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OUR VIEW

CSCF Simulator - ETS Trilogue Agreement

9/2/2023

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We've updated our CSCF Simulator based on the ETS trilogue agreement of December 2022, finding that the risk of a CSCF in Phase IV remains low.

The simulator works as described in our earlier post of 15/07/21 but has been adjusted to match the cap provisions in the final trilogue agreement. You can adjust the HAL (Historical Activity Level) parameter to test different scenarios.

Please note that the simulator does not consider the following:
  • The forthcoming revision of the benchmark boundaries, which will potentially entail giving free allocation to new processes, such as green hydrogen production.
  • New provisions for giving additional free allocation to district heating sub-installations.
  • The CSCF protection that will be provided to installations that outperform their benchmark using allowances that are not allocated due to Article 10a(1).

The simulator assumes that changes in allocation due to the CBAM Factor, Article 10a(1), and dynamic adjustments will be administered so as not to affect the general CSCF value.

​For further information, or to provide feedback, please contact damien.green@perspectiveclimate.com
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The new EU ETS Phase IV Cap

9/2/2023

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Here's our overview of the new EU ETS Phase IV Union-Wide cap based on our analysis of the trilogue agreement (and REPowerEU agreement) of December 2022. Precise cap figures have yet to be announced.

For further information, or to provide feedback, please contact damien.green@perspectiveclimate.com
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CSCF Simulator (Fit-for-55 Proposal)

15/7/2021

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Our CSCF Simulator suggests that the Commission's ETS Fit-for-55 reform proposal is more resilient to a CSCF than the Impact Assessment might suggest.

The difference in finding seems to be due to the following factors:
  • The Impact Assessment seems to include expansion that would be serviced from the NER within its calculations, which tends to overestimate the claims on the free share and CSCF buffering pool
  • The Impact Assessment does not add the maritime sector to the cap before deriving the size of the free share and CSCF buffering pool, which tends to underestimate the number of allowances available
  • The Impact Assessment assumes a 62% emissions reduction target and, in its initial analysis at least, a 1.6% benchmark reduction corridor, which increases the risk of a CSCF

Assuming the Commission's rule changes are introduced in 2024, and activity levels and emissions intensity improvements are consistent in the baseline periods, the proposal just avoids a CSCF.

See below for an explanation of the model and its assumptions in more detail. The parameters can be adjusted directly below.


For further information, or to provide feedback, contact damien.green@perspectiveclimate.com

​EXPLANATION 
   
  • Based on how you set the adjustable parameters, the model estimates the number of allowances owed to installations and the number of allowances available for allocation each year to generate a CSCF.
  • The following assumptions are built into the model (i.e. are not adjustable):
    • The observed annual improvement in benchmarks in 2021/22 will be the same as in 2016/17
    • The hydrogen benchmark will be decoupled from the refinery benchmark
    • Changes in activity level will be consistent across benchmarks
    • The fuel-electricity exchangeability factors for 2019-23 will be consistent with 2014-18 
    • The proportion of entitlements in 2026 that are not on the carbon leakage list will be the same as in 2021
    • The maritime sector will be added to the union-wide cap but will not receive free allocation
    • The LRF and cap will be revised in the manner set out in the Commission's proposal (with certain assumptions made about the correct interpretation)
    • The standard diversion of free-share allowances to funds results in a uniform reduction of the annual amount of allowances available for free allocation 
    • The transfer of CBAM-sector free allocation to the auction share proposed by the Commission will be administered in such a way so as not to reduce or increase the CSCF (i.e. the unadjusted final allocation for 2026-30 would be reduced in proportion to the reduction in preliminary allocation due to the CBAM Factor) 
  • Entitlement estimates are based on adjusting the known annual entitlement on each benchmark for 2021-25 (published in the benchmark data report) in the following manner:
    • Each entitlement is revised down based on the assumption that the observed annual improvement in benchmarks in 2021/22 will be the same as in 2016/17 and will be corrected to fall within the benchmark reduction corridor you enter in the table 
    • All the entitlements are then further adjusted uniformly according to the assumption you enter concerning how the overall activity level in the baseline period 2019-23 will compare to 2014-18
    • A quantity is then subtracted from the entitlements annually from 2027-30 based on the assumption that the proportion of entitlements not on the carbon leakage list will be the same in 2026 as in 2021
  • The number of allowances available for free allocation is a function of the cap, which is affected by the 2030 ETS target you enter, and the year you select for the inclusion of maritime sectors and upgrading the LRF. The model adjusts the cap as follows:
    • A reference stationary cap for 2010 is derived by dividing the known current LRF for Phase IV (i.e. 43,003,515) by 0.022
    • A reference stationary cap for 2005 is derived from the Commission's proposal based on the implied 2030 cap representing a 61% reduction
    • A nominal stationary cap for 2020 is defined by adding the known LRF (i.e. 43,003,515) for Phase IV to the known 2021 stationary cap
    • The nominal stationary cap for 2020 is reduced by a linear reduction factor to reach the 2030 cap generated by the target you enter
    • A nominal maritime cap for 2020 is defined separately as 90 million allowances (based on the figure stated on page 4 of the Commission's proposal) and this is reduced by a set quantity from 2021 onwards to reach 79 million in 2023 (based on the figure stated on page 46 of the Commission's proposal) and around 53 million in 2030 (based on the cap figure stated in the Impact Assessment on page 194 of the Commission's proposal).
      • This approach was taken because the Commission's proposal and attendant impact assessments do not make clear how shipping would be added to the target baseline or LRF baseline.
    • The stationary and maritime nominal caps are added together to give a union-wide nominal cap for 2021-30
    • The annual cap switches from its currently defined path to the nominally defined path in the year that you select for changes to apply
  • Expansions and contractions that are serviced by the NER do not influence the CSCF value, so are not considered in the model. The model also does not consider possible reductions in entitlements due to installations not implementing Article 8 audit recommendations, which would reduce the risk of a CSCF.
  • The adjustable parameters are by default set to be consistent with the Commission's ETS proposal, assuming that HAL is flat and changes are introduced from 2024.
  • We will make alternative versions of the model during the ETS reform debate, adjusting the built-in assumptions as required to match different proposals from the institutions.
   
DATA SOURCES 
   
Benchmark data report 

Phase IV cap and LRF value 

Phase III cap and LRF value

Commission's ETS reform proposal

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MSR Simulator (Fit-for-55 Proposal)

21/3/2020

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Updated on 29/07/21 and 13/05/22

Try our MSR Simulator to estimate how many allowances will be invalidated during Phase IV under the Commission's Fit-for-55 ETS proposals.

See below for an explanation of the model and its assumptions in more detail. The parameters can be adjusted directly below.

For further information, or to provide feedback, contact damien.green@perspectiveclimate.com
OVERVIEW 
  • The model generates an MSR projection based on how you set the adjustable parameters.
  • General parameters for the Phase are set in the top table and are applied from the year you select. Maritime and aviation sectors are also automatically added to the TNAC calculations from this date.
  • The withdrawal rate of the MSR and assumptions concerning issuance and surrender/cancellation are entered on an annual basis in the lower table.
  • If your assumptions are generating a negative TNAC in the graph they are inconsistent and should be revised, i.e. you are assuming more allowances have been surrendered (or cancelled post-issuance) than have been issued.
  • The parameters are set by default to generate a projection based on applying the Commission’s proposals from 2024.
  • If you would like to generate a projection that assumes current MSR rules change in 2025 or later (or not at all), set the withdrawal rate to 12% in years when existing rules remain unchanged from 2024 onwards.
  • Alternative versions of the model will be produced as required to generate projections in relation to proposals from the other institutions during the ETS reform debate (if they require different built-in assumptions).
   
METHODOLOGY 
  • The model uses the simplified accounting method proposed by the Commission, where TNAC is the difference between i) the number of allowances that have actually been issued (including MSR releases) and ii) the number of allowances that have been surrendered or cancelled post-issuance. In other words, allowances that go straight in the MSR are ignored in the calculation, as are allowances that are cancelled pre-issuance (notwithstanding cancellation due to the phasing in of maritime surrender obligations).
  • The model starts from known TNAC values and generates projected TNACs by calculating how many allowances would be issued and surrendered (or cancelled post-issuance) each year based on your assumptions.
  • Based on the generated TNACs, the model calculates MSR withdrawals and releases to track MSR stock levels, invalidating allowances above the threshold in place at the time based on your assumptions.
  • In years when the current invalidation rules would apply, the model estimates the number of allowances auctioned in the previous year by taking a share of the Phase IV stationary cap (assuming some CSCF buffering) and reducing it by the MSR withdrawal volume that year. No consideration is given to pre-issuance cancellation, increased aviation auctioning, or other factors that might affect auction volumes. In particular, no consideration is given to the influence of the CBAM Factor on auctioning because it is assumed that this would only apply if rules changed, in which case the invalidation threshold would no longer be defined as the auction volume of the preceding year.
  • The model counts 585 million ‘Article 10a (19) and (20)’ allowances as being in the MSR. The 2021 TNAC Supply also includes additional issuance in relation to the final exchange of international credits, which has now come to an end.
  • The model assumes that MSR withdrawal/release rules associated with a given calendar year apply to the full Sep-Aug period that begins in that calendar year (which is a simpler reading of the MSR Decision than our previous model).
   
TNAC SUPPLY 
  • Issuance estimates generated by the model are a function of the annual ‘extended ETS cap’, which covers all TNAC-relevant sectors that year (based on the date you enter in the top table) as well as an equal share of Phase III allowances that are available for issuance in Phase IV.
  • The Phase IV non-aviation component of the extended cap is adjusted according to the 2030 target and date you enter in the top table, following the same method set out in our CSCF Simulator (which is based on the Commission's proposal).
  • The aviation component of the cap, which is only factored into TNAC calculations from the date you enter in the top table, is based on applying a cumulative LRF haircut to 2020 allocation (adjusted in light of the EU and UK Cooperation and Free Trade Agreement) throughout the Phase, with a 10% increase in the baseline allocation in 2024 due to the proposed extension in scope.
   
TNAC DEMAND 
  • The model estimates how many allowances will be surrendered based on the assumptions you enter in the lower table concerning how emissions compare to 2019 in each year of the Phase.
  • The 2019 baseline value used to generate this value is adjusted to cover TNAC-relevant sectors at the time based on the date you enter in the top table, and excludes the UK. The inclusion of maritime and aviation emissions in the baseline is consistent with the scope of the Commission's proposal. 
  • TNAC Demand equates verified emissions and surrender, when in actual fact the maritime sector would not have to surrender allowances for all emissions during the Commission's proposed phase-in period. To compensate for this, TNAC Supply is not adjusted down to reflect the proposed pre-issuance cancellation of auction volumes during the phase-in.
  • Although the Commission's proposal is ambiguously worded, it is assumed that the intention is to include historic net demand from the aviation sector fully from the year changes enter into force. This results in a bump in Surrender volumes in this year.
   
CONSIDERATIONS 
 
When adjusting the parameters, it may be useful to bear in mind the following:
  • If changes are applied from the year after the law enters into force, as proposed by the Commission, '2024' is a reasonable assumption to enter in the top table, based on how long it may take for the ETS reforms to go through the ordinary legislative process.
  • 833 million and 400 million are the current TNAC thresholds for MSR withdrawal and release, respectively, and the Commission has not proposed changing these.
  • 100 million is the current quantity that the MSR releases when triggered (assuming sufficient allowances are available) and the Commission has not proposed changing this.
  • Under current rules, the MSR withdrawal rate will switch from 24% to 12% in 2024. The Commission, however, has proposed applying the 24% withdrawal rate throughout the Phase when TNAC is above 1096 million, and withdrawing whatever quantity is required to reduce TNAC to the withdrawal threshold (833 million) when the TNAC is between this threshold and 1096 million.
  • You can set a different 'buffer intake' threshold to the Commission's proposal in the top table, or remove this functionality entirely by setting the parameter to the same value as your withdrawal threshold.
  • The proportion of the 'annual extended cap' that is issued reflects the extent to which the annual free cap, past free cap, and NER are used that year, as well as how auction volumes are distributed, and the extent to which there is pre-issuance cancellation (not including cancellation due to the phasing in of maritime surrender obligations).
  • The default emission values are set on the assumption that emissions in TNAC-relevant sectors fall by 4% a year compared to 2019 throughout the Phase. In reality, the reduction rate is unlikely to be uniform and would be affected by sectoral coverage, as well as your cap assumptions and wider economic/technological factors.
  • Voluntary cancellation (of previously issued allowances) is set to 50,000 allowances a year. Cancellation has averaged about 40,000 a year to date but exceeded 90,000 in 2020 and 180,000 in 2021.
   
DATA SOURCES  
 
Commission’s ETS reform proposal  
   
Commission’s Aviation ETS proposal  
   
Commission’s MSR proposal  
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How might an EU Carbon Border Adjustment work?

25/2/2020

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​In this post we look at a simple EU Carbon Border Adjustment (CBA) design that would tax imports, before exploring some options for dealing with exports.
 
Import CBA design

Principles

1. Maintain the Phase IV free allocation methodology, where an installation in a sector on the Carbon Leakage List (that is not a new entrant and that makes a benchmarked product) is awarded allowances based on the following calculation: 
                                                                                       
                                                                                         Allocation = CLEF x PB x PT x CSCF
 
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
PT – Product Tonnage (adjusted over time in Phase IV to take account of production changes)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)


2. Levy a carbon tax on imports of the same energy-intensive products that have product benchmarks in the EU ETS
 
3. Use the EU ETS carbon price as the rate of the tax, taking the average price over a suitable time period
 
4. Charge the tax on an amount of emissions per tonne of imported product that is equivalent to the amount of emissions, on average, not covered by free allocation within the EU for a tonne of that product: 

                                                                         Chargeable Emissions = IT x [AEI – (CLEF x PB x CSCF)]
 
IT – Import Tonnage
AEI – Average Emissions Intensity for the product in question in the EU (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

 
5. Allow foreign producers to provide evidence that their emissions intensity is better than AEI, and/or that they are already subject to a carbon price in their jurisdiction for the emissions, so that their obligation can be reduced accordingly


Advantages

  • The system can reasonably claim to expose foreign producers to the same carbon costs (and carbon price signal) as domestic producers in receipt of dynamic free allocation. The import tax is applied to the same basic products made by industries regulated under the EU ETS; the default charge is based on the average situation in the EU; and provision is made for individual foreign producers to have their obligation assessed more precisely in a manner equivalent to an individual EU ETS installation. This symmetry should level the playing field for EU producers selling in the EU market and help satisfy WTO rules concerning non-discrimination against foreign products.
 
  • The system works in harmony with the agreed free allocation methodology that comes into force next year, mirroring free-allowance recipients’ exposure, avoiding double protection, and automatically providing for the import tax to increase as free allocation is phased out (by building in the CLEF and CSCF into the Chargeable Emissions calculation). As such, the design may be more amenable to ETS participants and could be phased in for different products with the agreement of industry associations.
 
  • The system would minimise administrative burden. Unlike a CBA requiring importers of foreign products to surrender EUAs, the ETS cap would not need to be redefined to include consumption emissions. And by only taxing fundamental benchmarked materials, it would not be necessary to calculate the emissions intensity of complex and diverse products.
 
  • The system also has environmental benefits beyond preventing domestic carbon leakage because it rewards foreign producers for reducing their emissions, and recognises if their jurisdiction uses carbon pricing, thereby extending the reach of the carbon price signal and encouraging international carbon pricing.
 
Issues

  • The most serious limitation of the system is that it does not apply an adjustment to protect the competitiveness of exports, so cannot constitute an alternative to free allocation for exporters. We look at some options to address this blind spot in the section below.

  • The system would not take account of indirect emission costs associated with the relevant imported products, but discriminating between products based on the electricity mix of the exporting nation and applying a tax that is not symmetrical to the EUA obligation faced by installations (which only covers direct emissions) could cause issues under WTO rules. It is probably more pragmatic, therefore, to retain indirect cost compensation for electro-intensive industries to deal with this threat of carbon leakage.
 
  • Whether the system is compliant with WTO rules would also need to be examined carefully. The EU ETS is not a tax assessed on products, but a system with a fluctuating price that charges producers for emissions. Applying a border tax assessed on products, therefore, may prompt objections that foreign products are being treated differently to EU products. It may be that an EUA-based adjustment would fare better legally, in this respect, but it would come at the cost of having to redefine the ETS cap. Modulating obligations may also prompt the objection that like products (sometimes from different countries) are being treated differently. This could perhaps be seen off (or circumvented via exceptions in GATT Article XX) on the grounds that the default is to charge the same amount of tax on a given product, and deviations from this are calculated following a defined process that is open to all and which recognises non-arbitrary differences.

  • A final technical issue with the system is that it does not treat foreign producers identically to domestic producers in the rare instance that they emit less than the EU allocation per tonne of product. That is, a domestic producer that emits less per tonne of product than their allocation is able to sell allowances to generate revenue, but a foreign producer emitting the same amount would not receive any revenue under the system—they would just avoid having to pay the tax. One possible solution would be to pay foreign producers (or to give them EUAs from under the existing cap) thereby preserving symmetry and ensuring the carbon price signal is sent out fully beyond EU borders. This seems unlikely to be politically popular, however, and the legal implications under WTO rules would need to be examined.
 
Export options
 
Reimbursement

One option to protect the competitiveness of exporters is to reimburse them up to benchmark level for emissions per tonne of exported product not covered by free allocation (again building in consideration of the CLEF and CSCF, so as to adjust automatically to any reduction in free allocation over time). That is,
 
                                                                Reimbursable Emissions = ET x [PB – (CLEF x PB x CSCF)]
 
ET – Export Tonnage
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

 
And emissions would be reimbursed at the rate of the EU ETS carbon price (averaged over a suitable time period).
 
Notwithstanding the fact that the carbon price used in the reimbursement may differ from the actual price paid for EUAs surrendered in relation to the production of the products, we can note that the net situation after surrender and reimbursement would be that an exporter pays (or receives) a percentage of the carbon price on every tonne exported, depending on their emissions intensity (where an installation meeting benchmark pays/receives 0%).

This would expose exporters fully to the carbon price signal with respect to emissions intensity performance while reducing their carbon costs. It would also abate (or even reverse) the carbon price signal with respect to production decisions, thereby protecting against carbon leakage.

There may be political obstacles to funding an export rebate, although we should bear in mind that the money could come from auction revenues, which the exporters would themselves have contributed to when buying allowances to meet their compliance obligations.
 
There may also be legal objections to subsidising exported production under the system when an installation outperforms its benchmark. But this feature could be removed by not allowing Reimbursable Emissions to exceed actual emissions at the end of the compliance year. This would come at the cost of not exposing exporters fully to the carbon price signal with respect to emissions intensity, however. Alternatively, the benchmark could be set slightly beyond best practice at the time, but this would come at the cost of weaker carbon leakage protection.
 
Perhaps the most fundamental issue, though, is whether the system would cause market distortions at home by treating ETS installations differently depending on whether they sell their product in the EU or abroad.
 
Take two identical installations making a product in the EU, for instance. Installation A—which sells its product in the EU—would have to buy EUAs to meet its compliance requirements not covered by free allocation. Installation B—which sells its product abroad—would have to do the same but would also receive a rebate as outlined above.
 
We can see that selling a product in the EU would only be as profitable as exporting it under this system if the product could be sold for a premium in the EU (due to the import tax). And the premium would have to be equivalent to the export rebate per tonne of product. That is,
 
                                                                     EU premium per tonne = CP x [PB – (CLEF x PB x CSCF)]
 
CP – Carbon Price
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

 
For this to hold there would have to be very substantial pass-through of the import tax into ETS product prices. Whether world supply curves can be assumed to be so elastic across all the relevant markets in the EU would need to be examined.
 
Alternatively, reimbursements might be 'reverse engineered' to reflect the EU market premium for the product in question due to the import adjustment:
 
                                                                  Reimbursable Emissions = ET x PTF x [AEI – (CLEF x PB x CSCF)]
 
 
ET – Export Tonnage
PTF – Pass Through Factor (i.e. the percentage of the import tax passed on into the EU price per tonne of product)
AEI – Average Emissions Intensity for the product in question in the EU (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

 
How PTF would be determined, and whether modulating reimbursements according to PTF would be consistent with assessments of carbon leakage risk, would need further consideration (as would the implications of retaliatory tariffs from major economies).

Exemption

As an alternative to reimbursement, emissions associated with exported production could be exempted from the obligation to surrender EUAs up to benchmark level per tonne not covered by allocation. Exporters could be rewarded with EUAs from a pot under the cap if their compliance emissions were lower than their exemptible emissions due to outperforming the benchmark.
 
                                                                        Exemptible Emissions = ET x [PB – (CLEF x PB x CSCF)]
 
ET – Export Tonnage
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

 
Like the reimbursement system, this would expose exporters fully to the carbon price signal with respect to emissions intensity but reduce their carbon costs. It would also abate (or reverse) the carbon price signal with respect to production decisions, thereby providing carbon leakage protection.
 
The same issues may present themselves in terms of forgoing ETS revenues and subsidising exports, but perhaps less directly by virtue of the adjustment not being administered in money. Similarly, the provision of subsidy could be avoided by not allowing Exemptible Emissions to exceed compliance emissions or by setting a more stringent benchmark.
 
Likewise, the same market distortion issues would need consideration, with the possibility of defining Exemptible Emissions to reflect pass-through of the import tax into ETS product prices.
 
In terms of how exemption differs from reimbursement, it has the disadvantage of requiring the ETS cap to be redefined (due to the exclusion of some territorial emissions) and would potentially cause a greater divergence in the cash flow situation of installations selling in the EU and those exporting. But it has the advantage of not having to provide a reimbursement based on a carbon price that may differ from the one paid to meet compliance.

Free allocation
 
Rather than providing an export adjustment, free allocation could be retained for exports (subject to review in relation to international carbon pricing) while phasing it out for other production. Allocations in this instance would be calculated using exported production levels rather than total production levels. 

Providing dynamic allocation would expose exporters to the carbon price signal with respect to emissions intensity, while reducing their carbon costs and abating (or reversing) the carbon price signal with respect to production (thereby providing carbon leakage protection). This would broadly raise the same issues as an exemption, but would not require a redefinition of the ETS cap.

Providing non-dynamic allocation, on the other hand, might help mitigate risks of market distortion, because domestic producers would not be rewarded with free allowances if they were to switch from selling in the EU to exporting. But it would come at the cost of creating windfall profits for contracting exporters and could not really claim to provide carbon leakage protection, insofar as it would not abate the carbon price signal with respect to production decisions.
 
Conclusions
 
A basic CBA for imports is relatively straightforward to design and could theoretically replace free allocation as a means of establishing a level playing field for EU producers selling in the EU. This transition could even be automated through inclusion of the CLEF and CSCF in the calculation of Chargeable Emissions.
 
This would not provide an alternative to free allocation for exporters, however, so an export adjustment would also have to be offered (or free allocation retained for exporters) if the system was to replace the current one.
 
A tandem system of this sort would face myriad political and legal obstacles and have complex implications for the domestic market, creating different conditions for installations selling in the EU and those exporting. Whether the benefits over the current system warrant dealing with the challenges would have to be carefully considered.
 
An import-only adjustment administered as a complement to the free allocation system, could strengthen carbon leakage protection at home and encourage emissions reduction abroad. It might also promote international carbon pricing, whether implemented or just threatened. But if such a scheme is introduced with the ultimate intention of replacing free allocation, it could be a wolf in sheep’s clothing for exporting installations.

For further information, please contact damien.green@perspectiveclimate.com

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Integrating CCU into the EU ETS

4/7/2019

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In a 2017 post we set out some guiding principles for accommodating CCU into the EU ETS, drawing on a report co-authored with André Bardow. Now seems like a good time to revisit the issue.
 
Late last year, in response to an ECJ ruling, the European Commission revised the Monitoring and Reporting Regulation (MRR) to exempt emissions from the ETS that are transferred out of an installation for the purposes of making precipitated calcium carbonate (PCC).

And this year the Commission is reviewing the MRR ahead of Phase IV, providing an opportunity to further accommodate CCU practices into the ETS. This has prompted a number of reports with recommendations in this area (e.g. Umweltbundesamt and CE Delft).
 
Building on the principles in our original post, then, let’s consider how best to move forward with the MRR revision and potential revisions to the ETS Directive during Phase IV.
 
1. Implementing the ECJ ruling
 
One of our immediate priorities should be implementing the aforementioned ECJ ruling in a way that does not create an incentive to move emissions outside the jurisdiction of the carbon price.
 
As amended, the MRR currently provides a full exemption for emissions transferred out of an installation for the purposes of making PCC, despite the fact that PCC can go into a range of applications, some offering permanent storage and others not, and despite the fact that Annex 1 of the ETS Directive has not been revised to ensure that installations involved in transporting and processing these emissions are regulated by the ETS.
 
This outcome reflects a problematic reading of the ECJ ruling, which has it that emissions are unreleased by the court’s reckoning when chemically bound in a stable product, such as PCC. This could open the door to exemptions across the board for CCU practices, even though they have very varied environmental performance (which often depends on very low-carbon electricity) and emissions are often released at the end-of-life stage where they are not subject to the carbon price.
 
The ECJ ruling, however, does not say that all emissions captured for the purposes of making PCC (or, more generally, that are chemically bound in a stable product) are unreleased. It only says that it is wrong to presume that all emissions captured for the purposes of making PCC are released: which is very different. Indeed, the ruling makes clear that leakage en route or at the processing installation would constitute a release. And the ruling does not preclude end-of-life emissions being classed as a release.
 
To protect the integrity of the ETS, therefore, the Commission should interpret ‘release’ in a strict sense to include all stages after capture, limiting exemptions to emissions that are permanently stored (e.g. through mineralisation) and adjusting Annex 1 to ensure that installations involved in transporting and processing such emissions are covered by the ETS. 
 
By contrast, the MRR revision should not be used to extend exemptions to CCU fuels and products more generally just because emissions are chemically bound in a stable substance. And the ECJ ruling—which concerns whether captured emissions are released—does not provide a legal basis or implicit methodology for calculating partial exemptions that would in fact derive their justification from counterfactual emissions savings cradle-to-gate in the value chain (cf. Umweltbundesamt).
 
2. Solving the CCU-fuel double-charging problem
 
A second issue we must address is that the ETS would currently double charge for emissions if a CCU-fuel was made and burnt entirely within the ETS.
 
To avoid this, the Commission could apply a zero-rate emissions factor for CCU-fuels burnt at ETS installations, provided the emissions used to make the fuel were captured and processed within the ETS. This could follow the approach taken with biomass currently and would be consistent with the interpretation of the ECJ ruling advocated above, which is to say that the captured emissions would not be exempted because they would be classed as ‘released’. 
 
Installations involved in transporting and processing emissions for use in CCU-fuel would have to be included in the ETS, and CCU-fuel produced within the ETS would need to be certified as such (distinguishing it from imported CCU-fuel). This seems much simpler than providing an exemption at the point of capture, which would require the capturing installation to prove that the emissions were later processed into a CCU-fuel that was burnt within the ETS. 
 
3. Reforming accounting practices
 
The proposed approach (exempting permanently stored emissions and avoiding double charging within the ETS) is consistent with existing ETS principles and does not require any adjustment to ETS or Effort Sharing Regulation (ESR) budgets. No additional EUAs/AEAs would be issued, and no exemptions would be provided in the ETS for counterfactual value-chain savings or savings in ESR sectors.
 
But there are still accounting issues to deal with, because emissions captured in the ETS for CCU-materials and extra-ETS CCU-fuels would be counted in the ETS and at the end-of-life stage in the ESR. Furthermore, there is a systemic accounting problem that needs attention; namely that currently the ETS fails to incentivise negative emissions technologies and practices that deliver compound benefits such as BECCS.
 
One solution would be to move to a gross-net accounting system in the ETS that distinguishes between an installation's EUA obligation and the emissions attributed to it for accounting purposes.
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​Table 1. ETS gross-net accounting
Under such a scheme, an installation would have a Gross Emissions value (GE), which would comprise its total emissions, minus any transferred for permanent storage (underground or otherwise) and any transferred under existing MRR waste-gas rules.
 
Total emissions, here, would cover all emissions released at the installation (including leaks of received emissions and emissions from burning biomass and intra-ETS CCU-fuel) as well as any emissions produced in the installation that were transferred. (To be clear, emissions from burning biomass and intra-ETS CCU-fuel would not be zero-rated when calculating GE.)
 
An installation would then derive its Net EUA Obligation (NEUAO) by subtracting its biomass and intra-ETS CCU-fuel emissions from its GE. And it would separately derive its Net Emissions for the Purposes of Accounting (NEPA) by subtracting any additional transfers out of the installation from its GE (e.g. for making CCU-fuel or CCU-materials).
 
This approach would: i) preserve the existing biomass incentives, ii) avoid intra-ETS CCU-fuel double charging, iii) prevent double counting by accounting for emissions where they take place, iv) improve the accounting for biomass emissions in the energy sector (currently done via LULUCF reporting), and v) provide incentives for negative emissions and practices with compound benefits for the first time.
 
On this last point, installations with negative emissions (e.g. those conducting BECCS or DAC) would have to be added to Annex 1 and they would be issued EUAs in accordance with their negative NEUAO. The EUAs could come from a reserve under the existing ETS cap to ensure emissions reductions are additional rather than a form of offsetting.
 
Now, double charging would happen under this system if emissions were captured from an installation for use in an application that did not offer permanent storage and the receiving installation leaked the emissions. But this is the only acceptable approach, because not charging for the leak at the second installation would create perverse incentives. (And the system would still correctly count the emissions once.)
 
4. Rewarding CCU value-chain savings
 
None of the above is to say that CCU applications that don’t offer permanent storage cannot reduce emissions. It’s just that savings would be counterfactual value-chain savings. That is, a CCU value chain can emit less cradle-to-gate compared to a virgin fossil feedstock value chain. Let’s consider, then, how this sort of emissions avoidance could be incentivised within the ETS, which is currently set up to charge installations for their actual emissions.
 
One option would be to modulate the EUA obligation at the installation capturing the emissions to reflect the estimated cradle-to-gate counterfactual saving (taking into account key factors such as the CCU application and energy mix). Modulating the attribution of emissions to the installation would create complications for accounting between the ETS and ESR, so accounting could be kept separate by distinguishing NEUAO and NEPA as above.
Picture
Table 2. Modulating EUA obligations
The problem with this approach, though, is that it would fundamentally change the nature of the cap by exempting actual emissions based on counterfactual emissions savings. It would also be difficult to calculate the EUA Obligation Rates and burdensome to administer, requiring coordinated reporting between installations along value chains.
 
A better option might be to issue EUAs under Article 24(a) of the ETS Directive to projects that deliver counterfactual savings (or savings in non-ETS sectors). The EUAs could be sourced from the existing cap (or transferred from AEAs) to preserve the integrity of carbon budgets. Accounting could still be based on the NEPA approach outlined above, with estimation of counterfactual value-chain savings done separately by the project consortium purely as a condition for receiving credits. Nevertheless, developing project mechanisms under Article 24(a) is a big task and project participants would face significant administrative burdens.
 
Given the current scope of the ETS, then, perhaps the best option is to explore other incentives for those CCU practices that do not offer permanent storage and where emissions are potentially released in non-ETS sectors. There are lots of options. As well as funding R&I and stimulating investment, we could look at quotas for alternative feedstocks in products, for instance, or price interventions to overcome barriers to the uptake of alternative feedstocks, such as CfDs.

And in the long run we should consider incorporating end-of-life emissions in CCU value chains (e.g. from incineration) into the ETS so we can provide a simple exemption at the point of capture without undermining the actuality of the cap. 

​For further information, please contact damien.green@perspectiveclimate.com
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Modelling the Phase III NER

16/1/2018

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According to the latest status update from the European Commission, the Phase III NER is currently 70% full, with 336 million allowances still remaining out of an original 480 million.

Using a simple model of how the NER works, we estimate that ~295 million allowances will be left by the end of Phase III.
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Explanation:
  • When new sites enter the ETS, or existing ones undergo a significant capacity increase, they receive free allocation from the NER. New entitlements are defined (retrospectively) from the start date of the entrance/expansion, and continue until the end of the Phase.
  • This is represented by the grey rows in the above diagram; each one representing allocation entitlements established from consecutive start years until the end of the Phase.  
  • The final column of the diagram indicates what proportion of total NER allocation each row represents, assuming that new entrance and expansion occurs at a consistent rate.
  • The dark grey rows represent entitlements that will have been processed and accounted for in the Commission's latest figures (mentioned above); the dotted grey row represents entitlements that will have been partially processed; and the light grey rows represent future entitlements that will not have been processed.
  • Counting the dotted grey row at approximately half value (5% of overall allocation instead of 11%), we can say that the Phase III NER has allocated (or committed to allocate) around 77% of the allowances it will allocate by the end of the Phase (assuming consistent rates of entrance and expansion).
  • Given that the latest figures from the Commission show that 144 million allowances have been allocated (or earmarked for allocation), this means that the NER will allocate ~187 million by the end of the Phase, leaving ~293 million allowances unallocated.
  • It is unclear, however, whether expansions with a start date in 2020 (especially the second half) could be processed before the end of the Phase. Given that unused Phase III NER allowances are due to enter the MSR in 2020, this means that such expansions may not receive allowances.
  • If this is the case, ~295 million allowances could be left in the NER by the end of the Phase.
​
For further information, please contact ​damien.green@perspectiveclimate.com
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ETS timeline

22/12/2017

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A summary of key dates relating to the implementation of the ETS Phase IV deal, and further ETS reform.
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CSCF outlook for Phase IV

22/12/2017

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This graph shows under what circumstances a CSCF will be triggered in Phase IV. A data point above the curve represents an activity level and benchmark scenario that would trigger a CSCF; a data point below the curve represents an activity level and benchmark scenario that would not trigger a CSCF. 
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Explanation
  • By 'Phase III Historical Activity Level' we mean the sum of all average annual activity levels originally used to calculate Phase III entitlements, based on data from 2005-08 or 2009-10 (installations were free to choose their baseline period).
  • By 'Phase IV Historical Activity Level' we mean the sum of all average annual activity levels used to calculate entitlements in Phase IV, which will likely be based on data from 2014-23 (split into two periods).
  • By 'Phase III Weighted Average Benchmark' we mean the average of all the benchmark values used in Phase III, weighted to reflect the amount of activity on each.
  • By 'Phase IV Weighted Average Benchmark' we mean the average of all the benchmark values used in Phase IV, weighted to reflect the amount of activity on each (and taking account of both halves of the phase).
  • It is assumed that if HAL and WAB were the same in Phase IV as in Phase III, installations would be entitled to 9 billion allowances during Phase IV. This is based on adjusting the Phase III entitlement to reflect the longer duration of Phase IV, as well as the shorter carbon leakage list and continued reduction of the CLEF for certain installations. (No adjustment has been made for the UK potentially leaving the ETS.)
  • It is assumed that the maximum number of allowances available for free allocation in Phase IV is 43.9% of the cap (6,806,087,813). (No adjustment has been made for the UK potentially leaving the ETS.)
  • Under these assumptions, to avoid a correction factor, the product of the index value for the Phase IV HAL and Phase IV WAB has to be less than ~7560 (i.e. 10,000 x 6,806,087,813/9,000,000,000).

Benchmark reduction rates

If we assume no change in the proportion of activity associated with each benchmark, Phase IV WAB values would correspond as follows to the annual benchmark reduction rates used by the European Commission to revise benchmarks:
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Of course, the weighted average benchmark reduction percentage is unlikely to be uniform across all benchmarks (or equivalent to the simple average) and it may be influenced by a change in the proportion of activity associated with each benchmark. 

Observations

If we assume production will be about 10% lower in the Phase IV baseline period (i.e. Phase IV HAL = 90), we would expect to avoid a CSCF if the weighted average benchmark reduction exceeded 1%. As we deviate from this scenario with a higher level of activity or lower benchmark reduction, we would expect to trigger a CSCF of increasing severity.

​Two such scenarios are shown below: one assuming 5% lower production in the Phase IV baseline period, coupled with a 1% weighted average benchmark reduction; and the other assuming 10% lower production in the Phase IV baseline period, coupled with a 0.5% weighted average benchmark reduction.
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It is assumed in the graph that there is no change in the proportion of activity associated with the benchmarks, and that the number of free allowances available in a given year is 40.9% of the relevant annual cap, plus whatever remains of the CSCF buffer pool of allowances, which is 3% of the total cap (where the total cap is defined as above, assuming a 2.2% LRF throughout and inclusion of the UK).

The trajectory of the CSCFs reflects the fact that the 3% buffer is concealing a growing shortfall between entitlements and the annual cap. In the year the buffer runs out, this large shortfall is partially revealed. In the following year, the shortfall is fully revealed (including an additional year of the LRF). And from this point on the CSCF tracks the LRF. 

Uncertainties

It is unclear where activity levels and benchmarks will come out at this stage. The Commission will gather data ahead of each half of the phase, so we will have a much better sense of the CSCF outlook in 2020, but the ultimate values will only be known around 2025.

It is assumed in the modelling that the LRF is 2.2% throughout Phase IV, but this could be upgraded, which would increase the risk of a CSCF.

Depending on how the Commission interprets the provisions in the ETS Directive, it is also possible that a CSCF might follow a different trajectory to the ones graphed above.

For further information please contact damien.green@perspectiveclimate.com
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Understanding the ETS Phase IV cap

30/11/2017

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[Revised on 17/11/20 to align the total cap with the Commission Decision on the Union-wide quantity of allowances to be issued under the EU Emissions Trading System for 2021]

Based on our analysis of the provisionally agreed Phase IV ETS text, the Phase IV cap breaks down as follows:
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Assumptions and notes:
  • Percentages relate to the total fixed installation cap, which is 13,781 million as of 17/11/20
  • This cap will be tightened to deliver a more ambitious 2030 climate target, with a proposal expected in 2021
  • Dotted arrow flows are not reflected in the percentages
  • The number of allowances available for compliance also includes the market surplus, which is not considered here
  • Auction volumes (and NER allowances) can enter the Market Stability Reserve (MSR), which is not represented here
  • Article 10c transitional free allocation is made from Member States’ auctionable allowances
  • Unused Article 10c allowances from Phase III may be added to 2021 auction volumes or the Modernisation Fund, which is not represented here

Auction Share Key Points
  • The auction share will comprise 57% of the total cap, but this can fall to as low as 54% if allowances need to be transferred to the free share to avoid a CSCF
  • 2% of the total cap will be taken out of the auction share for the Modernisation Fund; this increases to 2.5%, if allowances are not required for avoidance of the CSCF
  • 75 million allowances from the auction share will go into the Innovation Fund; this will increase to 125 million if allowances are not required for the avoidance of the CSCF
  • 10% of the allowances available for Member State auctioning will be used for solidarity purposes
  • Member States may voluntarily cancel auctionable allowances in the event of the closure of electricity generation in their territory
  • Member States may transfer solidarity and Article 10c allowances to the Modernisation Fund
  • The amount auctioned in practice will determine the level of cancellation from the MSR and is affected by the following factors:
    • The percentage of the auction share transferred to the free share to avoid a CSCF
    • The amount of allowances that the MSR withdraws (which is administered through adjusting down auction volumes)
    • The amount of Article 10c free allocation, which reduces the number of allowances auctioned
    • The amount of voluntary cancellation of auction volumes by Member States
    • The auctioning of non-auction share allowances (e.g. free allowances and Phase III unallocated allowances for the Innovation Fund), which increases the number of allowances auctioned
  • The timing of these factors will also have a bearing on the timing of cancellations from the MSR
​
Free Share Key Points
  • The free share will comprise 43% of the total cap, but this can rise to 46% if required to mitigate the CSCF
  • 325 million allowances from the free share will go into the Innovation Fund
  • The free share can be supplemented with allowances from the Phase IV NER to allow for allocation to new entrants and growing installations; the Phase IV NER is stocked with unallocated allowances from Phase III 
  • The actual amount given out for free in Phase IV will be affected by bottom-up eligibility calculations, the application of the CSCF (and in some cases the LRF) as a haircut, as well as the extent to which certain Member States use the Article 10c derogation

Funds Key Points
  • The Innovation Fund is stocked as follows:
    • 325 million allowances from the free share
    • 75-125 million allowances from the auction share (depending on whether CSCF flexbility is required)
    • 50 million unallocated Phase III allowances not allocated due to cessations, partial cessations, and the Phase III NER being underused, which enter the MSR under Article 1(3) of the MSR Decision in 2020
    • It is also supplemented with revenues from its predecessor NER300
  • The New Entrants' Reserve (NER) is stocked as follows:
    • Phase III allowances not allocated to installations not on the carbon leakage list (referred to as 'CLEF' allowances in the diagram above), which the EC's 2015 Impact Assessment estimated will number 145 million (Greece, however, has first claim on up to 25 million of these)
    • 200 million Phase III allowances not allocated due to cessations, partial cessations, and the Phase III NER being underused, which enter the MSR under Article 1(3) of the MSR Decision in 2020
    • Allowances will leave and enter the NER depending on growth/contraction in the industries receiving free allocation
    • Up to 200 million allowances will be transferred from the NER to the MSR at the end of Phase IV if NER allowances remain unused
  • The Modernisation Fund is stocked as follows:
    • 2-2.5% of the total cap, taken from the auction share
    • Member States may top this up with solidarity and Article 10c allowances

​For further information please contact damien.green@perspectiveclimate.com
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