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Emissions Trading Systems - Unlocking opportunities

Daniele Strippoli

At a glance:

 

  • The revision to the EU Emissions Trading System (EU ETS) was published in the EU Official Journal on 16 May 2023. Member States are required to transpose the requirements into national law by 1 January 2024, except for the provisions relating to the buildings and road transport sectors which have a deadline of 1 June 2024.
  • The EU ETS works on the ‘cap and trade‘ principle. A cap is set on the total amount of emissions; within the cap companies buy or receive emissions allowances which they can trade with one another as needed.
  • Companies must surrender allowances covering their greenhouse gas emissions (GHG) emissions for the previous year.
  • The revision to the EU ETS forms part of the Fit for 55 package and strengthens the scope of the EU ETS to provide appropriate contribution to an overall target of a reduction of at least 55% in GHG emissions by 2030, compared to 1990 levels.
  • The cap of total allowances in the system will start to decrease at a faster rate from 2024.
  • The provision of free allowances to companies will begin to be phased out from 2026 with the phase in of the Carbon Border Adjustment Mechanism (CBAM).
  • The maritime transport sector will be included in the EU ETS from 2024 with surrender obligations from 2025.
  • A separate ETS (ETS II) will operate from 2027 or 2028 to price emissions from the buildings and road transport sectors.

This blog discusses some of the potential financial impacts on companies covered by the EU ETS regulations from the forthcoming changes. In particular, we consider several scenarios to provide an indicative quantification of the compliance cost implications for companies.

We first outline the changes affecting the number of allowances in circulation and the quantity of allowances companies receive for free. The results from the scenarios provide an indication that the cost of compliance for ETS participants is likely to increase significantly and could even double. However, these results are only indicative in nature, considering that they are based on a fixed quantity of emissions and free allowances.

Next, we explore two scenarios to illustrate how these changes may affect a company’s cost of compliance under the EU ETS, including maritime transport. Finally, we consider how the separate system for the buildings and road transport sectors may affect fuel prices.


Financial impact of EU ETS changes on industrial installations

 

The overarching goal of the EU ETS is to reduce GHG emissions. This is achieved by capping the total amount of GHGs that can be emitted by certain industries and requiring participants to pay for their emissions through purchasing allowances. The recent changes significantly increase the ambition of the EU ETS, which now aims to reduce emissions by 62% for participating sectors by 2030, compared with 2005 levels. This represents a 19% increase on the previous target.

Three key changes have been introduced to the EU ETS to achieve the targeted emissions reduction of 62%. These are outlined below:

Reduction in the total quantity of EU ETS allowances available

The declining cap means that each year the total quantity of allowances available for participants in the EU ETS decreases (See Table 1 below).

Table 1: Linear reduction factor of EU ETS cap. Source: Directive (EU) 2023/959


Reduction of benchmark values

Companies (except electricity producers) currently receive a proportion of their required EU ETS allowances for free. Since 2013, under Directive 2003/87/EC (the original ETS legislation), the proportion of free allowances that each company receives has been based on product benchmarks. These are set according to company production and represent the performance of the top 10% of installations (where the activity covered by the EU ETS occurs) for each sector.

The free allocation benchmarks for each product are being revised for the period 2026 to 2030 (see Table 2) and will decrease at a faster rate than in the current benchmark period (2021 and 2025).

Table 2: Annual benchmark reduction values. Source: Directive (EU) 2023/959


Phasing out free allowances

The revised EU ETS regulation holds that allocation of free allowances will be phased out for sectors covered by the CBAM which at present include cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen. This will occur in conjunction with the diminishing benchmark values, and take place over a nine-year period, beginning in 2026, after a transition period starting in October 2023 (see Table 3).

Table 3: Phase out of free allowances for sectors covered by the CBAM). Source: Directive (EU) 2023/959


Regulatory changes driving up cost of compliance

Directive (EU) 2023/959 is likely to result in increased costs to existing participants in the EU ETS. To illustrate the impact that the reduction of benchmark values and the CBAM factor could have on a company’s cost of compliance, we analysed two options (‘scenarios’): Scenario 1 and Scenario 2 in Figures 1 and 2 below.

Scenario 1 assumes that the price of EU ETS allowances remains constant at €85 for the years 2023 to 2030. If the installation’s emissions remain constant at 46,000 tCO2e per year and it receives 22,000 free allowances in 2023, the annual compliance costs would increase significantly over this period. If the installation produces goods within scope of the CBAM the compliance costs could increase from approximately €2 million in 2023 to more than €3 million in 2030. This illustrates that even with a constant allowance price, compliance costs would still increase over time due to the gradual reduction of free allowances.

Scenario 2 assumes a gradual increase of the price of EU ETS allowances over the period 2023 to 2030. Beginning at €85 in 2023 and increasing at a rate of 5.5% per year, EU ETS allowance prices reach €100 in 2026 and €123 in 2030. The installation’s emissions and allocation of free allowances are the same as in Scenario 1, however with the gradual price increase in EU ETS allowances the annual compliance costs would increase from approximately €2 million in 2023 to almost €4.5 million in 2030. This shows how a gradual increase in the allowance price may significantly increase compliance costs for companies within the scope ETS, almost doubling by 2030.

These scenarios are representative of an industrial installation that is currently allocated approximately 48% of its required allowances for free. We note that the assumptions applied regarding the EU ETS Allowance price may in practice differ.

Figure 1: Scenario 1, showing possible increases in EU ETS compliance costs resulting from the revised regulatory requirements with a fixed allowance price.

Figure 2: Scenario 2, showing possible increases in EU ETS compliance costs resulting from the revised regulatory requirements with an increasing allowance price.

The impact of these increased costs on a company’s revenue would largely depend on the carbon intensity of the goods being produced (tonnes of CO2 emitted per €1 million of revenue). Aluminium, for example, has a relatively high-carbon intensity and an installation the size of that in Scenario 2 could see an increase in costs equivalent to approximately 8% of revenue. Paper products, on the other hand, have a lower emissions intensity and are not currently covered by the scope of the CBAM. In this case the increase in costs for an installation the size of that in Scenario 2 would be significantly smaller and would represent ca. 1% of revenue.1 Thus, companies’ decisions whether to pass these costs to final consumers will depend on the size of costs, type of product and position in the market.

It is important to note that the price of EU ETS allowances can be affected by numerous factors, with recent examples being the Covid-19 pandemic and the war in Ukraine. Both resulted in significant price drops (42% and 33% respectively). To account for this, recent changes introduced by the revision to the Market Stability Reserve (MSR) aim to reduce the volatility of allowance prices in the future and provide greater market predictability, incentivising further investment in technology or processes to reduce emissions.


Financial impact of EU ETS changes on maritime transport

The extension of the EU ETS to maritime transport is likely to result in an increase in costs for companies involved in shipping. Shipping companies - defined as either the ship owner or any other company that has assumed responsibility from the ship owner - will be obliged to purchase and surrender allowances. This will be phased-in, beginning in 2025:

Table 4: Phase-in of maritime transport to the EU ETS. Source: Directive (EU) 2023/959

Despite the phase‑in, the sector is likely to face substantial costs from 2025 when allowances will first need to be purchased. 100% of GHG emissions for intra‑EU routes, and emissions while at port will be covered by the EU ETS; 50% of emissions will be covered for voyages beginning or ending outside the EU.

The scenarios below map the increasing cost of compliance based on a container ship that has an emissions profile of 16,000 tCO2e per year covered by the EU ETS (average emissions of container ships operating in the EU).2

Scenario 1 shows the potential costs if the price of EU ETS allowances remains constant at €85 over this period. In 2025, the value of surrendered allowances is approximately €540,000. In 2026 this increases to almost €945,000 and €1.35 million in 2027.

Scenario 2 shows potential the costs if the EU ETS price increases over time. Beginning at €85 in 2023 and increasing at a rate of 5.5% per year, EU ETS allowance prices will be €94 in 2025, €100 in 2026, and €105 in 2027. In 2025, the value of surrendered allowances is approximately €595,000 increasing to approximately €1.10 million in 2026, and €1.66 million in 2027.

Figure 3: Annual EU ETS compliance cost for maritime shipping with fixed allowance price of €85 (starting at 2025)

Figure 4: Annual EU ETS compliance cost for maritime shipping with increasing allowance price: €94 (2025), €100 (2026), €105 (2027)

Pricing emissions from ships will likely increase the cost of shipping, both for voyages between EU ports and for voyages beginning or ending in the EU. Some shipping operators have proposed to increase costs for forty-foot equivalent (FEE) containers , in response to regulatory-related pressures. The proposed cost increase could represent a 5% increase in the cost of shipping for a FFE between Rotterdam and New York, for example, based on the June 2023 spot container freight rates.3 Additionally, several knock-on effects are likely to occur, including increasing demand for more fuel‑efficient ships, and a reconfiguration of shipping routes.


Future considerations

 

EU ETS II

A separate emissions system will be introduced to price emissions from fuel supplied to the buildings and road transport sectors. It will start in 2025, when fuel suppliers will be required to report on their emissions for 2024. Fuel suppliers will need to purchase and surrender allowances for the first time in 2027, or in 2028 if energy prices are high.

This separate system has its own emissions reduction target, aiming to reduce emissions in buildings and road transport sectors by 43%, compared to 2005, by 2030. When this system begins to operate (in 2027, or in 2028 if energy prices are high), fuel suppliers for buildings and the road transport sector will need to purchase allowances to cover the quantity of fuel placed on the market.

CBAM

Participants in the EU ETS will need to keep abreast of the CBAM as it develops as the scope may be revised in future. Despite initially only applying to a select number of imports, the European Commission will review the product scope to assess the feasibility of including other goods produced in sectors covered by the EU ETS during the transitional phase. The first obligations for importers will come into effect as early as October 2023, with the full scope applying from 1 January 2026. Further information on the CBAM can be found here.

The initial CBAM reporting obligations, and provisional methodology for calculating the embedded emissions are outlined in an Implementing Regulation which was adopted by the European Commission on 17 August 2023. Furthermore, current CBAM legislation may be revised in the future to make improvements and close out unintended loopholes, such as assigning a zero-emission profile to re-melted scrap aluminium.


What companies
can do now

 

Although some of the new EU ETS provisions begin to apply from the start of 2024, companies within scope can take steps now to understand how to best reduce their emissions, if they have not done so already.

Undertaking regular emissions audits can help companies understand their sources of emissions, where and how they can be reduced, and where energy efficiency could be optimised. Investigating options for emission-reduction projects and technologies can be effective to help reduce a company’s carbon footprint. The EU has various funding opportunities available for companies looking to implement low-carbon or emissions‑free processes which can assist in meeting the costs of such investments. Examples of funds include, the Innovation Fund and the Modernisation Fund.

By acting early, companies can minimise the cost and risks associated with compliance and ensure that they are well prepared to meet the upcoming regulations. For further information on any of the topics covered, or if you would like to know how your company may be affected by these changes, please get in touch with us.


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References

 

1Carbon intensity calculations are based on the S&P Dow Jones Indices LLC, Trucost indices. Carbon Efficiency Index (Emissions intensity by sector, Scope 1 CO2e per $1M revenue (tonnes)).

22020 Annual Report on CO2 Emissions from Maritime Transport (Appendix 5: CO2 emissions per ship type)

3Drewry World Container Index of spot container freight rates (US$ 40 ft container).