By Hege Fjellheim, Head of Carbon Analysis at Veyt

On 6 February, the European Commission laid out a greenhouse gas emission reduction target of at least 90 percent below 1990 levels by 2040. This is the missing link bridging the block’s 2030 ambition of at least 55 percent reduction with the carbon neutrality target in 2050.

The 2040 proposal is the start of a dialogue with all stakeholders that will bring controversial and inconvenient topics to the table – topics usually called the “elephants in the room.” In hopes of getting these talks going on the right foot, I’m going to name some of these elephants. But first, let’s make clear why they exist in the first place.

A revolution with carbon pricing as its sword

With all the talk about targets and percentages compared to base years, it’s not obvious what a net 90 percent reduction actually implies for the EU: it is nothing short of an industrial revolution. Massive abatement is required from all sectors of the economy, made possible through huge investments in technology development and deployment of low carbon solutions across Europe.

The EU emission trading system (EU ETS) is a key instrument to achieve all of this; the carbon price being the stick and revenues from allowance sales the carrot. The sectors the EU ETS currently covers – power production, heavy industry, air travel and shipping – will face a cap that declines fast, reaching zero in 2038 by Veyt’s estimates. This makes for such a dearth of emissions permits going forward that their price will rise significantly: Veyt project European emission allowances to cost close to €160/t by 2030. But when there are no more emission permits and simply no further abatement options for industries that inherently produce greenhouse gases, policymakers may have to offer other options.

Beyond Europe

Enter the first elephant: the possibility of allowing the use of carbon credits from reductions undertaken in other countries. Europe has been there before, with carbon credits under the Paris Agreement’s predecessor the Kyoto Protocol. European companies invested in emission reduction projects in developing countries – they then used the carbon credits stemming from those projects against their EU ETS compliance obligations. It didn’t go well: the quality of those credits was variable, and the volumes imported contributed to undermining the European carbon price signal.

Carbon credits are no longer allowed in Europe, neither by governments to comply with EU climate goals nor by companies to comply with EU ETS obligations. The EU Green Deal is domestic. To the surprise of no one, the 2040 target plan lacks any mention of credits.

But trading of carbon credits – both among countries and on the part of private sector entities – is allowed under the Paris Agreement, precisely to take advantage of the fact that reducing more emissions where it is cheapest allows more global climate change mitigation overall. Given that it’s already on the agenda at the UN level, and that nobody wants Europe to decarbonize through industry death or relocation, the idea of using carbon credits as a flexibility option for hard-to-abate sectors is bound to resurface during the broad dialogue that has now been kicked off in the EU. Get ready for some controversial discussion!

Bringing back the dead

The second elephant is less in the public eye:  only the nerdiest of carbon market followers knows what is meant by ”invalidation of allowances from the market stability reserve.” The introduction of a supply-adjusting tool in the EU ETS – a market stability reserve (MSR) – saved the day for the European carbon market after it had a glut of allowances due to lower-than-expected emissions during the financial crisis combined with Kyoto era carbon credits flooding the market.

Since its start in 2019, the MSR has soaked up a huge permit surplus and the carbon price signal has quickly recovered – allowance prices have gone from single digits five years ago to current levels below €60/t. The mountain of allowances stored away in the reserve was initially meant to trickle back into circulation when the market got tight. Veyt’s market balance estimates foresee the release from the reserve starting in 2031. But the way the MSR is structured, it will quickly empty getting into the 2030’s – the amount of allowances it puts back into the system will not be enough to rescue industries struggling to comply with a rapidly declining allowance cap.

And that’s where the elephant comes in: back in 2018, policymakers agreed to “invalidate” 2.5 billion allowances – around two years’ worth of emissions in the traded sectors – stored away in the reserve. They were considered “hot air” at the time, undermining environmental integrity of the ETS.

Still, it could be tempting for some stakeholders and policymakers to resurrect at least some of this invalidated volume. They are of huge monetary value and could provide a breather for European industry. But bringing them back is not only dubious from an environmental point of view, it would distort confidence in the ETS as a policy tool and mute carbon prices.

Removals or not removals – that is the question

Whether these elephants even enter the room depends on how things go with carbon removals. With a trajectory to net zero emissions in 2050, the greenhouse gases still being put into the atmosphere by European producers will have to be balanced by nature’s ability to soak up and store CO2, as well as – until quite recently considered science fiction – engineered solutions to suck CO2 out from the atmosphere and store it permanently. Negative emissions, that is.

The certification rules for such removals were recently agreed by EU lawmakers, but it remains undecided whether and how EU ETS entities may use carbon removals to balance residual emissions. The Commission isn’t set to offer a proposal on this until 2026, which is quite late given early investment signals are crucial.

Whether the final percentage by which EU emissions must decline below 1990 levels in those next 17 years ends up being 90 or a bit higher/lower, the implication is a veritable transformation of the European economy – one that will affect all European citizens. Having an inclusive debate is therefore the right thing to do – and so is addressing the elephants in the room.

Any opinions published in this commentary reflect the views of the author and not of Carbon Pulse.

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