A German perspective on the EU Emissions Trading System trilogues

As the EU institutions enter the final phase of the three-way trilogue on the reform of the Emissions Trading System (EU ETS), we present you with this handy analysis from GermanWatch outlining the issues at stake from the German perspective.

Background

As part of its ‘Fit for 55’ climate package, the European Commission proposed a comprehensive reform of the Emissions Trading System (ETS) in July 2021, including expanding the ETS to cover buildings and transportation, This was complemented with the introduction of a proposed Carbon Border Adjustment Mechanism (CBAM). In June 2022, the European Council and the European Parliament voted on their respective positions on the new files. As their positions diverge significantly, the subsequent trilogue negotiations between the three EU institutions have proven to be both tough and decisive.

The revision of the EU ETS revision will have different implications for different member states, which influences their position towards the reform process. This briefing explores the positions of the Parliament, the Council and the Commission from a German perspective.

Germany differs from many other member states in several respects. First, having a large industrial sector geared towards the global market, the economy relies on exports. Exports are often called the “engine” of the economy, with jobs depending on the prosperity of the respective sectors. Principal export goods include machinery and transport equipment, vehicles, electronic equipment and chemical products. Second, Germany has a climate protection law with a 2045 climate neutrality goal, which means the country intends to follow a more rapid decarbonisation path than the EU on average. Moreover, Germany currently has a centre-left governing coalition in which the Green party, among others, holds the Ministry of Economy and Climate. With the Greens holding key ministries, ambitious climate policy, including a rapid coal phase out and development of renewable energies, has become a priority for the government.

Third, Germany already has a carbon price for transport and heating, along with plans on how to use the respective revenues, which started in January 2021 with a fixed price of €25 per tonne of carbon dioxide equivalent. The price is set to rise each year until the fixed price is replaced by a price corridor of €55 to €65 in 2026. The government plans to use the revenues to finance, among other things, a payment to all households known as a climate dividend. Since the very beginning, Germany has been in favour of a European system of pricing emissions from road transport and buildings and the national ETS was designed in view of a future transition to a European system. 

Against this backdrop, key priorities for the German government and many other German stakeholders concerning the ETS reform include the overall ambition of the existing ETS, the transition from free pollution permits to the CBAM, the use of CBAM revenue, and the proposed ETS for buildings and road transportation.

A. Varying ambitions 

With respect to the overall ambition of the reformed EU ETS, the Council of the European Union and the European Commission take a different stance to the European Parliament. While the Council followed the Commission by proposing to shrink the emissions covered by the EU ETS by 61% by 2030, the Parliament demanded a higher 63% reduction. Given the EU’s enormous responsibility to drastically reduce its emissions in order to keep the 1.5°C global warming limit within reach, all of these proposals are insufficient. Given that the ETS is the key instrument for reducing emissions in the energy and industrial sectors, it must set ambitious reduction targets. Since civil society, based on what is required by science, demands a cut of over 70%; agreeing on a reduction of at least 63% should, therefore, be the trilogue’s outcome.

The German government, in particular, should support this higher reduction target. First, in light of its high historic per-capita emissions, Germany has a particularly high responsibility to slash its emissions. Second, given its significant expertise in engineering and the large number of German companies producing technical equipment, Germany is well positioned to benefit commercially from this high climate ambition by, for instance, exporting zero-emission technologies, setting standards, etc. Third, as Germany has a national 2045 climate neutrality goal, the country is required to substantially speed up its national energy and industry transformation and so should also support an EU-wide acceleration. With a coal phase out already planned and substantial economic opportunities related to the modernisation of industry, Germany will likely win if a higher reduction target is agreed.

B. From free allowances to CBAM

Given the importance of its industrial sector, a key priority for Germany is the prevention of alleged carbon leakage, which relates to the fear that polluting activities will relocate to jurisdictions with weaker environmental protections. This requires an effective transition from the allocation of free pollution permits to a full auctioning of emission allowances backed by a functioning CBAM, which would impose a carbon price on polluting imports.

The Commission proposes a reduction of free allowances of 10% each year starting in 2026 and ending in 2035. The Council weakened the Commission proposal by delaying the lion’s share of reduction of free allocation to the 2030s. Starting with a phase out in 2026-2028 with only 5%, 7.5% in 2029 and 2030, 10% in 2031 and 2032, the major reductions are meant to take place only in 2033 and 2034 (15%) and 2035 (20%), which is years after the crucial 2030 cut-off point for the EU’s medium-term climate target. The Parliament, in contrast, envisions a slower start of the phase out of free allowances but steeper reductions in the 2030s (7% in 2027, 9% in 2028, 15% in 2029, 19% in 2030 and 25% in 2031 and 2032 respectively).

The Council position to phase in the CBAM very slowly was strongly influenced by pressure from the German government. As it stands, the CBAM would only cover imports, i.e. level the playing field only for EU companies competing with imports from third countries. In contrast, CBAM would not cover exports, i.e., not level the playing field for EU companies exporting goods and competing with companies from third countries on the global market. Given the importance of exports in Germany, German industry is reluctant to commit to a more ambitious schedule. The government, too, believes there is a risk that companies would not be shielded from competitive disadvantages in the scenario in which free allocation is phased out and the CBAM only covers imports. Against this backdrop, Germany is not willing to agree to a fast phase down of free allocation. 

According to the German government, this problem could only be solved by addressing the exporting sectors, at least to some degree. One approach favoured by Germany is the establishment of an International Climate Club. However, there are many obstacles to the implementation of such an overarching club of many countries which is why this instrument needs more discussions and may, in the short term, not be the silver bullet that minimises the carbon leakage risk in the near future. Alternative approaches such as granting export rebates, can involve other significant disadvantages and risks that could even slow down or derail the green transformation of industry and could be incompatible with WTO rules. For instance, rebates for exports would lower the carbon price effectively faced by European industries and risk creating perverse incentives. Other approaches such as Carbon Contracts for Difference (CCfDs) or a more generous Innovation Fund can be part of the solution but might not be sufficient to convince the German government to change its stance. 

These instruments are vital if free allowances are to be reduced at a higher rate, which is key for several reasons. First, industry within the EU needs the full price signal as an incentive to invest in the required deep transformation. Second, a swift introduction of the CBAM is necessary as an incentive for trading partners to invest in the decarbonisation of their energy and industrial sectors. Third, phasing out free allocation substantially increases revenues for member states, as explored in the next section. As shown in the graph based on Climact’s modelling of the three proposals, there are slight variations in the volume of allowances that Germany would be able to allocate. Overall, for the period of 2021-2030, Germany would receive 1,074.3 million pollution permits under the Commission’s proposal, 1,089.2 million under the Parliament’s proposal, and 1,118.5 million as proposed by the Council. At a price of €80 per tonne and assuming all allowances are sold and none are given away for free, this would mean revenue, between 2021 and 2030, of just under €86 billion under the Commission’s proposal, just over €87 billion under the European Parliament’s proposal, and €89.5 billion under the Council’s proposal.

ETS revenues

The different proposals by Commission, Council and Parliament also have significant implications for the amount of auction revenue and the available finance for both EU and national funds.

The European Commission proposed to expand the Innovation Fund by increasing the share of allowances auctioned to finance the fund. The European Parliament, too, favours an expansion of the fund and envisions the rise of the share of allowances assigned to it. In contrast, the Council proposed to reduce the size of the Innovation Fund because it wishes to divert a portion of the revenue to the Social Climate Fund and to phase out free allowances very slowly. The upcoming decision on the financing of the RePowerEU plan to reduce the EU’s dependence on Russian fossil fuels means the Innovation Fund will likely shrink. This should only be a temporary development as the Innovation Fund is a key instrument to support industrial transformation and should be considerably strengthened rather than weakened.

In any case, the vast majority of auctioning revenues will continue to be at the disposal of member states. Therefore, it is crucial that EU countries are obliged to use 100% of revenues for climate-related purposes.

In Germany, this is already the case: 100% of ETS revenues go to the German Energy and Climate Fund which finances diverse programmes, such as renewable energy, industrial transformation, climate-friendly transport and energy efficient buildings.

Over the 2021-2030 period, Germany is set to have an overall auctioning volume of 943.8 million allowances under both the Commission’s and the Council’s proposals. However, although the overall auctioning volumes are the same in both proposals, we can discern a crucial difference as regards the additional auctioning revenues, based on the respectively proposed reduction of free allocations. In the Council proposal, the amount of additionally auctioned allowances would only be 54 million. In contrast, the Commission’s proposal would yield an additional 98.3 million allowances (source: own calculation based on the Climact model). If we assume a carbon price of €80 per tonne, the difference would amount to over €3.5 billion in additional revenue. Under the European Parliament’s proposal, Germany would have an overall auctioning volume of 783.5 million allowances over that same period. [Graph 6 with overall auctioning volume in Germany, created based on Climact model]

C. CBAM revenues

Another key aspect for Germany is the use of CBAM revenues, which could range from about €5 billion to €14 billion for the entire EU over a decade, depending on the final scope and the design of this instrument. Both the Commission and the Council are in favour of using the eventual revenues for the EU budget. Only the European Parliament proposes that the EU should commit itself to use CBAM revenues to finance so-called least developed countries in their efforts to decarbonise their manufacturing industries.  

In our view, using CBAM revenues to support climate action in poorer trading partner countries is essential. Firstly, this is for reasons of climate justice, as the EU has the responsibility to support poorer countries in terms of climate action. It would be irresponsible not to at least partly compensate for the negative consequences of the EU CBAM on (poor) third countries. Many observers expect that exporters based in less affluent EU trade partner countries may find it difficult to invest in low- or zero-carbon alternatives and may lose opportunities to export to the EU market. Secondly, this would act as a symbol of international cooperation instead of confrontation. Many voices in partner countries criticise the EU for introducing an allegedly protectionist instrument that the EU would use to raise revenue and finance its industrial transition on the back of poorer countries using revenues to support low-income trading partner countries would go a long way to enhancing international acceptance of CBAM, securing more support for the new instrument and possibly preventing a WTO case. Thirdly, the EU, and particularly Germany, will ultimately benefit from an accelerated industrial and energy transition in third countries as new trade opportunities  arise.

A very broad and diverse stakeholder alliance in Germany is supporting a more constructive and climate-just use of revenues, i.e., not using revenues for the EU budget. Social NGOs, environmental NGOs and even industry associations in Germany are in favour of using the revenues to support the decarbonisation of industry. Unfortunately, the German government does not seem to be listening to these voices. As the amount of revenues is not substantial in the grander scheme of things while the symbolic signal to trading partners is huge, Germany and the other member states should make use of this low-hanging fruit and support the Parliament’s position.

D. Expanding the ETS

Amongst the main priorities, if not the main priority, of the German government is the introduction of an ETS for road transportation and buildings (commonly referred to as ETS2). In January 2021, Germany introduced its national carbon pricing system covering emissions from heat and road transportation. The price, having started at €25 per tonne of emissions, is set to rise by a fixed amount each year. The German government aims to expand the carbon price to the whole EU by means of the proposed ETS2, as it considers carbon pricing to be a key instrument and is in favour of as much flexibility as possible.

However, the instrument is highly controversial both amongst member states and in the Parliament. While the Council eventually supported the Commission’s proposal in most respects, the Parliament is demanding major changes. The principal proposed amendments include limiting the scope to commercial emissions and putting in place a price cap of €50 per tonne of emissions. 

Another major issue of contention is the proposed Social Climate Fund (SCF), which is meant to complement the ETS2 with a measure of solidarity towards vulnerable households and countries. The fund would redistribute part of the ETS2 revenues to less affluent member states that normally have less favourable options for investing in zero-carbon alternatives.

Within the EU, Germany is among the principal proponents of an ETS2 and the major driving force behind the introduction of this new instrument. However, at the same time, parts of the governing coalition, especially the Chancellery and the Finance Ministry, are opposed to a comprehensive SCF. Hence, it was after pressure from the German government that the Council proposed to reduce the SCF’s size from €72 billion to €59 billion. The German government continues to be reluctant to agree to more solidarity in the form of redistribution of revenues. Their argument is that Germany cannot afford this solidarity because the country is in need of the (full) carbon pricing revenues itself.

There are many arguments in favour of introducing a second emissions trading system. Pricing carbon is an important incentive to switch from car to train, change your heating system or save energy. However, in the EU, carbon pricing is regressive and energy prices are already high as a result of other factors, such as Russia’s war against Ukraine. The additional carbon price would be a burden for many poor households, especially in the less affluent EU countries where the state can provide less favourable conditions for switching from high-carbon to low-carbon solutions. Therefore, a well-financed, comprehensive and targeted SCF is indispensable, not only to prevent social hardship but also to foster acceptance of ambitious climate measures in the eastern and southern member states. Germany should concede to more solidarity, in order to both ensure social cohesion within the EU and secure support for an effective ETS2 from the Parliament. 

Recommendations for the German government

1. Higher ambition

Germany should support the European Parliament’s more ambitious 2030 target of reducing emissions associated with the ETS by at least 63%. This requires an accelerated reduction of the ETS’s cap on emissions. The Market Stability Reserve (MSR), in which surplus allowances are stored, should also be strengthened to prevent the market from becoming overly liquid.

2. Phasing out freebies

Germany should support a rapid transition from free allocation to a full auctioning backed by a functioning CBAM. In concrete terms, this involves an annual reduction of 10% of free allocations in the 2020s, accompanied by the corresponding phase in of CBAM, and very high reduction rates from thereon to eliminate free allocations by 2032. This would incentivise a rapid industrial transformation and generate revenues for targeted investments in Germany’s industries, both through the country’s own revenues and through the Innovation Fund. In addition, the German government should support the European Parliament’s position of pledging at least the amount of the CBAM revenues to support so-called least developed countries in their decarbonisation efforts. 

3. ETS2 and Social Climate Fund

The ETS2 should, to be effective, apply both to private and commercial emissions and commence in 2026. An increasing price cap for the first years, or, ideally, a price corridor, would protect households from price hikes. In order to secure support from the Parliament and enhance social acceptability, the German government should urgently give up its blocking position on the Social Climate Fund. The government should support a comprehensive SCF that reflects cross-border and cross-class solidarity. In concrete terms, this means that payments from the fund should already start in 2024. The size of the Social Climate Fund should increase with the ETS2 price, which can be ensured by pledging at least 25% of the ETS2 revenues to the SCF. Furthermore, the SCF should be co-financed both through a contribution by each member state and through auctioning revenues from the existing ETS.