Green transition, part 2: emissions trading reform still veiled in mystery

Emissions trading in a nutshell

The European Union's emissions trading system (EU ETS) is being renewed. The Council of Europe and the European Parliament reached a preliminary political consensus on the reforms at the end of last year. Although the details are still lacking, we consider the possible impacts of the proposed model below. More detailed information is still needed from many directions.

The EU ETS is currently the largest in the world. The basic principles of the system sound simple: Each year, the EU issues a certain number of emission allowances to the market and companies included in the emissions trading system have to buy an equal amount of allowances to their emissions to be able to legally produce their products. Emissions trading currently covers, e.g., the production of electricity and heat, energy-intensive industries such as oil refineries, cement production, glass production, ceramics and paper production. Emissions trading covers about 40% of emissions in the EU. It has been estimated that since its establishment in 2005, the system has reduced emissions by 41% from industries included in emissions trading.

Emission allowances and free allowances will be reduced

It is proposed that 4.3% fewer allowances would be issued to the market each year (instead of 2.2%) in 2024-2027 and 4.4% fewer in 2028-2030. Some sectors have also received allowances partially free of charge (cement, aluminum, fertilizers, electricity production, hydrogen, iron and steel) and free allocation of allowances is to be abolished. Competitiveness will be supported by the introduction of a carbon border adjustment mechanism. In addition, sectors considered most sensitive to carbon leakage will continue to receive free allowances although they will be gradually reduced by 2034.  It should be noted that according to some calculations, different industries have used significant amounts of free allowances. For example, according to the IMF, e.g.,  the number of rights purchased in the chemical industry has on average been just over half of the total need.

Source: IMF Working papers the carrot and the stocks

Shipping emissions included in ETS, new separate system for the buildlings and road transport sectors, special characteristics for aviation sector

Shipping will be gradually integrated into emissions trading from 2024 onwards so that emissions from shipping in regulated areas will be fully covered by emissions trading in 2026. A new, separate system is being built for companies supplying fuel to the buildings and road transport sectors and for certain other sectors. The legislators have agreed that the system will be introduced in 2027.

In addition to emissions trading, the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) is applied to the aviation sector in the EU and it has been proposed that the free allowances to aviation will gradually disappear. 

Carbon border adjustment mechanism to protect European competitiveness?

Carbon tariffs will gradually enter into force at the same time as granting of free allowances will reduce. The Research Institute of the Finnish Economy (ETLA) estimated the impacts of carbon tariffs on Finnish industry in fall 2022. According to it, the carbon border adjustment mechanism would benefit sectors producing products subject to carbon tariffs in Finland and EU countries (aluminum, cement products, fertilizers and steel products). On the other hand, other industrial sectors could suffer from the tariffs as they would increase production costs for sectors using products subject to carbon tariffs. It remains to be seen how countries outside Europe will ultimately react to carbon tariffs.

With the lack of details, the impacts of the proposed reform are impossible to assess on company-level

Investors are likely to be interested in how the proposed reforms affect companies. As the ETS expands, players in, e.g., the shipping industry will learn to manage emissions trading and carbon tariffs but also companies like Finnair and Outokumpu are facing new issues. For Finnair, the proposed reduction in free allowances and the strengthening of CORSIA would probably increase the cost risks over the next few years. We estimate, however, that airlines ravaged by the COVID pandemic cannot afford to carry rising costs themselves, but they would be added to ticket prices, despite the tense competitive situation in the sector. This, in turn, would test the growth outlook of demand in the sector through the price elasticity of air travel, but it is difficult to assess the scale of change pressure at this time. In addition, the rising cost of emissions would put pressure on fleet renewal, but with CORSIA, international competitors would to some extent be in the same boat. The company therefore announced that it will invest in increasing the usage of sustainable aviation fuel and renewing fleets to achieve emission reductions.

As a sunny Finnish side, we should also mention that Neste can deliver CORSIA certified aviation fuel, which is an example of the business opportunities offered by the green transition .

The steel sector is classified in industries where free allowances will be granted until 2034 to maintain competitiveness. For Outokumpu , the key factors are carbon tariffs and their impact, electrification aid and reducing free allowances. According to Outokumpu's own estimate, the allowances they currently hold cover the need for allowances in the first half of emissions trading (years: 2021-2025). After that, we believe the adequacy of emission allowances will depend on the progress of reducing CO2 emissions and improving energy efficiency, which the company is also investing in.

However, emissions trading reforms can have an overall impact, as emissions trading also affects electricity prices. In addition, some partly unestimated impacts would be brought by  market stability reserve. The price of allowances affects the company both directly, as far as rights need to be bought and indirectly if they raise the price of electricity. Many details remain open, but investors should gradually start to whet their appetite for understanding emissions trading.

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The author of this article, Karoliina Loikkanen, is head of ESG solutions at Inderes. She has an extensive background on ESG issues and is passionated to develop the dialogue between investors and companies on ESG further. Co-auhtors of this article were head analysts Antti Viljakainen and Petri Gostowski respectively.