Whether ETS-2 will be effective in achieving the CO2 targets remains to be seen

To help achieve the EU’s 55% target for 2030 and 0 in 2050, the EU has determined that the EU Emissions Trading System for industry, energy, air and maritime shipping (ETS-1) will get a little brother as of 2027: ETS-2. This includes CO2 emissions from the combustion of fuels in traffic and for heating and cooling in buildings. And countries may also add other sectors where fossil fuels are burned, the so-called ‘opt-in’ sectors like smaller SMEs, fuel used on farms, domestic ships etc.

The ETS-2 Cap for 2027
A separate CO2 budget has been agreed for ETS-2, which will be reduced annually from 2027 by more than 5.15-5.43% per year to -42% in 2030, compared to 2005 and to zero around 2044. Today, Dec 3, the European Commission defined the total allowances for 2027 at 1 bln CO2 (=average CO₂ emissions from fuel combustion in ETS2 sectors 2016-2018 minus reduction path for Effort Sharing Sectors, minus annual linear reduction factor for the years 2025-2027, 5.1%). The CO2 budget for national opt-in sectors will be decided later, based on their average national emissions in 2016-2018.

To prevent motorists and tenants from incurring excessive costs, a number of safety buttons and funds have been built into the system

Coverage
Participants under ETS-2 are usually the same entities as those that pay the excise tax on energy and mineral oil. In the whole EU around 10,000 entities: 7000 tax warehouses for oil, 1400 gas suppliers, 3000 for coal. For fuel suppliers under ETS-2 with less than 1,000 tonnes of CO2 emissions per year, a simplified procedure for monitoring and reporting will be applied.

ETS-2 ‘Opt-in’
Some EU member states use the opt-in opportunity as broadly as possible to include more emissions sources under the ETS cap. This means that fuel suppliers who supply to those sectors must also monitor and avoid the emissions and /or purchase emission allowances. Which sectors do member states opt-in? See table; additional country opt-ins may be requested in the near future.

Some 63% of EU CO2 emissions will then fall under ETS-1 and ETS-2. Including the ETS-2 opt-in, will further increase this. Not included are, other and smaller ESR emissions, methane and hydro-fluorocarbons, and N2O. Besides this, there are emissions that fall under the land use sector (LULUCF) with a specified CO2 target of removing 310 Mton by 2030.

Upstream system
ETS-2 is a so-called ‘upstream system. This means that ETS-2 does not include the end users of the fuels, where emissions occur, but the fuel suppliers. The CO2 pricing stimulates suppliers to produce cleaner fuels for mobility (biofuels and recycled fuels that meet RED3, e-fuels, hydrogen) or to invest in electric transport or in sustainable heating and cooling networks and green gas, for example.

Scope-3 emissions
The scope of ETS-2 is actually covering the indirect CO2 emissions, ‘scope-3’, of the petrol and diesel producers and of the gas and fossil heat suppliers. These are the ‘regulated entities’ that, under ETS-2, must purchase emission allowances to cover the emissions by burning them in cars and buildings.
In the recent judgment in the Netherlands’ court case of Milieudefensie against Shell, the Court of Appeal said it could not apply the requested general -45% in 2030 for all companies, sectors and scopes the same way. It referred to the reductions that EU has already achieved and will achieve via ETS-1 (-62%) and ETS-2 (-42%) in 2030, meaning ETS-2 can indemnify companies against specified scope-3 targets.

Implementation
The ETS-2 permit requirement will come into effect on 1 January 2025; the emission report for 2024 must be submitted on 30 April 2025. In 2027, the additional emission rights will be granted to the member states with op-in sectors based on the average historical emissions. Auctioning will then take place from 2027. In May 2028, the rights must be surrendered for the emissions from 2027.
Participants can buy ETS-2 emission rights at the EU ETS auctions and the carbon market. No free rights are distributed. The ETS-2 rights are not interchangeable with ETS-1 and have their own CO2 price. In 2031, the European Commission will examine in 2031 whether ETS-1 and ETS-2 can be linked.
ICE-ENDEX will start offering trading for ETS-2 allowances via Mini EUAs in January 2025 to allow taking positions early and for price disclosure.

How is ETS-2 similar to ETS-1 and how does it differ?
The similarity is that both have a decreasing CO2 budget to 0 and that there is a price on CO2 emissions. The big difference is that ETS-2 is an upstream system. This means that if the CO2 reductions do not decrease quickly enough, the CO2 costs increase and can be passed on to the tenant and motorist. According to market analyst Veyt, an additional 55 Mt CO2 reduction per year will be needed in the sectors concerned to achieve a 5% reduction per year. Currently, this reduction is just 4.4 Mt with the use of water pumps and 5 Mt per year with electric cars. All ETS 2 allowances will be auctioned, no free allocation, separately from ETS-1 allowances.

ETS-2 CO2 Pricing
Another difference is in the CO2 pricing. In ETS-1, the marginal CO2 price was partly determined by the fuel switch price from coal to gas and now by the CCS price. For ETS-2, the marginal CO2 price is much more diffuse and determined by various technologies and national support. This separate ETS system has been agreed for mobility and the built environment in order to stimulate investments there and because the marginal costs are currently estimated to be higher there than in ETS-1.

Whether ETS-2 will be effective in achieving CO2 targets remains to be seen. CO2 reductions in mobility and the built environment are lagging behind. And if there is too little supporting government policy, and the Climate Fund is not used, there is a good chance that tenants and motorists will be faced with high energy costs

ETS-2 aims to prevent costs for tenants and motorists from becoming too high
In ETS-2, due to the CO2 price risk, there are a number of buttons and a fund to control cost increases for mobility and the built environment:

1. Possibility to postpone the start of ETS-2 from 2027 to 2028 if the gas price is too high in 2027. Poland, Czechia and Slovakia already asked to postpone ETS-2 to 2028.
2. The auction of ETS-2 rights will start with ‘frontloading’ for the first 17 months. So 30% extra rights will be auctioned earlier, thus 130% of the 2027 Cap mentioned above, to limit the price. Thus, 1.3 billion emission rights will be auctioned in 2027, a surplus of approximately 250 Mt. The additional 30% will be deducted from the auction volumes for the years 2029-2031.
3. There is a price mechanism until 2029. The European Commission wants to keep the price at €48 per emission right in the beginning. That amounts to approximately 10 cents more per m3 of gas. For a liter of petrol 20 cents extra and for a litre of diesel 13 cents. If the auction price is higher, the European Commission will auction extra rights from the Market Reserve: 20 Mton extra (every two months) at a price twice as high (100 euros) and a maximum of 120 Mton extra at a price three times as high (135 euros).
4. Prior to the start of ETS-2, the Social Climate Fund will be available for the EU in 2026 up to 2032: 86.7 billion euros for residents and motorists with 25% co-financing from the Member State. For the Netherlands, 720 million euros is available with 240 million euros co-financing. The fund is for measures intended to contribute, for example, to the decarbonisation of heating and cooling of buildings or the reduction of the energy needs of buildings, the integration of renewable energy sources, in home and neighborhood batteries and in manure fermentation for green gas, etc. It can also involve financial support for low-income households in the worst performing buildings or a reduction in excise duties.

Complementary government policy and use of the EU Social Climate Fund necessary
It is clear that in order to achieve the CO2 targets of ETS-2, while at the same time limiting the costs for tenants and motorists, additional national policy is needed. For example, in France they are considering support for subscriptions for electric cars. This is also a possibility in the Netherlands. And there could be support for heating networks and electricity use for the use of residual heat and water pumps could be given priority on the electricity grid.

Risk of high future CO2 ETS-2 costs
The combination of bringing forward the auction of emission rights (frontloading) and more scarcity later and the uncertainty whether there is sufficient supporting policy in the Member States (Low and Limited Complementary Policies in the graph) means that the projection of the CO2 price in 2030 and thereafter is very uncertain, but that there is a great risk of a high CO2 price. The European Commission expected a CO2 price of 68 euros in 2030. But various market analysts and researchers predict a CO2 price between 150 and 300 euros in 2030 (50-100 cents more per liter of diesel) and between 250 and 400 euros in 2040 in the absence of additional policy: the less complementary policy, the higher the CO2 price (see graph).

Whether ETS-2 will be effective in achieving CO2 targets remains to be seen. CO2 reductions in mobility and the built environment are lagging behind. And if there is too little supporting government policy, and the Social Climate Fund is not used, there is a good chance that tenants and motorists will be faced with high energy costs.