Agreement on the Revision of the EU Emissions Trading System

On 18 December 2022, the trilogue negotiators of the European Parliament, the Council and the European Commission (hereafter “Commission”, together “the EU institutions”) agreed on a provisional text on the proposal to review the EU Emissions Trading System (hereafter “ETS”). This milestone deal was reached only a few days after a similar provisional agreement on the EU’s carbon border tax on certain imported products, also known as the EU Carbon Border Adjustment Mechanism (hereafter “CBAM”) (see our related News Alert here).

The successful conclusion of the negotiations on the reform of the ETS is an important milestone on the path to the expected adoption of the EU landmark legislation CBAM early in the new year.

The EU ETS and the CBAM

Both the proposal for a directive amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union (hereafter ETS Directive) and the proposal for a regulation of the European Parliament and of the Council establishing a carbon border adjustment mechanism are part of the so-called Fit for 55 package, presented by the Commission in July 2021, which aims to reduce net greenhouse gas (hereafter “GHG”) emissions by at least 55% by 2030 compared to 1990 levels and to achieve climate neutrality in 2050.

The ETS is a carbon market based on a cap-and-trade mechanism of emission allowances for energy-intensive industries and the power generation sector. The reform of the system aims to align the ETS Directive with the target set out in the European Climate Law to reduce net GHG emissions by 55% by 2030, compared to 1990 levels.

Negotiators of the Council and the European Parliament have agreed to increase the overall ambition of emissions reductions in the sectors covered by the ETS to 62% by 2030 and in order to reach this target they propose a steeper annual reduction. The scheme will also be extended to cover more sectors of the economy, such as maritime transport. A separate ETS for fuel emissions from the road transport and building sectors (“ETS II”) will be established by 2027, with the possibility for it to be postponed until 2028 if energy prices are exceptionally high.

The ETS allocates free allowances to sectors at risk of carbon leakage identified in a list for energy intensive industries. With the introduction of the CBAM, the EU institutions intend to equalise the carbon price between domestic products and imports, allocate free allowances in a more targeted way and to incentivise the uptake of low-carbon technologies and the reduction of GHG emissions by third countries.

The CBAM is designed to complement the ETS, serving as an alternative means of reducing the risk of carbon leakage by allocating free ETS allowances to energy-intensive industries. The current free allocation of allowances under the ETS will be gradually phased out as the CBAM is phased in. Specifically, the Council and the European Parliament have now agreed to end free ETS allowances for the sectors covered by the CBAM over a nine-year-period between 2026 and 2034. Until free allocations end, the CBAM will only apply to the proportion of emissions that do not receive free allowances under the ETS. A transitional period will start already on 1 October 2023, during which importers will be subject to reporting obligations of their embedded GHG emissions without having to pay financial adjustments. Once the CBAM becomes fully operational, importers will need to obtain authorisation from a centralised CBAM authority and purchase carbon certificates corresponding to the carbon price that they would have had to pay to produce the goods at issue in the EU.

The CBAM will apply to imports from all third countries except those participating in the ETS or a linked mechanism from a limited number of emissions-intensive sectors that are at greater risk of carbon leakage: iron and steel, cement, aluminium, fertilisers, electricity generation, hydrogen, certain precursors as well as some downstream products such as screws and bolts and similar articles of iron or steel. Indirect emissions will also be covered under certain circumstances. Before the end of the transition period, the Commission shall assess whether to cover also other goods at risk of carbon leakage, including organic chemicals and polymers, and it will also evaluate the risk of carbon leakage for goods produced in the EU but exported to third countries. If deemed necessary, the Commission will present a separate legislative proposal on that.

Next steps

The successful conclusion of the negotiations on the reform of the ETS having been declared a prerequisite for reaching a final agreement on the CBAM, the provisional agreement on the ETS takes us a decisive step closer to seeing the CBAM legislation being finalized in the very near future.

In order to be final and adopted, both the provisional agreement on the CBAM and the provisional agreement on the review of the ETS now need to be formally approved by the two EU co-legislators, the Council and the European Parliament. The new legislation will come into force 20 days after its publication in the EU Official Journal, which is expected for March/April 2023.