EU ETS Reforms in store for phase IV

The European Commission review of the EU ETS is due in July and will be the start of the process to agree the additional Phase IV legislation. Following the Florence 10 year anniversary conference organised by the Commission, Redshaw Advisors takes a closer look at some of the possible reforms that are being debated prior to the release of the review.

The carbon leakage list is possibly the biggest point for debate of all the changes coming to the EU ETS in the near future. The debate around its rules and levels of protection has only intensified now that the MSR is all but finalised (the impact of which is forecast to raise prices threefold by the end of this phase - see Energy Aspects' carbon market research for more information). This has led to calls for greater protection for European industry which is said to be most at risk of carbon leakage, i.e. those businesses that may be forced to relocate to areas of the world where they will not face the same direct and indirect carbon costs. It is thought the carbon leakage provisions could either be a continuation of today's free allowance handout or an additional sale of allowances with the revenue raised used to directly compensate industry. The free allocation is finite so companies that qualify to receive 100% free allocation will gain it at the expense of those that don't. According to Reuters, regulators are considering drafting a new law that will offer free credits covering as little as 30 percent of companies' emissions depending on how likely they are to relocate abroad.

Currently industry protection from indirect carbon costs has been left up to member states so there have been calls for a formal, Europe-wide, response to this problem instead of the piecemeal policies individual member states have developed.

ETS linking is another area to be addressed with calls for the EU ETS to be linked to many of the other ETS around the world to try to create a worldwide carbon price, levelling the playing field for industry. The planned national scheme in China is one such possibility, however, there are many barriers standing in the way of linking with the political landscape and ambition of countries around the world differing enormously. The MSR also has the potential to create another hurdle to scheme linkages as a price support mechanism makes the level of ambition and indeed prices difficult to compare. Creating an MSR that extends beyond Europe will be near impossible given the complexities already involved in getting political agreement in Europe.

The future of unallocated allowances (i.e. those in the NER and other leftover EUAs) has been left to the European Commission to decide as part of the MSR compromise. Analysts predict there will be anything from 300Mt to 600Mt of unallocated allowances in the system come the end of phase III. Currently they are to go into the MSR but the European Commission, as part of its EU ETS review, will decide what is to happen to them with the possibility a large number of them being used in one way or another to support industry. Should this happen the effects would be two fold as not only would it support the receiving industry it would also damp down the effects of the MSR, a policy designed to reduce the EUA surplus and therefore to increase price.

Within the cap set by the European Commission, the allowances that are not handed out for free are auctioned by member states. The auctions are held on the EEX and ICE exchange platforms and generate vast sums of money for the member states. There have been calls for legislation to ensure the revenues from the auctions are spent on things with environmental benefit, however, this is likely to be resisted by a majority, if not all, member states. In a time of uncertainty and economic difficulty within the EU it is unlikely a policy that would put constraints on the use of member state revenue is likely to gain much traction.