Climate: how the EU carbon market works in 8 questions

MEPs on Wednesday rejected a text to reform the European carbon market, one of the pillars of the EU’s climate plan. But what does this carbon market mean? And how does it work? Les Echos answers eight questions.

1. What is the purpose of the European carbon market?

In 2005, the European Union created a carbon market to measure, control and reduce greenhouse gas (GHG) emissions from the continent’s major industrial players, as well as electricity producers. This mechanism is also referred to as Emissions Trading Schemes (ETS) or Emissions Trading Schemes (ETS).

The European Union is the first political entity to create a carbon market. China launched its own in 2021.

Specifically, this mechanism is to make companies pay for their CO2 emissions. For every ton of CO2 emitted, manufacturers and electricians covered by this market must submit a carbon credit. And the higher the price of carbon, the more incentive companies have to cut greenhouse gas emissions.

When the carbon market was launched, the EU aimed to cut GHG emissions by 40% by 2030 compared to 1990. In 2020, the European climate ambition was revised upwards with a 55% reduction in GHG emissions by 2030 compared to 1990

2. How does the carbon market work?

Each year, the EU sets a ceiling on total CO2 emissions and “allocates” emission allowances to the 11,000 industrial sites that account for 45% of CO2 emissions. A carbon cap is a title that corresponds to one tonne of CO2 (or CO2 equivalent) emitted into the atmosphere. In 2020, 2.2 billion carbon credits were distributed.

At the end of the year, each company must return to the government an amount of emission allowances equal to the number of tons of CO2 it has emitted. To get them, he can either buy them at auctions regularly organized by the authorities, or buy them in the market where other companies resell what they have in excess. However, some manufacturers still receive a significant portion of their allowances for free. Companies can also keep their unused quotas for the next year.

Thus, through this mechanism, producers are fully incentivized to reduce greenhouse gas emissions. If the company does not return the required number of allowances to the authorities at the end of the year, it will incur a fine of 100 euros per tonne of excess CO2.

3. How are quotas distributed?

Quotas are auctioned on a platform common to member states called the European Energy Exchange (EEX). Between 2013 and 2020, 57% of quotas were sold at auctions, and the EU has set itself the goal of gradually increasing this level.

In 2020 alone, the auction of permits brought the EU 19 billion euros. Auction revenues are redistributed among Member States and 50% of their value must be invested in sustainable development.

However, the EU continues to allocate quotas free of charge in industries with strong foreign competition. The goal is to avoid “carbon leakage”, i.e. moving activities outside the EU if environmental regulations become too strict. In 2020, 837 million benefits were distributed free of charge. For example, Arcelor Mittal in France has received over 83 million carbon permits free of charge.

Power plants, they no longer receive free allowance since 2013, because their operation is very difficult to transfer.

4. How is the quote price set?

The price of a carbon benefit is set by the law of supply and demand. Thus, the price per tonne of carbon increases when these “pollution rights” are in high demand. It is also assumed that the cost of permits will increase when supply decreases, i.e. when the EU lowers the limit on total CO2 emissions for the year.

Between 2012 and 2020, the EU reduced the number of carbon credits by 1.74% per year. And since 2021, the cap began to decline at a rate of 2.2% per year. In doing so, the EU encourages companies to reduce their emissions.

In line with EU targets, the price per tonne of carbon has risen sharply in the long term. In January 2014, companies could buy a CO2 quota for an average of 5 euros. These low prices did not encourage companies to reduce their emissions. In 2020, the European Commission announced a target to cut its greenhouse gas emissions by 55% by 2030 compared to 1990, leading to a rush to quotas and, mechanically, to higher prices.

In 2021, carbon prices peaked from 37.45 euros per tonne in February to 80 euros in December. The rise in gas prices, which prompted electricians to resume burning coal, which is cheaper, but also more environmentally friendly, is questionable. This forced them to buy more allowances to offset their emissions, which mechanically pushed up carbon prices.

This is enough to panic some producers who regularly sound the alarm, explaining that high prices reduce their ability to invest.

5. Which companies are interested?

The ETS rules apply to power plants as well as large industries. This applies to the steel, glass, oil refining, chemical and cement industries with a capacity of more than 20 megawatts. In 2012, the aviation sector was included in the ETS, but CO2 emissions from this sector are only taken into account by intra-European flights.

This mechanism is applied in all states of the European Union, as well as in Iceland, Liechtenstein and Norway. The European authorities aim to integrate maritime transport into ETS by 2030 and create a market dedicated to road transport and building heating.

6. Is the market efficient?

The European carbon market has long been inefficient due to large quota surpluses. Indeed, after the 2008 crisis and the associated drop in industrial production, the demand for carbon credits fell. The emission ceiling set by the EU, for its part, has remained stable, leading to oversupply. These two phenomena have led to a rather low price per tonne of CO2. Between 2012 and 2017, these “pollution rights” cost no more than 10 euros per ton.

Thus, at such extremely low prices, there was no incentive for companies to cut greenhouse gas emissions. Some even made big profits by reselling their free allowances. To address the issue of oversupply, European authorities created the Market Stability Reserve (MSR for Market Stability Reserve) mechanism in 2019 to automatically withdraw excess permits above a set limit. a certain threshold.

7. Have companies reduced their emissions?

It depends on the sectors. According to a report by the Institut Jacques Delors, emissions from the power industry fell by 27.7% between 2013 and 2019, while emissions from industry fell by only 2.1%. “The main difference is that electricians do pay for carbon: when they burn a ton of coal to generate electricity, they have to buy a ton of CO2 from the market. While industrialists receive free quotas,” explains Thomas Pellerin-Karelin, director of the energy center of the Jacques Delors Institute.

“The amount of free benefits they receive is almost equal to the amount they need each year. And in 2020, they received more free allowances than they actually issued emissions. So the carbon market is efficient for electricity production, but has become inefficient for industry with a system of free quotas,” the expert continues.

8. What are the EU’s plans for the carbon market?

The free distribution of quotas is the subject of a bitter struggle in the European Parliament. The Greens and part of the left want to end this as the carbon frontier adjustment mechanism is in place. Indeed, by imposing a carbon price on imports, this “carbon tax” should put European producers on an equal footing with their competitors outside the Union. The right, however, is seeking to temporarily keep free allowances in parallel with a carbon tax at the borders in the name of protecting European industry from displacement.

“This is the official argument of the polluting industry lobbyists. But there are no cases of resettlement due to ETS,” says Thomas Pellerin-Karelin. “The longer you delay the end of free quotas, the more you support the polluting industry,” the expert adds. In total, the industry will receive more than 50 billion euros of free carbon credits annually. Some experts argue that this does not encourage manufacturers to invest in greener production methods.

The text on reforming the ETS was submitted to the European Parliament on Wednesday. But to everyone’s surprise, parliament voted against the text because of an amendment put forward by the EPP (the pro-European right, the first force in parliament) to maintain free quotas until 2034. The red line for the Greens and Social Democrats who voted against the final text was considered not ambitious enough.

“Our goal is to help the industry not to be too violent,” MEP Agnès Evren (EPP) told Echos. “However, a text defended by the left and aimed at ending in 2030 would cut our emissions at the cost of multiple resettlements. We want to set reasonable goals,” she added. The text will be sent back to the Parliamentary Environment Committee for reconsideration in the coming weeks.