The European Commission Review of the EU ETS for Phase IV

The European Commission (EC) released its proposal for the revision of the EU emissions trading system (EU ETS) today, 15th July 2015. The review is deemed necessary to keep Europe on track to meet its aim of a 40% reduction in emissions by 2030 by extracting a 43% reduction from companies covered by the EU ETS. Redshaw Advisors have summarised the key points that we believe will increase the costs of the vast majority of companies forced to comply with the EU ETS.

The EC are predicting average Phase IV prices will be as high as EUR 25.40. Around 6.3 billion allowances are expected to be handed out for free to companies over Phase IV, estimated by the EC to be worth as much as EUR 160 billion, which means that the EC are expecting an average price in Phase IV of as much as EUR 25.40

Free allocations will be reduced. Phase 4 will be 10 years and will run from 2021 to 2030. It will be effectively split into two five-year phases because allocation and benchmarking figures will be re-evaluated after the first 5 years. This is to allow the free allocation process more flexibility to adjust to technological advances and changing production levels. The linear reduction factor will increase to 2.2% per annum from 2021, currently it is 1.74%. This will reduce the overall number of allowances in the system by 556 million tonnes over the decade, this is the equivalent to the annual emissions of the UK.

Production decreases will be penalised. Provisions are to be made to ensure allocations are more flexible in the event of a production decrease or plant closure or alternatively an increase in production. The New Entrant Reserve will absorb excess allocations from production decreases and provide the source for additional allocations for increases.

Carbon Leakage sectors to be severely curtailed. The rules will change as carbon leakage risk has been evaluated to affect only 50 sectors at the highest risk and will have the chance to receive 100% free allocation (relative to their sector benchmark). Under current leakage rules 180 sectors get 100% of their EUAs for free. The remaining sectors deemed to be below the highest risk will only receive 30% of their benchmark for free. Many sectors will therefore face much higher costs in Phase IV, especially considering that the EC forecast an average price of up to EUR 25.40 through the phase.

Benchmarking values will be cut for all. Benchmarking values will be reset in 2021 and re-evaluated in 2025 with the second set of new values applied from 2026. Free allocation is based on benchmarked values of the most efficient installations within the industry sector. Currently benchmark values are calculated on data from 2007-2008 and will be out of touch with the current state of technological advances by Phase IV. Effectively the free allocations of all within that sector are worked out in comparison to the most efficient installations.

This rewards the most efficient installations by leaving them with less allowances to purchase for compliance, effectively helping keep their marginal costs low. It is envisaged by the EC that the most efficient installations should not face "undue" carbon costs, this is being interpreted as getting more than everyone else in the sector but less than 100%, in some cases way less as the Cross Sectoral Correction Factor (by which everyone has their allocation decreased to accommodate the overall reductions required) will continue to be applied. Benchmark values for all sectors will decrease by 1% per year to ensure all sectors are contributing to the reduction of emissions and to reflect the improvements industry has been able to make. The improvements will be verified by data and the 1% decrease will be applied to all those with an improvement rate between 0.5% and 1.5% annually. For sectors below 0.5% improvement rate they will see a 0.5% reduction in benchmark values and those over 1.5% annual improvement will see benchmarked allowances fall by 1.5%.

Phase III unallocated allowances will go into the MSR except for 50 million tonnes that will be used to seed an innovation fund. It was originally thought that these would be auctioned at the end of Phase III but their withdrawal will, according to Thomson Reuters Pointcarbon, cause prices to rise by an additional �2.00 by 2020. 250 Mt will go into a New Entrant Reserve (NER) fund, crucially these allowances will only come to market in the event of new entrants joining the scheme or companies significantly increasing production. Any unallocated allowances from Phase IV, including allowances withheld from closures or production decreases, will also go into the NER fund meaning they will only come to market in the event of new entrants or production increases.

Other significant developments;

Member states will be left to decide their own policies for compensating indirect carbon costs (i.e. higher electricity prices). Currently 22 of 28 member states do not have a policy in place for this. Auction revenues can be used in whatever way a member state chooses, however, it is suggested that at least 50% should be used for climate and energy related purposes. There is also a recommendation from the European Commission that member states should invest in climate finance for vulnerable third countries. EU Allowances will be fully bankable from Phase III to Phase IV. Small emitters will face the same opt out rules as Phase III so there is no additional help for them. No new international offsets are allowed to be used. Modernisation and innovation funds will be in operation.

"My message to investors, businesses and industry: invest in clean energy," EU Climate Action and Energy Commissioner Miguel Arias Canete said in a statement on Wednesday in Brussels. "It's here to stay and continue to grow."

To understand what these proposals mean to your company, and more importantly, what you can do about it, please contact us so that we can help you assess and minimise the impact of these changes on your financial bottom line.