Will rethinking the European emissions trading system and RED II make us fit for 55?

During the past few years, we have witnessed a historic change within the energy sector aligning ambitions into contextualised policy frameworks. From a European perspective, 2021 has marked a shift from setting out a comprehensive vision for the transition to climate neutrality, and its supporting sectoral strategies, to proposing and implementing the resulting initiatives. Key moments in this regard were the adoption of the Climate Law in June and the publishing of the so called ‘Fit for 55’ package by the European Commission in July 2021. 

The July package

The Fit for 55 package that was published on 14 July 2021 comprising of 13 legislative proposals, including eight revisions of existing legislation and five novel proposals outlines a comprehensive and interconnected game plan. This package aims to  the reduction of 55% in greenhouse gas emissions in the European Union by 2030, as compared to 1990 levels, which will make it possible to achieve net-zero emissions by 2050. The Fit for 55 package aligns EU policy with the ambitious political mandates of the Green Deal and EU Climate Law. It will be at least another two years before this package is in force and next it will go into the European Parliament for approval.

The December package

The European Commission presented most of its proposals on 14 July 2021. Some proposals, however, will be put forth in the fourth quarter of 2021, such as a revision of the Third Energy Package for gas to regulate competitive decarbonised gas markets and legislation to reduce methane emissions from the energy sector. In other words, the European Commission is currently working on a package for December, which includes legislative proposal on how to address the decarbonisation of gas markets, including hydrogen. This ‘December package’ is an equal part of the Fit for 55 Package – described as the missing link that covers the market design for gases. Next to hydrogen, the December package will also aim at facilitating the integration of renewable and low-carbon gases in the existing gas grid. This concerns biomethane injected typically at distribution level, gas quality in the existing networks, access of renewable gases to LNG terminals and storage. It also includes topics on the integration of network planning between electricity, gas, and hydrogen networks. 

The current EU market rules for gas were created with fossil gas in mind. The value chains are different for the emerging renewable, methane-based gases, as well as hydrogen. They require the rethinking of the rules to ensure that gas is produced with new and clean technologies. Compared to fossil gas, it is anticipated that renewable gases and hydrogen are likely in the short and mid-term to be produced domestic and quite decentralised i.e., in hydrogen valleys where either dedicated hydrogen networks are in place or will be developed. Around 2030 the need to start connecting these valleys across borders will materialize. The December package will provide the framework in which the supply and consumption of hydrogen, be it low-carbon or green, will be leveraged. Allowing the transition to take place whilst at the same time providing the regulatory authorities the flexibility to support the development of the hydrogen market in the best way, considering Member State-specific situations. 

It is to be noted, that the awaited December package will not deliver decarbonisation in itself, but it will remove barriers and ensure that the right market framework is in place for this to happen in the most cost-effective way. The upcoming package together with the components introduced in July, such as extension of the ETS, effort sharing regulation, CBAM, with all the elements including the RED II, will ensure that we are on the path to decarbonise in accordance with the policies fit for reducing net greenhouse gas emissions by at least 55% by 2030. All proposals are in one way or another interlinked with each other making it interesting to see how this proposal package will change and in what shape it will eventually come into force. The proposals will be in force at the earliest in 2024.

Support to implement the energy transition

In addition to the proposed new regulations and directives and revisions of the same, the 2021-27 EU budget will provide significant support to implement the European Green Deal and the energy transition across the EU. In particular, the European Regional Development Fund (ERDF) and the Cohesion Fund will allocate at least 30% and 37% respectively of the available funding for the achievement of EU’s climate objectives. The Just Transition Mechanism will allocate 100% of its support to the achievement of EU’s climate objectives and will alleviate the socio-economic situation in the regions most affected by the transition to climate neutrality. InvestEU focuses primarily on supporting the green transition with its EUR 9.9 billion Sustainable Infrastructure Window. The Commission has also supported Member States in the development and implementation of reforms in view of the achievement of EU energy and climate goals in 2021 through more than 65 technical support projects.

In this short review, we will be focusing on EU Emissions Trading System (ETS), Carbon Border Adjustment Mechanism (CBAM) and the revision of the Renewable Energy Directive (RED II). The other parts of the proposals are the review of the existing effort sharing regulation, setting a target for afforestation, tightening CO2 emission standards for passenger cars and light-commercial, a new energy taxation directive, further amendments to RED II and changes to the energy efficiency directive.

References: European Commission 14 July 2021. European Green Deal: Commission proposes transformation of EU economy and society to meet climate ambitions; State of the Energy Union 2021 – Contributing to the European Green Deal and the Union’s recovery (COM(2021) 950 final)

Revision of the Renewable Energy Directive (RED II) – a shift from strategy to delivery of political priorities?

This proposal is for amending the Renewable Energy Directive (Directive (EU) 2018/2001). Due to the fact that the directive (RED II) is relatively recently adopted, the review of RED II is limited to what is considered necessary to contribute in a cost-effective way to the Union’s updated 2030 climate ambition, meaning that this is not a full revision of the RED II.

Energy production and use accounts for 75% of EU emissions, so accelerating the transition to a greener energy system is crucial. The new proposed article 1(2) amends the current RED II and sets an increased target to produce 40% (compared with the former target of 32%) of our energy from renewable sources by 2030. All Member States will contribute to this goal, and specific targets are proposed for renewable energy use in transport, heating and cooling, buildings, and industry. 

Hydrogen is anticipated to have a key role in EU’s future energy mix e.g., for the industry EU hydrogen demand is projected to increase to 400 TWh‑500 TWh in 2030, which implies a need for 200 TWh-250 TWh of renewable fuels of non-biological origin (RFNBOs). As explained below, the proposal has expanded the scope of the RFNBO concept from the currently applicable RED II, which applied it exclusively to transport fuels, to apply also to hydrogen when used in industry. The proposal establishes a progressive goal for green hydrogen in transport and requires that half of the hydrogen used in industry must be green hydrogen by 2030. In addition, the European Commission’s hydrogen strategy includes a goal of installing at least 40 GW of renewable hydrogen electrolysers and the production of up to 10 million tonnes of renewable hydrogen in the EU by 2030, aligning closely with the proposals added requirements for RFNBOs and making the scale of the task become tangible. It should be noted that the revised RED II proposal covers renewable hydrogen whilst regulatory measures relating to hydrogen produced from low-carbon energy has been left to the gas decarbonisation package due by year-end 2021. The revision of the current EU rules on gas and hydrogen is needed to ensure that the gas market framework, that builds inter alia upon the 2009 third energy package for natural gas, is in line with EU Fit for 55 ambition. The current understanding is that under the gas decarbonisation package the European Commission will include a proposal for a hydrogen act. 

The major changes in the revised RED II proposal are the following:

  • The definition of renewable fuels of non-biological origin (RFONBOs including renewable hydrogen and its derivatives), default value, new definitions of quality roundwood, renewable fuels, bidding zone, smart metering system, recharging point, market participant, electricity market, domestic battery, electric vehicle battery, industrial battery, state of health, state of charge, power set point, smart charging, regulatory authority, bidirectional charging, normal power recharging point, industry, non-energy purposes, plantation forest and planted forest are added. 

  • Updated 2030 EU target of at least a 40% share of energy from renewable sources in the EU’s gross final consumption of energy in 2030. 

  • As regards to the principle of additionality an updated calculation method of the share of energy from renewable energy sources is introduced so that (i) energy from RFONBOs must be accounted in the sector in which it is consumed (electricity, heating and cooling or transport), and (ii) the renewable electricity used to produce RFONBOs is not included in the calculation of the gross final consumption of electricity from renewable sources in the Member State. Since the introduction of the proposed additionality framework, market participants have engaged in active discussions on its proper practical adoption; the paramount question being to ensure the scaling up of a European hydrogen market whilst making sure that renewable energy is not diverted away from energy production. It is still unclear how the European Commission will deal with additionality, however, the awaited delegated act on the electricity for RFNBOs production should give further indication on the design that provides additional renewables required to decarbonise Europe in a way that new hydrogen electricity demand is matched with new extra renewable generation.

  • The proposal seeks to tighten the sustainability criteria for forest biomass to close several loopholes that might contradict the EU’s biodiversity strategy. The first step is to prohibit the use of all biomass from primary and highly biodiverse forests (rather than just agricultural biomass, as under current rules) and the use of stumps and roots. GHG emissions-saving criteria should also apply to existing biomass-based installations not just new ones, and the threshold for applying sustainability criteria for small-scale installations is lowered to 5 MW, rather than the current 20 MW level. To minimise the use of roundwood, the new rules also introduce an obligation on Member States to design support schemes in accordance with the biomass cascading principle whereby woody biomass is used according to its highest economic and environmental added-value and to phase out support for electricity installations using woody biomass.

  • There is a new obligation for the Member States to have a cross border pilot project within three years (by 31 December 2025) to foster regional cooperation on renewables and an additional paragraph on joint offshore energy planning per sea basin, under which Member States must jointly define and agree to cooperate on the amount of offshore renewable generation to be deployed within each sea basin by 2050, with intermediate steps in 2030 and 2040 is added.

  • As regards buildings, a strengthening provision on renewables power purchase agreements (PPAs) is added. Furthermore, the existing measures to encourage the uptake of renewable power purchase agreements should be strengthened and, therefore, Member States shall assess the regulatory and administrative barriers to long-term renewables power purchase agreements. Unjustified barriers to, and promote the uptake of, such agreements shall be removed. Including by exploring how to reduce the financial risks associated with them, in particular by using credit guarantees. Member States shall ensure that PPAs are not subject to disproportionate or discriminatory procedures or charges, and that any associated guarantees of origin can be transferred to the buyer of the renewable energy under the renewable PPA. These policies and measures promoting the uptake of renewables PPAs shall be describe in the Member States integrated national energy and climate plans.

  • A new indicative EU target of renewables in buildings by 2030 of 49% and a reference to the new definition of ‘efficient district heating and cooling’ that will be added to the recast Energy Efficiency Directive, which is one of the ways the minimum level of RES in new buildings and buildings undergoing major renovation can be satisfied. 

  • An article is added which removes Member States’ ability not to issue guarantees of origin to a producer that receives financial support, linking to the changes related to power purchase agreements in Article 15.

  • TSOs and DSOs obligations are increased by adding a requirement for them to make available information on the share of RES and the GHG content of the electricity they supply, in order to increase transparency and give more information to electricity market players, aggregators, consumers and end-users.

  • Battery manufacturers must enable access to information on battery capacity, state of health, state of charge and power set point, to battery owners as well as third parties acting on their behalf.

  • Member States shall ensure smart charging capability for non-publicly accessible normal power recharging points, due to their relevance to energy system integration.

  • Member States shall ensure that regulatory provisions concerning the use of storage and balancing assets do not discriminate against participation of small and/or mobile storage systems in the flexibility, balancing and storage services market. 

  • A new article is introduced by mainstreaming renewable energy in industry with an indicative target of an annual average increase of renewable energy of 1.1 percentage points and a binding target of 50% for RFONBOs used as feedstock or as an energy carrier. 

  • A new paragraph is added expanding third party access to apply to district heating or cooling systems above 25 MWth where this makes sense. Member States also need to put in place a mechanism to deal with unjustified refusals of third party access. 

Reference: European Commission 14 July 2021. Amendment to the Renewable Energy Directive to implement the ambition of the new 2030 climate target

Putting a price on carbon through a revised European emissions trading system (ETS)

European emissions trading system applies to industry sectors (currently power and heat generation, energy-intensive industrial sectors, and aviation within Europe) and can be described as a market-based mechanism for putting a price on carbon. The system works on the cap and trade principle. A cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system. The cap is reduced over time so total emissions fall. The proposal aims to introduce new sectors to be covered by ETS and also tightens the requirements for the current sectors.

The current scheme covers approximately 40% of the EU’s total greenhouse gas emissions, and the remaining 60% is covered by the effort sharing regulation (ESR, see European Commission's proposal on amending ESR), which addresses emissions from transport, industry, and agriculture. This regulation sets binding national greenhouse gas targets for each EU country, depending on their GDP. The Commission is proposing to lower the overall emission cap even further and increase its annual rate of reduction. It is also planning to phase out free emission allowances for aviation and align with the global Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) and to expand the ETS to cover the maritime sector. A separate new emissions trading system will be set up for fuel distribution for road transport and buildings. 

Since all the new proposals are designed to work together, it will be important that the ETS works together with carbon border adjustment mechanism (CBAM), that would apply to imports from all non-EU countries.

Free EU ETS allowances for those sectors covered by the CBAM would be phased out after the CBAM is made available in 2026 by 10 percentage points year on year from 2026 onwards. Free allocation of EU ETS allowances for aviation (intra-EU flights) would be phased out by 2027 (subject to a linear reduction factor).

The Commission is proposing to include shipping and maritime in the existing EU ETS for the years 2023-2026 and to create a parallel ETS for road transport and buildings from 2026 onwards. The fuel supplier suppling for these sectors need to surrender their allowances by 2026. For this sector, there will be no free allowances meaning that all allowances will be auctioned under the new ETS. Free allocation of EU ETS allowances for those sectors covered by the proposed CBAM would start to be phased out after the CBAM goes live.

EU ETS carbon price reduced to reflect any carbon price paid in the country of origin as well as any free allocation made under the EU ETS to EU installations producing equivalent goods to ensure parity of treatment. 

The aim is to strengthen the Market Stability Reserve, enabling it to absorb the historical surplus of allowances more quickly. The CBAM is an alternative to free allocation to protect against carbon leakage and so the two measures should not overlap (not least in order to remain compatible with WTO rules). For cement, fertilizers, electricity production, steel and aluminium, CBAM takes effect and free allocation of ETSs will be phased out.

Buildings and transport will be a part of the new Effort Sharing Mechanism (ESM) which means that national programs need to be put in place to reduce emissions. ESM applies to emissions from sectors not covered by the EU ETS (including agriculture and waste).

The explanatory memorandum to the proposal states that any possible merger of the existing ETS with the new parallel ETS should be assessed only after a few years of functioning of the new ETS.

For all other sectors, free allocation will continue to be based on benchmarks representing the level of performance of the best installations. The Commission aims to allocate free allowances in a more targeted way and to incentivise the uptake of low-carbon technologies. The maximum annual reduction rate of the benchmark values will increase from 2026 onwards, shifting more free allocation to sectors that are harder to decarbonise. In the future, free allocation will be made conditional on decarbonisation efforts. 

Based on the Commission's proposal EU member states should spend the entirety of their emissions trading revenues on climate and energy-related projects. A dedicated part of the revenues from the new system for road transport and buildings should address the possible social impact on vulnerable households, micro-enterprises, and transport users.

Reference: European Commission 14 July 2021. Revision of the EU Emission Trading System. 

Preventing carbon leakage through the Carbon Border Adjustment Mechanism (CBAM)

The CBAM is an alternative to free allocation of ETSs to protect against carbon leakage and so the two measures should not overlap (not least in order to remain compatible with WTO rules). CBAM complements the ETS, as an extension of sorts, and these schemes need to work together. Allocation under the ETS for in-scope sectors will be gradually phased out as the CBAM is phased in after 2026.

This proposal assumes the imposition of additional charges on products that are imported into the EU based on the level of greenhouse gas emissions necessary for their production. This applies initially to imported products in the following sectors: cement, electricity generation, steel, fertilizers and aluminium (CBAM proposal Annex 1). The Commission indicates that the extension of the scope will be evaluated (CBAM proposal Article 30).  There will be a gradual phase in into the system. Before the transitional phase, the certificates will be in use and the price of certificates is based on the average trading price of EU ETS allowances in the week prior to import. There is a transitional phase (2023-2025) and the period after the transitional phase (2026 onwards). The transitional phase will be a period for gathering information and reporting (importers importing these goods from a third country need to report on their embedded emissions). During the transitional period, the carbon price will be the actual emissions for each sector. From 2026 onwards, imports must declare amount of embedded emissions in the total goods they have imported. The rules for the calculating embedded emissions will be clearly regulated. EU ETS carbon price reduced to reflect any carbon price paid in the country of origin as well as any free allocation made under the EU ETS to EU installations producing equivalent goods to ensure parity of treatment. EU importers of these goods will be required to buy CBAM certificates, the price of which shall mirror that of the ETS and surrender them to a newly established CBAM Authority.

The previous ETS system has been effective in addressing the risk of leakage, but it also dampens the incentive to invest in greener production at home and abroad. The Innovation Fund, which supports business and SMEs’ investment in clean energy, will grow its financing for innovative projects and infrastructure to decarbonize industry. Particular attention will be given to projects in sectors covered by CBAM. (See more on Innovation Fund).

Reference: European Commission 14 July 2021. Carbon border adjustment mechanism.

Concluding remarks

Answering the question of “will we be fit for 55”? is not the easiest nut to crack. However, it is evident, that we cannot solve our problems with the same level of thinking that created them, a notion that is predominantly mirrored in EU’s ambitious targets and means of achieving set emission reductions. The next decade is crucial to Europe becoming the world's first climate-neutral continent by 2050 and making the European Green Deal a reality. We all have a central role to play in making good intentions equal to good outcomes for generations to come. The Commission proposals will now be subject to much discussion and analysis and it remains to be seen what the near future holds for their scope and implementation. EU’s acknowledgement of different approaches to climate action reflects the importance of harnessing cross-disciplinary understanding and sharing knowledge to find future-proof and technology neutral solutions. Creating a fit for purpose regulatory framework from anticipation is not an easy task. It is about assessing the positive and negative effects of proposed and existing regulations and non-regulatory alternatives in order to find a well-balanced solution that provides a robust framework and acknowledges Member State-specific attributes. The years ahead are dedicated to the formation and fine tuning of future energy legislation, and we look forward to providing our takes on the subject as we move forward on the path to decarbonisation. 

Stay tuned for our further analysis regarding the December package.

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