The EU-ETS System and its Reform

EU-ETS: the effects on the paper world

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In the light of the EU-ETS reform in December 2022, what are the compliance costs, i.e. adjustment costs, for the Italian paper industry? A study takes stock of the situation, considering a scenario in which activity levels and emission intensity are constant. Here is what it comes up with.

Decarbonisation is among the primary objectives that the European Union has set itself for the coming years.Very challenging goals for the industrial world, which are already having a major impact on technological improvement, from the point of view of innovation in both machinery and production processes. To understand how all this impacts the Italian paper industry, it is necessary to understand how the ETS is changing. Last May, in Isola del Liri (FR), on the occasion of the Aticelca 2023 Congress, Massimiano Capobianchi, head of EU-ETS sales Italy at Vertis Environmental Finance, described the effects of the EU-ETS reform on the paper industry, presenting a study developed together with his colleagues Stefan Feuchtinger, head of market R&A, and Riham Wahba, senior market analyst, at Vertis.

Decarbonisation target

This latest ETS reform, says Capobianchi, dates back to December 2022, but has actually been under discussion since mid-2021. “It has taken many forms, there have been different proposals, but basically the intentions of the EU policy makers were always evident to give themselves much more challenging goals, through a more decisive reduction of the CAP – i.e. the overall EUA (European Emission Allowance), which is the title that corresponds to an emission quota, equal to 1 tonne of CO2 equivalent – and possibly to encourage decarbonisation.

The intention, he explains, was to align the continental CO2 trading system – the EU-ETS – with the decarbonisation goals of the ‘Fit-for-55’ plan. The reform thus became the instrument for introducing the necessary changes aimed at a vigorous reduction in the number of emission allowances created each year and a gradual cut in the free allocation – the allocation given to those considered to be at risk of carbon leakage, i.e. of carbon leakage to another state.

For those industrial players that will not be able to significantly reduce their emissions in the coming years, the EU-ETS reform foresees an increasing cost of compliance, i.e. to comply with regulations. “This will be due to the dual action of the expected increase in the EUA price and the certain reduction in free allocation, driven by the downward revision of the parameters that the regulations consider in order to translate industrial activity levels into the number of free allowances allocated.”

The reform: what changes

“The mother of all changes,” Capobianchi continues, “is the promotion of the Linear Reduction Factor (LRF) from the current 2.2 per cent to 4.3 per cent for the years 2024-2027 and 4.4 per cent for the years 2028-2030. The LRF is the parameter that expresses the percentage reduction on a linear basis from the baseline of the year 2010, and raising it is not trivial. “Before this reform, so up to the end of last year, the CAP – which, as mentioned above, is the number of EUAs that the legislator creates each year and places on the market through primary auctions and free allocation -, i.e. the amount towards the emissions allowed in the European context, was declining by 2.2% each year compared to a 2010 baseline, i.e. compared to a fixed amount that was 43-44 million tonnes per year. The reform that has finally come to fruition changes the rules and, now, the CAP will evolve.

The consequence of this, seemingly harmless given that we are moving from 2.2 to 4.4 per cent, is that we would remove 86 million EUAs from the CAP each year. Not only that, the policymaker also introduces two cuts of 90 million allowances in 2024 and another 27 million in 2026. Combine all these and you find that while today the CAP put on total ETS emissions in Europe is about 1.5 billion allowances per year, by 2030 it will be 774 million or exactly half that. This will be a considerable step towards decarbonisation, the analyst points out, but the goal of such decarbonisation, precisely to keep up with such an ambitious policy, will thus become very challenging indeed (Figure 1).

The free allocation of quotas

The EUAs created each year are injected into the system in two ways: for a fee, through primary auctions, and through free allocation. The latter, however, has a constraint, explains Capobianchi, namely that it can only amount to a maximum of 43 per cent of the CAP of the reference year. “In this aspect we can already see an implicit consequence of the CAP reduction: that is, if the CAP at 2030 is half of what it is today, the cap on free allocation (or Industry CAP) at 2030 will also be half of what it is today. So the free allocation will fall not only because the benchmarks will be sharply adjusted, but will also eventually start to fall because of the need for further corrections required to comply with the constraint that the sum of all allocations given to installations within the ETS must be within the Industry CAP, even if this is increased by leftovers from previous years.”

In addition to the increase of the LRF, the other decisive factor in the calculation of compliance costs for the paper industry is the free allocation. Under the new approach of the reform, there will be an increasingly pronounced difference between the ‘best performers’, i.e. those companies with the lowest emission intensity, and the ‘worst performers’, who, on the contrary, have the highest emission intensity. The former will enjoy a few more privileges than in the past, while the latter will have more problems.

It is precisely the performance averages for each individual product or heat or fuel consumption that constitute the benchmarks used in calculating the number of EUAs allocated. The benchmark, the Vertis analyst explains, is the constant of proportionality between the tonnes of product or TeraJoules of energy being used and the free allocation; it is therefore derived from the average of the best emissions performance among the obligated sub-installations that refer to the specific benchmark. “The benchmarks are periodically revised to incorporate the improvement over time – i.e. the reduction – of the emission intensity of the best performers,” continues Capobianchi. “Regarding the mechanism for calculating and allocating the free allocation, the reform establishes an update of the minimum and maximum annual percentage cuts, to be used for the recalculation of the benchmarks for the years 2026-2030.

The maximum curtailment allowed so far by the legislator had been 1.6 per cent’. But with the reform there will be an important change: the previously impossible benchmark adjustment of 1.6 per cent per annum now increases to 2.5 per cent. The last adjustment made in 2021 took 1.6 per cent as the maximum value, which, projected over 15 years – i.e. the time span between 2008, the reference year, and the middle year of the first five-year allocation period (2021-2025) – means a cut in the benchmark of 24 per cent maximum, ‘even in cases where, as in the case of the paper industry, the emission intensity of the best performers has fallen to practically zero in just a few years’.

The move now from 1.6 to 2.5 per cent will have huge consequences, because the change is retroactive, so, the analyst explains, “when the next cut is made in 2026, it will spread over a horizon of the next 20 years a benchmark of up to 2.5 per cent. As a result, the next benchmarks, according to the new policy, will have to be 50 per cent lower than the benchmarks that run until 2020, or even 34.2 per cent lower than the benchmarks that apply today’.

At this point, the worst performers will have to adopt climate neutrality plans if they do not want to lose 20% of their free allocations, while the best performers will have an advantage “if, as we believe will happen, the Cross Sectoral Correction Factor (Cscf) will come back into force towards the end of 2024, i.e. the corrective factor that cuts the allocation to all installations and sub-installations receiving free allowances, with the exception of the best performers – which represent the 10% with the lowest emission intensity of all those adopting the same benchmark. The aim is to keep the amount of free allowances below the regulatory maximum. And the best performers will be exempted’.

The future risk of cuts

As far as the paper industry is concerned, there is another interesting aspect that will influence the application of the new rules. In recent years, explains Vertis’ expert, the total allocations given to companies have always been below the maximum that was set by the policy, and therefore a stockpile of allowances has accumulated. This stockpile of allowances will have a considerable influence because “initially the limit to the overall free allocation will not only be 43% of the Industrial CAP – i.e., the annual free allocation constraint in the system – but it will be this percentage plus the surplus that will continue to rise. This surplus, however, will decrease over the years, Capobianchi warns, as the absolute CAP will decrease over time, thus shrinking the 43% capacity. “According to our model,” he says, “the most likely cause is that between 2028 and 2029 there will be no more legacy accumulation from previous years and the sum of free allocations will regularly exceed 43% of that year’s CAP. Everything will then have to be multiplied by a value of less than 1, which corresponds to the correction factor for all sectors – the Cross Sectoral Correction Factor (Cscf) – needed to reconcile the summation of all free allocations and the CAP set by the policy” (Figure 2).

According to Vertis analysts, this situation will result in the introduction of a correction factor of 0.82, which will have the effect of further depressing free allocations, but will fortunately – they point out – only occur in 2030. This situation will therefore only have to be addressed towards the end of phase 4 (2021-2030), but will only be possible because the surplus quota capacity has been built up over time and can be consumed over the next few years (Figure 3).

“Ultimately, the industry’s overall free allocation depends on three parameters: on activity levels, on benchmarks and on the Cross Sectoral Correction Factor, which, as mentioned above, is always equal to 1, except at 2030 when it will become 0.82, on activity levels that we assume and hope will remain constant between now and 2030.”

Beyond the assumptions and projections that can be made, Vertis’ recommendation to companies in the sector, concludes Capobianchi, is to beware of the risk that one runs “if, faced with the external environment that changes and does so in an increasingly rapid manner, one does not take corrective action”.