Reform of the EU ETS

The EU ETS is the EU’s key instrument used to mitigate carbon emissions and is based on the “polluter pays” principle. It functions as a so-called “cap-and-trade” mechanism, where “cap” refers to the total number of emission allowances in circulation and “trade” refers to the market as the place where allowances are exchanged. Emission allowances are either allocated free of charge, bought directly from other installations or via auctions and allow their owner to emit certain amounts of GHG.

The EC initially proposed a reform of the EU ETS involving one-off cuts to the “cap” together with an increase of 2% in the annual reduction of allowances to 4.2% (“linear reduction factor”). In addition, the current EU ETS will be extended to maritime transport, while a separate EU ETS system (“ETS II”) will be introduced for fuel distribution for commercial road transport and buildings.

These measures should ensure that the overall quantity of allowances will decline at an increased annual pace resulting in an overall reduction of emissions by EU ETS sectors of 61 % by 2030 compared to 2005. This represents an increase of 18% compared to the current -43% contribution from the system to the EU's climate target.   

Compared to the Commission’s proposal, the EU Council and the EP have agreed on a more ambitious EU ETS. Emissions in the ETS sectors must be cut by 62% by 2030, which is 1% more than proposed by the EC. To reach this target the EU Council and the EP propose a steeper annual reduction. This reflects a trend whereby in recent years the EU Council and EP have often shown a higher level of climate ambitions than the EC (rather than watering down the latter’s proposal).

In general, with the reduction of the overall emissions cap, the number of free allowances will be reduced even more. The EC’s proposal does not change the basic rules for calculating the free allocation; free allocation will continue to be based on benchmarks representing the level of performance of the best installations. With the introduction of the CBAM (see below), the EC aims to allocate free allowances in a more targeted way and to incentivise the uptake of low-carbon technologies. The maximum annual reduction rate of the benchmark values will increase from 2026 onwards, shifting more free allocation to sectors that are harder to decarbonise. In addition, free allocation will be made conditional on decarbonisation efforts.

Introduction of a CBAM

In its “Green Deal”, the EC announced the introduction of a CBAM to reduce the risk of carbon leakage (i.e. companies transferring their production to third countries with less stringent climate policies). The risk of carbon leakage is currently addressed inter alia by means of free emission allowances. The EU ETS allocates free allowances to sectors at risk of carbon leakage, identified in a “carbon leakage list” for energy intensive industries. This is drawn up in consultation with the market, taking into account also the additional cost the EU ETS may cause for a sector, compared to the sector’s non-EU trade intensity.

The CBAM will address the risk of carbon leakage in a different way and stimulate the reduction of GHG emissions by third countries. The CBAM will function in parallel with the EU ETS, mirroring it to imported goods to ensure equivalent carbon pricing between imported goods and EU-produced goods. Under the CBAM, importers will have to buy and surrender a number of CBAM certificates corresponding to the embedded emission intensity of their imported products. In the proposal, the concept of importation is aligned with the customs procedure “release into free circulation” of the Union Customs Code (“UCC”). Goods e.g. placed under a customs suspension procedure may not be in scope.

To avoid double protection of EU industries, free allocation of allowances under the EU ETS will be phased out gradually while the CBAM is phased in at the same speed. The EC initially proposed a phase out of 10% per year as from 2026. The Council and the EP each proposed a more ambitious phase-out in their first readings, with the EP even envisioning a complete phase-out by 2032, and eventually compromising on a gradually accelerating phase-out of free allocations from 2026 to 2034. The CBAM will therefore be fully phased in by 2034. A transition period will start on 1 October 2023 during which the importers’ CBAM obligations will be limited to reporting. The CBAM will cover the sectors originally included in the EC proposal (i.e. iron and steel, cement, aluminium, fertilisers and electricity) and will be extended to hydrogen, indirect emissions under certain conditions (i.e. emissions related to the use of electricity by manufacturers), certain precursors and some downstream products (e.g. screws and bolts and similar articles of iron or steel). Moreover, before the end of the transition period, the EC intends to evaluate whether the CBAM’s scope should be extended to other goods, such as organic chemicals and polymers.

Although this was expected, the CBAM does not cover the issue of carbon leakage for EU exports to third countries. Both the EU Council and the EP mentioned in their press release that “further work is required on [such] measures” and additional allowances within the EU ETS will be used to address this risk. By 2025, the EC will assess the risk of carbon leakage for goods produced in EU and exported to third countries, and if needed propose legislation on this point.

What does this mean for you?

It was announced that the CBAM transitional period will take effect from 1 October 2023, while the CBAM will be gradually phased in from 2026 until 2034. During the transitional period, importers’ CBAM obligations will be limited to reporting. However, EU importers in scope of the CBAM (import of e.g. electricity, hydrogen, certain indirect emissions produced outside EU) would be well advised to evaluate in good time / at an early stage the potential impact on their business model.

We note that the agreements on the EU ETS reform and CBAM are still to be formally approved by the EP and EU Council. Feel free to reach out in case you have any questions on the above.