Navigating the Evolving EU ETS: What Can Transport Actors Expect?

The European Emissions Trading System (EU ETS) was originally put in place to regulate CO2 emissions from electricity/heat generation, energy-intensive industry, and aviation sectors of the European Economic Area (EEA), covering about 40% of the EEA’s GHG emissions, unlike the Carbon Border Adjustment Mechanism (CBAM) which on the other hand focusses on non-EU production emissions.

Since 2005, companies in these sectors have reported on their CO2 emissions as follows: each year, companies receive allowances through an allocation system, and some are provided for free by Member States. One allowance corresponds to the right to emit one tonne of CO2. These allowances must cover the emissions of the previous year. Companies that emitted less than the allowed limit can sell their excess allowances at an auction market. The ones that do not have enough allowances to cover their emissions must buy the difference at auction (from Member States or other companies).

The European Union sets a decreasing CO2 emissions cap per sector, therefore reducing the number of allocated allowances every year. The price of allowances sold on the market increases as the CO2 emission cap is lowered, giving companies an incentive to reduce their CO2 emissions as it becomes cheaper to pollute less than to buy allowances. For each tonne of CO2 emitted, without surrendering an allowance in due time, a penalty of a minimum €100 is applied on top of the cost of the due allowances. In addition, Member States must use at least 50% of the auctioning revenues for climate and energy-related purposes.

In December 2022, new agreements were reached between the Council and the European Parliament, to adapt the current scheme as well as to target new CO2 emitters. In this article, we will review the key learnings from EU ETS applications to part of the transport sector since 2012, as well as dive into its latest changes, starting with its early application to air transport, followed by its recent extension to maritime transport, as well as its future coverage of road transport.

The aviation sector has been included in the EU ETS since 2012 and only applies to flights within the EEA. For the period 2013 – 2020, the total number of allowances reached around 311 million, which were distributed as followed:

• 82% were granted (for free) to aircraft operators, proportionally to their tonne-km flown
• 15% were put up for auction
• 3% were allocated for a special reserve for fast-growing operators and new entrants

So far, the expected results from the application of the EU ETS to the aviation sector have not been achieved. Aviation emissions increased by +27.6% between 2013 – 2019 (2020 not being considered due to the bias of the Covid-19 crisis), whereas stationary installation emissions (other sectors covered by the EU ETS) decreased by 19.7% in the same period.  As a result, the share of aviation in the EU emissions has more than doubled from 1.5% in 1990 to 3.8% in 2019. This can be explained by the fact that too many allowances are allocated to aviation, which results in very low allowance prices. Even though some adjustments were made in 2017 and the price of allowances tripled in a few months, it remains low. In 2019, the average price of allowances was around €20, oscillating between €18 and €29. Allowances bought in the auction market resulted in a cost of €900 million for airlines, this can be considered a negligible cost since airlines benefit from a jet fuel tax exemption estimated at € 27 billion a year. If no free allowances were distributed, it has been estimated that auction costs would have increased from €900 million to €1.7 billion. Therefore, one way to improve the efficiency of the EU ETS in aviation would be to accelerate the rate at which allowances are withdrawn and to reduce/stop fossil fuel subsidies.

The European Commission has revised the rules of the EU ETS in aviation to ensure reaching the target of a 55% reduction in greenhouse gas emissions by 2030 (Fit for 55), by settling on the following:

• Flights within the EEA will continue to be covered by the EU ETS, as well as flights to Switzerland and the UK. In addition, flights between the EU’s outermost regions (OMRs) will be included in the EU ETS.
• International flights with OMRs and EEA countries will be included (flights between OMRs/EEA countries and other countries).
• The number of allowances is set to approximately 24.5 million in 2021, compared to 38.6 million in 2020 (-37%) and will decrease annually by 2.2% until 2030, compared to a linear reduction factor of 1.74% for the previous period (2013 – 2020).
• The number of free allowances allocated by Member States will be reduced progressively to disappear completely by 2027.
• 75% of the auctioning revenues are to be allocated to climate and energy-related purposes (compared to the former 50%).
• The share of sustainable aviation fuels (SAF) in the EU airports should increase over time: 2% by 2025, 37% by 2040 and 85% by 2050. 
• The Carbon Offset and Reduction Scheme for International Aviation (CORSIA) will be implemented under the International Civil Aviation Organization for extra-European flights. If emissions linked to those flights exceed the 2019 levels, emissions would have to be offset. 

To address another part of the European Union’s emissions, in December 2022 EU institutions reached a political agreement to add the maritime transport sector to the existing EU ETS. The exact scope targets most large vessels from 400 to above 5000 gross tonnages, nevertheless following slightly different timelines depending on ships’ categories.

Big offshore vessels of 5000 gross tonnages and above will be fully included in the EU ETS from 2027. This also includes a gradual obligation for shipping companies to surrender allowances starting from 2024 emissions: 40% for verified emissions of 2024, 70% for 2025 and 100% for 2026 (N.B. 100% of emissions on voyages and port calls within the EU/EEA but only 50% of emissions on voyages into and out of the EU/EEA). General cargo vessels and offshore vessels from 400 to 5000 gross tonnages will be subjected to monitoring, reporting and verification (MRV) requirements of CO2 emissions from 2025 and their inclusion in EU ETS is planned to be reviewed in 2026. In addition, the Union agreed to include non-CO2 emissions (i.e., methane and N2O) in the MRV regulation from 2024 and the EU ETS from 2026.

The number of allowances for the maritime transport sector will follow the new linear reduction factor applied in the EU ETS PHASE 1, meaning that the entire emission cap will be reduced by 4.30% annually from 2024 to 2027 and 4.40% annually from 2028 onwards.

Ships that fail to comply with the EU MRV requirements for two or more consecutive periods may be expelled and denied trading in the EU. As mentioned in the introduction, companies that fail to surrender allowances are liable to an excess emissions penalty of €100/tonne CO2 and are still responsible for the surrendering of the required allowances. Companies that do not comply for two or more consecutive periods may be denied entry into the EU for all ships under their responsibility (N.B. The agreement recognizes derogations for ice class ships, small islands, outermost EU regions and other public service journeys).

It is interesting to note that contrary to the aviation sector, the maritime sector will never benefit from free allowances. Certainly, as a key learning from the previous implementations of the EU ETS in other sectors, all EU emissions allowances for the maritime sector will have to be acquired through the EU ETS. This should prevent allowances prices from dropping under a certain level, from where they do not incentivize market actors to reduce their emissions.

As part of the new agreements reached between the Council and the European Parliament in December 2022, the decision was made to introduce a new – separate – EU ETS PHASE 2 targeting the emissions from buildings and road transport sectors, both commercial and private. The new system will apply to distributors that supply fuels to buildings, and road transport, with the scope being extended to fuels used in certain industrial sectors. This represents a significant step as 75% of the bloc’s emissions will now be brought under a pricing scheme, thanks to the latest introduction of the EU ETS PHASE 2.

The system is expected to start in 2027, but it may be postponed until 2028 in the event of exceptionally high energy prices. The envisioned linear reduction factor is set at 5.15% from 2024 and increase to 5.43% from 2028. (N.B. The agreement includes a temporary provision for member states to exempt suppliers from surrendering allowances until December 2030 if they are subject to a carbon tax at the national level, the level of which is equivalent to or higher than the auction price for allowances in the new emission trading system). Moreover, it has been agreed to auction an additional 30% of the allowances volume on the year of the system’s launch, to ensure a smooth run on its first year, also referred to as “frontloading”.

In addition to the elements mentioned above, the EU ETS PHASE 2 has also introduced a new measure called the Market Stability Reserve (MSR) designed to address the issue of oversupply in the EU ETS, which has led to a low carbon price and reduced incentives for companies to reduce their emissions. The MSR will work by removing allowances from the market when there is an oversupply and returning them when there is a shortage. This will help to stabilize the carbon price and ensure that the EU ETS remains an effective tool for reducing emissions.

However, once the system is in place, a price stability mechanism will be implemented, releasing an additional 20 million allowances if the price of allowances exceeds 45€ over a significant period. This cap of 45€ raises questions about the system's ability to drive decarbonization in the targeted sectors, as it is far below the actual CO2-avoidance costs ranging from 100 to 300€/tonne in the building and road transport sectors. The EU ETS II, in its current form, appears to be closer to a carbon tax with a maximum price level of €45/tonne than an actual trading scheme, at least until 2030. From 2030 onwards, no price cap is currently foreseen, which could mean stronger incentives for companies to reduce their emissions.

While the transport sector will be included in a new EU ETS as of 2027, the sector has already been regulated by the Effort Sharing Regulation since 2018.

The Effort Sharing Regulation (ESR) has been launched back then as part of the EU’s climate and energy policy framework for 2020, establishing national binding targets and laying down emissions allocations on Member States for the period of 2013-2020. The ESR aimed at a collective reduction of 30 % in GHG emissions by 2030 compared to 2005 levels and applies to sectors not covered by the EU ETS, such as the transport sector. While emission allocations are distributed according to a wealth criterion, Member States can decide on how those goals will be reached. Flexibility mechanisms are set up under the ESR to help Member States reach their targets. Members states can bank surpluses to use them later, borrow allocations from the following year, and buy and sell emission allocations to and from other Member States. Safety reserves are also put into place.

The Effort Sharing Regulation has been revised in July 2021 as part of the “Fit for 55” package and extended for the period of 2021-2023 with an increase of the collective reduction target to a 40 % reduction in total GHG emissions by 2030 compared to 2005 levels. Besides this, following an impact assessment conducted by the European Commission, the proposal has concluded the need to maintain the existing scope of the ESR, despite the upcoming new EU ETS on the transport sector. From an economic point of view, the rationale for setting up a double regulation system is rather weak in light of the significant number of legislative pieces needed to set up the system and the regular coordination measures required. However, from an environmental perspective, the impact assessment conducted by the European Commission shows how this policy mix would be the best set of measures to reach the EU climate targets under the European Green Deal. The principal argument for maintaining the ESR is the low price-sensitive abatement potential of the sector, requiring the need for other measures than carbon pricing.

Some reflections on the co-existence and coordination of the upcoming EU ETS on transport and the existing ESR emerge. The entanglement of both policy packages, without the mentioning of a coherent measure package to ensure their co-existence, raises questions on their coordination, and the unintended consequences that those simultaneous frameworks may trigger. However, the European Commission has not yet referred to any concrete measures that will be implemented to avoid unintended consequences linked to the double scope coverage of the transport sector, apart from cautious planning and data gathering. Efficient coordination of the new EU ETS in the transport sector and the ESR could be ensured by a set of measures, such as legislative measures with linking provisions between both frameworks, to enable trading between both systems, enabling the use of a few allowances from the new EU ETS to be used for compliance under the ESR, and vice-versa. Eventually, particular attention should be given to the cap setting of the new EU ETS in transport, which should be aligned with ESR measures, to prevent over-supply of EU ETS allowances that could make the policy mix ineffective.

Considering its strengthened environmental ambitions, the European Union has decided to scale up its measures through the reinforcement of the EU ETS as a crucial driver of decarbonization for the transport sector. This sector is responsible for more than a quarter of Europe’s emissions.

Road transport, as the biggest emission source in the transport sector, is responsible for more than 70% of the sector’s GHG emissions. While the upcoming EU ETS on transport and the ESR will be applied on the same scope in road transport, the European Commission however has not yet defined how this will be achieved. This raises questions about these measures’ efficiency and how they will be coordinated to coexist simultaneously. Besides, the price cap set raises questions about the system’s ability to drive efficient decarbonization.

As the second biggest emission source, maritime transport represents about 14% of the sector’s GHG emissions. While the European Commission intends to include the maritime sector in the existing EU ETS, the efficiency of this measure remains to be determined. Nevertheless, there seem to be more chances to see positive results as no free allowance will ever be issued to maritime transport actors.

The aviation sector accounts for about 13% of transport emissions in Europe. However, its inclusion in the EU ETS has, so far, not been successful at cutting greenhouse gas emissions, especially due to the low price of allowances. Besides, the Commission’s revision regarding this system and its efficiency remains to be clarified.

Overall, while the European Union faces environmental challenges of unprecedented scale and urgency, the efficiency of the revised EU ETS system to drive decarbonization in the transport sector is still to be proven. Bold actions will be needed to bring Europe back on track and reach its environmental targets. Concrete actions are starting to emerge. For example, to encourage a modal shift from air to rail, as France recently forbade domestic flights under 2.5 hours duration - that have a direct rail alternative in both directions with less or similar travel time - or by reintroducing night trains, as Midnight Trains intend to do by 2024, connecting Paris to other major European cities.

Nevertheless, these emission reduction initiatives and regulations face serious limitations as soon as any economic interest is at stake. The European Union and its member states need to align their priorities, and not let economic protection become the downfall of too many emission reduction efforts. This translates into decisions to invest significantly more in sustainable modes of transport, as well as stopping investments in the most carbon-intensive ones (if not related to the decarbonization of the sector).