COMMENT: We need to talk about the EU’s carbon market

Published 12:30 on July 2, 2021  /  Last updated at 12:30 on July 2, 2021  /  Conversations, EMEA, EU ETS, Views  /  No Comments

If Europe is serious about remaining a frontrunner in meeting the objectives of the Paris Agreement, then it urgently needs an ambitious EU ETS reform to clean up its historic addiction to free handouts so the practices of sustainable frontrunners become the market norm, argues Leon de Graaf of #SustainablePublicAffairs.

By Leon de Graaf, Senior Consultant, #SustainablePublicAffairs

It was difficult to miss this week’s headlines with record-shattering temperatures in Canada and elsewhere. It reminds us that climate change is not some lingering risk decades in the future, but that already today it threatens us on our doorstep. On the back of this, the European Commission is set to publish a slew of policy proposals on July to reduce the EU’s greenhouse gas emissions by at least 55% by 2030, compared to 1990. For those following the debates closely, one of the most eagerly awaited proposals in this so-called “Fit-for’55” package will be the reform of the EU Emissions Trading System (EU ETS). Leaks of this proposal have come to light in recent days, giving a glimpse of what the Commission wants to do to bring down emissions in industry and the energy sector, as well in new sectors like (maritime) transport and buildings.

If you have followed the discussions, then you know that the most contentious issue gripping the debates on the EU ETS reform is the future of free handouts to industry sectors. For too long the system of free allowances to the so-called ‘best in class’ has been non-targeted. For example, on paper, only the most efficient steel-producing installations should have been getting enough free allowances to cover their emissions. Yet, in a recent interview, the boss of the EU steel lobby admitted that every steel producer up until recently has been able to offset on average 80% of their emissions with these free handouts. This is unfortunately not just a problem in this one sector. In fact, a recent study commissioned by Carbon Market Watch found that the EU’s heavy industry has made a whopping €50 billion in windfall profits from these free handouts between 2008 and 2019.

How could this have happened? Well, the way these free handouts are given out is based on a very technical process called “product benchmarks”. A whole value chain like that of steel is not put into a single benchmark, but instead each technique in the production process gets its own benchmark. For example, the key ingredient for iron to produce steel is iron ore. Therefore, most producers of iron ore are placed in the so-called Sintered Ore benchmark. Within this benchmark, each Sintered Ore producer competes to produce the “cleanest” sintered ore and this determines who receives the most free allowances. The big problem with this? Cleaner techniques to produce iron are excluded from this benchmark. For example, the Swedish iron ore group LKAB produces iron with a technique using iron ore pellets, which are basically little iron ore balls, whereas sintered ore are small iron ore rocks. Both can be used interchangeably to produce iron and eventually steel. The big catch? LKAB’s production of pellets emits only around one tenth of the greenhouse gases emitted by the average sintered ore installation. By a rough estimation, a large-scale transition from sintered ore to pellets production and use in the EU would – in itself – represent yearly climate gains of 16 million tonnes of CO2 emissions. This by comparison is almost equal to the annual CO2 emissions of Sweden’s entire industry. However, because it is a slightly different technique, the Commission and the EU steel lobby do not want it to be included in the sintered ore benchmark, and therefore LKAB is prevented from setting the standard for CO2 efficiency in its industry. Its dirtier competitors meanwhile are being kept alive with free handouts because they only have themselves to worry about. Sustainable frontrunners like LKAB are being heavily disadvantaged.

Imagine if you had benchmarks for the energy sector; this would be like having a separate benchmark for coal producers and one for solar power producers, and so on. Within this hypothetical coal benchmark, all coal producers would compete with each other on who producers the cleanest coal. But, of course, this should not be the point. The point should be to produce the cleanest energy. In the same vein, the goal should be to produce the cleanest steel, cement, chemicals and everything else. If instead the benchmarks were to capture value chain-wide emissions, then you could actually have different techniques compete with each other on their CO2-reduction potential. The recent EU ETS leak is hinting at this fact by stating that it wants to make the product benchmark system more technologically neutral and by ensuring equal treatment of installations independent of the technology or production process used:

“The EU ETS free allocation rules are amended to better support decarbonisation of energy intensive industries by the deployment of break-through technologies.

Efficient technologies just below benchmark level receive more free allocation than they emit. This puts innovative technologies outside the EU ETS at a competitive disadvantage, so investments in those technologies may be discouraged. Innovative installations can fall out of the EU ETS because they change their production process or because their total rated thermal input of the combustion units of an installation decreases to less than 20 MW.

This disincentive is addressed by: (i) specifying that installations stay within the EU ETS if they reduce the total capacity of their combustions units to reduce greenhouse gas emissions (e.g. through electrification); (ii) making the definitions of activities technology neutral (removing references to fossil fuels or specific production processes); (iii) referring to production capacities instead of combustion capacities and (iv) reviewing the benchmark definitions to ensure equal treatment of installations independently of the technology used, including when using low- or zero-carbon technologies. Maintaining innovative installations in the EU ETS will also reduce benchmark values and thus encourage greater emissions reductions.”

That would be great because, so far, this issue is one in the EU ETS where the European Commission has unfortunately remained silent for many years. That is why LKAB has recently taken the Commission to the Court of Justice of the EU over the issue. LKAB is one of the only frontrunners in the iron and steel industry that wants to see an accelerated phase out of free handouts in the EU ETS. This is because free allowances are hardly benefitting frontrunners like LKAB, and are keeping environmental laggards alive.

If Europe is serious about delivering on its recently agreed Climate Law and on remaining a frontrunner in meeting the objectives of the Paris Agreement, then it urgently needs an ambitious EU ETS reform. That can only happen if the practices of sustainable frontrunners become the market norm. And, for that to happen, the EU ETS needs to clean up its historic addiction to free handouts.

Leon de Graaf is a senior consultant at #SustainablePublicAffairs, a public affairs agency based in Brussels that represents LKAB.