EU ETS extension: opportunities and challenges of a quantity control

The European Commission’s Fit for 55 package enhances the importance of carbon pricing, envisioning an extension of the EU Emission Trading System (ETS). Among its main highlights, we see an extension to the transport and building sectors, an end to free ETS allocations, a revision of the energy taxation with greater emphasis on environmental aspects and the elimination of harmful subsidies.

There are important overlaps with Germany’s system, which has been extended earlier this year and acted like a sort of blueprint for the EU. However, there are also significant differences in the approach used to set control mechanisms: Germany opted for a price control while the EU went for a quantity control. Germany has set fixed prices rising steadily from €25 to 55 per CO₂ ton through 2025, and a corridor in 2026 (€55-65/CO₂ton).

The EU caps CO₂ quantity through a “backstop” mechanism: a 5,15% linear reduction factor (the LRF defines the annual decrease of allowances provided to the market either via free allocation or via auctions) is set in line with the Effort Sharing Regulation targets (the ESR sets national targets for emission reductions, ensuring that Member States with higher GDP per capita have higher reduction targets), and later on adjusted according to the related emission reductions.

Both mechanisms generate challenges and opportunities. With a price control politics might defy science, meaning that the agreed prices might not allow for the necessary emissions reduction; on the other hand, certainty is ensured in planning ahead. If a quantity control can grant higher extents of emissions reduction, it risks generating instability due to potential price surprises. To estimate revenues in a free-floating price environment might be difficult for the programs that complement the ETS; however, expectations of increasing prices can make a difference in purchase choices.

Support for carbon pricing among German citizens has risen over the past years as government and civil society prioritized balancing the social impacts and facilitated by high analytical capacity and surveys. Revenues from carbon pricing are set to flow into ring fenced Climate and Energy Fund, used to lower electricity rates, while additional tax-financed compensation measures have been specifically designed for low-income/high burden households.

The use of revenues envisioned by the EU goes along the same spirit, but further efforts are needed to  increase public support. Revenues are used for climate and energy-related purposes, with at least 50% dedicated to low-income households and another 25% set to flow into the Climate Action Social Facility. Building non-state carbon pricing “constituencies” may be essential in member states with low regulatory quality.

Carbon pricing needs high society engagement and clarity on revenue distribution schemes is a key strategic variable. Carbon pricing literacy through education is also fundamental to build greater public support.

From his keynote speech at WCP Webinar: Assessing the EU proposal to extend the ETS in light of the experiences with Germany’s new system, 16 July 2021 – Video accessible here