Phase IV of the European Union Emissions Trading Scheme (EU ETS) will cover the period from 2021 to 2030. The initial proposal on the rules and regulations to govern Phase IV were released by the European Commission (EC) in July 2015 and are not expected to be confirmed into law until Q1 2017 at the earliest. The major debate will centre around the free allocation process as industry fights to protect itself from rising costs and the European Commission aims to ensure the targets are met without harming European industry.

As expected the proposal ensures the EU ETS will achieve a 43% reduction in emissions from sectors covered under the scheme. This contributes to the European Union emissions reduction target of at least 40% by 2030 (the EU ETS only covers ~50% of European emissions). As a consequence, there will be an increase in the Linear Reduction Factor from 1.74% to 2.2% annually from 2021 onwards.

Free allocation will continue after 2020 to alleviate the risk of carbon leakage due to climate policy however, it will be reduced due to the tightening of the cap. This will increase the pressure on industry to invest in low carbon technology as compliance costs start to rise.

The share of allowances to be auctioned over Phase IV remains at 57% with member states urged to use auction proceeds to help the transition to a low carbon economy, however, no binding rules on the use of funds are in place.

Analysts have warned the current EC proposal will mean the Cross Sectoral Correction Factor (CSCF) will have to be applied to protect the integrity of the cap. The CSCF will reduce the free allocation for all installations by a certain percentage, carbon leakage exposed or not. The CSCF is applied when the preliminary free allocations of each member state are greater than the total number of allowances available for free allocation.

The Market Stability Reserve (MSR) starts in 2019 and will continue to run indefinitely to tackle market oversupply by withdrawing allowances from the market up to pre-defined thresholds. The MSR creates supply side flexibility and it will lead to higher prices as supply is tightened in times of lower demand. The MSR will hold all unused allowances from Phase III except for 50 million tonnes that will be used to seed an Innovation Fund. 

Several support mechanisms will be established to help the industry and power sectors meet the innovation and investment challenges of the transition to a low-carbon economy. The main two are the Innovation and Modernisation funds. The Innovation Fund aims to extend existing support for the demonstration of innovative technologies to breakthrough innovation in industry such as carbon capture and storage. The Modernisation Fund will facilitate investments in modernising the power sector and wider energy systems and boosting energy efficiency in 10 lower-income Member States.

Offset use will not be permitted in Phase IV. The end of Phase III will see a ‘use it or lose it’ approach to installations with any remaining entitlement. The use of offsets through Phase II & III was a major contributor to the supply overhang as installations maximized cost savings by using the cheaper offsets for compliance.