Ahead of the United Nations' COP26 climate conference, FIA's MarketVoice looks at the EU's "Fit for 55" climate package and its implications for the global derivatives markets.
What is Fit for 55?
The European Union adopted a new climate law in June that formalises the aims of the European Green Deal and commits the bloc to reducing its greenhouse gas emissions by 55% by 2030 (compared to 1990 levels) and net zero by 2050.
In July, the European Commission took the next step by issuing its "Fit for 55" package, an interlocking set of ambitious proposals to enable the EU to achieve this target – i.e., a legislative and policy package that is "fit for" delivering a 55% reduction in greenhouse gases by 2030.
The package is a long way from becoming law, but the overall direction of travel is clear: European policymakers are embarking on a course of action that will increase the importance of carbon pricing in the EU economy and make carbon markets, including carbon futures markets, even more central to pricing decisions for many sectors of the EU economy. In addition, the package will lead to important changes in the cost structure for many parts of the global supply chain for commodities, especially for metals such as steel, iron and aluminium.
The Commission proposals do not cover all the changes needed to deliver the goals. Another package is due in December that will cover gas markets and the building sector as well as an initiative to reduce methane emissions in the energy sector.
Which parts of Fit for 55 will impact derivatives markets?
The package includes more than a dozen sections overall, but there are three sections that will have particularly important implications for the global derivatives markets:
First, the package will expand and strengthen the Emissions Trading Scheme, the cap-and-trade program used by the EU to reduce carbon emissions. The Commission is proposing to include maritime shipping in the existing EU ETS (over the period 2023 to 2025) and create a parallel ETS for road transport and buildings (from 2025). In addition, the proposal will tighten the ETS by reducing the allowable amount of emissions and phasing out free allocations of emission allowances. These changes to the ETS will likely increase the cost of emission allowances as well as trading activity in the related futures.
Second, the package includes a "carbon border adjustment mechanism" that is intended to put a price on the carbon embedded in imported commodities with the aim of discouraging businesses from shifting their operations outside of the EU. The CBAM will be especially important for producers and importers of steel, iron and aluminium and may lead to sizeable changes in metals pricing and hedging.
Third, the proposal will accelerate the transition to renewable energy by setting higher targets for renewable energy supply and investing more heavily in the development of offshore renewable energy generation. This may bring new players into the electricity futures markets, such as producers of renewable energy that need to hedge their risks.
How will the carbon border adjustment mechanism work?
The proposed CBAM is a carbon levy that will initially apply to importers of iron, steel, cement, fertilisers, aluminium and electricity. As proposed, the CBAM will be introduced on a transitional basis starting in 2023, with full implementation for covered products from the start of 2026.
For many years the EU has wrestled with "carbon leakage" where EU producers have relocated production to areas outside of the EU with less stringent measures, or customers have replaced EU products with cheaper, more carbon-intensive imports. The CBAM is intended to put EU producers on a level playing field with companies from other countries where carbon pricing measures are less stringent.
At a high level, the proposed CBAM will create an obligation on importers of certain products to purchase CBAM certificates matching the embedded emissions associated with that product at a price matching the EU ETS allowance price, unless certain exemptions apply. The legislation allows exceptions for countries that have emissions trading schemes that are considered equivalent to the EU ETS or that are linked to it in certain ways.
The CBAM will replace the current solution, which is to give free allowances to companies that are most at risk of competition from high carbon producers. Under the proposals, free EU ETS allowances for these sectors will be phased out over a 10-year period after the CBAM goes live.
By the end of the transition period, the Commission's ambition is to extend the CBAM to more products and services at risk of carbon leakage, and to possibly also cover so-called 'indirect' emissions, i.e., carbon emissions from the electricity used to produce the goods.
Not surprisingly, the CBAM is unpopular both with some EU member states and with several non-EU countries, including China, Russia and Turkey. Others, however, have called for some form of CBAM within the EU as the EU ETS carbon price continues to climb. France, for example, which will lead negotiations on CBAM in the Council as of 1 January 2022 for six months, has been a fierce advocate of CBAM and has pressed the Commission to produce the proposal.
How soon will this package become law?
The Fit for 55 package needs to be approved by the European Parliament and the EU member states, which could take up to two years. Challenges lie ahead. Both the CBAM and the extension of the EU ETS have proved to be divisive proposals. For instance, the plan to include buildings and transport in an emissions trading scheme – a priority for Germany, which has its own domestic version – is already attracting criticism from countries such as Poland, which fears costs will be passed on to consumers and cause social unrest like the 2018 Yellow Vest movement in France.
Discussions have already begun among the environment ministers of the EU member states. At the monthly Council of Ministers meeting in October, the ministers exchanged views on the package and highlighted their key concerns. Most of the ministers agreed that the package is necessary to reach the EU's climate goals, but clear divisions emerged on several key issues, notably the extension of the emissions trading scheme to road transport and buildings.
Denmark, Finland, Germany, the Netherlands and Sweden spoke positively about the benefits of this extension, whereas the Czech Republic, France, Hungary, Ireland, Latvia, Luxembourg, Malta, Poland, Portugal, Romania, and Slovakia were more reserved, sometimes even showing fierce opposition. These concerns are likely to be even stronger now with soaring energy prices in Europe.
Despite the political challenges, EU policymakers have made it clear that they see the expansion of the ETS as one of their top priorities.
"In many ways, the ETS is front and centre to all our efforts," said Frans Timmermans, the Dutch politician who is executive vice president of the European Commission and head of its climate policy, when the Fit for 55 package was released. "With its cap on emissions, it is a proven and effective tool to bring down emissions. It gives a price signal to industry to switch to cleaner production, it drives innovation, and it generates revenues for redistribution and reinvestment."
How are companies affected by the Fit for 55 proposals responding?
Some companies have welcomed the proposal as an important step in the transition to clean energy. For example, the European Federation of Energy Traders expressed support for the strengthening and expansion of the ETS and praised the decision to put carbon pricing "front and centre to all EU decarbonisation policies."
RWE, the German energy company that is now the third-largest producer of renewable energy in Europe, also welcomed the proposal, focusing in particular on the emphasis on market-based tools for climate protection, the expansion of wind and solar power, and the incentives for "green hydrogen" as a fuel and an industrial feedstock.
"The 'Fit for 55 package' creates new opportunities to really increase the pace of the ramp-up of renewables and get the hydrogen economy moving," said Markus Krebber, RWE's chief executive officer. "At the same time, it strengthens the importance of the Emissions Trading Scheme as [a] market-based key tool."
Many other firms have expressed strong opposition, however. One of the biggest flashpoints is the potential impact on EU competitiveness relative to other countries. "The climate plan will only be a success and find international followers if our industry remains globally competitive despite decarbonisation," said Siegfried Russwurm, the president of the Federation of German Industries.
Aluminium producers have been quite vocal about their opposition to the CBAM, which will replace the free allocation of emissions permits and the financial compensation for carbon-related electricity costs. If the current carbon compensation scheme is scrapped, smelters in Europe would be hit with higher costs. For example, France's Constellium and Norway's Norsk Hydro have complained about the adverse impact on European producers of aluminium relative to competitors in China and Russia.
There are also doubts about the practicality of the CBAM. During a quarterly call to discuss the company's earnings, Martin Brudermüller, the chief executive of BASF, the German chemicals company, blasted the CBAM as overly bureaucratic and in conflict with the rules of the World Trade Organization.
"I am personally very critical of CBAM," said Brudermüller. "I think it is just not going to work. It is not only the WTO compliance, it is a very bureaucratic piece, because if you apply that to chemistry and you just think about how value chains are branching out, you have to know for each and every product that is imported and exported what actually the fair CO2 carry is. I think it is almost impossible."
Brudermüller said firms need more specificity on how the proposals will be implemented.
"It is a starting point of a long, long journey with a lot of question marks," he said. "So far, 'Fit for 55" is actually a wish list of what they want to do. But it is not a list of regulations to help us realise those targets."
What is the current state of the EU carbon market, and its relationship with the rest of the world?
In early October, EU carbon allowances hit a record high of €65 per tonne ($75 USD) as market participants responded to rising gas prices and increasingly strict limits on carbon emissions. The spike in prices prompted some politicians to call for price limits to protect power generators dependent on coal, but EU policymakers reiterated their determination to press forward, saying the rise in prices provided a further incentive to decarbonize the economy.
For instance, the European Commission's Timmermans recently said that the "European Green Deal is the solution, not the problem" and that the ETS is only responsible for about one-sixth of the energy price rises, so it can't be the "one to blame".
The EU ETS is the largest carbon trading market in the world, with about 90% of the total value traded, and it has served as a model for similar cap-and-trade schemes in other parts of the world. Earlier this year the UK launched its own emission trading scheme after breaking away from the EU, and China launched the first phase of an emissions trading scheme that over time could become the world's largest.
The rising interest in emissions trading has sparked the interest of financial players. Exchanges and data providers are developing indices to track prices of emission allowance futures traded in Europe and the US, and these indices are being used by fund managers for carbon ETFs and other investment products. Markets are also emerging for emission reductions undertaken on a voluntary basis, and exchanges such as CME Group, Intercontinental Exchange and Nodal Exchange are steadily increasing the range of futures they offer that are based on carbon offsets, renewable fuels and other environmental products.
How will various regulatory bodies and emission trading markets fit together around the world?
Carbon markets are still in their early stages, so it is difficult to predict how they will evolve or how they will interact in the long term. However, it is clear that derivatives markets will be a key part of the global transition to a low-carbon future.
FIA recently released the 2021 Sustainable Finance Report to highlight the derivatives industry's work on climate-related policy and other efforts to combat climate change. This followed a policy paper FIA published the year before, How derivatives markets are helping the world fight climate change, which highlights how the industry is already addressing this issue, and the importance of three key principles in the development of successful carbon markets: openness to innovation, industry-led standardisation and regulatory harmonisation.
More recently, FIA has been engaged with the Taskforce on Scaling Voluntary Carbon Markets, a private sector-led initiative working to foster robust and transparent voluntary carbon markets to help meet the goals of the Paris Climate Agreement.
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