THE CARBON MARKET IN THE EUROPEAN UNION
When, on December 11, 1997, at the conclusion of the Third Conference of the Parties, held within the framework of the United Nations Convention on Climate Change, the so-called "Kyoto Protocol" was signed, a long road had to be undertaken for the achievement of climate neutrality. A road full of obstacles that have only been slowly cleared from that date up to the present, when a vast majority of countries finally seem convinced of the need to act on different fronts in order to accomplish the objectives of the Paris Agreement of 2015, in force since 2021, which replaced the former Kyoto Protocol.
The main difficulties faced to reach a global satisfactory pact in Kyoto were, firstly, the need of fixing a percentage of emission reductions (just 5 %, at that time, with respect to those of 1990), and secondly, to have to link the commitments for reduction of emissions only to the developed nations, exempting the less advanced ones from these kinds of obligations. Added to these problems was the fact that some important signatory countries of the Protocol, such as the United States or Canada, later abandoned the Agreement because they did not consider it convenient for their interests.
The European Union assumed the leadership role, establishing in its territory a scheme for greenhouse gas emissions allowances trading similar to the international mechanism for carbon transactions between developed countries regulated for the first time in article 17 of the Kyoto Protocol. This is how, even before the United Nations legal instrument came into force (2005), the Directive 2003/87 was published laying down a carbon market system, deemed to be one of the essential means for the achievement of the European ambitions in climate matters.
Since this somewhat problematic start, things have changed a lot, both globally and within the Union.
At an international level, the Paris Agreement also involved less developed participants in substantially increased reduction targets, including some of the countries with significant polluting activity: China, India, Mexico or Brazil. Besides, the Agreement regulated a new interstate emission allowances trading system, controlled by a specialized body. Furthermore, internal carbon markets have multiplied since 2005, so no longer isolating the EU. Countries such as Canada, Japan, Korea, Mexico, New Zealand, Australia, Switzerland, the United Kingdom, the United States (California, Massachusetts, Oregon, Washington, New York) have developed their own systems, and even China has carried out pilot projects in the regions of Beijing, Chongqing, Fujian, Guangdong, Hubei, Shanghai and Shenzhen.
As for the European Union, the "Green Pact" of 2019 and the so-called "Climate Law" (Regulation 2021/1119), brought to a drastic increase of emission reduction goals, which will become 55% with respect to those of 1990 in 2030, to place them at zero emissions in 2050.
Now we understand the background, let us see what a carbon market consists of.
In this regard, it can be defined as:
a commercial, official, and public framework in which companies can acquire greenhouse gas emission allowances, as well as selling those surpluses, that is to say, allowances previously obtained and not used.
However, a market of this type, framed within the objectives of combating climate change, cannot function like any other. It has been obliged to adapt its operations to particular rules. One of them, perhaps the most important, is that the amount of allowances put on the market should be gradually reduced, so that companies are forced to improve their anti-polluting systems. Another, equally important, is that a long period of adaptation must be foreseen in order that the industry becomes aware of the climate problem and creates the necessary internal mechanisms to deal with it.
In the European Union, the Emission Allowance Trading Scheme established by Directive 2003/87 did not begin to function as a true market, in fact, until a few years ago, and there was a good reason for that: introducing this new system into an industrial structure not accustomed to this type of financial burden would have posed difficulties requiring caution. Indeed, it must be taken into account that in the early days of carbon regulation the European Union Scheme was the only one in operation, and that if the principle "the polluter pays" have been applied directly, without any transitional phases, this would have meant for European companies a negative economic factor non-existent in other parts of the world, which would probably have involved the transfer of part or all of the production of essential industrial sectors to other countries with a less harsh climate policy than the EU. This would have increased the global level of emissions worldwide, causing an effect contrary to the desired one.
To avoid this "carbon leakage" which would imply a deterioration of the European economy and a ultimately a rise of total carbon emissions, during the first two phases of application of the European Emissions Trading System (2005- 2007 and 2008-2012) practically all the emission allowances were assigned free of charge to the sectors exposed to a genuine risk of carbon leakage. These sectors currently include oil refining, production of steel, ferrous and non-ferrous metals, aluminium, cement, glass, ceramic products, paper, fertilizers, and hydrogen.
In the third (2013-2020) and fourth (2021-2030) phases of the European system, the free allocation of allowances has been gradually cut back, also being granted only if certain benchmarks linked to best practices are met, so that this way of assignment has dropped to something less than 50% of the total allowances issued. It is, in fact, from the implementation of the third phase when we can begin to talk about the existence of a true European commercial system, since the price of carbon is obtained through regular auctions in which companies participate, generally through expert intermediaries in this kind of operation. This is going to be the future system because free allocation of allowances should disappear in 2030 to give way to a genuine carbon market, which will be more and more limited, since it must not be forgotten that the final objective, in 2050, is climate neutrality.
But despite all the precautions taken with respect to the introduction of the greenhouse gas emission allowances market in the EU, the risk of carbon leakage would have continued to exist if the local system had not been balanced with a border mechanism that prevented massive imports of products obtained from polluting industries in third countries. For this reason, the European Commission launched in 2021 a proposal for a Regulation that promoted the establishment of a "Carbon Border Adjustment Mechanism", proposal that has been embodied in Regulation 2023/956, of May 10, 2023.
Of course, the implementation, from 2026 onwards, of the obligations derived from said regulation, will imply that the internal system of emission allowances and the border adjustment mechanism (in which there will be no free allocation of allowances) should have an adjustment, so that importers do not suffer a greater penalty than EU producers and vice versa. This will mean, in addition to the payment for the acquisition of emission allowances in both systems, the extending to the CBAM of all sectors affected by the internal system, since these are now more limited in the case of imports. Compensation will also have to be made to take into account those third countries having a functioning market with a carbon price effectively charged to the industry.
In conclusion, with the application of the Carbon Border Adjustment Mechanism the European Union once again leads, for the moment alone, the list of countries that have chosen to transfer the domestic allowances trading system to import operations. The result of such action in the improvement of the climatic situation may be seen after some time, but for the moment importers, as well as EU producers, will have to be prepared to make any necessary changes in order to achieve a less polluting future.