The EU Emissions Trading System (ETS) at a Crossroads
Market-based climate policy in an era of geoeconomic fragmentation and industrial policy resurgence. A commentary by Rose Boucraut, and Romain Svartzman
The EU Emissions Trading System (ETS) is the EU’s flagship climate policy instrument. Since 2005, the ETS: (i) sets a declining cap on greenhouse gas (including CO2) emissions from covered sectors: originally power generation and energy-intensive industry, later extended to aviation and maritime shipping; (ii) issues a corresponding number of tradable allowances, each permitting the emission of one tonne of CO2-equivalent.
Companies subject to the ETS must surrender allowances matching their verified emissions, obtained either through free allocation, auctions, or purchase on the secondary market. The system creates a market price for carbon and, thus, an economic incentive to decarbonise.
After two decades in operation, evidence suggests that the ETS helped reduce emissions in most covered sectors, without producing a collapse in EU industrial competitiveness.
However, amid higher energy prices driven by the wars in Ukraine and, more recently, Iran, and against the backdrop of a broader backlash against climate policies in the EU, many – including some government officials – have argued that the ETS is undermining EU competitiveness.
Part of the concern centres on carbon leakage: the risk that higher carbon costs push energy-intensive production, and associated emissions, to jurisdictions with laxer climate rules. The carbon border adjustment mechanism (CBAM) was designed precisely to address this risk.
A new European Commission proposal to reform – or weaken? – the ETS
It is in this context that the European Commission just has unveiled a proposal to reform the ETS, on July 17. The proposal will now have to go through the ordinary legislative procedure with the Parliament and the Council before being legally binding.
Formally, the Commission seeks to reduce the volatility of carbon prices and mitigate impacts on electricity prices while preserving the ETS’s central role as a strong carbon pricing mechanism, creating the incentives to invest clean technologies.
However, many fear that the proposal concedes too much to actors seeking to weaken or even dismantle the ETS. The major change concerns the ETS cap trajectory after 2030.
The proposal aligns the ETS with the 2040 climate target (-90% of GHG emissions by 2040 compared to 1990 levels) but does so through a more gradual pathway than currently planned – that is, slowing the decline in allowance supply.
The proposal also partially reverses the ETS’s long-term shift from free allocation towards auctioning, which was intended to strengthen the polluter-pays principle. Even though these free allowances would be conditional on decarbonisation investments, they could still dilute the carbon-price signal.
However, the proposal also adjusts sectoral coverage, including changes for aviation and maritime transport and the inclusion of municipal waste incineration.
The uneasy quest to reconcile market-based climate policy with industrial policy
The ETS fits within a market-based approach to environmental issues, or “liberal environmentalism“. Its underlying logic is that GHG emissions are a negative externality: firms emit because the social and ecological costs of carbon are not reflected in market prices.
By setting a cap on emissions and creating tradable allowances, public authorities internalise this externality while letting market participants identify the cheapest technologies and abatement options.
This reliance on market-based instruments, which has dominated over the past few decades, has increasingly been challenged by geoeconomic fragmentation (tariffs, conflicts, volatility of energy prices) and by the success of alternative models. The results are notable: in particular, China now holds a substantial lead in clean technology manufacturing, and the EU’s balance of trade with China is increasingly in deficit on clean technology goods.
This raises a question that advocates of carbon pricing as a sufficient policy tool tend to overlook: if market-based instruments like the ETS were sufficient on their own, why has clean-technology leadership shifted so strongly towards economies relying on more targeted industrial policy, mostly China? Put differently, shall the EU be satisfied, in the current geopolitical environment, with having contributed to lowering the relative cost of green technologies through the ETS without reaping the benefits in terms of domestic production and supply chain resilience?
From this perspective, one could argue that while it comes with real risks for environmental ambition, the ETS reform proposed by the Commission also has some merits: it attempts to reconcile the ETS with the EU’s emerging agenda on industrial competitiveness, climate policy and strategic resilience. It reflects a difficult yet needed effort to adjust environmental policy to a changing geopolitical landscape.
In particular, the Commission seeks to make ETS revenues a more direct instrument of industrial transformation. The proposal requires Member States to allocate at least 50% of ETS revenues to priority areas linked to decarbonisation of ETS sectors, including industrial decarbonisation, electrification, grids, storage, clean energy, low-carbon transport, circularity, lead markets, and innovation.
This willingness to push for industrial transformation is also reflected in the stronger EU-level financing architecture proposed.
It establishes the Industrial Decarbonisation Bank (IDB), aiming to mobilise €100 billion for industrial decarbonisation, mainly through reserved ETS allowances and auction revenues. Moreover, the EU Innovation Fund would receive additional ETS allowances for innovative low-carbon innovation and industrial decarbonisation, while the Modernisation Fund – supporting energy-system modernisation in lower-income Member States – would be extended.
There is still a long way to go before the EU fully factors in the new geopolitical and industrial reality.
As a matter of fact, the funds raised through the mechanisms indicated above will likely fall massively short of what is needed to decarbonise the EU economy while securing leadership in key clean technologies.
As such, more politically charged questions will have to be discussed sooner rather than later. For instance, whether green public investments should benefit from a ‘golden rule’ (exempting them from budgetary constraints of the Stability and Growth Pact); or whether the EU should develop green technologies and resilient supply chains alongside other middle powers, or instead accept Chinese leadership in at least some technologies and seek to benefit from inward Chinese green investments.
For now, the debate appears to be moving in the right direction, one in which market-based policy and price signals are embedded in a more ambitious and realistic economic programme.
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
