The spectre of the ETS gap

Context

In December 2020, all EU Member States agreed to a 55% reduction target by 2030. Following this decision, the European Commission proposed to increase the emission reduction target in the EU ETS from 43% to 61% by 2030 compared to 2005 ¹. According to the principles of the reformed ETS ², in the new accounting period (2021-2030) about 9.3 billion CO2 ³ emission allowances [EUA] will be transferred to participating States. In practice, all participating countries, including Poland, will receive allowances, some of which will be transferred to industry for free or sold on the market. Energy and industrial installations in countries where emission reductions are not undertaken, will have to spend more and more in relative terms to buy emission allowances on the international markets. This will lead to so-called imbalances.  

• In principle, the risk of an allowance shortage is a desirable phenomenon, as it forces emission reductions and shapes the demand for allowances and their price.
• The problem can arise when the imbalance gap grows and the State does not react and learn from this.
• The main reason for the imbalance of CO2 emission allowances is an insufficient level of action to ensure emission reductions - in the context of made commitments.
• According to the scenario from the National Energy and Climate Plan (NECP), ETS emissions would total approximately 1.8 billion tonnes of CO2 in the new accounting period ⁴, which would mean exceeding the Polish allowance budget by approximately 660 million tonnes. With the average CO2 price at the level of EUR 60 per tonne of CO2, the imbalance in the entire period would be close to EUR 40 billion, i.e. PLN 160 billion.

What is the ballance of EU's emissions and allowances?

Over the last 15 years of the EU ETS, some countries have reduced emissions at a lower, and others at a higher, rate. In Poland, Germany and the Netherlands, emission reductions were lower than the EU average.

The lack of reduction efforts in line with set targets, has translated into a more difficult starting point for the new trading period. Either countries will catch up by quicker reductions, or they will fall into an imbalance, as illustrated below.

Assuming an equal reduction of emissions, in 15 out of 31 countries (e.g. Romania, Slovakia, Sweden) we estimate an oversupply of CO2 emission allowances. In another 6 countries, the deficit will not exceed 15% (e.g. Bulgaria, Greece, Czech Republic). A potentially significant deficit of allowances will occur in Germany, Poland, Italy and the Netherlands. The actual emergence of an allowance shortage and its size will depend on real emission reductions in each country.

How many CO2 allowances for Poland

According to the proposal of the new ETS Directive, Poland will probably be allocated ca. 10% of the new pool of CO2 allowances for the EU, ca. 1.1 billion EUAs  ⁶.

It will consist of:

• free allowances given to industry, to prevent carbon leakage[7],
• auction allowances - broken down by:
  • the basic allowance pool - allocated based on historical emissions,
  • the solidarity provision pool - allocated based on wealth and the need to expand energy networks,
  • the Modernization Fund established before the EU ETS reform (Modernization Fund 1),
  • the new Modernization Fund (Modernization Fund 2).

Considering the Modernization Funds and solidarity provision, Poland will receive approximately one third more allowances than would result from historical emissions and industry needs for free allocation. Apart from Poland, other less wealthy EU countries also benefit from solidarity mechanisms, which are created by allowances supplied by richer countries. It is worth pointing out that solidarity mechanisms create a higher imbalance for, in example, Germany, Italy and the Netherlands.

Compared to other countries, Poland receives relatively more allowances through solidarity mechanisms, which means that Poland's specific circumstances in the EU, including its slow shift away from coal dependency, are taken into account. The question of whether this is sufficient is an element of the political discussion.

Recommendations

The issue of the CO2 imbalance in Poland is a difficult topic in the context of the EU's Fit for 55 negotiations due to the lack of interest in the subject by other Member States. The issue was recognized in the Council conclusions adopting the new reduction target in December 2020[8]. In an attempt to address this issue, the European Commission proposed setting aside an additional pool of allowances for the new Modernization Fund.

If Warsaw wants to negotiate something more than is on the table, a strategy for convincing other countries to Poland's point of view and building the right narrative will be crucial. Rather than arguing that the outdated NECP is the limit to our engagement in climate action, it is important for Poland to push for important issues in the EU negotiations in the coming months, such as:

- 100% of ETS revenues for transformation.

Guaranteeing that 100% of the financial proceeds from the sale of CO2 emission allowances by the state will be used for investment in emission reductions[9]. This proposal is already in the European Commission's draft and will not necessarily receive support from other Member States. In theory, states can decide on their own to increase the spending of ETS funds on emission reductions. Anchoring this standard in the directive, however, will give certainty to our partners that any increase in Poland's allowance pool will translate into additional reduction measures. It is important that these funds are earmarked and trigger large investment projects that reduce emissions and reduce the risk of imbalance.

- More allowances in the Modernisation Fund

Increasing the Modernisation Fund instead of the Innovation Fund (cf. What is EU-ETS for and what reform awaits us?) after the partial withdrawal of free allowances for industry, under the ongoing CBAM negotiations (Carbon Boarder Adjustment Mechanism). The number of allowances in the Modernization Fund, of which Poland is the main beneficiary, could almost double[10].

- Social Climate Fund under the extension of the ETS to buildings and transport

Even though negotiations on the ETS extension are under a different workstream, these are interconnected topics. It is important to maintain our status as the largest beneficiary of the new Social Climate Fund in the extension of the ETS to transport and buildings.

Action is also needed at home. Firstly, increasing absorption of the Innovation Fund’s resources by business in Poland. The IF will be endowed with more than 500 million allowances[11]. We need innovative projects that can compete at European level.

Secondly, it is necessary for Poland to take action to reduce emissions - starting with updating the NECP. It is important to increase reduction ambitions in all EU ETS sectors - power generation, heating and industry. All funds raised from the sale of allowances should be used for this purpose in order to reduce costs. Proposals for emission reduction measures have been included in other Forum Energii analyses (e.g. How Poland can achieve increased GHG emission reduction targets by 2030 - Forum Energii (forum-energii.eu)

Summary

An emissions reduction plan not aligned with EU targets over the next decade could lead to an imbalance of emissions with allowances - Polish companies would have to buy more allowances than were allocated to the State. However, an ETS deficit is currently just a risk that needs to be managed. Negotiating additional allowances may help, but only real reductions will guarantee that an imbalance is avoided.