Carbon pricing in Europe began in 2005 with the start of the EU Emissions Trading System (EU ETS). This legally binding carbon market made it mandatory for emissions-intensive industries to surrender carbon allowances each year to match their verified output of CO2 – effectively making the polluter pay for their greenhouse gas emissions.
After a somewhat shaky start, EU regulators have since expanded the system to include new sectors and bolstered its design with innovative mechanisms to prevent carbon prices from collapsing in future.
But soon, new policies that interlink with the EU ETS will encourage other countries to adopt similar carbon pricing mechanisms, or face a loss of demand in Europe for their emissions-intensive exports. What we are likely to see is a ‘ripple effect’ as the EU’s Carbon Border Adjustment Mechanism (CBAM) pushes carbon prices from Europe outwards to the bloc’s major trading partners.
Let’s examine how carbon pricing in the EU has evolved over time. Understanding the policies can help analyse what might be around the corner for other countries affected by the EU’s environmental regulations.
Phase 1 of the EU ETS ran from 2005 to 2007. The system was untested at this scale and relied upon voluntarily-submitted CO2 data on which to build the annual ‘caps’ on CO2 emissions, which determined the supply of allowances. This caused the system to be oversupplied, and this was further compounded by rules preventing any carry over of allowances into the second phase. The result was a collapse in the carbon price to almost zero.
Phase 2 ran from 2008-2012. This new era got off to a good start, with the annual caps now linked to better quality, independently-verified CO2 data, and more robust prices (around Eur5 to Eur30 per tonne). However, the global financial crisis of 2008 caused a supply/demand imbalance that once again pushed carbon prices far below the levels initially envisaged.
Phase 3 ran from 2013-2020: The historical oversupply continued to keep carbon prices in the doldrums – under Eur10/tonne for much of the period 2013 to 2017. Efforts to manage the supply through ‘backloading’ of allowances (holding supply back until later) had some effect, but only really managed to avoid another price collapse, rather than triggering a paradigm shift into new highs. By 2015-2017, EU regulators had been working on a flexible supply control mechanism called the Market Stability Reserve (MSR), which would limit future supply of allowances entering the market, based on the size of the surplus seen in the previous year. The MSR would work on a rolling basis, making the supply of allowances more responsive to real-world demand in an automatic and transparent way that was free of arbitrary interventions by the regulator. The MSR was highly effective, helping to drive carbon prices as high as Eur28/tonne by 2019.
Phase 4 began in 2021 and will run until 2030. The combined effects of the MSR and a steeper decline in the annual supply of new allowances had driven carbon prices to a range of roughly Eur50 to Eur100/tonne, finally sending a powerful price signal for decarbonisation, both in the short-term as a decider for fuel switching decisions in the power sector and as a longer-term signal for investment in low-carbon fuels, processes and technologies.
But the story doesn’t end there. After finally getting to grips with the policy design needed to deliver a strong carbon price signal, EU regulators had a further hurdle to clear: how to equalise carbon prices inside and outside of the EU in order to avoid competitive disadvantages for EU-based companies. Enter the Carbon Border Adjustment Mechanism (CBAM).
From the outset, EU regulators needed to shield emissions-intensive industries from the full cost of carbon, in cases where they were exposed to competition from outside EU borders. This stood in contrast to the electricity and heat sectors which were not exposed to outside competition. To do this, companies in sectors such as iron and steel, chemicals and refining, were given free carbon allowances. However, free allowances reduced the financial incentive to decarbonise. For these sectors to play a fair share in the decarbonisation agenda, free allowances needed to be phased out.
This created a conundrum for EU regulators: how to remove free allowances without harming EU-based heavy industries. The EU’s CBAM is designed to do just that. By imposing a charge on the carbon content of CO2-intensive imports, carbon prices could be equalised within and outside of Europe. In the initial years, the CBAM will apply to imports of iron and steel, aluminium, cement, electricity, hydrogen and fertilisers.
The CBAM would make EU-based importers have to pay for the carbon emissions created during the production of imported goods. This potentially does several things:
1. It creates an incentive for EU-based importers to buy their goods from within the EU, instead of elsewhere, to avoid paying the CBAM charge
2. It creates an incentive for non-EU-based exporters to use lower-carbon processes in the production of their goods, to reduce the impact of CBAM charges when these products enter the EU. In some cases, this can be achieved by countries implementing their own carbon pricing policies, so that their exported goods will be exempt from the CBAM charge, and to retain carbon revenues ‘internally’, instead of sending them to the EU
In this way, the EU’s CBAM is already triggering an outwardly-expanding ripple effect around the world as countries begin to impose their own carbon pricing regimes in order to decarbonise their economies while maintaining the competitiveness of their industrial exports. Brazil and Turkey are examples of countries where new national carbon markets are being launched, both as a response to the Paris goals and to deal with the EU’s CBAM.
The second and final year of the CBAM’s transitional period will come to an end in December 2025, ushering in the full implementation phase in January 2026, at which point the CBAM charge will be payable on relevant imports into the EU.
The CBAM will be implemented using a phased-in approach, as the EU gradually withdraws the free allocation of allowances to industrial sectors under the EU ETS.
Companies importing goods made outside Europe for which the embedded carbon has already been paid will have a partial or full exemption from paying the CBAM charge. This stands as a clear incentive for other countries to implement domestic carbon pricing systems, as they will be under pressure to maintain the competitiveness of their own industries.
Countries planning or considering domestic carbon pricing systems include Argentina, Brazil, Chile, Colombia, India, Turkey and Vietnam. These potentially add to the growing tally of countries already operating carbon markets such as the EU, UK, China, US (at the state level), Canada, New Zealand, South Korea, and Mexico.
Many of these countries are planning or implementing carbon markets for their own reasons, but the CBAM will certainly create an additional reason for other nations to introduce carbon pricing systems of their own.
The combination of the EU Emissions Trading System and the EU’s CBAM is therefore a powerful driver that will push carbon pricing far beyond the EU’s borders. Watch this space as more countries utilise carbon markets as a way to drive industrial innovation, promote jobs in low-carbon sectors, reduce greenhouse gas emissions and local air pollutants and meet their national climate targets under the Paris Agreement.
To find out more about the EU’s CBAM, see this article: What is a Carbon Border Adjustment Mechanism? – Carbonwise. And to learn more about how compliance carbon markets work, check out this article: How Do Compliance Carbon Markets Work? – Carbonwise
