EU ETS and voluntary carbon markets: key features and current challenges

Abstract

Introduction

Carbon emissions trading constitutes an important instrument in reaching global climate goals and enhancing energy transition, as it is considered to mobilize public and private sector entities to contribute to these goals. It can take place either in mandatory/compliance schemes or in voluntary schemes. Mandatory/compliance schemes—also referred to as cap-and-trade systems, emissions trading systems (ETSs) or allowance trading systems—are provided by law and thoroughly regulated, whereas participation in them is mandatory, under a regulatory framework aiming at reducing CO₂ emissions.¹ There are almost 25 ETS systems around the globe,² the EU ETS being one of them. Voluntary schemes operate alongside mandatory schemes in the framework of Voluntary Carbon Markets (VCMs) and allow private and public entities (eg, companies, non-profit organizations, universities, municipalities, individuals) to purchase carbon credits or offsets on an optional basis.

Carbon emissions trading was one of the so-called ‘Kyoto Mechanisms’ or ‘Flexibility Mechanisms’, which intended to lower the overall costs of achieving the Kyoto Protocol emissions targets.³ Although the Kyoto Protocol created a framework for a global carbon market, there have been several distinct schemes with varying degrees of linkages among them.

Carbon emissions trading schemes are regarded as playing a crucial role towards meeting the 1.5°C temperature limit of the Paris Agreement, which requires global greenhouse gas (GHG) emissions to halve during the decade to 2030 and CO₂ emissions to reach net zero by 2050 to restrain climate change. Article 6 of the Paris Agreement sets the parameters for cooperative approaches in countries’ efforts to meet their Nationally Determined Contributions and establishes a Sustainable Development Mechanism at supranational level for the generation and approval of credit-generating projects. The Paris rulebook introduces substantive and procedural requirements to ensure the integrity of the credits, with no double counting and additionality being the most considerable principles thereof. Even though it does not specify how carbon credits could be used, the Paris Agreement framework is expected to further boost the integrity and demand of credits in compliance markets as well as VCMs. In fact, it is argued that despite that Article 6 of the Paris Agreement does not directly regulate VCMs, the potential fungibility between VCMs and regulated carbon credits might require the alignment of the VCM rules and methodologies with those of the Paris rulebook.⁴ Thus, the enhanced requirements of the Paris Agreement noticeably upgrade the significance of both the EU ETS and VCMs, which could be considered as playing an important role in the context of the efforts towards the achievement of climate goals and the competitiveness of the affected industries.

The scope of this brief is limited to a succinct illustration of the two categories of carbon markets, focusing on their main features and highlighting some of their current challenges from a regulatory point of view, also with reference to their interaction and the impact that they have on the energy sector.

The EU ETS

Introduced in 2005, the EU ETS is the world’s first international emissions trading system. It operates in the European Economic Area (EEA), which includes the 27 EU Member States plus Iceland, Lichtenstein, and Norway. Currently being in its fourth phase (2021–2030), it is one of the key pillars of the EU’s decarbonization efforts.⁵

The system was established by Directive 2003/87/EC⁶ and has been lastly revised in 2023.⁷ Companies that during 1 year achieve reductions in their emissions below the set limits can sell the excess amount in the form of allowances either to other companies that failed to meet the limits or to those companies where the cost to reduce emissions exceeds the cost of buying rights. In special cases, the concession of free allowances was provided to sectors considered at risk of carbon leakage. In case of non-compliance, high fines are provided, significantly higher than the cost of buying rights. The allowances are auctioned in the context of an innovative auction system which must operate in such a way that everyone’s access and information is transparent, and that the organization and operation of the auction are economically profitable.⁸

Since 1 January 2020, the EU ETS is linked to the Swiss ETS. Since Brexit, the UK has operated its own ETS, which is not linked to the EU ETS, though the EU and the UK agreed to apply the EU ETS to flights from the EEA to the UK. Linking systems are considered to create a larger carbon market which can reduce overall compliance costs, increase market liquidity and generate more stability, also showing willingness to undertake a common effort to reduce CO2 emissions. Despite these advantages, ETSs globally remain largely heterogeneous and segmented. The different types of linking (eg, unilateral direct linking, bilateral or multilateral linking, indirect linking), the drivers and the advantages and challenges of linking as well as necessary and optional features that would ensure the compatibility and comparability of various ETSs are issues extensively analysed in the respective literature.⁹

The EU ETS while regional requires national implementation. For example, in Greece, the EU ETS was introduced by Ministerial Decision 54409/2632/2004,¹⁰ which initially included only fixed industrial installations, and was subsequently amended by a series of Ministerial Decisions, also expanding to the air transport sector. The Directorate of Climate Change and Atmospheric Quality of the General Directorate of Environmental Policy of the Ministry of Environment and Energy has been designated as the Competent Authority of the EU ETS in Greece. Since 2014, the Renewable Energy Sources Operator & Guarantees of Origin has assumed the duties of the Auctioneer of the GHG emissions allowances corresponding to Greece, representing it in the auctions held on the EEA Common Auction Platform.

In order to align with the targets set by the European Green Deal and its ‘Fit-for-55’ package, the EU ETS was recently reformed (i) to increase the EU emissions reductions target to 62% by 2030, (ii) to expand its jurisdiction to include emissions from shipping, and (iii) to provide for the creation of a separate new ETS 2 for buildings and road transport as of 2026.¹¹

The reform also introduced a new approach to the protection against the relocation of CO₂ emissions to countries without CO₂ pricing, by gradually phasing out the existing allocation of free allowances and replacing it with the Carbon Border Adjustment Mechanism (CBAM).¹² The main driver behind introducing the allocation of free allowances has been to make up for the competitive disadvantage induced by manufacturing industries while incentivizing abatement within those industries operations, since those who emit less than the amount covered by their allowances can sell their surplus for profit. By introducing a CO₂ pricing of imported goods and greater support for technological innovation in the covered sectors, all of them related to energy (iron, steel, aluminium, cement, fertilizer, electricity, and hydrogen), the CBAM aims to assist in making such European industries less exposed to international competition, as it will be just as expensive to export the same products to Europe. It remains to be seen whether the CBAM will successfully deal with carbon leakage risks without excessively burdening the affected industries.¹³

Voluntary carbon markets

VCMs started to develop in the 2000s, alongside mandatory schemes, since there was a demand for the acquisition of carbon allowances or credits by persons or activities not subjected to mandatory schemes, but primarily incited by the need to achieve corporate social responsibility goals.¹⁴ Business entities voluntarily chose to purchase Voluntary Carbon Credits (VCCs), to offset their emissions and contribute to the achievement of net-zero carbon consumption goals.¹⁵ Such demand has been accelerated by the Paris Agreement and the net-zero obligations imposed on states and companies.¹⁶

VCCs are issued by various certification bodies worldwide, the so-called ‘Carbon Standards’. Internationally recognized certification bodies are, among others, the Verified Carbon Standard (Verra), the Gold Standard, the American Carbon Registry, and the Climate Action Reserve.¹⁷ Each body follows specific rules that carbon reduction projects must meet in order to be certified. For a project to generate VCCs under a certification body, it must demonstrate that GHG reductions or removals are real, measurable, permanent, additive, independently verified, unique, and traceable. It should also be demonstrated that appropriate safeguards are in place to assess and mitigate any other potential environmental or social impacts associated with the project. The projects are evaluated based on the methodology defined by the rules of each certification body. After a project is certified, tradable VCCs are issued for each tCO₂e reduced or removed, which are then sold in the open market.

VCCs are registered in centralized record-keeping systems—the so-called ‘Registries’ —which are governed by different rules. The Registry tracks the creation, issuance, transfer, withdrawal, and cancellation of VCCs. Since VCCs are issued for a specific project with specific characteristics, the methodology, location, and social and environmental benefits of the latter have a direct impact on the quality of the resulting VCC and the price at which it is marketed. Once a VCC is cancelled or withdrawn, it is permanently removed from circulation and can no longer be traded or used to offset further emissions.

Interested organizations purchase VCCs either in the context of primary markets, concluding sales contracts, or in the context of secondary markets, concluding VCCs derivative contracts. The universal nature of VCC trading schemes allows investments to be made in projects built anywhere in the globe. A large part of the projects that create VCCs are located in the developing countries of the Southern Hemisphere, and, as a result, such voluntary systems also contribute to increasing the flow of capital to emerging markets. For example, the Greek insurance company Eurolife FFH voluntarily offset 912.58 tons of GHG emissions from its operations in 2020, through its participation in the REDD+ Project¹⁸ (an offset project based in the Amazon basin in Peru), minimizing its footprint.¹⁹ Likewise, the Greek company ION SA voluntarily offset the 586 tons of GHG emissions that resulted from its operation in 2019, through its participation in a project aimed at protecting the environment in Ghana.²⁰ In both cases, the relevant certification and offset were carried out by the international organization First Climate,²¹ with the participation of the Greek Center for Sustainability and Excellence.²² The FDL Group also offset GHG emissions through the purchase of certified emission reductions by the United Nations Organization.²³

The heterogeneous nature of VCCs and the existing fragmentation of VCM schemes—in terms of geographical areas, systems, registries, certification bodies, and assessment methodologies—have complicated the process of standardizing and developing an effective voluntary system at the market level. This creates uncertainty and insecurity for investors as to the effectiveness of the system, at a time when the transition to a low-emission economy requires significant long-term financing, estimated to reach $110 trillion by 2050.²⁴

Due to the global nature of VCMs and VCCs, a regulatory requirement would be the establishment of coherent arrangements that will govern a vast range of issues at the international level, mostly through uniform rules. Such arrangements can be summarized²⁵ as follows: First, the legal nature of VCCs and, consequently, the applicable legal principles thereto should be defined. Secondly, based on the VCC’s legal nature as an asset, certain legal aspects, such as their creation, ownership, transfer, and the withdrawal thereof shall be regulated. Thirdly, also broader issues concerning VCC’s fungibility, such as security of transfer, mediation, netting and their treatment in case of insolvency must be determined.²⁶ In the same context, in order to ensure VCCs’ integrity and broad fungibility as well as the proper function of VCMs, the provision of licensing procedures for certification bodies and of standard evaluation criteria for projects generating VCCs must be set. For this reason, the establishment of a competent body in charge of the regulation and supervision of the VCM is also imperative.²⁷

Interaction between EU ETS and VCM schemes

Although mandatory and voluntary carbon emissions trading schemes are initiated as separate and distinct mechanisms, in the course of their implementation, such distinction is gradually becoming less absolute.

The first expression of the interplay between mandatory and voluntary carbon emissions trading schemes is depicted in the interaction between the EU ETS and the voluntary Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).²⁸ The former applies to flights within the EU and EEA and departing flights to Switzerland and the UK and requires airlines to monitor, report, and verify their emissions and to surrender allowances against such emissions. The latter was agreed in 2016, under the framework of the International Civil Aviation Organization (ICAO) to address emissions generated by international aviation. Thereunder, ICAO Member States must require their aircraft operators to offset any growth in their CO₂ emissions, compared to a baseline year, by purchasing carbon credits generated by emissions-reducing projects in other sectors. In this framework, some airlines will be subject to both regimes: some airlines may be subjected to one scheme for one route and to the other scheme for another route, while for some airlines the two schemes may simultaneously apply to the same emissions generated on the same routes.²⁹

The second expression of the interplay between mandatory and voluntary carbon emissions trading schemes is depicted in the rising trend of enactment of national laws and regulations concerning VCMs in specific sectors. For example, the Greek National Climate Law 4936/2022³⁰ provided for the first time the possibility for specific existing facilities outside the scope of the EU ETS to offset their emissions, among others, through a national voluntary purchase of emission credits through planting, afforestation, and reforestation.³¹ The specific issues of this mechanism—which is yet to be implemented—are expected to be regulated by decisions of the Minister of Environment and Energy. Moreover, in October 2023, the Greek Minister of Environment and Energy announced the establishment of a voluntary carbon credits trading mechanism, which will enable industry, energy production, shipping, and aviation sectors to access products and services related to voluntary CO₂ offsetting, in addition to mandatory participation in the EU ETS. Such a scheme will concern CO₂ offsetting through afforestation, reforestation, improvement of forest management, production of wood products, etc and is intended to self-finance a new forest management mechanism to prevent wildfires.³²

The above cases raise concerns regarding the violation of the principle of double counting and double claiming avoidance as regards emissions reductions or removals. Double counting may take place when a single emission reduction or removal is counted towards more than one goal, target, or pledge and is irrespective of other concerns related to the ‘quality’ of carbon credits, such as lack of additionality, etc.³³ The principle of double counting and double claiming avoidance is adopted by Article 4.13 of the Paris Agreement as well as by the protocols of most VCMs standards, while corresponding adjustment measures are provided to face the risk that emission reduction claims may misrepresent their actual impact on the climate.³⁴

Carbon emissions trading schemes and the energy sector

The energy sector is at the core of the climate change discussion, playing an essential role as both CO₂ emissions producers through fossil fuels and a tool for decreasing CO₂ emissions through RES development. The implementation of carbon emissions trading schemes has influenced the energy sector by enhancing energy transition as well as by promoting energy efficiency.³⁵

On the one hand, one may note the case of Norway, where the reduction of allowances in the fourth phase of the EU ETS, along with specific tax measures, caused a significant increase in carbon prices in 2021, making oil and gas extraction much costlier. As a result, the profitability of oil and gas activities was affected, eventually prompting fossil fuel phase-out and accelerating electrification,³⁶ as it is currently explored by Herrera Anchustegui and Tscherning in this same issue.³⁷

On the other hand, one may note that the participation of renewable energy sources (RES) projects in VCM schemes by selling VCCs has aided the development of such projects in certain countries (eg, China, India, Brazil, Turkey),³⁸ offering RES developers an additional source of revenue. However, following the gradual decrease of costs for RES project development, questions concerning their additionality—as a criterion for their participation in VCMs—were raised, given that in such cases the emissions would have been avoided even without revenue from the sale of carbon credits.³⁹ Based on these considerations, the practice of VCM standards and registries are differentiated. Two of the largest VCM certification bodies, ie, Verra and Gold Standard,⁴⁰ allow RES projects only in countries defined as ‘Least Developed Country’ by the World Bank,⁴¹ whereas other bodies, such as the Global Carbon Council⁴² carbon registry, still accept RES projects.⁴³ In the same context, the applicable rules should determine whether RES projects participating in Renewable Energy Certificates (RECs) or Guarantees of Origin (GOs) schemes would also be eligible to participate in VCMs.⁴⁴ RECs and GOs are instruments certifying the production of one-megawatt hour (MWh) of electricity from RES and are sold to energy suppliers, companies, and consumers, who can claim to be supplying or powering their facilities with the corresponding amount of RES (even if in reality they do not use RES). The participation of such RES projects may give rise to double counting concerns if both RECs/GOs and VCCs are issued for the same unit of electricity. If such an approach was adopted, it would, for instance, automatically exclude from VCMs the majority of RES projects in Greece, which participate in the GOs scheme currently in force.⁴⁵

Concluding remarks

Given the enhancing importance of the efforts towards climate targets, both the EU ETS and VCMs are expected to play a crucial role. Inherent challenges, such as carbon leakage and linkage with other ETSs in the framework of the EU ETS as well as ensuring the overall project quality and avoiding ‘greenwashing’ risks in the framework of VCMs, have to be successfully faced for such schemes to be effective. Issues, such as the interplay between EU ETS and VCM schemes and the rising trend of enactment of national laws and regulations concerning VCMs, as well as the impact of carbon emissions trading mechanism on the energy sector, are anticipated to be much discussed. Focusing on offsetting schemes, nevertheless, should not shift regulatory attention from supporting energy transition projects.

This brief is a revised and expanded version of her presentation at the 6th Athens Conference on EU Energy Law and Policy ‘Quest for Energy Independence and Sustainability: A Regulatory Insight’, which was co-organized by the Hellenic Energy Regulation Institute and the University of Bergen and its Research Group for Natural Resource Law, Environmental Law and Development Law, and took place on 16 December 2022, gathering some of the most distinguished academics and practitioners in the field. Having participated in the Conference in her affiliation with the Hellenic Energy Regulation Institute, the author wishes to express her gratitude to Prof Antonis Metaxas for the kind invitation and constructive discussions on the topic, as well as to Ass. Prof Ignacio Herrera Anchustegui for coordinating this Special Issue and for his comments on the first draft of her brief.

Footnotes