Fit for 55 – the key takeaways from Europe’s decarbonisation package

On July 14th, the long-awaited ‘Fit for 55’ package was announced by the EU Commission as part of the European Green Deal.

The package contains a set of proposals aimed at reducing net greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels – a target which, once enacted, will bind the 27 member states by law.

The 'Fit for 55' package contains legislation to reform the EU Emissions Trading Scheme as well as 11 other regulations covering non-ETS sectors. Broadly, the package seeks to turn long-term Net Zero commitments into tangible actions by aligning proposals across a wide scope of sectors. Spanning thousands of pages of legislative documentation, the ‘Fit for 55’ proposals represent the most comprehensive and ambitious climate policy framework for Europe to date, including:

• Application of emissions trading to new sectors and a tightening of the existing EU ETS;
• Increased use of renewable energy and improved energy efficiency;
• Growth of low-emission transport and the infrastructure/fuels to support this;
• Alignment of taxation policies with the European Green Deal objectives;
• Measures to prevent carbon leakage;
• Tools to preserve and grow our natural carbon sinks.

Reforms to the EU ETS

The EU Emissions Trading Scheme (ETS) - which regulates nearly half of EU’s overall emissions including those from power generation, industrial and aviation sectors - will be the primary policy tool used to achieve the 55% target by 2030. The proposal for the EU ETS sector aims to cut GHG emissions by 61% by 2030 compared to 2005 levels, creating tighter targets for EU ETS operators.

An increase in the rate of the tightening of the cap (the Linear Reduction Factor), a reduction in the number of free allowances given to industry, and a forecast rise in EU carbon prices (which have already reached record highs of over €58 this year) will see increased compliance costs for ETS operators.

The EU ETS Market Stability Reserve (MSR) - one of the main tools to reduce oversupply in the market since 2019 - would also be reformed. The draft legislation would see the MSR continue to operate at a 24% withdrawal rate until 2030.

Increase in the linear reduction factor (LRF)

The Linear Reduction Factor (LRF) – the annual decrease in the EU ETS cap – will increase from 2.2% to 4.2%. This increase aims to achieve an ambitious reduction target that sits 18% above where it is today. The increase in LRF would be combined with a one-off reduction of 117m allowances, in order to align the market with the updated target while the new LRF kicks in. This one-off cap should see the LRF have the same effect as if applied from 2021

A reduction in free allocation

The free allocation of allowances will continue in the EU ETS until 2030. From 2026 however, they will be conditionally granted on the basis of decarbonisation efforts, and 100% of revenues generated from the auction of these allowances must be used to fund climate-related actions. Sectors covered by wider energy audit obligations will be required to implement recommendations, otherwise free allocation will be reduced by 25%.

Sectors at risk of carbon leakage will see free allocation continue to 2030, albeit under tighter guidelines. Whilst the provision of free allowances proved efficient at addressing the risk of carbon leakage, it’s argued that they may disincentive investments in green technology and methods or production, and so will be curtailed to further innovation.

Introduction of the Carbon Border Adjustment Mechanism (CBAM)

The commission has proposed a Carbon Border Adjustment Mechanism (CBAM) from 2026 to tax high-carbon imports and require importers to pay for the carbon content of their products.

The CBAM would act as an alternative to the free allocation currently used to protect industry from ‘carbon leakage’ .

This would not only create upstream pressure for participants to decarbonise their supply chain, but also competitive leverage for countries that set ambitious climate targets versus those who don’t.

The CBAM is proposed initially for five key sectors - iron and steel, aluminium, cement, fertilisers and electricity. It will have a transitional period from 2023-2025 before full implementation from 2026. There will be a 10-year transition before free allocation is completely removed.

Given the potential impact on international trade, the CBAM will likely face significant political resistance and regulatory hurdles before coming into effect.

Inclusion of shipping within the EU ETS

One of the major reforms to the ETS will see the inclusion of shipping within the scope of the EU ETS from 2023. The inclusion of shipping will add about 7% to the overall emissions covered by the scheme.

The inclusion would cover all intra-European voyages and 50% of extra-European voyages, amounting to about 75% of overall shipping emissions. A three-year phased approach has been proposed, with maritime operators facing an obligation to buy allowances for 20% of emissions in 2023, 45% in 2024, 70% in 2025 and 100% in 2026.

Emissions trading for transport and housing

Whilst EU ETS emissions from power generation and energy-intensive industries has fallen by 42.8% in the past 16 years, emissions in sectors such as transport have risen. A parallel emissions trading scheme has been proposed to cover emissions from buildings and road transport in a similar fashion to the existing ETS.

One of the main differences between the two schemes, however, is that there will be no free allocations within the parallel scheme and an LRF starting at 5.15% (compared to 2.2% within the current ETS). This LRF would be adjusted as necessary with the aim of curtailing emissions to 43% below 2005 levels by 2030.

The new ETS would be subject to the same Market Stability Reserve as the current scheme, with further allowances being released only under certain market conditions.

These proposals represent an unprecedented and ambitious climate commitment for Europe which is aiming to become the world's first climate-neutral continent by 2050. The road ahead will be somewhat arduous and will require significant negotiation between member states before we see the final proposals become law.

Whatever the outcome, it is clear that the EUs ambition will require companies to put in place a strategy to manage rising carbon compliance costs in the short term and identify innovative ways to achieve real GHG reductions in the longer term.