In late February 2023, the price of carbon permits on the European Union’s carbon market hit 100 euros ($106.57) per metric ton – the amount of increased costs that factories and power plants must pay when they emit carbon dioxide. The benchmark EU Allowance (EUA) contract had hit a high of 101.25 euros per metric ton. EUAs are the main currency in the European Union’s Emissions Trading System (ETS) which forces manufacturers, power companies and airlines to pay for each metric ton of carbon dioxide they emit as part of EU’s efforts to meet its self-imposed climate targets. The EU committed to cutting net emissions by 55 percent by 2030 from 1990 levels. EU companies have an April deadline to buy and submit enough permits to cover last year’s emissions. Power sector demand for permits in 2022 increased when Russian gas supplies were cut, helping to fuel a 7 percent increase in EU power generation from coal, which contributed to 2022’s record world coal consumption. Prices were also driven up due to expectations of colder weather and low wind speeds that increased the demand for permits from fossil fuel power generators.
Background
The EU Emissions Trading System was launched in 2005. It sets a cap on the amount of carbon dioxide emissions that a sector, or group of sectors, can produce. The cap decreases each year to obtain a continual reduction in emissions. The system creates carbon permits, called EU Allowances (EUAs) for those emissions, which companies must buy for each metric ton of carbon dioxide they emit. Industries either have to pass the carbon permit cost to customers or absorb it themselves, lowering their margins. For perspective on the impacts, a $100 per metric ton carbon tax would increase the price of gasoline by 90 cents per gallon, the price of natural gas by $5.30 per thousand cubic feet, and add $1 per gallon to the price of diesel and heating oil.
The EU’s emissions trading system covers about 40 percent of EU emissions, forcing over 10,000 manufacturers, power plants and airlines flying within Europe to submit EU carbon permits each year for their emissions. The bloc agreed to add shipping to the trading system by 2026 and launch a separate trading system in 2027 to cover emissions from fuels used in road transport and to heat buildings.
The carbon permit price has varied over time. Prices, however, rallied in 2021 by 150 percent when EU policymakers launched a series of carbon reduction laws. Those laws prompted utilities to switch from coal to natural gas. But skyrocketing gas prices last year temporarily made coal generation cheaper.
Power sector companies are required to buy all the permits needed to fully cover their emissions, but many manufacturing industries receive free permits each year, reducing the costs they pay to comply, called free allocation. About 57 percent of the carbon permits in the EU emission trading system are sold, with the rest given to companies for free.
Free permits are given to sectors that are vulnerable to “carbon leakage”– the risk that high carbon costs would prompt companies to relocate abroad to regions without carbon costs. Over 40 sectors could be at risk of carbon leakage and thus receive free permits, including oil refineries, steel works and producers of iron, aluminum, metals, cement, lime, glass, ceramics, pulp, paper, fertilizers and organic chemicals.
EU has curbed the amount of free permits industry receives over time. It gave industry 80 percent of its permits in 2013, falling to 30 percent in 2020. Airlines receive more than 80 percent of their permits for free, but the EU agreed to make carriers pay for all of their permits by 2026. The rules are set to get tougher this decade, as the EU has agreed to phase out free allocation for industry by 2034.
In phasing out its free carbon permits, the EU plans to replace them with a carbon border levy on the emissions of imported goods to make firms abroad pay the same carbon price as European industry. Carbon costs vary greatly globally, with permits in China currently costing less than $10. The EU will impose a levy on imports of carbon-intensive steel, aluminum, cement, fertilizers and electricity, phased in gradually from 2026 until it covers all such imports in 2034. The cost paid by firms exporting those goods to Europe would be linked to the price of permits in the EU carbon market to put EU and overseas companies on a level footing, with consumers paying more for everything made with hydrocarbons. Overseas firms will be required to buy a digital certificate for each metric ton of carbon dioxide emissions embedded in the goods they export to the EU.
High Carbon Permit Prices Could Incentivize New Carbon Reduction Technologies
EU hopes that the 100-euro permit price will incentivize some of the expensive carbon-reducing technologies such as hydrogen produced from renewable energy. The iron and steel sector, for example, is looking to “green hydrogen” to help with the production of carbon-neutral steel. “Green” technologies could also receive EU aid to avoid firms from relocating to take advantage of U.S. subsidies to companies who develop “green” technologies in North America. The European carbon price, however, could decline from the 100 euro level as the EU agreed to auction more carbon permits to help raise 20 billion euros for countries to wean themselves off Russian natural gas. As can be seen, carbon fees quickly become useful devices for governments to pursue many different policy goals even as consumers must absorb higher prices which eventually affect their quality of life.
Conclusion
In 2005, the EU instituted a cap and trade system to reduce carbon dioxide emissions. The system determines a carbon price that is expected to make emissions meet a cap that declines over time, which then raises the permit price. That price gets passed onto consumers or else eats into company profits. EU’s carbon price hit a record of $100 euros as utilities were forced to use more coal due to cuts in Russian natural gas supplies along with the expectation for colder weather, increasing demand for heating fuels, low wind speeds lowering utility generation, and an April deadline for companies to have permits to meet their carbon dioxide emissions in 2022. The EU’s energy is becoming more expensive by design, and will become even more expensive in the future.
The United States does not have a carbon tax or a carbon emissions trading system. Rather, regulations, subsidies and other interventions are being used to lower carbon dioxide emissions. Those also result in cost increases to consumers or the use of tax dollars for products that are not economic in free markets. President Biden has a goal to reduce greenhouse gas emissions, of which carbon dioxide is the major component, by 50 to 52 percent by 2030 from 2005 levels.
