All About the Emission Trading System (ETS)

 

What is the ETS?

The Emission Trading System (ETS) creates a financial incentive for polluters to reduce emissions by putting a price on each tonne of emissions. This is in line with the polluter pays principle at the heart of European climate policy.

Emissions trading, sometimes referred to as “cap and trade” or “allowance trading,” is an approach to reducing pollution that has been used successfully to protect human health and the environment.

The ETS was adopted in 2003 and came into force in 2005. It covers all EU states plus Iceland, Liechtenstein and Norway. It mainly covers carbon dioxide (CO2 but also other greenhouse gases such as methane and nitrous oxide from energy intensive industries such as electricity and heat generation, oil refineries and production of various metals and chemicals, as well as aviation. From 2024, the ETS will apply to maritime shipping.

 

How does the ETS work?

The ETS works through the concept of ‘cap and trade’. Every year, a total limit is set on the amount of greenhouse gases (GHGs) that companies under the ETS can cumulatively emit in that year. This ‘cap’ is reduced each year by a politically decided percentage: the Linear Reduction Factor (LRF). The cap will eventually reach zero, meaning that companies operating under the ETS should no longer be allowed to pollute. Each tonne of emissions corresponds to 1 emission allowance (EUA). Companies can get EUAs either from European auctions (organised on behalf of Member States) – where companies bid for a certain amount of EUAs – or from trading with other companies. Hence the system is known as ‘cap and trade’.

In the past, some EUAs were allocated for free each year to certain sectors to mitigate the supposed risk of becoming uncompetitive as a result of the ETS and moving outside of Europe (often referred to as ‘carbon leakage’). Companies could use those free allowances to either comply with ETS or, if they lowered their emissions, they could sell these free allowances to other companies for profit. But these free allowances are gradually being phased out because of their environmental ineffectiveness. Each auction requires a certain minimum amount – e.g. 10,000 EUAs – to be sold. If, altogether, companies bid for less EUAs on that auctioning day, the EUAs are not sold. Larger companies tend to buy and sell allowances themselves, while smaller companies tend to get their EUAs through trading houses (‘aggregators’).

The auctioning of EUAs takes place throughout the year. From 2024, companies covered by the ETS will have to demonstrate that they have bought enough EUAs to cover their annual emissions by September 30, as opposed to April 30 as it has been the case so far. They will then ‘surrender’ these EUAs as an act of compliance. Surplus EUAs can either be kept for the next year or traded. If emissions are greater than the number of surrendered EUAs, a penalty of €100 (plus an inflation adjustment) is imposed for every missing EUA. The company will still need to surrender the missing EUAs the following year.

 

 

Has the ETS been successful?

The ETS has demonstrated that a cap and trade system works. Numerous other countries have copied the model, notably China. Moreover, ETS revenues have financed the development of clean technologies, for example through the Innovation Fund. However, the ETS has not always succeeded in its main goal of emissions reduction. In the aftermath of the 2008 economic crisis, European industrial production fell dramatically, leading to a surplus of EUAs, low ETS prices and no incentive for emissions reduction. Consequently, the European Commission established a mechanism, the ‘Market Stability Reserve’ (MSR), to keep the annual supply of EUAs in check. This mechanism makes sure the EUA price is at a high enough level to incentivise companies to reduce emissions. The MSR has helped to push the ETS price up to around €90 per EUA, whereas the ETS price struggled to go above €5 per EUA from 2013 to 2017.

Similarly, while the most recent revision of the ETS improves climate ambition, the impact of the ETS is still limited due to the late phase out of free allowances and relatively low prices of fossil fuels compared to renewables, hence most sectors are subject to other climate laws alongside the ETS.

 

Which emissions are covered by the Shipping ETS?

The ETS will apply to 100% of emissions on voyages between European ports and 50% of emissions on voyages from a country outside the EU to an EU country and 50% of emissions in the opposite direction (Fig.1). A voyage is defined as any movement of a ship that originates from and terminates in a port of a Member State and that transports passengers or goods for commercial purposes. A cargo ship will therefore pay for its emissions if it transports goods from the USA to Spain, but not if it only stops in Spain only to refuel or if a vessel simply transits Spanish territorial waters without calling at a Spanish port to load or unload cargo.

The ETS will cover CO2 emissions emitted in 2024 and onwards. Methane (CH4 ) and nitrous oxide (N20) emitted in 2026 and onwards will also be included in the EU ETS. There are some specific exemptions for specific national circumstances. For example, ships travelling on ice will pay less until 2030, while voyages to outermost EU regions like the Azores or Canary Islands and ferries travelling between islands with a population of under 200,000 are also exempted.

 

Maersk R&D center to launch tradable 'tokens' for low-carbon shipping

The Maersk Mc-Kinney Moller Center for Zero Carbon Shipping is developing a tradable instrument based on the greenhouse gas intensity of marine fuel consumption, following the example of similar mechanisms in the utility and aviation sectors, according to project developers.

Since the third quarter of last year, the Denmark-based research and development center has been designing a "book and claim" platform where shipping companies and cargo owners can digitally record emissions from their voyages.

The emissions then will be tokenized and expressed in CO2e/Megajoules in units, exchangeable among project participants that can use this instrument in their carbon accounting.

Frederik Jacobsen, a project manager at the center, said the system will allow those on the supply chain using more expensive low-emission fuels to sell their decarbonization effects to those consuming conventional oil-based fuels.

Such voluntary transactions would "funnel capital back to companies which are investing in green shipping capacity," Jacobsen recently told S&P Global Commodity Insights.

In turn, prospective buyers would be those who seek to make decarbonization claims but could not physically achieve low-emission shipping, Jacobsen said.

Industry participants said limited availability of low-emission fuels is among the main deterrents to maritime decarbonization. S&P Global expects such fuels to make up just 2.2% of global bunker consumption in 2030 in its reference case, versus 0.2% in 2021.

"It isn't necessarily a given that everyone has access to ships using alternative fuels," Jacobsen said.

The center is working on the system with Rocky Mountain Institute, Danish Shipping and Maersk Oil Trading, having received project funding from the Danish Maritime Fund.

It has been receiving feedback from 17 unspecified companies across the supply chain, including fuel suppliers, to launch a pilot platform in May, according to the center.

Jens Johannes Keppler, an MPC Capital executive also involved in the project's development, said transactions are expected to take place on an over-the-counter basis or via direct negotiations in the pilot phase.

The system could evolve into a fully fledged trading platform in the marketplace later, depending on the resolution of financial regulatory and other issues, Keppler suggested.

"It's very likely that we will start quite simple, and then we build out the system," he said. "it's not yet set in stone how this will look like in the future."