Phase 3 of the European Union Emissions Trading System (EU ETS) is coming to an end this year. The amended Phase 4 of the EU ETS Directive, which will cover 2021-2030, will help the EU to achieve the overall greenhouse gas emissions reduction target for 2030 through a mix of interlinked actions. With this year’s deadlines for emission verification and surrender approaching soon (verification deadline is 31st March, surrender deadline is 30th April), many of our customers are not only seeking to ensure they are compliant this year, they are also curious about the future compliance and risk aspects of the EU ETS.
2021 will be a transitional year from Phase 3 to Phase 4; all qualified companies will receive emission allowances for Phase 4, and will simultaneously need to finalize Phase 3 obligations (emission verification and allowance surrendering). This creates some confusion and raises many questions for operators trying to plan ahead and comply with the EU ETS obligations. In this Q&A blog we will answer our customers’ most common questions about the transition between Phases 3 and 4 and overall management of the EU ETS.
CALL OUT: Read our previous blog post for an overview of the recent updates on the EU ETS.
Mila Krivokapic, Sustainability Consultant, Schneider Electric Energy & Sustainability Services, answers our customers' most common questions about the transition between Phases 3 and 4 of the EU ETS.
I believe my company will have a surplus of allowances in Phase 3 - Can I carry them over to Phase 4?
YES - All residual emission allowances an operator has on their account at the end of Phase 3 will continue to be valid in Phase 4 and beyond. Allowances will be automatically carried over to Phase 4 accounts with no actions required by operators.
Will I receive free allowances in Phase 4? How many?
IT DEPENDS – To accelerate emission reduction, the EU has decided to cut the total number of emission allowances at an annual rate of 2.2% from 2021 onwards, compared to the current 1.74% rate. The EU revised the system of free allocation for EU ETS to focus on sectors with the highest carbon leakage risk (risk of relocating their production outside of the EU). For these sectors, allocation of free allowances will continue in Phase 4. For sectors with lower risk of carbon leakage, free allocation is predicted to phase out post-2026 from a maximum of 30% to 0% at the end of the phase (2030). Free emission allocations for Phase 4 are not yet visible in the registry for any operators, but unless an operator’s NACE code matches the codes on the carbon leakage list, they are at risk of losing their free allowances in Phase 4.
I believe my company will have a deficit of allowances in Phase 3 – Can I use Phase 4 free allowances to cover the deficit?
NO - The emission allowances given to operators in Phase 4 will not be valid for usage in Phase 3.
Companies were previously allowed to use the free allowances allocated in February to surrender in April of the same year during Phase 3. This will unfortunately not be an option during the transition from Phase 3 to Phase 4. Consequently, the CO2 registry will not allow operators to surrender Phase 4 allowances before the final closing of Phase 3. This means that participants who must surrender allowances for Phase 4 should make sure they have enough emission allowances from Phase 3 in their account to surrender, or otherwise purchase Phase 4 allowances.
Will I know if the allowances are from Phase 3 or Phase 4?
YES - Phase 4 allowances will be recognizable by a special marking that indicate that they are from Phase 4. This affects all Phase 4 allowances, including allowances on the market (auctioned allowances) and freely-allocated allowances. Auctioned allowances will be issued beginning 1 January 2021. Operators are advised to pay special attention if they are buying allowances from third parties during the transition period and verify whether those allowances are Phase 3 or Phase 4.
Can I use exchanged international credits for EU ETS compliance until the end of Phase 3?
YES - The EU ETS mechanism allows the use of certain credits from flexible mechanisms set up under the Kyoto Protocol. These include Certified Emission Reductions (CERs), i.e. credits from Clean Development Mechanism (CDM), or Emission Reduction Units (ERUs) from Joint Implementation (JI) projects. This option improves the cost-effectiveness of the EU ETS by allowing compliance through lower-cost methods, as CERs and ERUs are significantly cheaper than allowances. The legislation, however, has limits on the use of credits for EU compliance in Phase 3:
- Installations which were under the EU ETS in Phase 2 (2008–2012): up to 11% of their allocation for Phase 2 can be used between 2008 and 2020.
- New entrants in Phase 3: up to 4.5% of their verified emissions in the Phase 3
- Aviation operators: up to a of 1.5% of their verified emissions in the Phase 3.
Companies can verify their capacity in the Union Registry. It is important to note that in Phase 3, credits cannot be surrendered for compliance directly, but need to be exchanged for allowances first.
Can I exchange credits for emission allowances and surrender them in Phase 4?
NO – In the Phase 2 trading period, operators could use credits up to a percentage threshold determined in the National Allocation Plans (NAPs). Unused entitlements were transferred to the Phase 3 trading period. In Phase 4, use of credits will no longer be permitted in the EU ETS.
Operators will have until 1 May 2021 to can exchange CERs for Phase 3 emission allowances in the registry. After 1 May 2021, transactions with CERs will no longer be allowed in EU accounts. CERs already held in accounts after this date will still be allowed for a limited time in the CO2 registry (in EU accounts: until 1 July 2023 for, in Kyoto accounts: until 1 January 2026).
How will the changes in participating countries affect the EU ETS?
The EU ETS has started to spread outside of the European Union. As we discussed on our blog, after decade-long discussions, as of 2020, Switzerland has become a member of the EU ETS.
There are several practical implications of this for operators:
- The EU Transaction Log will be linked with the Swiss Supplementary Transaction Log and all allowances eligible for compliance in one system will be eligible in the other.
- Swiss operators will be able to apply for access to both Swiss and EU auctions. An FAQ on the Swiss linking can be found here.
- In line with the Brexit Withdrawal Agreement, the UK will remain in the EU ETS until 31 December 2020. This means that the UK operators will have to fulfill all EU ETS compliance obligations for 2019 and 2020. It is still uncertain what the future of carbon trading in the UK will be post-Phase 3, however, operators are encouraged to follow most recent guidelines to get the latest updates.
Are there any robust forecasts available for Phase 4 emission allowance pricing?
Due to the complexity of factors that affect the price of allowances, there are currently no clear predictions regarding the EU ETS price in Phase 4. Nevertheless, there are several factors that clearly have an impact on the price in the coming years. For instance, the free allocation cut is likely to drive the prices higher in Phase 4. On the other hand, the phase out of coal in Europe could potentially result in a new surplus of allowances, which could lower the market price.
The overall trend we see with is that, unlike in the earlier phases where companies had sufficient free allocations to cover their emissions or even a surplus that they could trade, more and more companies are likely to be short of allowances in Phase 4. For many years, the EU ETS acted as more of a compliance exercise, where companies had to ensure they monitor emissions and surrender allowances. A paradigm shift has occurred in the last couple of years, whereby Phase 4 will require solid carbon risk management on top of pure compliance. To get ahead of this shift, companies should consider proactively switching to greener energy options. For instance, Europe has already been pushing for greener data centers. Its possible that we see data centers switching from generators with dirty energy sources to cleaner ones, which could exempt them from the EU ETS.
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