Reform of the EU ETS 1 and accompanying instruments: A policy mix for the decarbonisation of industry

The provisions of the EU ETS 1 must be adapted to the new framework set by the legally-binding climate targets for 2040 and 2050. As a central pillar of the EU’s climate policy, the EU ETS 1 is of particular importance in this context. Furthermore, the reform of the EU ETS 1 must strike a new balance between climate protection and industrial competitiveness and the capac-ity for transformation. The EU ETS 1 should achieve emissions reductions primarily through investment in climate-neutral technologies rather than through the relocation of production. It should be borne in mind that transformation profiles and rates may vary between sectors and companies. Investments that have already been made require plan-ning certainty. In other areas, infrastructural, regulatory and economic conditions must first be established. During transitional phases, the co-existence of conventional and transformative production processes – which is closely linked to industry modernisation cycles – must also be taken into account.

As emissions reductions in the energy sector advance, the focus of the EU ETS 1 is increasingly shifting towards energy-intensive industry. However, as an instrument for greenhouse gas pricing and for highlighting clear transformation pathways, the EU ETS 1 is not sufficient on its own to ensure the far-reaching transformation of industry needed for climate neutrality. Rather, a coherent policy mix of CO₂ pricing and accompanying measures is required. These include, in particular, technology-specific support instru-ments for electrification, hydrogen and carbon capture and storage (CCS), which address both investment and operating costs. Contracts for Difference, infrastructure de-velopment and measures to reduce electricity system costs are key elements of the nec-essary policy mix. The establishment of lead markets can also create reliable demand for climate-neutral basic materials, at least in some sectors and through a phased approach. 

Maintaining and cautiously expanding the scope. It seems sensible to expand the scope of the EU ETS 1 to include, for example, waste management and the indirect emissions from aviation. More far-reaching changes (e.g. with regard to the EU ETS 2 or sinks) or the opt-out of sectors or installations are not currently recommended due to high systemic risks.

Aligning the cap and the Market Stability Reserve (MSR) with the 2040 target. With a view to individual regulations, particular attention must be paid to the relevant diverse interdependencies. First of all, the emissions pathway must be harmonised with the EU’s climate targets. In the short term, the continued ambitious emissions reductions of the energy sector should be taken into account and the current linear reduction factor should be maintained. From 2036 at the latest, a flattening of the trajectory is compatible with the 2040 climate target and is necessary to take account of the constraints on the indus-trial sector’s transition. Market liquidity should be safeguarded by reforming the MSR to create a considerably more responsive mechanism. However, the fundamentally vol-ume-based approach of the MSR should not be altered.

Integrating international carbon credits and offsets only through government channels. The integration of flexibility options – in particular international carbon credits under Article 6 of the Paris Agreement and offsets for carbon sinks – should take place at a central level, e.g. by means of cap adjustments or the MSR, in order to preserve the integrity of the ETS market.

Reforming free allocation as a comprehensive package. Further recommended ad-justments relate to the free allocation of emission allowances. The existing roll-over mechanism of the benchmark system is not fit for the future and should be supplemented by a simplified and largely uniform linear mechanism. The introduction of fallback bench-marks suitable for industrial heat applications is also recommended. In view of the exist-ing uncertainties, risks and, in some cases, counterproductive effects relating to the Car-bon Border Adjustment Mechanism (CBAM), the time required for necessary adjust-ments, and the fact that a suitable model for taking exports into account within CBAM has yet to be established, the CBAM-related reductions in free allocation should be frozen for several years.

Using ETS revenues for transforming industry. The EU ETS 1 is not only an incentive mechanism for emissions reductions but also generates fiscal revenue through the auctioning of emission allowances. The use of these revenues should be strictly ear-marked. The loss of revenue, primarily due to extending free allocation in the context of CBAM, leads to a substantial decrease in funding for EU programmes supporting indus-try transformation. However, the extended free allocation primarily serves to offset com-petitive disadvantages and can therefore only be regarded to a limited extent as addi-tional investment capital available to companies. Such an allocation would, however, be entirely justifiable in the context of carbon leakage structures – that is, with regard to the ratio of operational to investment leakage.

Ensuring protection against carbon leakage. CBAM has created a new instrument, the effectiveness of which, however, still needs to be empirically validated and, where necessary, improved. For the EU ETS 1 to continue to be a central element of the EU’s climate policy, it is of paramount importance that CBAM is maintained and further devel-oped as a robust mechanism. Nevertheless, complementary instruments such as the basic materials surcharge or the carefully assessed use of trade policy instruments can also play an important role.

Creating the conditions for transformation investments. A range of complementary instruments (companion policies) is required to support the transition of industry towards climate neutrality. These primarily concern the provision of cost-effective electricity for industrial electrification (electricity price compensation, industrial electricity price), as well as the ramp-up of the hydrogen and CCS markets. Long-term Carbon Contracts for Dif-ference for hydrogen and for CCS, along with accelerated infrastructure development (hydrogen network, CO₂ transport and storage infrastructure), are key instruments for this. The demand side can be stimulated through green lead markets. Depending on the sector, these tend to be public procurement (particularly for certain building materials such as cement) or private demand signals (for steel and other metals). In the short term, lead markets will primarily involve affordable and readily available CO₂-reduced raw ma-terials such as low-clinker composite cements or secondary steel produced using green electricity. The actual near-zero technologies, such as direct reduced iron (DRI) steel or CCS cement, will only come on to the market in significant quantities at a later stage, but must be addressed at an early stage.

Finally, it should be emphasised that climate policy instruments alone will not be suffi-cient to safeguard the competitiveness of European industry in the current geopolitical and geo-economic environment. External factors such as international subsidy regimes, exchange rate developments and rising protectionism are creating considerable pres-sure to adapt. A successful transition therefore requires the EU ETS 1 to be supported by a coherent industrial and trade policy that ensures industrial value creation remains in Europe.