What role does carbon pricing play in the German and European energy transition?

The European Union Emissions Trading System (EU ETS) contributes to the decarbonisation of the power and industry sectors by putting a meaningful price on carbon emissions

The EU ETS started in 2005 to regulate carbon and other greenhouse gas emissions. The system covers the emissions of approximately 11 000 installations in the power, refining and energy-intensive industrial sectors (e.g., steel, cement, aluminium, basic organic chemicals production). Since 2012, the EU ETS also includes intra-EU aviation. Furthermore, the European Commission has proposed to expand it to cover emissions from shipping – within, and to and from, the European Union.

Installations in these sectors are subject to a declining cap on their cumulative emissions. The cap is enforced by requiring companies to surrender CO2 allowances equalling their total verified emissions at the end of each calendar year. The number of allowances that installations receive decreases each year in line with the European Union’s emissions reduction targets. Since there are not enough allowances to cover the “desired” level of emissions for all installations, and since allowances are tradeable between installations, the “carbon market” determines the allowance price.

Currently, the cap decreases by 2.2% points per year in line with a reduction target of -43% by 2030 relative to 2010 levels. However, the EU ETS is currently being revised as part of the European Commission’s European Green Deal initiative. The European Commission has proposed that starting in 2024, the cap should decline by -4.2 percentage points per annum, to meet an increased reduction target of -64% relative to 2010 levels. Because of the reforms, the European Union carbon price has risen significantly in recent years. After hovering around 5–10 EUR/tCO2 between 2012 and 2018, the price now ranges between 60–100 EUR/tCO2.

A high enough carbon price incentivises a transition away from fossil fuels in the industry and power sectors. It is therefore important to ensure a smooth functioning of the EU ETS, one of Europe’s main climate tools, even in the current energy crisis.

The European Union’s Carbon Border Adjustment Mechanism (CBAM): a tool to avoid “carbon leakage” for specific products

One of the challenges facing industrial companies in Germany and Europe that are regulated by the EU ETS is that the European Union is one of the very few places to price carbon in these sectors. Since these sectors produce basic commodities such as steel, fertilizers, and aluminium that compete on international markets, if the price of carbon in the EU ETS is too high compared to the price faced by major trading partners, European companies may lose market share and eventually need to cease operations. But this would only shift the location of carbon emissions, not reduce them globally. This risk is referred to as “carbon leakage”.

During the past 17 years of the EU ETS, carbon leakage risks have been dealt with by exempting energy-intensive, trade-exposed installations from the obligation to buy their allowances at auction or on the carbon market. Instead, they were mostly granted free emissions allowances via a derogation. However, this system is starting to reach its limits. By the late 2020s, there will no longer be enough allowances left to cover all of the industry’s requirements. Moreover, free allowances are widely believed by economists and other experts to weaken the carbon price signal and slow down progress towards a climate-neutral industrial sector. For this reason, the European Union has proposed a new system to allow countries to phase down the level of free allocations to specific energy-intensive industrial sectors – namely, steel, aluminum, cement, and fertilizers – between 2026 and 2035. The new system also includes the gradual introduction of a carbon border adjustment mechanism (CBAM).

The CBAM will allow the European Union to gradually cease free allocations and auction of CO2 allowances for energy-intensive sectors. In effect, the CBAM will in effect charge the same EU ETS carbon price to the importers of these goods into the European Union. Importers of CBAM products into, say, Germany, will need to report the emissions that were created when the product was made in the country of origin and the importer will need to buy and surrender allowances under the EU ETS like any other European industrial installation.

Some countries have expressed concern that the CBAM is a “protectionist” measure. However, the CBAM will cover only a very small share of global trade into the European Union (estimated at around 3-4% of all goods) and will treat these goods entering the European Union exactly the same way as goods produced in the European Union – i.e., they will have to pay for their emissions. The system will be phased in very slowly – 10% per year over the 2026–2035 period – to allow time for adjustment and the reduction of emissions in imported goods so that they can avoid paying the CBAM charge if they are truly emissions-free. Rebates will also be given for carbon prices paid in the country of origin to ensure fairness and WTO compatibility.

A national ‘cap and trade’ system has been introduced to cover the German building and transport sectors

The German CO2 pricing system in the transport and building sectors is designed as a ‘cap and trade’ system. It exists in parallel to the European-wide ETS and covers the bulk of the greenhouse gas emissions not included in the EU ETS. In this national system, the federal government sets an annual total emissions limit for transport and heating fuels in line with its total budget.

Participants are not the emitters themselves, but companies that put fuels into circulation or suppliers of the fuels (upstream approach). To avoid a double burden from the national system and the ETS, fuel deliveries to ETS facilities are exempt from the national price. The government also introduced a carbon leakage regulation to accompany the CO2 price legislation and to ensure compensation for certain companies facing international competition. Compensation under the regulation is tied to climate action investments by the companies.

Emission allowances are transferable and can be traded. They will generally be auctioned. However, during an initial phase (2021–2025), there will be a fixed price at which they are simply sold to companies. Should the emissions budget not suffice and targets in non-ETS sectors be missed during the fixed price/price corridor phase, Germany will use the flexibility of the European Union effort sharing scheme – this could include buying emission allocations from other member states. Based on projections, the government expects the CO2 price to save 3.1 million tons of CO₂ in 2025, 7.7 t in 2030, and 12.4 t in 2035. It also expects the new system to generate revenues of 40 billion euros in 2021–2024 (the budget planning period).