In 2005, the EU launched the Emissions Trading System, the world’s largest market for greenhouse gas emissions. It’s been through several reforms since. Most recently, concerns around carbon leakage have led to the announcement of a new measure: the carbon border adjustment mechanism (CBAM).

What is the contribution of the EU ETS to lowering the emission intensity of our economy? As it goes through another evolution, we take a look at the scheme’s effect on cutting emissions, and assess its role in a global context.

Progress in reducing emissions has slowed

The chart below plots the evolution of emissions intensity – the ratio of carbon emissions to output produced – for a range of European sectors. It shows that emissions have fallen significantly since the early 2000s, but that the steepest falls seem to have occurred before the ETS was rolled out in 2005.

Note: Those industry used the NACE Rev.2 classification and includes mining and quarrying, manufacture of paper and paper products, manufacture of coke and refined petroleum products, manufacture of chemicals and chemical products, manufacture of other non-metallic mineral products, manufacture of basic metals and production and distribution of electricity, gas, steam and air conditioning supply.

Has the ETS been ineffective?

Why is this the case? Has the ETS been ineffective?

In assessing this, it’s important to remember that the ETS is not the only measure policymakers have taken to cut emissions. Subsidies for renewables and energy efficiency improvements have played a role, and one of the main contributors to the reduction in carbon has been the expansion of renewable power generation. It’s therefore difficult to isolate the effectiveness of the ETS from that of other measures.

Looking closer at the chart, it’s notable that the steep decreases in emissions end in 2008. Looking across all industries that were directly regulated by the EU ETS, emissions intensity fell from an average of nearly 1.5 at the turn of the millennium to 0.6 by 2016. In the case of energy, which account for the majority of EU GHG emissions today, the reduction from an emissions intensity has been even steeper – from 4.0 in the early 2000s to 1.3 in 2016. Should we question the ETS as a result? Or can this be explained by the effects of the global financial crisis?

The economic events of 2008 drove the carbon spot price from €30 per tonne in 2007 to nearly zero. This created an excess of allowances, and as the chart below shows, carbon prices remained low for several years after. This began to change when the EU put in place backloading measures from 2015 until 2017, and consequently the introduction of the Market Stability Reserve and a mechanism to cancel excess allowances, slowing reducing the structural surplus that had built up the financial crisis. Due to these measures, prices then increased considerably – from €10 to €30 per tonne. For this reason, the latest provisional deal on ETS between the Council and the Parliament agreed on strengthening the MSR by prolonging beyond 2023 the increased annual intake rate of allowances (24% of allowances in circulation ) and setting a threshold of 400 million allowances.

So what effect did the ETS have on emissions in the recent period, when carbon prices have been higher?  This would be a fairer test of its effectiveness. But unfortunately data is unavailable from 2016 onwards, so we can’t make any firm conclusions yet.

The case of aviation

The aviation sector provides evidence in favour of the ETS.

Aviation is only indirectly affected by the scheme: emissions from international aviation were only included in 2012, and since then the industry has received a sizeable quota of free allowances. Nonetheless, emissions intensity in the aviation sector has followed a similar pattern to that of sectors that are directly affected by the ETS, with steep drops prior to 2008 but little to no progress since then.

This indicates that restricting the emissions of the main inputs of high-emitting industries, like aviation, might have an impact on their own emissions intensity. In particular, the increase in competition between airlines incentivises them to invest in more efficient fleets and look for alternative green fuels.

Emissions are higher in countries that export to the EU

The EU’s own emissions are not the only factor in assessing the ETS. It’s important to consider the global context.

In 2018, the EU’s contribution to global emissions was around 8%. The two largest emitters – China and the US – together accounted for 44%. The EU also has lower emission levels than a number of other leading economies in the highest-emitting industries, as the chart below shows. In energy, for example, while India emits 8.34 tonnes of CO₂ to produce one unit of output, and China emits 5.17 tonnes, the EU emits only 1.3 tonnes per unit.

Note: We have excluded the emissions intensities of countries that contribute less than 1% of total output.

There is little evidence of carbon leakage

This global context is important because it leads to concerns that the ETS could result in carbon leakage. The ETS only applies to certain inputs produced within the EU, so there’s a worry that firms might move production to countries where they don’t have to pay for their emissions.

This would not only harm the effectiveness of the ETS, but would also place EU-based firms at a competitive disadvantage.

Has the ETS resulted in carbon leakage? To explore this question, the chart below shows the proportion of goods and services consumed in the EU that required input from ETS input sectors. This is a split between inputs from the EU (and therefore subject to the ETS) and inputs produced outside the EU.

If the ETS had caused significant carbon leakage, we’d expect to see an increase in use of ETS inputs from outside the EU. But as the chart shows, that has not happened.

Why not? It could be that measures to protect ETS industries from carbon leakage, such as free allocation and electricity cost compensation, have worked. If so, it’s important to consider that these measures will be phased out as the CBAM is introduced.

The CBAM is intended to offer a level playing field for European firms and incentivise those outside the EU to lower their carbon footprint if exporting to Europe. This means it should not only offer protection to firms producing in Europe, but should also help to reduce overall emissions globally.

However, it has to be noted that the CBAM only covers goods imported into Europe. Domestic producers exporting their goods to other jurisdictions with more lenient carbon regulation might face a competitive disadvantage.

The EU cannot fight climate change alone

What have we learned from progress so far under the ETS? The main lesson seems to be that emissions trading schemes, while not a panacea, are a good place to start in the fight against climate change.

Designing them in a way that it is effective has been one of the major challenges in Europe, though progress has been achieved. The EU’s ETS can therefore serve as a reference point for other countries – both China and California, for example, have implemented their own emissions trading schemes in recent years.

Together with ETS, European policymakers are looking for new ways to restart progress in the drive to reduce emissions for several industries and sectors. The ‘Fit for 55’ package will introduce additional tax incentives to encourage the transition to cleaner energy and reduce the use of fossil fuels in energy production. For example, within the package, the EU will launch the ETS II, which will not only strength the current policy but also include more sectors, such as road transport and buildings. In the aviation sector, plans are afoot to ramp up taxes to transport fuels, which intends to cut down emissions further for planes coming from anywhere in the world and landing in the EU. The ‘Fit for 55’ proposals again look to build on this, by introducing the ReFuelEU aviation and FuelEU maritime initiatives, which plan to increase the uptake of sustainable fuels by aircraft and ships to reduce their environmental footprint over the next 10 years from 2025 onwards.

A major lesson is that the EU cannot fight climate change alone: incentivising other countries to adopt emission standards schemes is a good start. And looking forward, if the world has to move, then there may be an advantage in moving first. If Europe can lead the way in incentivising its firms to decarbonise, technologies developed in Madrid, Milan or Munich today could find markets in Miami, Melbourne or Mumbai tomorrow.