In the design of the European Union’s Emissions Trading Scheme (EU ETS) aiming at reducing greenhouse gas emissions in Europe in a cost-effective manner, the co-legislators introduced an element aimed at restoring global level playing field for the industrial sectors which would see their international competitiveness hampered by the additional costs brought by European policy. It was decided that sectors exposed to a high risk of carbon leakage would benefit from a certain amount of free allocation of emission allowances as long as their competitors outside of the EU are not subject to comparable policies. The definition of “carbon leakage” itself is multifaceted and disputed. The system that has been built ad hoc at EU level is no less complex and burdensome. It has resulted in the elaboration of a series of eligibility steps, going from the periodic carbon leakage list through product-specific benchmarks to the application of a reduction factor aiming at keeping the level of emissions under the cap set in the Directive. This course will look at this system from the legislative principles viewpoint as well as from the practical side based on past experience. It will also present some perspectives from the EU ETS review exercise launched in July 2015. Last but not least, it will revert back to the global perspective by observing the state of play in the aftermath of the COP21.

1. EU ETS AND GLOBAL LEVEL PLAYING FIELD:
THE CARBON LEAKAGE LIST
SUSTAINABLE EUROPEAN ENERGY & CLIMATE POLICY 6.3
15th April 2016

2. Session contents:
• Introduction: the EU ETS and the global context
• Principles of free allocation
• Free allocation in practice
• Challenges to the EU carbon market
• Perspectives from the 2015 EU ETS proposal
• Back to the global context

3. INTRODUCTION
• European Union Emissions Trading Scheme (EU ETS)
• Global context
• Definition of carbon leakage

4. EU EMISSIONS TRADING SCHEME (ETS)
• Cornerstone of EU climate policy and
main decarbonisation instrument
• Principle: put a price on carbon

5. SNAPSHOT OF THE SYSTEM
• Objective: reduce GHG emissions + incentivise low carbon technologies
• Design:
 Limit on overall emissions from emitting industry sectors, reduced each year
= cap
 Within this limit, companies can buy and sell emission allowances as needed
= trade
 The carbon price is determined through the balance of supply and demand
of emission allowances
 N.B. Participation is mandatory for sectors covered by the EU ETS Directive
• Scope: more than 11,000 power stations and manufacturing plants in the 28 EU
Member States + Iceland, Liechtenstein and Norway; aviation operators flying
within and between most of these countries
 In total, around 45% of total EU emissions are capped by the EU ETS

6. EU CARBON MARKET
• Trade of EU allowances (EUAs): right to emit 1 tonne of CO2
equivalent
• Default allocation method: auctioning of EUAs
• Exception: free allocation = proportion of the allowances given
to certain participants and under certain conditions for free

7. EU IN GLOBAL PERSPECTIVE
• To efficiently fight against climate change, the ultimate solution is to put a price
on carbon everywhere, i.e. to establish a global carbon market
• In such case, operators would face the same costs everywhere: there would be a
global level playing field
• However this is not the case today
 The absence of global level playing field is the rationale for protection
against carbon leakage: the system is transitional per nature
• Protection against carbon leakage through free allocation was proposed by EU
Member States in 2005
• According to the European Council conclusions of October 2014, the approach is
to be continued after 2020
• Free allocation vs. carbon tax: free allocation has become the preferred solution
 It establishes a level playing field across the EU
 It avoids potential trade conflicts with third countries

8. DEFINITION OF CARBON LEAKAGE
A multifaceted and disputed definition…
• Legal definition: no definition in the EU ETS Directive; only criteria for its
assessment
• Explanation given by the European Commission:
 Situation that may occur if, for reasons of costs related to climate policies,
businesses were to transfer production to other countries which have laxer
constraints on greenhouse gas emissions
 This could lead to an increase in the total emissions
 The risk of carbon leakage may be higher in certain energy-intensive
industries
• Definition by the International Energy Agency (IEA): an increase in emissions
outside the region as a direct result of the policy to limit emission in a country or
region in the form of a cap or a tax
But how is carbon leakage recognisable and when does it start?

9. EVOLUTION ALONG THE WAY
• EU ETS Phase 1 (2005-2007)
 Learning by doing
 5% of allowances to be auctioned
 95% free allocation
• EU ETS Phase 2 (2008-2012)
 ETS enlarged to the EEA + aviation
 10% of allowances to be auctioned (in reality only 4% were)
 90% free allocation (96% in practice)
• EU ETS Phase 3 (2013-2020)
 EU-wide cap on emissions
 >50% of allowances to be auctioned
 <50% of allowances to be given for free
free
allocation
auctioning

10. FREE ALLOCATION VS. AUCTIONING
• In phase 3, initial repartition of around 43% vs. 57%
• Free allocation share to continually decrease
Source: European Commission’s Carbon Market Report 2015
43.30%
42.80%
42.20%
56.70%
57.20%
57.80%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
2013
2014
2015
Repartition free allocation vs. auctioning
Free allocation Auctioning

11. PRINCIPLES OF FREE ALLOCATION
• Legislation in force
• Calculation of free allocation level

12. LEGISLATION IN FORCE
• EU ETS Directive 2003/87/EC adopted on 13th October 2003
 Amended several times; last reform adopted in 2009
 Article 10a: Transitional Community-wide rules for harmonized free allocation
 Annex I: list of sectors eligible for free allocation
• Commission Decision 2011/278/EU determining transitional Union-wide rules
for harmonised free allocation of emission allowances adopted on 27th April
2011
 Annex: carbon leakage list; regularly updated
• Commission Decision 2013/448/EU concerning national implementation
measures of 5th September 2013
 Determines free allocation levels for phase 3
• Guidance documents and templates to help Member States

13. SHARE OF EU GHG EMISSIONS PER SECTOR (2012)
Source: EEA, EU greenhouse gas inventory, 2014 submission
33%
27%
20%
10%
7%
3%
0%
Energy supply
Energy use
Transport
Agriculture
Industrial processes
Waste
Solvents and other

14. SECTORS COVERED BY THE EU ETS DIRECTIVE
• Power industry with ≥20MW thermal rated input
 Free allocation granted only in exceptional
cases (modernization of electricity network
in 8 Member States)
• Manufacturing industry: Energy intensive
industries with ≥20MW thermal rated input
(oil refineries, coke ovens, iron and steel,
cement clinker, glass, lime, bricks, ceramics,
pulp, paper and board, aluminium,
petrochemicals, ammonia, nitric, adipic,
glyoxal and glyoxylic acid production)
 Free allocation granted on basis of carbon
leakage risk assessment
• CO2 capture, transport in pipelines and
geological storage of CO2
• Aviation

15. CALCULATION: CARBON LEAKAGE LIST (1)
• Principle: manufacturing industry will receive 80% of its allowances for free in
2013, a proportion that will decrease in a linear fashion each year to 30% in 2020
• Sectors and sub-sectors on the carbon leakage list: in theory 100% free allocation
 EU ETS Directive, Article 10a: a sector or sub-sector is deemed to be exposed
to a significant risk of carbon leakage if:
1. Quantitative assessment:
 Sum of direct and indirect additional costs induced by the EU ETS
would lead to an increase of production cost, calculated as a
proportion of the Gross Value Added, of at least 5% and trade
intensity (imports and exports) of the sector with countries outside
the EU is above 10%; or
 Sum of direct and indirect additional costs of at least 30%; or
 Non-EU trade intensity above 30%
2. Qualitative assessment: subjective assessment based on potential for
abatement, market characteristics, profit margins
 The assessment is carried out by (on behalf of) the European Commission
 The sectors on the list can not be removed during the period covered
by the list; others can be added

16. CALCULATION: BENCHMARKS (2)
• The sectors and sub-sectors deemed exposed to carbon leakage receive
100% free allocation up to their benchmarks (in theory)
 Benchmark = specific performance per
unit productive output
 Article 10a (2): in defining the principles
for setting ex-ante benchmarks in
individual sectors or sub-sectors, the
starting point shall be the average
performance of the 10% most efficient
installations in a sector or sub-sector in
the Community in the years 2007-2008
 “One product, one benchmark” principle: benchmarks are not
differentiated by technology, fuel mix, size, age, climatic circumstances or
raw material quality of the installations producing the product
 Blueprint for a methodology based on benchmarking developed by
Ecofys, Fraunhofer Institut and Öko-Institut for DG CLIMA in 2009
• 52 benchmarks for 2013-2020 (Annex II to 2011 Decision)

17. CALCULATION: FALLBACK APPROACHES (3)
• Exception to the benchmarking principle: fallback approaches
 The Commission’s consultants realized that not all products could receive
benchmarks
 The Commission added fallback approaches to its 2011 Decision on free
allocation
 3 fallback approaches:
 Heat production benchmark (i.e. t CO2/unit of heat produced) for
combustion of fuel activities where an intermediate heat carrier (e.g.
hot water, steam) is produced that can be measured and monitored
 Fuel mix benchmark (i.e. t CO2/GJ of fuel used) for combustion of fuel
activities where the heat or mechanical energy produced cannot be
measures and monitored (e.g. furnaces)
 Grandfathering for non fuel related process emissions (historical
emissions x 0.97)
 For 2013-2020, 25% of products are covered by fallback approaches

18. CALCULATION: REFERENCE YEARS (4)
Ex-ante allocation system -> need for reference years
 The benchmarks need to be combined with
historical activity data to determine an allocation
 Average performance of the 10% most efficient
installations in a sector in the EU in 2005-2008 or
2009-2010

19. CALCULATION: CORRECTION FACTOR (5)
• Need to ensure that the overall cap for emissions reduction is respected
• In the 3rd EU ETS phase (2013-2020), the foreseen allocation exceeds the cap
• Application of a uniform cross sectoral correction factor
• Commission Decision of 5th September 2013: from 5.73 % in 2013 increasing
gradually to 17.56% in 2020 -> less than 100% free allocation at benchmark level

20. EMISSIONS AND ALLOCATION OF ALLOWANCES
DURING THE THREE PHASES OF THE EU ETS
Source: Nature Climate Change, 2011

21. NATIONAL IMPLEMENTATION MEASURES (NIMS)
• All Member States and EEA-EFTA countries carried out a
preliminary calculation of the number of free allowances to
be allocated to each installation in their territory (national
implementation measures or NIMs) and notified them to the
Commission
• The Commission carried out an in-depth assessment of each
notification and published a Decision on NIMs on 5th
September 2013, where it confirmed the number of free
allowances
 This Decision announced the implementation of a cross
sectoral correction factor
• On the basis of the Commission decision, EU Member States
and EEA-EFTA countries took final allocation decisions for
2013 onwards

22. COMPLIANCE CYCLE
• The EU ETS is accompanied by a Monitoring, Reporting and Verification
system (MRV)
• Industrial installations and aircraft operators covered by the EU ETS are
required to have an approved monitoring plan, according to which they
monitor and report their emissions during the year
• The data in the annual emissions report for a given year must be verified
by an accredited verifier by 31st March of the following year
• Once verified, operators must surrender the equivalent number of
allowances by 30th April of that year
• This annual procedure of monitoring, reporting and verification (MRV), as
well as all processes connected to these activities, is known as the
'compliance cycle' of the EU ETS

23. FREE ALLOCATION IN PRACTICE
• Who is covered?
• Has it worked?

24. WHO IS COVERED BY FREE ALLOCATION?
• Annex I to the EU ETS Directive:
sectors and sub-sectors eligible for
free allocation under the protection
regime against carbon leakage
• Two lists have been adopted so far
for the EU ETS 3rd phase:
 2013-2014
 2015-2019
• The current carbon leakage list covers
97% of emissions in the EU
• All energy-intensive industries, as
well as a number of small sectors
are counted in

25. HAS FREE ALLOCATION WORKED?
• What is received by an installation under the carbon leakage regime:
 Best installation(s) in a given sector in the EU receive(s) 100% free
allocation – CSCF = from 94% in 2013 to 82% in 2020
 Those installations that do not reach the benchmarks receive fewer
allowances than they need and therefore have to reduce their
emissions or buy additional allowances to cover their emissions
• In 2013, DG CLIMA commissioned Ecorys with a study gathering evidence
of carbon leakage
 General conclusion: no carbon leakage has taken place in the
sectors covered by the study
 N.B. The study was covering only EU ETS phases 1 and 2
 Possible explanation: free allocation has worked
 N.B. The Commission recognizes that investment leakage is
taking place

26. CHALLENGES
TO THE EU CARBON MARKET
• Oversupply of emission allowances
• Carbon price level
• Political intervention

27. ROLE OF CARBON PRICE
Carbon price plays a
central role in the EU
ETS: expected to both
reduce emissions and
support low carbon
investments

28. OVERALLOCATION OF EMISSION ALLOWANCES
• Low flexibility of the EU ETS: allocation based on outdated reference
years
• Impact of the economic and financial crisis not taken into account
• Same for impact of emissions reduction efforts by industry
Source: European Commission

29. CARBON PRICE EVOLUTION
Source: Business Spectator

30. INTERVENTIONS ON THE EU CARBON MARKET
• Backloading Decision
 Commission Regulation (EU) 176/2014 of 25th February 2014
 The Commission postponed the auctioning of 900 million allowances from
2013-2015 until 2019-2020 to allow demand to pick up
 Temporary measure only (at least originally)
• Market Stability Reserve
 Commission Decision 2015/1814 of 9th October 2015
 More structural measure
 Aims both at addressing the surplus of emission allowances that has built up
and at improving the system's resilience to major shocks by adjusting the
supply of allowances to be auctioned
 Incorporates the backloaded allowances (therefore backloading is definitive)
 Operational from 2019
 Challenged in court by Poland in January 2016…

31. PERSPECTIVES
FROM THE 2015 EU ETS PROPOSAL
• Fixed free allocation share
• Longer EU ETS phase
• Reduced carbon leakage list

32. FIXED FREE ALLOCATION SHARE
• Legislative proposal published by the European Commission on 15th July
2015: review of the EU ETS Directive for the period 2021-2030
 Fixed auctioning share: 57%
 Therefore 43% of allowances go to free allocation
43%
57%
• Expected amendment of Auctioning Regulation to follow
6267
7674
853
680 310
Structure total allocation quantity Phase 4 (mln EUAs)
Free allocation to industry Auctioning 90% based on verified emissions
Auctioning 10% redistribution Article 10c (max.)
Modernisation fund 2%
43.30%
42.80%
42.20%
56.70%
57.20%
57.80%
0% 50% 100%
2013
2014
2015
Repartition free
allocation vs. auctioning
Free allocation Auctioning

33. LONGER EU ETS PHASE & SHORTER CARBON LEAKAGE LIST
• Compared to the three previous phases, phase 4 (2021-2030) will be
longer
 There will be a carbon leakage list valid for a longer period as well
• It is considered that the current carbon leakage list is too broad
 The Commission proposes a new combined criterion which would
leave only around 50 sectors on the list… but which would still cover
>90% of EU emissions
 A so-called tiered approach
is proposed by some
Member States

34. BACK TO THE GLOBAL CONTEXT
Where to after COP21?

35. TOWARDS A GLOBAL CARBON MARKET?
Source: Carbon Pricing Watch 2015, World Bank

36. PROTECTION OF INDUSTRY IN OTHER SYSTEMS
• There is no homogeneity with regard to carbon pricing on the global
level
• Disparity among the instruments used around the world remains: the
EU ETS is the most advanced and its setup is not replicated as such
 Quebec: sectors exposed to international competition receive part of
allowances for free (gradual reduction), based on historical levels, with
100% allocation for process emissions
 California: allocation taking into account emissions intensity and trade
exposure of sectors, based on benchmarks, no cap on free allocation
 South Korea: 100% free allocation for energy-intensive industries at least
until 2025
 Chinese pilots: mostly free allocation, grandfathering based on 2008-2012
or 2009-2011 depending on region, correction factor if overall cap is
exceeded, benchmarks in some regions
• Linkages with other ETS-like systems are a possible first step

37. THANK YOU!
Iva Ganev
ganev@euroalliages.be