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Preventing Carbon Leakage in the EU

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The European Union has committed to reduce greenhouse gas emissions by at least 40% by 2030 (vs 1990) in line with the 2030 climate and energy policy framework and as part of its contribution to the Paris Agreement. To achieve this target, the EU ETS sectors will have to reduce their emissions by 43% compared to 2005. The rules set for the fourth phase of the EU ETS, beginning in 2021, aim at achieving this objective and include (but are not limited to):

  • An annual reduction of allowances by 2.2% vs 1.74% currently
  • The implementation of the Market Stability Reserve to absorb the excess of allowances on the market
  • Updated benchmarks to reflect technological progress and better reward best in class installations
  • Shortened carbon leakage list to better target sectors at risk

On May 8th 2018, the EU published in the official journal the preliminary carbon leakage list for Phase 4 (2021-2030). We provide here a summary of the information available and how it will impact companies in the coming years.

What is Carbon Leakage and How Does it Impact Phase 4 Exposure?

In brief, being in the carbon leakage list means reduced carbon costs post 2021.

The EU ETS is a ‘cap and trade’ scheme, meaning companies must surrender a number of CO2 units proportional to their CO2 emissions. A portion of these units may be received for free, the rest must be purchased on the market (European Union Allowances, EUAs). This free allocation is defined by various factors, including carbon leakage. Carbon leakage is a mechanism aimed at maintaining the competitiveness of European companies, despite carbon costs originating from the EU ETS, by providing them with additional free units. This special treatment of highly exposed industries will help to avoid companies needing to transfer operations out of the EU to countries with more lenient climate regulations.

Similar to Phase 3, all installations in a sector or subsector on the carbon leakage list during Phase 4 will receive 100 percent of their calculated free allocation based on the updated benchmarks. Those not on the list will receive 30 percent of their calculated free allocation (up to 2026), gradually phased out by 2030. Power generation will not receive any free allocation except in lower-income member states eligible for the Modernization Fund. For companies on the carbon leakage list in Phase 3, not being on the list in Phase 4 will have serious financial impacts on their portfolio, particularly with EUA prices rising from €5 in Summer 2017 to €16 currently and expect further increases in Phase 4.

Who is on the Carbon Leakage List? How to Apply?

The Commission has defined a “carbon leakage indicator” to assess which sectors are eligible. This indicator is defined as the product of the sector’s intensity of trade with third countries and the sector’s emissions intensity. When the indicator exceeds 0.2, a sector or sub-sector is included in the list (this is called “first level assessment”). Under certain conditions listed in Table 1 (below), sectors may apply to a second level assessment in order to be included in the list. This evaluation can consist of a quantitative assessment of the carbon leakage indicator at a sub-sector or product level, or a qualitative assessment.

What to Know About the Qualitative Second Level Assessment

  • Application must be done by the sector and provide information on all installations falling under the same NACE code within the EU ETS perimeter.
  • There are 3 main criteria assessed by the Commission:
    • Abatement potential : the extent to which it is possible for individual installations in the sector concerned to reduce emissions and/or electricity consumption;
    • Market characteristics : the extent to which there is scope to pass cost increases onto customers, and the influence of market characteristics on the ability to pass cost increases on;
    • Profit margins : the extent to which profit margins associated with serving the EU market are negative or too low to make further long-term investment economically viable (and provide a strong incentive to relocate production).
  • Data for assessments must cover 3 years: 2014, 2015, 2016
  • The data provided has to be verified by an accredited third party

Next Steps for Second Level Assessments

Sectors and subsectors eligible to apply for second-level assessments under criteria A, B or C (see Table 1) may submit applications to the European Commission at the latest 3 months after the publication of this preliminary carbon leakage List (August 2018). Applications, together with the relevant evidence, shall be submitted electronically to CLIMA-CARBON-LEAKAGE@ec.europa.eu.

Sectors and subsectors under criterion D must submit their application to Member States by 30 June 2018, containing duly substantiated, complete, verified and audited data for the five most recent years, and should include any other relevant data. Further framework guidance is to be published by the Commission. Such sectors and subsectors may be integrated into the carbon leakage list if the carbon leakage indicator exceeds the 0.2 threshold.

The Commission aims to adopt the final carbon leakage list by the end of 2018.

Table 1: eligibility criteria to apply for the ‘second-level’ assessments

For more information on the approved updates to the EU ETS, read this blog.

Contributed By: Frédéric Pinglot, Sustainability Consultant, Schneider Electric Energy & Sustainability Services