In 2005, the European Union introduced the emissions trading system, more commonly referred to as the “carbon market”. Fifteen years later, how can we achieve a fair and effective redistribution of this rent between economic actors? This is the second edition in our series “Fifteen years of the European carbon market: what’s the point?”
When an emissions trading system is established, the rationing of emissions causes a price to emerge. We can find a value by multiplying this price by the volume of emissions: €42 billion in 2005, €8.5 billion in 2013, €40 billion in 2019, in other words, a serious fortune that could potentially double in 2021 due to the rising price per allowance in the market!
This value, generated by scarcity, is a rent. An ambitious reform of the carbon market requires the right choices to be made in the redistribution of this rent between economic actors. In practical terms, this brings two issues into question: the free distribution of allowances and the use of proceeds from the auctions.
A temporary arrangement that lingers on
During the first two periods of the market (2005 to 2012), the vast majority of CO2 allowances were allocated by Member States free of charge. The carbon rent was distributed to companies who were required to return part or all of this amount on a yearly basis according to the level of their emissions.
The distributional impacts within the productive system increased. Some companies used this rent to reduce their emissions: this was precisely what was intended! Others took advantage of the initial over-allocation of allowances: this was the case for the majority of industrial companies. Other companies kept the rent by having their customers finance the value of the allowances they had received free of charge: this was primarily observed in the power sector.
Beginning in 2013, the auctioning of allowances theoretically became the standard practice (except for the air transport sector). The initial timetable provided for the gradual phaseout of free allocations in the industry between 2013 and 2020 and granted transitional derogations in the power sector for the ten low-income countries that had joined the European Union since 2000.
Although the majority of the power sector has shifted to the auctioning system, the same cannot be said of industrial companies. Despite being theoretically reserved for sectors subject to strong international competition, free allocations continue to be used for over 90% of industry allowances. In an audit report on the situation, the European Court of Auditors estimated that 40% of allowances will continue to be distributed free of charge during the fourth phase (2021-2030), if the existing rules remain in effect.
When the system subsidizes the fossil fuels
The system was greatly weakened by the significant volume of allowances that continued to be distributed free of charge. In the power sector, countries benefiting from derogations reduced their emissions much less than the others. In the manufacturing industry, variations in emissions came more in response to fluctuations in the economic environment and oil prices than to actions aimed at reducing CO2 emissions. Large companies producing steel, cement, and other commodities became experts in reaping the benefits of the carbon rent. This energy they devote to defending their free allowances is not available when it comes to decarbonizing their processes and reducing their use of fossil fuels.
It is important to note that free allocations represent a huge subsidy for fossil fuels. From 2005 to 2019, the majority of large industrial companies received more free allowances than those surrendered for compliance. Therefore, the system designed to encourage emission reductions has generated significant subsidies for the biggest CO2 emitters. In 2019, free allocations accounted for a transfer of a little under €20 billion to these industrial companies. Given the prices observed at the start of 2021, this transfer could more than double!
If we want to begin seriously decarbonizing the industrial sector, we will need to return with greater commitment to the original objective for the market’s third period: a switch to an allocation system based on the auctioning of allowances. By overprotecting industries subject to allowances, free allocations not only pervert the system’s environmental foundations, they also negatively affect the industries’ capacity for innovation by causing them to lose energy in pursuit of defensive strategies that hamper their competitiveness.
Auction shares: everyone wants a slice of the cake!
Over the entire third period (2013-2020), proceeds from auctions represented 40% of the carbon rent. This figure has fluctuated from one year to the next (Table 1), because the restrictions on allowances during the period did not involve auctioning: the choice was made to reduce public resources rather than address the free distribution of allowances.
Table 1: Estimation of the carbon rent and auction shares
Source of data: EEX and the European Commission.
Note: in 2019, the auctioning of British allowances was suspended due to preparations for Brexit. These allowances were put on the market in 2020 and no longer appear in EU auctions.
Less than 5% of the proceeds from these auctions (€2.1 billion) were devoted to European projects in the context of the NER-300 project managed by the European Investment Bank. Originally designed to promote CO2 capture and storage techniques in order to reduce emissions in the industrial sector, the program shifted its focus to renewable energy projects. This shift came as a confirmation of the industrial sector’s hesitance to invest in emission reductions.
Member States receive a dividend from auction proceeds using a distribution key, 88% of which is based on their historic share of emissions and 12% is based on their support of the ten low-income countries that have joined the EU since 2000. This distribution key, established through heated negotiations, favors the largest emitter countries. It now appears to be set in stone.
The regulation recommends that Member States use at least half of this income for internal or external climate action. Based on reports submitted by the Member States, this is the case for over 70% of auction proceeds.
An alternative distribution of the carbon rent
For the most part, this approach, which favors the largest historical emitters and gives Member States a broad prerogative, was renewed in 2018 for the 2021-2030 period. This idea of sharing the cake between countries is reminiscent of the “hands off my allowances” mentality of industrial stakeholders. A sort of national ownership of a common resource has emerged.
In our study “15 years of the European carbon market”, we propose a combined approach of expanding the scope covered by the market and establishing new distribution rules for the carbon rent. In 2023, the entirety of this rent (€131 billion) is expected to be allocated to facilities through auctions, the proceeds of which will be distributed into three groups.
The auction proceeds from international transport, which will become subject to allowances, should generate abundant own resources for the European budget, much like customs duties.
The 50% of proceeds Member States must devote to climate action can be maintained, as long as the Member States are required to provide better definition of their actions increase their reporting.
The remaining 50%, supplemented by auction proceeds from diffuse emissions (transport, buildings, small facilities) should be redistributed to households. This type of redistribution has been recommended by many economists in the case of a tax. The most appropriate system would be a lump-sum redistribution per capita, drawing on the “Carbon Dividend ” supported by many American economists and certain NGOs.
This could be paid as a “green check” for each European citizen. According to our calculations, Member States could distribute a check of €400 to each citizen in 2023 to help them deal with the rising price of fossil fuels. Simple and understandable redistribution of this kind could also help to reconcile citizens with the EU’s primary climate policy instrument.
Source of data: https://www.eea.europa.eu
Note: the surplus of allowances received by the steel secto includes allowances received by the industry which were then surrendered to external facilities using blast furnace gas.
Our series “Fifteen years of the European carbon market: what’s the point?”
The opinions expressed on this blog are those of the authors and do not necessarily reflect the official position of their institutions or of AFD.