The European carbon market is strengthening to introduce an adjustment tax at the Union borders

Olivier ABULI, advice and analyses consultant

July 11, 2022

This was the priority objective of the French Presidency of the European Union : it has been achieved. The five mainstay texts of the Climate Package presented by the Commission in July 2021 have passed the decisive stages of examination by the European Parliament and then, during the night of 28th-29th June, the Council of the 27 Environment Ministers took its stand.

Observers were expecting particularly tight negotiations about the end-of-sale mechanism regarding vehicles propelled by internal combustion engine. This prediction was eluded by the appearance of more pronounced differences within the Parliament concerning another topic : the pace of adaptation and the extension of the internal carbon market, a technical and economic prerequisite for the implementation of the future Border Carbon Adjustment Mechanism (BCAM). These disagreements led to an initial vote of rejection on June 8th, before negotiations between groups allowed for the adoption of a compromise text in extremis during a second examination on June 22nd.

History, assessment and future of the European carbon market

Created on January 1st, 2005 to fulfill the commitments of the Kyoto Protocol, it concerns 11,000 sites that account for about 50% of the Union CO2 emissions. It applies to the following sectors : power generation, refining, steel industry, cement works, chemicals, district heating and, partly, aviation (domestic commercial flights since 2012).

Being the largest carbon market in the world, this European system operates on the basis of degressive greenhouse gas emission permits (so called « rights to pollute »), going with an obligation to financially compensate for excesses by acquiring unused allowances on a regulatory marketplace.

The climate emergency and the challenges of relocation require a significant overhaul of the framework

As it was designed fifteen years ago to meet very progressive GHG emission reduction targets, this organization is now outdated. Being more of an incentive than a constraint, it is no longer adapted to the extent of climate change, as it is highlighted by the speeding up of the 2030 catch-up trajectory set out in the EU's « Fit For 55 » roadmap.

From the outset, this market has been biased by the allocation of too many allowances, including an extremely high volume of free allowances (80% at the beginning of 2013). Since it was slightly below €15 in 2009, the price of a ton of carbon has been on a downward trend, influenced by fluctuations in the economy, but above all by a growing volume of « carbon leakage » (between 1995 and 2018, domestic emissions fell by 30% while imported emissions rose by 78%).

In January 2018, a risky lower limit at €7/t led the European authorities to withdraw surplus allowances from trading. This decision had an immediate mechanical effect : €25.5/t in December 2018, €32/t in December 2020. The market then found a kind of equilibrium threshold during 24 months.

Since then, it has sharply increased following the presentation of the « Fit For 55 » plan (from 53 €/t on July 16th, 2021 to 96 €/t on February 8th, 2022) and has become extremely reactive to political announcements and the international context (decreasing to 58 €/t on March 7th, 2022 at the outbreak of war in Ukraine).

Assigning new issuing economic sectors to foreshadow the border adjustment mechanism

For the carbon tax that the European Union plans to introduce at its borders to be effective and accepted by its trading partners, it has to meet at least two conditions :
- an unquestionable ecological coherence, by encompassing all high-emission activities ;
- conformity with the exceptions to the agreements dealing with customs tariffs that the jurisprudence of the World Trade Organization acknowledges to strive towards environmental objectives.

In concrete terms, this means that over the next five years, the EU must work to put an end to the exemptions and the last free allowances (aviation) regarding the coverage of its current carbon market. At the same time the EU must organize the extension of its carbon market perimeter to new sectors in order to integrate them into the future Border Carbon Adjustment Mechanism (BCAM) : shipping and road transport, air transport as a whole, housing and possibly (in the long run) farming.

As the respective stances of the Parliament and the Council have been established regarding the core of the guidelines and the elements of the timetable, the decision-making process is now entering the negotiation phase in order to reach an agreement between the two institutions before the end of this autumn.

The challenge is to position the cursors at best to optimize the articulation of the two twin projects that are opening up. The aim is to accelerate the pace of change, while allowing the industries and affected companies realistic time to transform themselves without overly weakening their competitiveness in globalized markets.

At the beginning of July, the trend that is emerging is that of a gradual restructuring of the current carbon market, together with its extension to new sectors, between 2027 and 2032.

The operational implementation of the border adjustment mechanism could then take place in the following 12 to 24 months.

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