The Prospects and Challenges of Phase IV in the EU ETS

Phase IV of the European Union Emissions Trading Scheme (EU ETS) will span from 2021 to 2030. The initial proposal for the regulations governing Phase IV was released by the European Commission (EC) in July 2015, and its confirmation into law is not expected until Q1 2017 at the earliest. The focal point of the upcoming debate will revolve around the free allocation process, as industries strive to protect themselves from rising costs while the European Commission aims to meet targets without jeopardizing European businesses.

The proposed regulations ensure that the EU ETS will achieve a 43% reduction in emissions from the covered sectors. This contribution aligns with the European Union’s emissions reduction target of at least 40% by 2030, recognizing that the EU ETS covers only approximately 50% of European emissions. As a result, the Linear Reduction Factor will increase from 1.74% to 2.2% annually starting in 2021.

Free allocation will continue beyond 2020 to mitigate the risk of carbon leakage caused by climate policies. However, due to the tightening of the cap, the amount of free allocation will be reduced. This will exert pressure on industries to invest in low-carbon technologies as compliance costs rise.

The proportion of allowances to be auctioned during Phase IV will remain at 57%, with member states encouraged to utilize auction proceeds to facilitate the transition to a low-carbon economy. Nevertheless, no binding rules on the use of funds have been established.

Analysts have cautioned that the current EC proposal will necessitate the implementation of the Cross Sectoral Correction Factor (CSCF) to protect the integrity of the emissions cap. The CSCF will reduce the free allocation for all installations by a certain percentage, irrespective of their exposure to carbon leakage. The CSCF is triggered when the preliminary free allocations of each member state exceed the total number of allowances available for free allocation.

The Market Stability Reserve (MSR), set to commence in 2019 and operate indefinitely, aims to address market oversupply by withdrawing allowances from the market based on pre-defined thresholds. The MSR provides supply-side flexibility and is expected to drive up prices as supply tightens during periods of reduced demand. The MSR will hold all unused allowances from Phase III, except for 50 million tonnes that will be utilized to establish an Innovation Fund.

Several support mechanisms will be established to assist industries and power sectors in meeting the challenges of innovation and investment during the transition to a low-carbon economy. The Innovation Fund aims to expand support for demonstrating innovative technologies and breakthrough innovations in industries such as carbon capture and storage. The Modernisation Fund will facilitate investments in modernizing the power sector, broader energy systems and enhancing energy efficiency in 10 lower-income Member States.

Offset usage will not be permitted during Phase IV. As Phase III concludes, there will be a “use it or lose it” approach to installations with any remaining entitlements. The utilization of offsets during Phases II and III significantly contributed to the supply surplus as installations maximized cost savings by employing cheaper offsets for compliance.