The EU’s Emissions Trading System: free allocation of allowances needed better targeting

Executive summary

I

The reduction of greenhouse gas emissions is one of the main challenges of our times. The EU has established a series of climate change targets to be achieved in 2020, 2030 and 2050. While the EU is firmly on track to achieve its 2020 targets, this is not the case for its – more ambitious – 2030 and 2050 targets. The Commission’s “Green Deal”, put forward in 2019, proposed moving to a target of cutting emissions by between 50 and 55 % by 2030 and achieving “no net emissions” of greenhouse gases by 2050. This implies a significant increase in efforts.

II

The EU Emissions Trading System is one of the EU’s key climate change mitigation policies and it is the world’s first carbon market. It aims at providing an efficient mechanism to reduce emissions. Under the EU ETS companies need to obtain emission allowances covering their carbon emissions. The default option is for these to be purchased at an auction; they can also be allocated for free.

III

This audit focused on the free allocation of allowances. In phases 3 and 4 of the EU ETS (years 2013-2020 and 2021-2030 respectively), free allowances aim at mitigating the risk of carbon leakage while the carbon price is intended to provide a progressive incentive for decarbonisation. This is supported by the use of benchmarks derived from the top performers in a given sector. The power sector in eight Member States also received free allowances linked to the modernisation of electricity production.

IV

Our audit question was “Did decisions on free Emissions Trading System allowances provide a reasonable basis to encourage the reduction of greenhouse gas emissions?” We examined whether free allocation of allowances was successfully used to modernise electricity generation, sufficiently targeted and allocated to provide incentives to reduce greenhouse gas emissions, and had not contributed to increasing such emissions. We found that while the use of free allocation was justified, better targeting of free allowances would have had multiple benefits for decarbonisation, public finances and the operation of the single market.

V

In particular we found:

1. The specific rules for free allocation to modernise the electricity generation sector applying to the EU ETS phase 4 have been improved. However, we consider that free allocation to the power sector did not promote decarbonisation in phase 3.
2. Free allowances were intended to provide an exceptional method of allocating allowances in contrast to the default method (auctioning). However, during phase 3 and the early stages of phase 4, they continue to represent more than 40 % of the total number of available allowances. We found that the number of free allowances allocated to the industry and aviation sectors in phase 3 was not based on their ability to pass through costs and that, while carbon leakage has the potential to affect the EU carbon market and the evolution of the greenhouse gas emissions worldwide, there was limited targeting of the allocation of free allowances.
3. The approach to allocate free allowances on the basis of benchmarks provided significant incentives for improvement of energy efficiency, but there is scope to improve the application of these benchmarks. The Commission has not quantified the impact of allocation of free allowances on changes in energy efficiency.

VI

Based on these findings, we make recommendations aimed at better targeting the allocation of free allowances as well as improving the methodology for setting benchmarks.

Introduction

01

The European Union has established a series of climate change targets to be achieved in 2020 and 2030, and is currently revising its targets for 2030 and 2050. In its European Climate Law proposal of 2020¹, in line with its Green Deal communication, the Commission has proposed a target of “no net emissions” of greenhouse gases (GHGs) by 2050². These targets are summarised in Figure 1.

02

According to the European Environment Agency (EEA), the EU is firmly on track to achieve its 2020 targets, but not its 2030 targets³. The EU emitted about 8.5 % of global GHG emissions in 2018, a share that has been declining over time⁴; per capita emissions in the EU are still higher than the world average, although this gap is narrowing. Since 2005 and the creation of the EU’s Emissions Trading System (EU ETS), EU per capita emissions have fallen. At the end of 2018 they were below those in the USA, China and Japan⁵.

03

The Commission considers that the EU as a whole has performed better in terms of decarbonisation than most other jurisdictions, and has decoupled economic growth from growth in greenhouse gas emissions. Between 1990 and 2016, greenhouse gas emissions in the EU fell 22 % while economic growth was 54 %. Many factors have contributed to this, including energy efficiency, fuel switch policies, increased use of renewables and technological changes⁶.

04

The EU ETS is one of the two key pillars of EU climate policy aiming to reduce greenhouse gas emissions (the second is the Effort Sharing Decision and Regulation⁷). The EU ETS covers, broadly, heavy industries and electricity installations (together known as “stationary installations”), as well as aviation⁸, encompassing all EU Member States plus Norway, Liechtenstein and Iceland. It is currently in its third phase (2013-2020). Its first two phases ran, respectively, from 2005-2007, and from 2008-2012. Phase 4 will run from 2021 until 2030.

05

The EU ETS works as a “cap-and-trade” programme. Legislation defines the annual maximum number of allowances available (the “cap”) and a market is created where allowances are bought and sold. Operators need an allowance for each tonne of carbon dioxide equivalent emitted. Allowances are obtained either through auctions – where installations have to bid for them – or for free. Operators can also buy allowances on specialised markets, and from each other. The system is explained in Figure 2.

06

The EU ETS is governed by a 2003 Directive⁹ (EU ETS Directive) last amended in 2018, alongside with several Commission’s Decisions and Regulations (see Annex I).

07

Requiring operators to pay for their allowances through auctions respects the “polluter pays” principle and provides a stronger incentive for them to reduce GHG emissions, than providing free allowances¹⁰. Free allowances were to be allocated in a way that:

1. Reduced risks of carbon leakage (offshoring of production in a way that produces a rise in global GHG emissions);
2. Provided an incentive for decarbonisation (avoiding increases in GHG emissions¹¹), through the application of free allocation benchmarks derived from the top performers in a given sector. This should encourage less efficient operators to improve their performance, while rewarding those that perform well.

08

Figure 3 shows how all greenhouse gas emissions covered by the EU ETS compare with allowances allocated either at auctions or for free. Until 2012, all sectors received most of their allowances for free.

09

Since 2013, the industrial and aviation sectors receive free allocation. Between 2013 and 2019, industry received over 5 000 million free allowances, and aviation received over 200 million free allowances¹². For industrial sectors, the amount of allowances allocated for free decreases each year. The sectors classified as at risk of carbon leakage benefit from additional free allocation and, independently of how the installations in those sectors perform, they receive as many free allowances as the most efficient installation in line with the established benchmarks. The power sector only benefits from free allocation to help modernise the sector in specific Member States under specific conditions. Figure 4 shows how free allowances are allocated.

10

The free allocation of allowances was, in phases 1 and 2, based on historical emissions. This led¹³ to an over allocation of allowances to many operators, in particular in light of the reduction in production caused by the 2008 recession. Under phase 3 (2013-2020), free allocation took account of product benchmarks, basing allocation on the performance of the most efficient operators. This aimed at providing an incentive for efficiency gains (i.e. lower emissions per unit produced) at the operator level, but may still allow an increase in emissions in the industrial sector if production levels grow. The choice of the sectors entitled to receive free allocations is in principle linked with the incapacity of some sectors to pass costs through to their customers (see Box 1).

11

Figure 5 shows that after the introduction of benchmarks in 2013 all industrial sectors continued to receive most of the allowances they needed to cover their emissions for free, and also that industrial emissions remained relatively stable. For some sectors, free allowances allocated exceeded emissions. This was due to the poor quality of the data used for the first established benchmarks and the limited alignment with the operator’s production volumes (see paragraph 48).

12

Operators and investors trade allowances on both the primary and secondary markets, where price is influenced by the dynamics of supply (limited by the EU ETS’ cap) and demand. The price signal should act as an incentive to reduce GHG emissions. In 2019, the lowest registered price of a European Union Allowance (EUA) stood at €19.59 and the highest, at €29.03¹⁵ (see Figure 6). Many experts have concluded that significantly higher carbon prices would be needed to provide the right incentives to reach the Paris Agreement’s objectives¹⁶.

13

The EU ETS Directive provides that at least half of the revenue from the auctioning of allowances must be used by Member States for climate and energy actions. According to data from the European Environment Agency (EEA), between 2013 and 2020 over 6.66 billion allowances were allocated for free under phase 3 (2013-2020) of the EU ETS. During this time, the prices of allowances fluctuated but increased from less than €3 to around €25. If more allowances for industry had been auctioned, Member States would have received significant additional revenues. The Commission has identified that Member States received €42 billion in auction receipts between 2012 and June 2019¹⁷.

14

The roles of the key actors in the EU ETS include:

1. The Commission overseeing action by Member States under the EU ETS Directive; devising rules for auctioning and the free allocation of allowances; providing guidelines on applying the Directive to Member States, operators, and third-party verifiers; and making legislative proposals on the EU ETS to the European Parliament and the Council.
2. Competent authorities in EU Member States checking and approving operators’ emissions monitoring plans; inspecting operators; and accepting operators’ verified emission reports, based on EU legislation and Commission guidance.
3. Operators subject to the EU’s GHG emissions cap, obtaining and surrendering, each year, an amount of allowances corresponding to their emissions. Failure to surrender enough allowances results in a penalty of €100 per uncovered carbon dioxide equivalent (CO₂e), plus additional penalties established at Member State level (according to harmonized provisions in the EU ETS Directive).
4. Third-party verifiers (approved by accreditation bodies in the Member States) checking and certifying operators’ emissions data.

15

From 2005 until 2012 (the first two phases of the EU ETS), almost all allowances were allocated for free. Each year the number of allowances allocated was greater than the amount needed to cover actual emissions, particularly when the economic downturn after 2008 kicked in, leading to increasing balances of allowances (see Figure 7) held by operators. This caused the price of allowances to tumble (see Figure 6), weakening the incentive of operators to reduce emissions. Many operators were able to rely on allowances previously received for free to comply in full with their surrendering obligations. Changes to the system in its 3^rd phase largely eliminated this system-wide annual surplus.

16

The consolidated EU ETS Directive provides for the revision of certain provisions relating to phase 4 (2021-2030), in light of the following circumstances:

1. The global stocktake under the Paris Agreement, scheduled for 2023, where the parties to the agreement will assess their current commitments and ratchet up their efforts to meet the agreement’s targets¹⁸.
2. The implementation of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), under the aegis of the International Civil Aviation Organization, a programme aimed at globally offsetting emissions from civil aviation (see Box 4)¹⁹.
3. The potential adoption of carbon border adjustments on imports from third countries (see paragraph 40).

In 2020 the Commission proposed a new European Climate Law²⁰ and planned to launch a public consultation on a carbon border adjustment mechanism. The Commission’s communication on a European Green Deal dealt with the potential to amend the provisions governing the EU ETS.

Audit scope and approach

17

We examined whether the Commission’s decisions on free EU ETS allowances provided a reasonable basis to encourage the reduction of GHG emissions. In particular we examined whether free allocation was:

• successfully used as a modernisation instrument for the power sector;
• targeted the sectors at highest risk of carbon leakage;
• used in a way that provided incentive to reduce GHG emissions and did not contribute to increase such emissions.

18

As part of our audit work we:

• examined the Commission’s proposals, guidelines, and other relevant reports;
• consulted relevant Member States authorities in Czechia, Germany, Poland and Sweden, as well as representatives from the industrial, power and aviation sectors, and non-governmental organisations;
• assessed the available records and reports on the operation of the EU ETS and of the free allowance mechanism;
• consulted an expert panel. Their expertise was used to assess preliminary findings on the effects of the free allowances system;
• surveyed competent authorities responsible for monitoring the EU ETS in all EU Member States, to collect relevant information on benchmarks and carbon leakage.

19

The period covered by the audit is 2013‐2019, thus covering phase 3 of the EU ETS and the legislation put forward for phase 4. The impact of the coronavirus epidemic on EU ETS prices, and the likely impact of the resulting economic downturn, has therefore not been covered by this audit.

20

This report provides material which can feed into the planned review of the legislation, needed for the global stocktake scheduled for 2023 under the Paris Agreement (see paragraph 16).

Observations

Free allowances brought uncertain results when used as a modernisation instrument for the power sector

21

Free allowances for the electricity sector were allowed during phase 3 as a derogation to the general rule that this sector had to acquire its allowances by auction or on the market. These free allowances should support investments to modernise the power sector in the eight Member States applying the derogation. We looked at the changes in the allocation of free allowances between phases 3 and 4 and examined whether the power sectors in these Member States reduced their carbon footprint.

Tighter conditions on the use of free allowances in the power sector apply from 2021

22

The electricity sector is, since 2013, not entitled to receive free allocation, given that it can pass through costs to its consumers. A derogation²¹ to this general principle was made for ten Member States which in 2013 had a GDP per capita below 60 % of the Union average. Eight of them used this derogation during phase 3 (see Figure 8). From 2013 to 2018, over 479 million allowances were freely allocated under this provision (Figure 6 indicates the changing price of allowances). The aim of this free allocation was to contribute to modernise the electricity generation sector in these countries, some of which were heavily reliant on coal.

23

The Member States that intended to use the derogation had to send to the Commission an application meeting a number of requirements set out in the Directive and subsequent Commission guidance documents²² (see Box 2). The Commission endorsed the Member States applications following several rounds of discussions between the Commission and the eight applicant Member States.

24

In its 2014 conclusions on the climate and energy policy framework to 2030²³, the Council recognised that free allocations to the power sector should be improved, to ensure that the funds were used to promote real investments modernising the energy sector. The revised Directive for phase 4 requires that competent authorities select investments following a compulsory bidding procedure (instead of the fixed national investment plans used for phase 3). For phase 4, of the ten eligible Member States, only Bulgaria, Hungary and Romania will provide free allowances to their power sectors.

Available data point to ineffective results of free allocation as a tool to modernise the power sector in phase 3

25

The investments resulting from the use of free allowances under Article 10c were expected to result in a decrease of the emission intensity of electricity production as well as a reduction in the absolute emissions. A study performed for the Commission in 2015 concluded that the effectiveness and efficiency of GHG reductions fostered by these investments could not be evaluated²⁴.

26

Figure 9 shows that the majority of the revenues flowing from allowances allocated for free have been used to refurbish lignite and hard coal power plants, mainly in Bulgaria, Czechia, Poland and Romania.

27

We assessed the reduction of carbon intensity for the power sector for countries eligible for free allocation of allowances under Article 10c and compared it with the same data for countries not benefitting from free allocation (see Figure 10). The results show a much lower decrease in terms of carbon intensity for the Member States that received free allowances to modernise the power sector. Recent research²⁵ on the reduction of coal as a basis for power generation in 2019 confirms this trend.

Free allocation of allowances to industry and aircraft operators took limited account of the ability to pass on costs, and tended to slow decarbonisation

28

The EU ETS Directive provides that the free allocation of allowances is a “transitional and exceptional” derogation from²⁶ the default option of auctioning (see Figure 4). Free allocation should be targeted at those sectors most exposed to international competition and least able to pass through carbon costs to customers.

Free allocation to industry and aircraft operators did not reflect sectoral capacity to pass through costs

29

As noted above, with the exception of ten lower income Member States (see paragraph 21), the EU ETS excluded the electricity sector from the allocation of free allowances because this sector was able to pass costs through to its customers and was therefore not at risk of carbon leakage. We found that the allocation of free allowances to other sectors was not always consistent with their capacity to pass on costs:

• The aviation sector receives free allowances. However, this sector can pass EU ETS costs through to customers. The 2006 impact assessment preceding the inclusion of aviation within the EU ETS²⁷ confirmed this.
• The Commission impact assessment for the revision of the EU ETS for phase 4 provides²⁸ information concerning cost pass through rates for different industrial sectors. The Commission has not proposed to modulate the amount of free allowances allocated to any sector.

30

When free allocation is not properly targeted, this can result in situations where sectors may pass through carbon costs even when receiving free allowances. As a result “free allowances imply a financial transfer from consumers (or client industries) to energy-intensive industries, which would give rise to what is often referred to as ‘windfall profits’”²⁹. The impact assessment accompanying the Commission’s 2014 proposal acknowledges³⁰,³¹ that free allocation can reduce incentives for installations to cut emissions and that sectors which get allowances for free can pass through some of their costs.

31

In its 2014 conclusions³², the European Council agreed that the share of allowances to be auctioned under the EU ETS post‐2020 should not be reduced. The Commission proposed auctioning the same share of allowances as in phase 4 as in phase 3³³ (57 %). The legislator then introduced³⁴ the possibility to increase the amount of available free allowances up to 3 % if necessary (see the “free allocation buffer” in Figure 11). The legislator has power to decide when to apply this increase. This clause was not part of the Commission’s impact assessment nor of the Commission’s proposal. The result is that around 40 % of the allowances will still be allocated for free in phase 4.

Sectors producing over 90 % of industrial emissions received all or most of their allowances for free

32

The EU ETS uses the free allocation of allowances to mitigate the risk of carbon leakage (see paragraph 07). Carbon leakage “refers to the possible increase in global greenhouse gas emissions if, because of costs related to climate policies in the EU, businesses were to transfer production to other countries where industry is not subject to comparable climate policies”³⁵. The risk of carbon leakage exists because of differences in the cost of carbon within the EU, and between the EU and third countries.

33

According to the OECD (see Figure 12) carbon costs vary significantly between states. For example, overall carbon costs in most EU Member States were lower than in Switzerland and Norway; but higher than the USA and China. A study paid for by the European Commission has found no evidence of carbon leakage³⁶, although other studies argue that carbon leakage has not happened precisely because of the free allocation of allowances³⁷. Given that carbon leakage can translate into fewer jobs and investments in the EU, it has economic and social implications.

34

The free allocation of allowances deals with the risk of carbon leakage by reducing the costs of compliance faced by the operators covered by the EU ETS. These allowances thus help them to remain competitive against producers based in third countries.

35

Industrial operators from sectors considered at risk of carbon leakage benefit from free allocation based on the product benchmarks mentioned in paragraph 42 each year – unlike other sectors (not considered at risk of carbon leakage), which see their free allowances progressively reduced (see Figure 4) to zero. For phase 4, and following Commission proposals, the share of industrial sectors considered at risk of carbon leakage was substantially reduced. But these sectors still represent 94 % of EU industrial emissions (see Figure 13). The carbon leakage list does not establish different degrees of carbon leakage risk for the various sectors included in it, treating all of them equally (see Box 3 for a comparison with other ETS systems).

36

The EU ETS legislation uses emissions intensity and trade intensity as criteria for assessing the risk of carbon leakage. The impact assessment for the revision of the EU ETS for the upcoming phase 4 also looked into the pass-through rates (see Box 1) for different sectors³⁹, but the Commission did not include this among the criteria for assessing carbon leakage risk⁴⁰, in its proposals for phase 4.

37

The lack of targeting of free allowances for carbon leakage means that under current arrangements most allocations of free allowances will not be reduced to zero before 2030 – which is the default for free allowances (see Figure 4).

38

An OECD study on the first ten years of the EU ETS, published in 2018, found that sectors considered at risk by the European Commission “indeed operate in fiercely competitive markets and face difficult economic times”. But it also found that “companies regulated under the EU ETS performed relatively better than their non-ETS counterpart (….) (which) indicates that the distribution of free allowances may have more than compensated EU ETS firms at risks for the induced carbon abatement costs of the regulation”⁴¹. A more targeted distribution of free allowances would therefore have addressed the risk of carbon leakage, reduced windfall profits, and (by increasing the share of allowances auctioned) improved public finances.

The Commission examined but did not propose other approaches to mitigate the risk of carbon leakage caused by EU ETS

39

The Commission looked into alternatives to free allocation to address carbon leakage in the 2008 Impact Assessment for the phase 3 revision⁴², and in a 2010 Commission communication on ways to increase emission reductions and assess carbon leakage⁴³, but did not make specific proposals. In particular, in 2014, when assessing the possible policy framework for climate and energy in the period from 2020 up to 2030, the Commission assessed the situation of carbon leakage in the EU and proposed pathways to address it, all of which relied exclusively on free allocation⁴⁴. A key alternative to free allocation, currently under discussion by the Commission, is using carbon border adjustments to equalize GHG costs of imports with those of domestic production⁴⁵.

40

Carbon border adjustments would include the cost of carbon mitigation in imports originating from places without climate policies comparable to the EU ETS, thus mitigating the risk of carbon leakage (although it would not address costs embedded in EU exports to third countries). The 2015 Impact Assessment accompanying the Commission’s original legislative proposal for phase 4 of the EU ETS found that there were no plausible alternatives to the benchmarking system to address carbon leakage. It noted that a border tax was a significantly less appropriate tool, pointing to potential conflicts with multilateral trade rules and negative reactions by third countries⁴⁶. However, the Directive for phase 4 mentions that free allocation of allowances could be replaced by, adapted, or complemented by carbon border adjustments⁴⁷. The communication on the “European Green Deal” proposes moving forward with a proposal for a “Carbon Border Adjustment” if significant differences in carbon prices persist⁴⁸.

Benchmarking used to allocate free allowances is progressively improving incentives to reduce emissions

41

In line with the EU ETS Directive, free allowances under phase 3 were to be allocated in a manner that provides incentives for reduction of GHG emissions. The rules governing this allocation should not contribute to an increase in GHG emissions.

The approach based on benchmarks provided incentives to reduce greenhouse gas emissions

42

From phase 3 onwards, the amount of free allowances that each operator receives is calculated using product-specific benchmarks, (or where this is not possible, by a fall-back approach linked to the use of heat and fuel). In line with the EU ETS Directive⁴⁹, the Commission used benchmarks to ensure “that allocation takes place in a manner that provides incentives for reductions in greenhouse gas emissions and energy efficient techniques, (…), and shall not provide incentives to increase emissions”.

43

Product benchmarks are set as the average emission level of the 10 % most efficient installations within each sector. In this way, “installations that are highly efficient should receive all or almost all of the allowances they need to comply with EU ETS obligations. Inefficient installations have to make a greater effort to cover their emissions with allowances, either by reducing emissions or by purchasing more allowances (...)”⁵⁰.

44

The use of benchmarks is widely accepted as an improvement on the system used in previous EU ETS phases, when allocation was based on historical GHG emissions⁵¹. The approach based on benchmarks provides stronger incentives to reduce emissions in the production process.

The effective use of benchmarks faces some technical challenges

45

Free allocation benchmarks currently do not fully account for indirect emissions in supply chain linkages. This can be problematic in some sectors if some installations are able to reduce their apparent emissions intensity (but retain free allocation levels) by replacing direct (onsite) emissions with indirect emissions⁵².

46

GHG emissions caused by burning biomass are not included when calculating the allowances that an operator is requested to surrender (see paragraph 05). Industrial installations which use biomass therefore typically receive more free allowances than they need to surrender. In addition, operators producing electricity with biomass do not have to surrender allowances for the emissions generated from this fuel. The EU ETS system does not impose any sustainability criteria for this type of fuel. The revised Renewable Energy Directive (RED II) included sustainability criteria for biomass⁵³, with the rationale that only sustainable bioenergy that reduces GHG emissions compared to fossil fuels is eligible for financial support. The Commission has not proposed changes to EU ETS rules to limit free allocation to operators using biomass meeting the RED II criteria.

47

The application of the polluter pays principle and the users pay principle to carbon costs can provide incentives for producers and consumers to modify their behaviour and reduce emissions. The impact assessment for phase 4 of the ETS recognised that free allocation does not fit well with the polluter pays principle⁵⁴: the incentive to lower emissions that this principle brings is reduced when allowances are given for free.

48

For phase 4, in 2014 the Council agreed⁵⁵ that, in order to avoid windfall profits, the level of allocation had to be better aligned with the operators’ production volumes. In 2015 the Commission proposed a method for updating the benchmarks, which would allow this dynamic allocation in line with the operator’s production volumes. In doing so, the Commission proposal considered several criteria (e.g. better alignment with production levels, no increase of administrative complexity).

Phase 4 of the EU ETS is expected to provide better information on incentives to decarbonise

49

The EU ETS legislation sets out obligations of installations, verifiers and Member States to reliably calculate free allowances and report emissions data⁵⁶. The Commission can also rely on the EU ETS compliance reviews and the EU ETS compliance forum to ensure that information on emissions is accurate. The current legislation does not provide for the collection of information to assess whether the free allocation of allowances has resulted in greater energy efficiency by installations. The Commission has therefore not yet made such an assessment. The revised EU ETS Directive establishes⁵⁷ that installations receiving free allocation in phase 4 will need to submit data on production activity as part of the National Implementation Measures (NIMs). According to the Commission, this data will enable it to assess the results of free allowances in providing incentives for industrial sectors to decarbonise.

Free allocation of allowances favoured air travel over rail travel

50

Free allocation of allowances aims at preventing carbon leakage and avoiding an increase in global GHG emissions from activity shifting from the EU towards third countries. Within the EU, we noted that free allocation of allowances can support carbon-intensive air travel, to the detriment of rail transport.

51

Aviation operators receive free allowances, and must surrender allowances to cover their emissions originating from flights within the EU (plus Norway, Iceland, and Liechtenstein). At the prices for EU ETS allowances prevailing during phase 3, the additional cost per passenger is limited: between €0.3 to €2 per passenger for most of the flights set out in Table 1. Rail transport is not included in the EU ETS, but electrified rail pays for the EU ETS costs passed through from the power generation sector (and 54 % of the EU rail network was electrified by 2016⁵⁸).

52

The International Energy Agency reported in 2019 that rail is one of the most efficient and lowest emitting modes of transport⁵⁹. Most intra-EU flights cover a distance of less than 1 000 km⁶⁰, for many of which trains could be a less carbon-intensive alternative wherever rail infrastructure already exists (see Table 1). However, emissions from rail infrastructure construction also need to be taken into account when assessing rail transport’s potential contribution to decarbonisation⁶¹.

53

To address global aviation GHG emissions, the International Civil Aviation Organisation (ICAO) has devised the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), which will require aviation operators worldwide to offset their emissions through reductions in other sectors (see Box 4). Offsetting entails investment in emissions reductions in other sectors, rather than in the aviation sector itself.

Conclusions and recommendations

54

This audit concentrated on the role of free allocation of allowances within the EU ETS. Our main audit question was “Did decisions on free Emissions Trading System allowances provide a reasonable basis to encourage the reduction of greenhouse gas emissions?” We found that, despite good reasons for their use, better targeting of free allocation would have had multiple benefits for decarbonisation, public finances and the operation of the single market.

55

The Directive describes free allowances as a transitional method of allocating allowances in contrast to the default method (auctioning). However, for both phase 3 and 4 of the EU ETS, they continue to represent more than 40 % of the total number of available allowances.

56

Free allocation was provided to eight Member States where per capita GDP was below 60 % of the EU average, to support modernisation of their electricity production sectors. We note that the legislative authorities improved the rules for free allocation of allowances to better promote real investment in the power sector (see paragraphs 22 to 24) for phase 4 of the EU ETS. We find that, collectively, the power sectors of the Member States providing these free allowances made significantly slower progress in decarbonisation. Investments made focused on improving power generation through coal (see paragraphs 25 to 27).

57

We found that the number of free allowances allocated to the industry and aviation sectors in phase 3 was not based on their ability to pass through costs (see paragraphs 29 to 31) and that, while carbon leakage has the potential to affect EU carbon markets, and thus the evolution of the greenhouse gas emissions worldwide, there is limited targeting of the free allocation of allowances (see paragraphs 32 to 38).

Recommendation 1 – Better targeting the allocation of free allowances

The Commission should use the review of the operation of the Directive (required under Article 30) to re-examine the role of free allowances, and in particular, to assess the scope to apply a consistent approach to their allocation, targeting sectors based on their exposure to risks of carbon leakage, for example by classifying the sectors currently receiving free allowances as highly exposed, moderately exposed, or lightly exposed.

Timeframe: 2021.

58

We found that the approach to allocate free allowances on the basis of benchmarks provided significant incentives for improvement of energy efficiency (see paragraphs 42 to 44) but that there is scope to improve the application of these benchmarks (see paragraphs 45 to 48). At the same time, we found that the Commission has not yet quantified the impact of the free allowances on efficiency gains, but plans to do so (see paragraph 49) and that free allowances have tended to favour air travel over rail travel (see paragraphs 50 to 53), potentially contributing to an increase in total emissions.

Recommendation 2 – Improving the methodology for benchmarks

Taking into account the EU’s obligations under the Paris agreement, and the aspirations of its proposed “Green Deal”, the Commission should revise the methodology for allocating free allowances to better address technical challenges such as those identified in this report, for example:

1. to improve price signals at all stages of production and consumption,
2. to distinguish between RED II compliant and non-compliant sources of biomass.

Timeframe: 2022.

This Report was adopted by Chamber I, headed by Mr Samo Jereb, Member of the Court of Auditors, in Luxembourg at its meeting of 8 July 2020.

Annex

Annex I – Overview of the EU ETS legal framework for phase 4

Terms and abbreviations

Allowance: Under the European Union Emissions Trading System (EU ETS), one European Union Allowance (EUA) corresponds to the right to emit 1 tonne of carbon dioxide equivalent during a specific period (CO₂e). European Union Allowances can be used by operators within the EU ETS to cover their verified emissions or can be traded with other operators.

Benchmark: Reference value in tCO₂, set at the average emission level of the 10 % most efficient installations within each sector. In this way, installations that are highly efficient should receive all or almost all of the allowances they need to comply with EU ETS obligations.

Biomass: Plant or animal material used for energy production, such as wood, wood residues, and waste from food crops.

Cap-and-trade: The EU ETS is considered to be a ‘cap-and-trade’ system. This means that there is a ‘cap’, or limit, on the total amount of allowed emissions by the installations covered in the system. Operators under the system may receive allowances for free or have to buy them in auctions. Voluntary traders may also enter the market to buy and sell allowances. The limit on the total number of available emissions allowances ensures that they have a value.

Carbon border adjustment: A fee imposed on products originating from a country or jurisdiction without a climate change policy that provides a carbon price.

Carbon intensity: Measure/level of how much CO₂ emissions are produced in the course of specific economic activity, or an industrial production.

Carbon leakage: Increase in greenhouse gases emitted when businesses transfer production from a jurisdiction with a strict climate policy to other countries with laxer emission constraints.

Climate change: Changes in the Earth’s climate system that result in new weather patterns that remain in place for an extended period. Scientific research points that the current process of climate change is being caused by anthropogenic (manmade) emissions of greenhouse gases.

Climate change mitigation: Policies and actions aimed at reducing emissions of greenhouse gases and thus slow down or stop climate change.

CO₂: Carbon dioxide

CO₂e: Carbon dioxide equivalent. Accounting unit used to consolidate emissions of different kinds of greenhouse gases. Emissions are adjusted based on a Global Warming Potential (GWP) calculated according to their contribution to global warming relative to carbon dioxide, and expressed in CO₂e. For instance, methane (CH₄) has a GWP of 25 over 100 years, meaning that 1 tonne of emitted CH₄ (methane) is expressed as 25 tonnes of CO₂e.

CORSIA: Carbon Offsetting and Reduction Scheme for International Aviation, a system developed by the International Civil Aviation Organization (ICAO) aimed at mitigating the impact of global civil aviation on climate change.

Cost pass-through: An increase in the price a customer pays for the products because of an increase in a company’s costs.

Cross sectoral correction factor (CSCF): Factor to ensure total allocation remains below the maximum amount pursuant to Article 10a(5) of the Directive 2003/87/EC (EU ETS Directive).

Decarbonisation: The process of reducing the emissions of greenhouse gas emissions resulting from an economic activity or from the overall economy.

Effort Sharing Decision (ESD): Establishes annual greenhouse gas emission targets for Member States for the period 2013-2020, expressed as percentage changes from 2005 levels. These targets concern emissions from most sectors not included in the EU Emissions Trading System (EU ETS), such as transport, buildings, agriculture and waste. Emissions from land use, land use change and forestry (LULUCF) and international shipping are not included.

Emissions intensity: A ratio of GHG emissions per unit of a product.

Emissions trading: A market-based approach to controlling pollution. It is based on the creation of emissions rights (allowances) that can be traded among operators covered by the system. It can also make use of offsets, i.e. certificates of emissions reductions obtained elsewhere.

Emissions cap: The overall amount of emissions permitted under a cap-and-trade system.

EU ETS: European Union Emissions Trading System

European Green Deal: Package of measures, presented by the European Commission, aimed at enabling Europe to become the world’s first climate-neutral continent by 2050. It involves investing in innovation and research, redesigning economy, updating industrial policy and decarbonising energy-intensive industries.

Fall-back approach: The use of an alternative benchmark for the allocation of emissions allowances under the EU ETS. Rather than based on specific products, these fall-back benchmarks are based on heat or fuel consumption.

Greenhouse gases (GHG): Gases acting as a blanket in the Earth’s atmosphere, trapping heat and warming the Earth’s surface through what is known as the ‘greenhouse effect’. The main greenhouse gases are carbon dioxide (CO₂), methane (CH₄), nitrous oxide (N₂O) and fluorinated gases (HFCs, PFCs, SF₆ and NF₃).

Market stability reserve (MSR): A rule-based mechanism that allows the supply of allowances to respond to changes in demand, maintaining the balance in the EU ETS carbon market. The MSR adjusts the number of allowances available at auctions in response to changes in supply and demand.

Mitigation policies and measures: Policies and measures to reduce emissions and thus mitigate climate change.

Offsets: Carbon offsets are reduction of emission of greenhouse gases performed to compensate for greenhouse gases emitted elsewhere.

Operators (in the EU ETS): Installations and business in sectors covered by the EU ETS.

Polluter pays principle: An environmental law principle that states that those who produce pollution should bear the cost of managing it. In the EU, it is laid down in article 191 of the Treaty on the Functioning of the European Union (TFEU), which states that the cost of preventing, reducing or repairing environmental impairment should be borne by the polluter.

Third countries: Countries that are not Member-States of the European Union.

Tonne-kilometre: A unit of measure used to calculate emission from aircraft operators covered by the EU ETS. It represents one tonne transported by an airplane over a distance of one kilometre.

Trade intensity: A measure of intensity of trade between the EU and third countries. It corresponds to the ratio between total of value of exports to third countries plus the value of imports from third countries and the total market size for the European Economic Area (annual turnover plus total imports).

Verifiers (in the EU ETS): Third-party verifiers verify the EU ETS operators’ GHG emissions reports, as well as the tonne-kilometre reports by aviation operators covered by the EU ETS.

Windfall profit: additional revenue earned by operators subject to the EU ETS when the CO₂ cost passed through to consumers exceeds the level of compliance costs incurred by the operator under the EU ETS.

Audit team

The ECA’s special reports set out the results of its audits of EU policies and programmes, or of management-related topics from specific budgetary areas. The ECA selects and designs these audit tasks to be of maximum impact by considering the risks to performance or compliance, the level of income or spending involved, forthcoming developments and political and public interest.

This performance audit was carried out by Audit Chamber I, headed by ECA Member Samo Jereb. The audit was led by ECA Member Samo Jereb, supported by Kathrine Henderson, Head of Private Office and Jerneja Vrabič, Private Office Attaché; Colm Friel, Principal Manager; Maria Eulàlia Reverté i Casas, Head of Task; Ernesto Roessing, Deputy Head of Task; Kurt Bungartz and Oana Cristina Dumitrescu, Auditors. Lars Markström, Marek Říha and Anna Zalega provided linguistic support; Marika Meisenzahl, graphical support and Terje Teppan‑Niesen administrative support.

As a consequence of the COVID-19 pandemic and the strict confinement conditions, no picture of the audit team could be provided.

Endnotes

¹ COM(2020) 80 final – Proposal for a Regulation of the European Parliament and of the Council establishing the framework for achieving climate neutrality and amending Regulation (EU) 2018/1999 (European Climate Law).

² COM(2019) 640 final – Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions – The European Green Deal.

³ EEA, Trends and Projections in Europe 2019: Tracking progress towards Europe’s climate and energy targets, 2019, p. 7.

⁴ UNEP, Emissions Gap Report 2019, 2019, p. 5.

⁵ Idem, p. XVI.

⁶ COM(2018) 773 final – “A clean planet for all: a European strategic long-term vision for a prosperous, modern, competitive and climate neutral economy”.

⁷ Governed by Decision No 406/2009/EC of the European Parliament and of the Council of 23 April 2009 on the effort of Member States to reduce their greenhouse gas emissions to meet the Community’s greenhouse gas emission reduction commitments up to 2020, and by Regulation (EU) 2018/842 on binding annual greenhouse gas emission reductions by Member States from 2021 to 2030 contributing to climate action to meet commitments under the Paris Agreement and amending Regulation (EU) No 525/2013.

⁸ Categories of activities as defined by Annex I of Directive 2003/87/EC.

⁹ Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union.

¹⁰ SWD(2015) 135 final – Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

¹¹ Article 10a(1) of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union.

¹² Report from the Commission to the European Parliament and the Council on the functioning of the European carbon market, January 2020.

¹³ See, for example, “Post-2020 reform of the EU Emissions Trading System, European Parliament Research Service 2018; “Last Chance Saloon for the EU ETS”, Sandbag, 2016; or “The EU ETS phase IV reform; implications for system functioning and for the carbon price signal”, Oxford University for energy studies, 2018.

¹⁴ EU ETS Handbook, p. 42.

¹⁵ See Sandbag Carbon Price Viewer.

¹⁶ See “Report of the High-Level Commission on Carbon Prices”, by the carbon pricing leadership coalition, 2017, which identified prices of up to $80 by 2020, and $100 by 2030.

¹⁷ Report from the Commission to the European Parliament and the Council on the functioning of the European Carbon market, COM(2019) 557 final of 31.10.2019.

¹⁸ Article 30 of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union.

¹⁹ Article 28b of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union.

²⁰ Commission proposal for a regulation: European Climate Law.

²¹ Article 10c of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union.

²² Set out in: Directive 2003/87/EC, Article 10c; Communication from the Commission “Guidance document on the optional application of Article 10c of Directive 2003/87/EC” (2011/C 99/03) and Commission Decision of 29 March 2011, C(2011)1983 final.

²³ EUCO 169/14 – European Council (23 and 24 October 2014) – Conclusions.

²⁴ Environment Agency Austria (Umweltbundesamt). Evaluation of the EU ETS Directive: Carried out within the project “Support for the Review of the EU Emissions Trading System”. European Commission, 2015.

²⁵ Sandbag. The Great Coal Collapse of 2019 – Mid-year analysis of the EU power sector.

²⁶ Articles 10a, 10b and 10c of Directive 2003/87/EC of the European Parliament and of the Council 13 October 2003, establishing a system for greenhouse gas emission allowance trading within the Union and amending Council Directive 96/61/EC. See also https://ec.europa.eu/clima/policies/ets/allowances_en.

²⁷ (SEC)2006 1684 – Commission Staff Working Document Accompanying document to the Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to include aviation activities in the scheme for greenhouse gas emission allowance trading within the Community - Impact Assessment of the inclusion of aviation activities in the scheme for greenhouse gas emission allowance trading within the Community {COM(2006) 818 final} {SEC(2006) 1685}.

²⁸ P. 199, Table 32, of SWD(2015) 135 final – Commission Staff Working Document Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

²⁹ Ex-post investigation of cost pass-through in the EU ETS. CE Delft and Oeko-Institut. November 2015.

³⁰ Memo/08/35 – Questions and Answers on the Commission’s proposal to revise the EU Emissions Trading System.

³¹ Pp. 83-90 of SWD(2014) 15 final – Commission Staff Working Document – Impact Assessment Accompanying the document “Communication of the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions – A policy framework for climate and energy in the period from 2020 up to 2030.

³² EUCO 169/14 – European Council (23 and 24 October 2014) – Conclusions.

³³ COM(2015) 337 final – Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

³⁴ Article 1(14)(e) of Directive (EU) 2018/410 of the European Parliament and of the Council of 14 March 2018 amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments, and Decision (EU) 2015/1814.

³⁵ Page 4 of SWD(2019) 22 final, Commission Staff Working Document – Impact Assessment Accompanying the document “Commission Delegated Decision supplementing Directive 2003/87/EC of the European Parliament and of the Council concerning the determination of sectors and subsectors deemed at risk of carbon leakage for the period 2021 to 2030”.

³⁶ Bolscher, Hans; Graichen, Verena; Hay, Graham; Healy, Sean; Lenstra, Jip; Meindert, Lars; Regeczi, David; Von Schickfus, Marie-Theres; Schumacher, Katja; Timmons-Smakman, Floor. Carbon Leakage Evidence Project: Factsheet for selected sectors. Ecorys. Rotterdam, p. 11. September 2013.

³⁷ Montenegro, Roland; Fahl, Ulrich; Zabel, Claudia; Lekavičius, Vidas; Bobinaité, Viktorija; Brajković, Jurica. D3.2 - Case study on carbon leakage and competitiveness. REEEM Project 2018.

³⁸ More information on California and Québec available, respectively, at: https://ww3.arb.ca.gov/cc/capandtrade/allowanceallocation/allowanceallocation.htm; http://www.environnement.gouv.qc.ca/changements/carbone/mecanismes-proteger.htm.

³⁹ Pp. 193-202 of SWD(2015) 135 final – Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

⁴⁰ COM(2015) 337 final – Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

⁴¹ The joint impact of the European Union Emissions Trading System on carbon emissions and economic performance. ECO/WKP(2018)63; Economics department working papers No. 1515. By Antoine Dechezleprêtre, Daniel Nachtigall and Frank Venmans.

⁴² Section 5.6.3 of SEC(2008) 52 – Commission Staff Working Document Accompanying document to the Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to improve and extend the EU greenhouse gas emission allowance trading system – Impact Assessment.

⁴³ COM(2010) 265 final – Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions - Analysis of options to move beyond 20 % greenhouse gas emission reductions and assessing the risk of carbon leakage.

⁴⁴ Section 5.5 of SWD(2014) 15 final – Commission Staff Working Document – Impact Assessment accompanying the document “Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions ‘A policy framework for climate and energy in the period from 2020 up to 2030’”.

⁴⁵ Claeys, Grégory; Tagliapietra, Simone; Zachmann, Georg; How to make the European Green Deal work. Policy Contribution. n. 13. November 2019. Bruegel, Brussels, p. 6.

⁴⁶ P. 139 of SWD(2015) 135 final – Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

⁴⁷ Recital 24 of Directive 2018/410 of the European Parliament and of the Council of 14 March 2018.

⁴⁸ Section 2.1.1 of COM(2019) 640 final – Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions – The European Green Deal.

⁴⁹ Article 10a(1), second paragraph of Directive 2003/87/EC of the European Parliament and of the Council 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union and amending Council Directive 96/61/EC.

⁵⁰ EU ETS Handbook, p. 41.

⁵¹ See e.g. Position paper on benchmarking and allocation rules in phase III of the EU Emissions Trading System, CAN Europe, February 2010.

⁵² Zipperer, V., Sato, M., and Neuhoff, K. (2017) Benchmarks for emissions trading – general principles for emissions scope. GRI working paper.

⁵³ As laid down in Article 29(2) to (7) of Directive (EU) 2018/2001 of the European Parliament and of the Council of 11 December 2018 on the promotion of the use of energy from renewable sources.

⁵⁴ SWD(2015) 135 final – Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments.

⁵⁵ EUCO 169/14 – European Council (23 and 24 October 2014) – Conclusions.

⁵⁶ Commission Regulation (EU) No 601/2012 of 21 June 2012 on the monitoring and reporting of greenhouse gas emissions pursuant to Directive 2003/87/EC of the European Parliament and of the Council.

⁵⁷ Article 11 of Directive 2003/87/EC of the European Parliament and of the Council 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union and amending Council Directive 96/61/EC.

⁵⁸ Page 2 of COM(2019) 51 final, Report from the Commission to the European Parliament and the Council – Sixth report on monitoring development of the rail market.

⁵⁹ IEA (2019), “The Future of Rail”, IEA, Paris.

⁶⁰ Alonso, G.; Benito, A.; Lonza, L.; Kousoulidou, M. Investigations on the distribution of air transport traffic and CO₂ emissions within the European Union. Journal of Air Transport Management. v. 36, pp. 85-93, April 2014, p. 92.

⁶¹ Timperley, Jocelyn. Eight charts show how ‘aggressive’ railway expansion could cut emissions. Carbon Brief, 2019.

⁶² ICAO Assembly Resolution A40-19.

⁶³ Van Zon, N., Analysis of the technical feasibility of sustainable liquid hydrogen powered commercial aircraft in 2040, 2018, TU Delft, p. 1. See also Browne, M. W., “Clean Hydrogen Beckons Aviation Engineers”, The New York Times, 24 May 1988.

⁶⁴ Directive (EU) 2018/410 of the European Parliament and of the Council of 14 March 2018 amending Directive 2003/87/EC to enhance cost-effective emission reductions and low-carbon investments, and Decision (EU) 2015/1814, OJ L 76, 19.03.2018, p.3

⁶⁵ COM(2019) 640 final – Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions – The European Green Deal.

Timeline

Event	Date
Adoption of Audit Planning Memorandum (APM) / Start of audit	15.5.2019
Official sending of draft report to Commission (or other auditee)	7.5.2020
Adoption of the final report after the adversarial procedure	8.7.2020
Commission’s (or other auditee’s) official replies received in all languages	29.7.2020

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Luxembourg: Publications Office of the European Union, 2020

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