EU-Chinese cooperation can become a game changer for global climate talks, with a carbon market deal drawing in the United States

BREXIT BLUES
The UK has been a world leader in free-trade solutions to the climate crisis, making its departure from the EU a big blow to the trading bloc’s ability to keep its carbon reduction efforts on an affordable track

CHINA CONFIDENCE
Announcement by China of its goal to achieve net-zero emissions by 2060 boosted confidence in the willingness of big Asian economies to participate in global climate-cooperation, such as the carbon market favoured by the EU

BLOCKCHAIN BOOST
Introduction of IT ledger technology could help oil the wheels of cross-border emissions trading between the EU and the rest of the world, as well as trade in cleaner energy-intensive goods

KEY QUOTE
International cooperation matters because a global solution is the only way of tackling all the pollution that is harming the climate

Europe’s Emissions Trading System (ETS) for buying and selling carbon allowances is the world’s largest and is watched by traders and lawmakers around the world. In the first 15 years of the market’s existence it proved to be an effective agent for behavioural change: heat-trapping emissions fell as financial strategists took avoiding action to dodge carbon penalties. The drop in emissions has helped the EU’s member countries to easily beat their collective target for a 20% reduction by this year, compared with emissions in 1990. Much of the carbon reduction is down to the ETS and the carbon penalties it applies to power stations, factories and domestic flights. The system’s caps on emissions—enforced by penalties—and the price it puts on units of carbon reduction that are sold to market players who cannot otherwise avoid penalties, has spurred power utilities to switch to renewables and natural gas from dirtier coal and encouraged billions of euros to flow into energy efficiency projects that may not have happened otherwise. The EU is now seeking to transform the ETS and by doing so create a standard for the rest of the world. The transformation will introduce a dramatically tighter emissions reduction target for 2030, review the rules of the “reserve” designed to soak up spare allowances, and link currently separate policies for trade and climate protection. New advances in information technology, such as blockchain trading software, can help unleash the power of market forces to boost carbon trade, potentially ushering in a period of clean economic advancement around the world under the 2015 Paris climate deal. But for the EU’s carbon market to be effectively reformed, a few wrinkles have to be ironed out first.

MARKET UPHEAVAL

The UK’s exit from the EU will shrink the carbon market by the biggest amount ever, with more than 1000 factories, power stations and airlines pulling out or scaling back. Britain has been a world leader in free-trade solutions to the climate crisis, so its departure will be a big blow to the EU system. The country could establish its own carbon market and potentially link back into the ETS. Still, the shrinking of the ETS market is one of the many disadvantages of Brexit, as it erodes international cooperation on the climate crisis. International cooperation matters because a global solution is the only way of tackling all the pollution that is harming the climate. National measures will not work if companies can shift activities to a country with more relaxed climate policies. Ultimately though, the UK, the EU and North Africa are set to become much more linked via power networks, whatever happens with Brexit, says Michael Liebreich, of clean energy advisor Liebreich Associates. Whatever Britain decides on carbon pricing after its exit, convergence on the price levels needed is likely because of the power-network links planned across Europe and North Africa. “It is pointless speculating what comes out of a negotiation … (but) there needs to be close alignment with the EU. You trade most with those closest to you,’’ he says. Norway has participated in the EU carbon market from its periphery and has done fine, he adds. The biggest threat to the carbon market posed by Brexit is the broad economic fallout from a disorderly divorce on December 31, 2020, restricting commercial activity already stricken by the effects of the coronavirus pandemic. Demand for carbon allowances could plunge, unless there is also a countering level of buying from speculative money that has been entering the carbon market the past three years. The prospect of weak output is one of the reasons why European carbon allowances had plunged below €24/tonne in mid October 2020 from above €30/tonne about a month previously. As Mark Lewis from the asset management arm of bank BNP Paribas says, a no-deal exit can be a bigger hit to the UK’s economy, but it will also hit the EU.

TOUGHER TARGETS

Making the ETS more effective is vital to keeping the EU’s flagship climate policy effective and influential. Top priorities are to tighten the 2030 emissions reduction target and stop handing out so many free carbon allowances with the purpose of shielding particularly dirty industry from crippling penalties. European member governments are yet to make a decision on a more aggressive emissions-reduction target for 2030, an indication that the various countries in the bloc are still struggling to agree on the pace of the region’s energy transition. For its part, the European parliament has sought to tighten the 2030 emissions target to 60% below 1990 levels. That is five percentage points tighter than the level suggested by the European Commission and much more ambitious than the current mandated level at 40%. Whatever the end result, it means fewer carbon allowances in the market and likely higher prices. “I would not rule out some sort of compromise between 55% and 60%—57% or 58%,” says Lewis. “The parliament is increasingly keen to be seen as a meaningful developer of policy.” The European People’s Party, the biggest group in the European Parliament, is in favour of including international cooperation in any deal on the more ambitious 2030 target. That could include links with other carbon markets and would provide the region with a pool of credits to tap into—this would help ensure the target can be complied with cost as effectively as possible. The reason the EU is being so ambitious is simple. Cutting emissions was easier than it feared when the market was launched in 2005. The system has been so successful at helping to cut emissions it was vastly oversupplied with emission credits (allowances) for much of the past decade. With supply well-outstripping demand, allowance prices reacted to market forces and stayed much lower than expected. The EU set up a market-stability reserve (MSR) to soak up that surplus. At the end of 2019 the reserve contained 1.3 billion tonnes of allowances, enough to cover total emissions for about four months. The urgent incentive to invest in the emissions reductions was still missing. A further reduction of even more allowances, using the reserve as the tool, is being considered by the EU as part of its reform of the market. Meantime, the most ambitious element of the EU’s plans to change its carbon market is also the most controversial. It is planning to impose a carbon border adjustment as soon as next year on imported energy-intensive goods, to shield its own industries against cheaper imports from countries with less-strict climate policies. Design and feasibility details are still being worked out but the plan could initially be tested on industries such as steel, cement and aluminium. Even a test, however, risks breaching World Trade Organisation (WTO) rules, which prevent discrimination between domestic and foreign producers.

THE CHINA CARD

China’s adoption in September 2020 of a “net-zero” carbon target for 2060 has boosted confidence among climate change lawmakers that developing economies may be willing to participate in efforts to create global climate-cooperation systems, such as the carbon market favoured by the EU. The world’s most populous country exports more goods to the EU than any other and the carbon border adjustment proposal is providing China with an incentive to clean up. It already has several pilot carbon markets and is now setting up a national system to replace them. China’s climate plan may also signal a key pivot in global climate protection and give the EU an opening to adjust its carbon market and its terms that currently govern energy-intensive imports. The EU-Chinese cooperation could also potentially become a game-changer for global climate talks since a deal between those two could draw in the United States, Europe’s biggest export market. Distributed ledger, or blockchain, technology has the potential to make the EU’s border adjustment measure easier to implement than critics of the import tax realise. A distributed ledger is a database that is consensually shared and synchronised across multiple sites, institutions and geographies, accessible by multiple people. It allows for transparent and secure trading of goods and financial instruments, including carbon allowances. Such a ledger could link to customs and carbon markets in Europe, allowing a steelmaker in Turkey—outside the EU—to instantly pay the same carbon price as an EU producer selling to an EU buyer. To do so, the blockchain could tap directly into live market prices. Structured this way, such adjustments to prices at the border could be within WTO rules, argues Marco Zolla, a lawyer. “Blockchain could be a tool to integrate trading and carbon systems around the world,” he says, while admitting it would still be “a super complex measure” to implement. China’s precise strategy in announcing its net-zero target remains unclear. It might be mainly seeking to ensure its exports to the EU are protected, Zolla says.

BLOCKCHAIN BENEFITS

Another benefit of blockchain technology may be to boost confidence in carbon markets more generally, increasing the prospects of new speculative money flowing into the EU’s market. Speculative money, flowing from hedge funds and proprietary trading desks, has been a crucial reason for gains in EU carbon prices, because that money ties up allowances, meaning they are no longer available for purchase by factories and power stations covered by the system. More such interest from investors would underpin future price gains expected by analysts. It could herald the start of what Zolla calls a “new digital commodity”. The European Commission would not be drawn on if blockchain technology could help the region implement its border measure. “It is too early to speculate on the final design of the future carbon border adjustment mechanism. Our public consultation ended on Wednesday evening past, and we will now proceed to examine closely all contributions. The results of the consultation will also be published as usual in due course,” says an EC spokeswoman. Whether the EU ends up introducing its carbon-border adjustment or not, planning it may be a way to draw more national governments into accepting carbon markets as a climate solution, agrees BNP Paribas’s Lewis. “The politics of it are still pretty complicated,’’ he says. Still, unless the adjustment or something like it is introduced, the EU will need to keep giving away free allowances to factories—its current system for protecting its industry against “dirty competition” from outside the block. “If you do not do that, then you can never move on from a system where only the power sector is paying the full cost of allowances,’’ Lewis says. “You have to have industry paying for the allowances—you have to grasp that nettle at some point.”

TEXT Mathew Carr