed to a drop in allowance prices between 2013 and 2018. For this reason, a Market Stability Reserve was introduced. Currently, if the surplus exceeds 833 million allowances, 24% of the surplus’ value is deducted from the annual pool of allowances to be auctioned. From 2023 onwards, the number of allowances in the MSR that exceeds the allowance pool for a given year is to be permanently removed from the market. If the surplus were to decrease to 400 million, 100 million allowances from the MSR should return to the market. The review of the MSR will verify the thresholds and the pace at which allowances are removed and returned to the market.
   
• Carbon pricing in transport and buildings.
  The essence of this proposal is to introduce a carbon price on emissions in the buildings and transport sectors, which today are not in the ETS, but account for about 30% of total EU emissions[13]. Several options are being considered for introducing this policy: a new tax, the inclusion of buildings and transport in the current ETS, or the creation of a separate ETS for these new sectors (in which case the two ETS schemes would operate in parallel)[14] .
  
  Putting a price on the environmental costs of emissions from buildings and transport is important in driving the most emitting technologies (coal-fired boilers, internal combustion engines) out of the market. In addition, it will be key to take regulatory measures, to set specific norms, standards and targets, and to organize financial support systems for less wealthy countries. The introduction of CO2 pricing should be gradual, so as not to cause a price shock to end consumers. Ultimately, 100% of the proceeds of the new charges should go to support low-emission technology deployment and for social protective measures. The new ETS option is also an opportunity to create a dedicated social fund, similar to the Modernization Fund, which could be used, for example, to fight energy poverty[15].
• New allowance distribution.
  This is an issue raised by Poland[16]. Currently, the basic pool of auctioning allowances is divided among countries according to their share of emissions in the whole EU from 2005-2007. This rewards countries which have since then reduced emissions the most. Maintaining this historical proportion means that countries that have made larger reductions could expect to have a surplus of allowances for 2021-2030. Their sale will generate additional budgetary revenue. Surplus allowances can be purchased by installation operators in countries such as Poland, where the allocated pool will likely not fully cover domestic emissions.
  
  As part of the ongoing discussions on the EU-ETS reform, the Polish Government has put forward an idea to change the way auctioning pools are allocated. The Polish proposal is to change the reference point from 2005-2007 to the share of emissions in the 2016-2018[17] period. This would increase the number of allowances for Poland and reduce it for countries whose share of EU emissions has fallen.
  
  Such a change will be difficult to accept for countries that have put significant effort into reducing emissions earlier. However, since these are mainly countries with a higher GDP/capita than Poland, the government could request an increase of allowances in the Modernization Fund and the solidarity mechanism. 

Summary

The ETS is like democracy – despite its flaws, no better system exists to support emission reductions in a cost-effective manner. In Poland, high CO2 prices are a source of fear - they are forcing action from sectors, which have been historically reluctant to change. On the other hand, technological stagnation in power generation, heating and industry is no longer possible. Poland is losing its competitiveness quickly and without reducing emissions, our economy may fall into a high-cost spiral. Therefore, aside from compensation for energy-intensive industry, all the proceeds from the sale of CO2 allowances should now go towards reducing emissions and combating energy poverty[18]. At the same time, it is important to engage in constructive dialogue on the EU-ETS reform and carbon pricing in transport and buildings. This will make it possible to concentrate our negotiating efforts in areas where we have the greatest chance of gaining additional resources for Poland, namely increasing the solidarity mechanism and the Modernization Fund.