EU Emissions Trading System Reform: Making Things Simple or Simplistic? The Case of Copper

During the COP22 in Marrakech, the international community has once again gathered to discuss its responsibilities in the fight against climate change, because to this day there is still no international regulatory system that is comprehensive and binding.

There is a legislative framework at EU level highly debated this week in Brussels and Strasbourg: the emissions trading system, known as EU ETS. This system is considered the cornerstone of the Union’s policy in combating climate change, and a key tool for reducing greenhouse gas emissions ‘cost-effectively’.

The EU ETS: a System Based on Two Key Aspects:

1. A cap on maximum greenhouse gases that can be emitted by those units that are covered by the system. The EU ETS currently covers combustion plants with an installed capacity of more than 20 MW within the energy sector as well as industrial installations that emit CO2 (e.g. during power production or through industrial processes). For each ton of CO2 emitted, the owner of the emitting installation has to present an emission allowance certificate “EUA”. Each year, only a limited number of certificates are available. This guarantees that the emission cap within the EU ETS will not be exceeded. The cap is defined as a European cap – specific caps for a certain region (e.g. a Member State) are not part of the system. The cap is reduced at a linear rate so that total emissions fall over time. The household, transport or building sectors are not covered by the EU ETS.

2. A market of emission allowances. Within the EU ETS, companies can trade with one another as necessary. As only a limited amount of certificates is issued each year (cap), the European emitters of the covered sectors compete for the right to emit carbon. This mechanism “puts a price on carbon”, thereby internalizing the cost of emitting CO2 into decisions for investments and/or for dispatching/production of units. Economic theory concludes that carbon emitters who have the lowest abatement costs will thus try to use those abatement options in order to set free (and sell) allowances to others.

Why “Carbon Leakage” is Considered to Be the Achilles’ Heel of the EU ETS

Since the EU ETS is only applied within the territory of the 28 EU Member States (as well as in Iceland, Norway and the Liechtenstein), an effect known as “carbon leakage” can occur: If emitting carbon in Europe incurs costs that do not occur for the same industry in other regions (e.g. China, US), industrial activities in Europe are – de facto – more expensive than those in other regions. This does not mean that putting a price tag on carbon emissions in Europe is wrong, but it does result in competitive issues for those products and industries that emit carbon dioxide and face international competition.
Businesses, worried about maintaining their competitiveness, are tempted to relocate or to divert investment (investment leakage) to non-EU countries with more lax carbon regulation. In the long run, this could result in the move of energy intensive industries to outside Europe. The positive effect on EU emissions may result in a detrimental impact on global emission levels (e.g. production processes in China are typically more carbon intensive than in Europe).

Policy makers therefore decided to introduce some form of compensation. Those sectors that are most exposed to the risk of carbon leakage (because they are emission intense and compete with players from other regions) receive a limited amount of free emission allowances so that they can remain competitive. DG CLIMA is in charge of identifying the beneficiaries on a case-by-case basis using a qualitative approach. It is an administrative burden, but it is a lesser evil that encourages industries to continue stimulating the European economy while reducing greenhouse gas emissions to protect our planet.

A Simplistic Reform with Disastrous Consequences

In July 2015, the European Commission proposed a revision of the ETS covering the 2021-2030 trading period. Policy makers seem to be surprised (or disappointed) about current price levels for EUA certificates. While allowance prices at the start in 2007 were about 15 EUR/t CO2 (with a peak price of about 30 EUR/t) current prices are in the range of 5 EUR/t. The reason for this price decrease is twofold:

• Firstly, the economic crisis in 2008/2009 resulted in lower industrial activity and power production in Europe. With the cap being calculated at “normal industrial activity levels”, a “surplus” of allowances occurred.
• Secondly, policy makers introduced parallel carbon avoidance policies, such as Energy Efficiency measures and the promotion of Renewable Energies – both instruments dilute the price signal from the EU ETS market.

In order to try to raise prices again, the Commission envisages now a stricter system:

• the overall amount of available emission allowances (“cap”) is reduced, and
• the rules on compensation for carbon leakage are being overhauled so that the share of certificates that will be issued to industry for free will be reduced.

While the approach to reduce the overall volume of allowances might indeed result in higher prices (if the volumes are really taken out of the system and not just auctioned later) the impact of reducing the share free allocation instead of auctioning certificates is unlikely to have a significant price effect. It will more likely mainly have a “distributional effect” meaning that the industry will face additional costs compared to an allocation with a higher free allowance. The overall demand for allowances will not be effected in the short term.

In the existing draft legislation, the list of sectors ‘highly affected’ by the carbon leakage risk would be reduced from 150 to 50, and the method to decide on which sectors are “at risk” would become quantitative instead of qualitative, i.e. relying on a simple mathematical formula that multiplies global trade intensity by emission intensity.

It is understandable that the Commission wants to make things simpler. However, this simplistic approach does not take into account real-world situations and the specificities of certain products. Taking copper as an example: copper production and its products are heterogeneous. An overly simplistic approach to allocations will not provide the required accuracy and will result in unintended under-allocations for industry – increasing the risk of investment leakage. Apart from the negative effects on employment, GDP and tax income, this can be counterproductive for the transition towards a low carbon energy economy as copper products play an important role in innovative and green technologies.

Therefore, not only is the proposed reform potentially damaging for the European economy, it is also counter-productive for the fight against global climate change.

In a nutshell, an adequate allocation of allowances to European industry that is both carbon emission intensive and which faces strong international competition will be important due to the following reasons:

1. Many industries would no longer be protected against the risk of carbon leakage

Without free emission allowances, those businesses that are not able to pass-on the costs of carbon trading, will be obliged either to buy allowances or make considerable uneconomic investments. In extreme cases, businesses will leave the EU to maintain a competitive cost base.

2. Free allowances stimulate innovation

Granted allowances are stimulating the sectors concerned and are enabling business to innovate in the right direction – towards a greener economy – because they are fully aware that the cap on maximum greenhouse gas will decrease. Within the non-ferrous metals sector, the copper industry has invested in technologies to reduce its per ton CO2 emissions by 60% since 1990. By proposing such a rigid quantitative approach, the EU would effectively be punishing good performers in future trading periods.

3. A quantitative method does not take into account price mechanisms

Introducing a simplistic, quantitative method presents a major flaw: it does not take the specific features of products and market volatility into account. Many sectors produce commodities that are priced globally on commodity exchanges, such as the London Metal Exchange. EU producers are unable to pass on ETS based costs to their customers. Therefore, regulations that impose additional costs, only on EU companies, will damage their international competitiveness. This is inconsistent with the EU’s efforts to create more jobs by encouraging more industrialisation (20% of GDP by 2020).

While fully supporting the climate change benefits delivered by the ETS, our knowledge shows us that the current reform proposed by the European Commission contains many flaws. However, we remain committed to engaging in a constructive dialogue with the EU Institutions and civil society in order to develop concrete solutions.

Have a look at all your options for trading coppers or emissions with Option.Finance Commodities.

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