Fit for 55 – EU aligns emissions trading system with 2030 emissions ambition

The EU Commission has published a proposed Directive to amend the EU (Emissions Trading System) ETS Directive (Directive 2003/87/EC), the Market Stability Reserve (MSR) Decision (Decision (EU) 2015/1814) and the MRV Regulation (Regulation 2015/757). Being part of the EU’s ‘fit for 55’ package, the purpose of these amendments is to align the EU ETS Directive with the EU’S 2030 ambition to reach the legally binding 55% net emissions reductions target by 2030 under the EU Climate Law. Below, we have summarised the key amendments of these proposals.

The key changes are:

  • an expansion of the EU ETS to cover maritime transport;
  • an increase of the linear reduction factor to 4.2% (from previous 2.2%);
  • introduction of emissions trading for buildings and road transport; and
  • confirmation that the normal intake rate for the MSR at 24% will apply until 2030.

EU ETS Directive Amendments

Maritime Transport

From 2018, pursuant to the MRV Regulation, large ships over 5,000 gross tonnage loading or unloading cargo or passengers at ports in the EEA must monitor and report their CO2 The Commission now proposes to extend the EU ETS Directive to cover emissions from these ships from intra-EU voyages, half of the emissions from extra-EU voyages and all emissions occurring at berth in an EU port. The same rules on auctioning, transfer, surrender and cancellation of allowances, penalties and registries that apply to other sectors under the EU ETS will apply. Under the Directive, shipping companies will have to surrender 100% of their verified emissions as of 2026, an obligation which will be phased in between 2023 and 2025 as follows:

Year Surrender Allowances (% verified emissions reported that year)
2023 20%
2024 45%
2025 70%
2026 onwards 100%

During this phase-in period between 2023 and 2025, to the extent that fewer allowances are surrendered, the allowances not surrendered should be cancelled rather than auctioned. The monitoring and reporting rules as well as verification and accreditation rules from the MRV Regulation, as amended, shall apply.

In addition to the general EU ETS rules on penalties, the Directive proposes to introduce expulsion orders, which may prevent entry into an EU port and the ship being detained by the flag Member State. These can be issued against ships if there has been a failure to surrender allowances for two or more consecutive reporting periods.

The Commission has also proposed to present a report to the European Parliament and the Council by 30 September 2028 in relation to the proposed global market-based measure for maritime emissions proposed by the International Maritime Organisation.

Linear Reduction Factor and one-off cap reduction

The linear reduction factor will be increased to 4.2% (from previous 2.2%) from the year following the entry into force of the Directive. The increased linear reduction factor is combined with a one-off downward adjustment of the cap so the new linear reduction factor will be in line with this level of reduction having been applicable for 2021. From this same year, the cap will be increased to reflect the maritime transport emissions to be included in the EU ETS and derived from data from the EU maritime transport monitoring, reporting and verification (MRV) system for the years 2018 and 2019, adjusted from year 2021, by the linear reduction factor.

Use of auction revenues

Currently, 2% of allowances are used to support the Modernisation Fund for Member States with a GDP per capita at market prices below 60% of the EU average in 2013 (Beneficiary Member States). The Commission now proposes that an additional 2.5% of allowances will be used to fund the energy transition of Member States with a GDP per capita below 65% of the EU average in 2016-2018.

Furthermore, to the extent that they are not attributed to the Union budget, all proceedings from auction revenues must be used for climate-related purposes. Adjustments to the EU budgetary framework will be included as part of the upcoming “Own Resources” package including a proposal to amend the multiannual financial framework, a more stringent benchmark approach and establishing conditionality for free allocation.

The free allocation mechanism is based on a product benchmark that is calculated based on the average GHG emissions of the best performing 10% of the installations producing that product in the EU and EEA-EFTA states. Installations that meet the benchmark will receive all allowances required to meet their emissions, but those that do not meet the benchmark will receive fewer allowances. Previously under Phase 4, the benchmarks were to be reduced by an annual minimum rate of 0.2% up to a maximum rate of 1.6%, leading to reductions of the benchmarks between 3% and 24% over the 15 years between 2008 and 2023, the mid-point of the period 2021-2025. Under the new Directive, the maximum annual adjustment will be increased from 1.6% to 2.5% per year as of 2026. The determined Union-wide benchmarks shall be reviewed before 2026.

Furthermore, in order to incentivise the use of low-carbon technologies, free allocation will be made conditional on decarbonisation efforts. Installations which are required to conduct an energy audit under the current Article 8(4) of the Energy Efficiency Directive (Directive 2012/27/EU) (EED) will be required to implement the recommendations, or demonstrate the implementation of measures with emissions reductions equivalent to those made in their respective installations audit report. If they do not comply, their free allocation shall be reduced by 25%. Currently, SMEs are exempted from carrying out an energy audit. It is proposed that this should be changed under the revised EED so that the exemption is instead based on energy consumption.

It was further clarified that sectors which will be covered by a Carbon Border Adjustment Mechanism (CBAM) should not receive free allocation under the EU ETS. There will be a transitional period put in place to adjust to the new regime, with a gradual reduction of free allocation as the CBAM is phased in, to reach no free allocations by the tenth year of the operation of the CBAM.

Carbon Contracts for Difference (CCDs)

The Innovation Fund is intended to be geared towards innovative technologies that would not be commercially viable at scale without support but must be sufficiently mature for application at pre-commercial scale. Support under the Innovation Fund for these projects has been extended to allow it to provide support in the form of price competitive tendering support such as CCDs. In this case, up to 100% of the relevant costs of projects may be supported.

Furthermore, the Innovation Fund is increased by 50 million allowances sourced from auctioning (10 million) and the allowances available for free allocation (40 million).

Modernisation Fund

The Modernisation Fund is a fund to support investments proposed by the beneficiary Member States including the financing of small-scale investment projects to modernise energy systems and improve energy efficiency. The investments made into the Modernisation Fund must be consistent with the objectives of the European Green Deal, the European Climate Law and Paris Agreement. The proposal states that support will no longer be provided to energy generation facilities that use fossil fuels of any kind, as opposed to only solid fossil fuels as is currently the case. In addition, the percentage of the fund that must be invested in priority investments has been increased from 70% to 80%. Examples of priority investments include: the generation and use of electricity from renewables, the support of households to address energy poverty concerns and a just transition in carbon-dependent regions of the beneficiary Member States.

CCUS

Under the proposal, surrender obligations will not arise for emissions of CO2 that have been captured and utilised to be permanently chemically bound in a product so that they do not enter the atmosphere under normal use.

Removal of barriers for innovative low-carbon technologies my modifying the EU ETS scope and benchmarks

Previously, innovative technologies that fell outside of the EU ETS were at a competitive disadvantage. These technologies may fall out of the EU ETS because they change their production process or their total rated thermal input of the combustion units of an installation decreases to less than 20MW. In contrast, efficient technologies just below benchmark level receive more free allocation than they emit.

The proposal attempts to rectify this by making the following changes:

Installations will stay within the EU ETS where they reduce the total capacity of their combustions units to reduce emissions;

  • Making the definitions of activities technology neutral;
  • Referring to production capacities instead of combustion capacities; and
  • Reviewing the benchmark definitions to ensure equal treatment of installations independently of the technology used, including when using low or zero-carbon technologies.
Introduction of emissions trading for buildings and road transport

The proposal establishes a new system for emissions trading for buildings and road transport as a separate self-standing system from 2025. This new system will apply to emissions in relation to release for consumption of fuels which are used for combustion in the buildings and road transport sectors. However, it shall not include: (i) the release for consumption of fuels that are otherwise covered by this Directive (for example; the refining of mineral oil, production of ammonia, and production of coke) unless used for combustion in the activities of transport of GHGs for geological storage; or (ii) the release for consumption of fuels for which the emissions factor is zero.

The scope of the sectors of buildings and road transport is defined on the basis of relevant sources of emissions included in the 2006 IPCC Guidelines for National Greenhouse Gas Inventories. The regulated entities are defined in line with the system of excise duty of Council Directive (EU) 2020/262. The emissions cap will be set from 2026 based on data collected under the Effort Sharing Regulation and emissions targets for the sectors of buildings and road transport (to reach 43% 2005 emissions by 2030).

Under this new system, the MRV obligations will be largely aligned with those established for stationary installations and aviation. In the first year, regulated entities are required to hold a greenhouse gas emissions permit and to report their emissions for 2024 and 2025, with allowances and compliance obligations applying from 2026. The total quantity of allowances for 2028 will be adjusted on the basis of the available MRV data for the period 2024-2026. The linear reduction factor will only be revised if the MRV data is significantly higher than the initial cap. A MSR will be in operation from the start. From 2026, Allowances for the new emissions trading will be auctioned unless placed in the MSR and a certain amount of allowances will be front-loaded.

The proposal has also stated that emissions trading for road transport and buildings will contribute to the already existing low-carbon funds. 150 million allowances will be made available to the Innovation Fund to stimulate the green transition.

The Commission will propose a review of the rules by 1 January 2028 if necessary.

MSR Decision amendments

The MSR is managed in accordance with Decision (EU) 2015/1814. As part of the Fit for 55 Package, the Commission has proposed a new Decision to amend Decision (EU) 2015/1814, and has made a number of further proposed amendments to the MSR regime within the proposal for the updated EU ETS Directive. The key changes to the MSR are summarised below.

Taking into account net demand from aviation and maritime

The calculations for the total number of allowances in circulation (TNAC) and the reserve are proposed to be amended to include the previously excluded aviation emissions and allowances issued in respect of aviation if they have occurred, or were issued as of the year following the entry into force of the amendment.

In addition to aviation allowances, maritime allowances will also be included in the calculation of the reserve through modifications to the text to include allowances and emissions in relation to the maritime sector. The difference between verified emissions and allowances surrendered for the maritime sector, which will be cancelled rather than auctioned will be counted towards the TNAC as if the allowances had been issued.

Intake Rate

The intake rate mechanism is amended under the proposal to include a buffer MSR intake when the TNAC is between 833 million and 1096 million. In this case, the intake into the reserve is the difference between the TNAC and the 833 million threshold. This intake will be placed into the reserve for 12 months from 1 September that year. However, where the TNAC is above 1096 allowances, the normal intake rate will apply (24% until 2030).

In conjunction with a further proposal amending the MSR decision, the 24% intake rate and the minimum amount to be placed in the reserve of 200 million allowances, which were due to expire in 2023, are now proposed to continue until 2030.

The TNAC calculation has been amended so that only allowances issued and not put in reserve are included in the supply of allowances. In addition, the number of allowances in the reserve is no longer subtracted from the supply of allowances. The Commission has noted that these changes should have no material impact on the result of the calculation.

Invalidation mechanism

From 2023, allowances in the MSR above the level of auction volumes of the previous year will not be valid. As the level of auction volumes of the previous year is dependent on the cap and the operation of the MSR, to ensure the level of allowances in the reserve is more predictable, it is proposed that the number of allowances in the reserve is limited to 400 million allowances.

MSR for the emissions trading for road transport and buildings

An MSR will operate for emissions trading of road transport and buildings, with a number of allowances for these new sectors created in the reserve. The intakes and releases of allowances will be based on the thresholds for the surplus of allowances in that market.

Measures are established to allow for release of additional allowances from the MSR, with the triggering mechanism for the release based on the increase in the average allowance price as opposed to the surplus of allowances in the market.

Amendments to the Effort Sharing Regulation

The Effort Sharing Regulation (Regulation 2018/842) (ESR) establishes an annual emissions budget for each member state that declines at a linear rate towards its individual nationally binding ESR target for 2030. This mostly concerns sectors that are not included in the EU ETS. As part of the Fit for 55 Package, a separate proposal has been published to amend this regulation in accordance with the revised EU targets. The envisaged changes to the ESR are summarised below..

It is proposed that the scope of the ESR be adjusted to take into account the proposed inclusion of maritime transport into the EU ETS as detailed above. Specifically, Malta will be given access to an increased ETS flexibility (from 2% to 7%) and has been provided with a deadline to indicate whether it intends to use this.

Furthermore, it is proposed that the framework under which the Commission will set the new Member States’ annual emission levels in the years 2023-2030 will be updated. This will include updating the national annual emission allocations and making use of the new data that will become available in accordance with the 2025 review to allow an adjustment of the annual emission allocations for 2026-2030.

It is proposed that use of the Land Use, Land-Use Change and Forestry (LULUCF) flexibility will be split into two five-year periods and each period will be subject to a cap corresponding to half the total amount. If a Member State exceeds its removals in the 2021-2025 period, the amount exceeded will be deducted from the Member State’s annual emission allocations.

Any unused LULUCF credits at the end of the second compliance period may be used to set up a voluntary additional reserve. This reserve is to be used by Member States in order to comply with their ESR 2030 target, subject to the condition that the 55% reduction EU-level target is reached with a maximum contribution of 225 MtCO2Eq of net removals in accordance with the European Climate Law.

More on the Fit for 55 suite of proposals

For more, see also our Decarbonisation Hub where you can also access our full series of posts – Fit for 55: A greener transition for Europe.

Contacts

Silke Goldberg
Silke Goldberg
Partner, London
+44 20 7466 2612
Jannis Bille
Jannis Bille
Associate, London
+44 20 7466 6314
Steven Dalton
Steven Dalton
Partner, London
+44 20 7466 2537

Fit for 55 – EU aims to protect against carbon leakage with a carbon border adjustment mechanism (EU CBAM)

On 14 July 2021, the European Commission (the Commission) published its proposed regulation which would establish a carbon border adjustment mechanism (EU CBAM) (the Regulation), and is intended to come into effect, subject to transitional provisions, from 1 January 2023.

The Regulation would require importers of certain goods to purchase a number of electronic certificates, each certificate corresponding to one tonne of embedded emissions in certain goods (CBAM certificate), in order to cover the total embedded emissions in imported goods. Although the obligation to purchase CBAM certificates and account for embedded emissions rests on importers, it is likely that the EU CBAM will have important impacts on international producers.

The role of a CBAM

As explained in our previous blog post here, a CBAM can be used to protect against the risk of carbon leakage and preserve the competitiveness of domestic operators. Carbon leakage occurs if, due to costs incurred in relation to climate policies, businesses in certain sectors transfer an underlying economic activity and its associated emissions to a different country with less onerous climate policies. This can lead to an increase in emissions globally.

A CBAM may prevent carbon leakage as all goods within its scope, whether produced domestically or internationally, would be subject to carbon costs, thereby discouraging businesses from relocating their operations elsewhere, or importing goods from countries with less ambitious climate policies.

Goods within scope of the EU CBAM

The goods within the scope of the EU CBAM include cement, electricity, fertilisers, iron, steel and aluminium. With the exception of electricity, the production or manufacture of these goods all figure on the ‘Carbon Leakage List‘ under the EU Emissions Trading System (EU ETS), as sectors and subsectors deemed at risk of carbon leakage for the period 2021 to 2030. However, not all sectors and subsectors on the Carbon Leakage List are within scope of the EU CBAM.

The mechanics of the EU CBAM

The EU CBAM applies when the above goods are imported into the Union’s customs territory from a third country. It would not apply to goods originating in countries and territories listed in Annex II of the Regulation, which include Iceland, Liechtenstein, Norway and Switzerland. A process is proposed for other countries to be exempted.

Annual declaration

Before any goods within the scope of the EU CBAM are imported, an importer must apply to the competent authority in the Member State where it is established for authorisation to import those goods into the customs territory of the Union. Each Member State is required to designate a competent authority to administer the EU CBAM.

Once authorised, an importer must submit to the competent authority a declaration by 31 May each year (CBAM declaration) for the calendar year preceding the declaration. A CBAM declaration must include certain information relating to the embedded emissions in imported goods, and the total number of CBAM certificates which will be surrendered.

During the transition period, the EU CBAM shall apply as a reporting obligation: importers must report the information above, as well as the carbon price due in a country of origin for the embedded emissions in imported goods.

CBAM certificates

By 31 May each year, each importer must surrender to the competent authority a number of CBAM certificates that corresponds to the embedded emissions in its CBAM declaration.

Embedded emissions are defined as direct emissions released during the production of the goods, i.e. emissions from the production processes of goods over which the producer has direct control.

The Regulation provides that the amount of embedded emissions will be based on the actual direct emissions of goods. If this cannot be determined, a default value will be used. The Commission shall adopt implementing acts to establish detailed rules regarding the methods for calculating the actual embedded emissions of imported goods. Operators and installations in third countries will have the option of registering in a central database: once the embedded emissions of their goods have been verified, importers may use these embedded emissions figures in their CBAM certificate calculations.

The default value will be set in accordance with the average emission intensity of each exporting country for each of the goods within the scope of the EU CBAM (other than electricity), increased by a mark-up. If reliable data is not available, the default values will be based on the average emission intensity of the 10% worst performing EU installations for that type of goods.

Importers will be able to purchase CBAM certificates from the competent authority in the Member State in which they are registered. CBAM certificates will be sold at the price calculated by the Commission, which shall be the average price of the closing price of EU ETS allowances on the common auction platform for each calendar week. Each CBAM certificate will be valid for two years, which will enable importers to take advantage of fluctuations in the price of EU ETS allowances.

Reduction to reflect carbon price paid in a country of origin

In its CBAM declaration, an importer may claim a reduction in the number of CBAM certificates to be surrendered, in order to take into account a carbon price paid in the country of origin. The Commission is empowered to adopt implementing acts to establish the methodology for calculating the appropriate reduction, the conversion of a carbon price paid and the certification process for these.

The number of CBAM certificates to be surrendered may also be reduced in light of EU ETS allowances which would be freely allocated to EU producers of the same products (see below).

Interaction with the EU ETS

The EU ETS will continue to apply to the goods within its scope produced in the EU, whilst the EU CBAM will create a carbon price for goods (within the scope the Regulation) imported into the EU.

Although there are differences in scope between the EU ETS and the EU CBAM, the Regulation demonstrates that the two carbon pricing systems will not operate in separate vacuums. In addition to the link to the EU ETS allowance price (see above), the Regulation also provides that the number of CBAM certificates to be surrendered will be adjusted, to reflect the extent to which installations producing goods within the scope of the EU CBAM are entitled to free allocation of allowances under the EU ETS. The methodology of this calculation will be adopted by the Commission in an implementing act.

Further, in the event of non-compliance with the Regulation, i.e. if an authorised importer fails to surrender sufficient CBAM certificates by 31 May each year, the authorised importer shall be liable to a penalty identical to the excess emissions penalty under the EU ETS. However, payment of such a penalty would not relieve an authorised importer from the obligation to surrender the outstanding number of CBAM certificates in a particular year.

Impact on the UK

As the UK is now a third country under the Regulation, EU importers would be liable to comply with the EU CBAM when importing certain goods (see above) from the UK. The Regulation empowers the Commission to adopt implementing acts to establish the methodology for calculating the reduction in the number of CBAM certificates to be surrendered in light of carbon prices paid in a third country. The Regulation also includes a transitional period during which such acts may be adopted.

However, until the reduction methodology is established, EU importers of UK-produced goods may experience a degree of uncertainty, with goods subject to the UK ETS upon production in the UK, and also to the EU CBAM upon import to the EU.

Comment

Ahead of the publication of the Regulation, a number of commentators raised concerns that an EU CBAM could be anti-competitive and protectionist in nature. The Commission stresses that it has taken such concerns into consideration in the design of the EU CBAM, as the final version of the Regulation contains a number of features which it claims addresses such concerns:

  • The price of CBAM certificates is linked to the EU ETS price. As the goods within the scope of the EU CBAM (when imported from third countries) are within the scope of the EU ETS when produced in the EU, all such goods in the EU will be subject to a carbon price, set at a similar level. This would in theory prevent carbon leakage (see above), as importers would not be able to obtain cheaper goods by importing from a country with less onerous climate policies.
  • The Regulation also provides for a reduction in the number of CBAM certificates to be surrendered in the event that domestic EU producers of such goods would be entitled to free allowances. This feature aims to ensure that EU producers and EU importers compete on a ‘level playing field’: if an EU producer would have been entitled to freely allocated allowances for producing the imported goods, the importer will be required to surrender fewer CBAM certificates (thereby reducing the carbon price paid by the importer). Because of the different bases of calculation of free allowances and CBAM certificates, it may be complicated to implement this mechanism in a way that is non-discriminatory in all cases.

In spite of the Commission’s assertions that the effects of the EU CBAM will be EU-focussed, concerns have been raised that it will have a significant impact on producers in third countries. The price of imported goods within the scope of the EU CBAM is likely to increase, which may reduce the price competitiveness of these products within the EU single market. Alternatively, if such a price increase were not passed on to consumers, the value of the imported goods may decrease, as EU importers may try to off-set the new carbon cost of these products against their initial purchase price.

Although the primary aim of the EU CBAM is to prevent the risk of carbon leakage, the Commission has suggested that it may encourage the use of more greenhouse gas emissions-efficient technologies by producers from third countries. It remains to be seen whether this will be the case, and whether the EU CBAM will trigger other countries to adopt more ambitious domestic climate policies.

We will continue to monitor developments in this area, and encourage you to subscribe to be kept informed of latest developments. Please contact the authors or your usual Herbert Smith Freehills contacts for more information.

More on the Fit for 55 suite of proposals

For more, see also our Decarbonisation Hub where you can also access our full series of posts – Fit for 55: A greener transition for Europe.

Contacts

Silke Goldberg
Silke Goldberg
Partner, London
+44 20 7466 2612

Jannis Bille
Jannis Bille
Associate, London
+44 20 7466 6314

Lode Van Den Hende
Lode Van Den Hende
Partner, Brussels
+32 477 883 709

Eric White
Eric White
Consultant, Brussels
+32 2 518 1826

Fit for 55 – EU reveals suite of proposals to combat climate change

The EU has revealed its ‘fit for 55’ suite of policies, which extends to about 2,000 pages and is designed to take a pro-active approach to combating climate change and to introduce a suite of proposals aimed at making Europe ‘the first climate neutral continent in the world’.

Fit for 30: striking a balance

The overall objective of the ‘fit for 55’ package is to try to strike a balance between the need to reach the 2030 target set by the EU and the financing required to achieve this target as quickly as possible, whilst providing that the transition to climate neutrality is achieved in as fair a manner as possible for all.

To manage this balancing act the EU, in acknowledging that carbon pricing and increased financial burdens alone will not address the market’s perceived consistent failure to transition quickly, provides for a mix of measures that both aim to encourage and ensure the transition to a cleaner and greener environment. The suite is a mix of financial incentives and revised regulation that focuses on pricing, emissions targets, standards and support measures.

Fit for life: reducing emissions

In providing for this mix, the ‘fit for 55’ package introduces five new initiatives and revises eight pieces of existing legislation. On carbon pricing, the package introduces an expanded Emissions Trading System (ETS) including in aviation, and extending the ETS to maritime, road transport and buildings. The EU considers that the ETS, where greenhouse gas emissions are traded, has been shown to bring down emissions in a cost-effective manner and proposes that the revenues generated from the new ETS can be used to help fund the energy transition.

The package also proposes a Carbon Border Adjustment Mechanism (CBAM) that will introduce over a period of time a system under which the same carbon price is paid in EU Member States by both domestic and imported goods. The proposed categories of goods include cement, electricity, fertilisers, iron, steel and aluminium.

Along with updating existing legislation, the use of alternative and sustainable fuels are encouraged with the introduction of new infrastructure for alternative fuels, and proposed use of more sustainable aviation fuels and cleaner maritime fuels. On a global level, in addition to the proposed introduction of the CBAM, the package proposes implementing the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) through the EU ETS Directive to further encourage aviation operators to reduce their emissions. Further encouragement in the effort to reduce emissions in the transport sector is proposed in revisions to the Energy Tax Directive aimed at making use of cleaner fuels in transport more attractive.

Fit for everyone: encouraging solidarity

The financial and regulatory support measures proposed under the ‘fit for 55’ climate change package are aimed at encouraging innovation and solidarity, and ensuring the impacts of the transition are mitigated for the most vulnerable. In line with these principles, the package introduces a new Social Climate Fund that will fund €72.2 billion from the new ETS in the period 2025 to 2032 in the EU budget for EU Member States to support those most at risk from the impacts of the transition.

Fit for the future: the green deal

Over the next few days and weeks we will be looking in more detail at the ‘fit for 55’ suite of proposals, and continuing to look at how the EU proposes to deliver the European Green Deal.

Watch this space.

More on the Fit for 55 suite of proposals

For more, see also our Decarbonisation Hub where you can also access our full series of posts – Fit for 55: A greener transition for Europe.

Contacts

Silke Goldberg
Silke Goldberg
Partner, London
+44 20 7466 2612
Steven Dalton
Steven Dalton
Partner, London
+44 20 7466 2537