Will EU Emission Trading Remain A Major Source Of Low-Carbon Finance?

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Originally published on EnergyPost.
By Emil Dimantchev

Image: Karen Eliot
Image: Karen Eliot

Last year for the first time many of the CO2 allowances in the EU Emission Trading Scheme (ETS) were auctioned rather than handed out for free. Surprisingly perhaps, the EU member states used much more of the ETS revenues for low-carbon development than EU law suggests they should. This suggests that the ETS could become a major source of low-carbon finance in the future, writes Emil Dimantchev, senior analyst at Thomson Reuters. But Dimantchev notes that there is no guarantee member states will continue this practice. He recommends a broader use of earmarking at the EU level to provide the necessary public funds for Europe’s transition to a low-carbon society.

On 28 October the European Commission published its annual Progress Report showing the EU is making good headway toward meeting its 2020 targets. Most of the news coverage around this report focused on how low the carbon price currently is and on the ongoing political discussions to reform the EU ETS. Little attention was paid to a rather remarkable finding in the report. It turns out that member state governments have spent 84% (€3 billion) of the money they received (€3.6 billion) from the auctioning of CO2 allowances on low-carbon development, whereas the ETS directive states that at least 50 percent of the revenues “should be used” for climate related purposes. The choice of member states to spend so much on climate change implies a high degree of willingness to use the ETS as a source of low carbon finance, even at a time of austerity.

Last year marked a crucial shift for the European emissions trading system (ETS). Until 2013, CO2 most allowances were given away for free to emitters by the member states. A small number of allowances were offered on auctions, where companies could buy permits in case the amount they received was not enough. As of 2013, the ETS entered its so-called third phase, which came with significant regulatory changes. From now on a significant (and growing) portion of the CO2 allowances will be auctioned.

For the power generation sector, the rule is that operators no longer receive any free allowances but have to buy them. However, eight of the Member States which have joined the EU since 2004 – Bulgaria, Cyprus, Czech Republic, Estonia, Hungary, Lithuania, Poland and Romania – have been given an exemption which allows them to give a decreasing number of free allowances to existing power plants for a transitional period until 2019.

Member states will spend as much as € 3 billion or 84 percent of the total revenues on low carbon development

In the manufacturing industry, companies receive allowances depending on whether they are deemed by regulators to be exposed to international competition. Most emitters are on the so called “carbon leakage” list, and are to receive the majority of their needed allowances up until 2019 for free. The small number of companies which are not on the list are to receive a decreasing portion of their allowances for free starting from 80%  in 2013 and falling to 30% in 2020. Allowances not allocated for free will be auctioned. In the aviation sector, however, only 15% of aviation allowances will be auctioned over the whole 2013-2020 period.

All in all in 2013 around 40 percent of all allowances in the ETS were auctioned last year. The total amount of revenue raised through these auctions amounted to 3.6 billion euro, according to a Commission announcement on 28 October. Member states have the right to choose how they spend their share of the revenue. The ETS directive only states that at least 50 percent of the revenues “should be used” for climate related purposes. The member states are required to report to the Commission how they spent the money.

Badly needed

The Commission compiled and made public some of this information in late October, revealing for the first time how EU countries are spending their share of the multi-billion-euro revenues. According to the Commission’s report, member states will spend as much as € 3 billion or 84 percent of the total revenues on low carbon development. About three fourths of these revenues (€2.3 billion) will go towards climate finance within the EU. The remaining quarter will be spent on climate and energy outside of the EU, helping EU governments meet their commitments to the Green Climate Fund, the main global instrument meant to transfer funds to developing countries for climate mitigation and adaptation.

It seems likely that over the next few years the ETS revenues will be in the ballpark of their 2013 value. But they could rise substantially as we get closer to 2020

The money spent within the EU is almost evenly split between energy efficiency improvements, renewables, and other mitigation options (including R&D). However, it is not clear which specific projects will benefit as the Commission has aggregated the information provided by member states and has not made public individual member state reports. There is therefore much to be desired when it comes to transparency of where ETS revenues are spent.

To put these numbers into perspective, consider the amount of public climate related spending before 2013. Government spending in 2012 across Europe totaled only €3.9 billion on air pollution and climate change combined, according to Eurostat. Public spending on climate has come under pressure because of the economic recession. This trend is likely to continue and, in this context, the €3 billion raised through the ETS in 2013 appears as a major source of public finance for low carbon growth.

This money is badly needed. The challenge posed by EU’s climate efforts continues to loom large. The Commission estimates that its low carbon roadmap requires investment amounts as high as 270 billion euro annually (!). It is clear that most of this finance must come from the private sector. But public funding will be needed as well, in particular in areas such as R&D and stimulating innovation.

Double dividend

The spending of ETS revenues could provide a double dividend, achieving both environmental goals by reducing emissions and economic goals by propelling a low carbon economy. The experience of the Regional Greenhouse Gas Initiative, an emissions trading system in the US Northeast, is a prime example of how this can work. Research by the Analysis Group consultancy shows that the auctioning of CO2 allowances under this program generated nearly $1 billion of revenue for the ten participating states between 2009 and 2011. Regulators committed to using at least 25 percent of the proceeds for low carbon investments, but ended up investing as much as 48 percent of revenues in energy efficiency projects. In this way, they generated net savings for electricity consumers. Together with spending on other programs, this produced a $1.6 billion net gain for the economies of the participating states in the 2009-2011 period.

Several member states, including the UK, Denmark and the Netherlands, direct their revenues into their national budgets

The EU ETS, being by far the largest emission trading system in the world, has the potential to generate much greater levels of low carbon finance. Whether this will come true, depends first of all on the amount of money raised through the auctions and secondly on how governments will choose to spend the money.

Going forward, the revenues raised from the ETS will inevitably fluctuate with the carbon price and the amount of allowances auctioned. Both will depend on decisions taken by EU policy makers in the next year with respect to reforming the EU ETS and the current proposal for a market stability reserve. Discussions on how many free allowances industrial manufacturers will receive post 2020 will also affect how much revenues member states can raise.

Currently, it appears likely that over the next few years the ETS revenues will be in the ballpark of their 2013 value. They could however rise substantially as we get closer to 2020 and beyond as the price of CO2 allowances is driven higher by the EU’s reform efforts and its post-2020 commitment to reduce emissions by 40 percent in 2030..


But how will countries spend these large sums of money? The management of ETS revenues varies greatly from state to state. Several member states, including the UK, Denmark and the Netherlands, direct their revenues into their national budgets. There is therefore no guarantee how their share of the future revenues will be spent. By contrast Germany has created a special Energy and Climate Fund, which will by law receive all future ETS revenues, with the exception of a small amount appropriated for administrative costs.

The EU should amend the ETS directive to encourage a broader use of budgetary or political earmarking

The use of budgetary earmarking in Germany allows for a predictable and consistent flow of low carbon finance. The existence of a separate fund also enhances transparency, which can improve the accountability and performance of publicly funded programs. This approach seems as a best-practice example for other governments that seek to maximize the climate impact of their ETS revenues.

Budgetary earmarking is however politically challenging in many countries. An alternative can be the middle-of-the-way approach of political earmarking, where governments use political commitments to tie carbon price revenues to climate spending.

But any form of earmarking will be most effectively achieved at the EU level. To make the most out of its carbon price revenues, the EU should amend the ETS directive to encourage a broader use of budgetary or political earmarking. The EU must also encourage the transparent tracking of ETS revenues. This can be accomplished by the creation of special funds as in Germany or by a requirement for member states to publish detailed reports of where revenues go and what impact they have had and are expected to have. Otherwise the EU will likely limit the potential of the ETS as an effective climate policy instrument.

Emil Dimantchev (@EDimantchev) is a senior analyst in the Point Carbon team at Thomson Reuters, which provides independent analysis on carbon markets and global climate policy. The views expressed here are his own.

Reprinted with permission.

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