Navigating the EU ETS, its extension to shipping and the future of ETS 2

Global law firm Reed Smith hosted a Carbon Markets event on the European Union Emissions Trading System, in which a panel of regulatory, environmental, and shipping lawyers delved into compliance, emission allowances, the extension to maritime, and the next phase – ETS 2.

A packed audience joined to hear the views of transportation partner Nick Austin, environment health and safety counsel Julie Vaughan, and energy partner Brett Hillis. Panel moderator and Reed Smith partner Simone Goligorsky introduced the first topic of the EU ETS and how it works.

EU ETS and how it works

Vaughan explained: “The EU ETS operates as a cap-and-trade mechanism. A finite number of emission allowances are issued each year, and the total made available reduces year on year. There is a list of specific industry sectors whose members are required to participate in the scheme. They must obtain enough EU ETS allowances each year to cover the tonnes of carbon dioxide emitted from facilities that they operate in the EU. Allowances may be obtained at Member State government auctions or can be purchased on the carbon markets, since EU ETS allowances are tradeable assets, and they are also subject to financial regulation.

“EU ETS operators must each have an operator account at the EU ETS Registry. On the annual surrender date, there must be sufficient allowances in the account for the operator to meet its compliance obligations. Operators must also have a greenhouse gas permit for each facility within scope of the scheme. Stringent regulations govern the reporting of emissions data and require those reports to be independently verified. The system employs checks and balances to secure the Registry against fraudulent transfers and regulate government auctions.

“There are sanctions for operators who fail to comply. Each Member State can impose an excess emissions penalty and will have its own national set of enforcement provisions. The stringent rules surrounding compliance set it apart from more lenient rules found in voluntary markets.”

Emission Allowances bought and sold in secondary markets

The panel moved on to address the use of auctions for obtaining Emission Allowances (EUAs) and how they are bought and sold in the secondary markets.

Hillis explained: “The EU ETS utilises auctions as the primary means of obtaining EUAs, complemented by a secondary market for buying and selling. The auctions, conducted by the European Energy Exchange (EEX) on behalf of member states, are distinct for various sectors such as traditional facilities, aviation, and maritime. Specific eligibility rules govern participation, restricting it to entities with a compliance obligation covered by the auction as well as EU credit institutions and investment firms. Notably, third-country investment firms and banks are typically excluded from direct participation in these auctions.”

Hillis discussed trends in the EU towards limiting the ability of third country entities to open trading accounts in the EU registry: “There are now far fewer countries in which third country entities without a compliance obligation can open a trading account in the EU registry,” he said.

Introduction of EU ETS to the maritime sector

The conversation turned to the maritime industry and the introduction of the trading scheme to this sector.

Austin, who acts for shipowners, operators, and charterers, said: “It’s a brave new world for the maritime sector. Obviously, the EU ETS has been around for many years in other industries but it’s new to shipping from this year, with the recent inclusion of shipping in the EU ETS since January 1st. This is bringing with it significant implications as the EU continues to unveil new details, rules, and regulations on a regular basis.

“Presently, the EU ETS covers ships of over 5000 tons, placing obligations on entities known as ‘shipping companies’ – In the coming weeks, these companies will need to set up a “maritime operator holding account” to comply with the evolving framework. The key responsibility lies in surrendering allowances corresponding to carbon emissions by September 30 each year, with verification required in the preceding March.

“There are no free allowances being made available but instead a phase-in has been offered on the allowances that need to be surrendered. For 2024, it is 40% only of those emissions from intra EU voyages, and 20% from an EU port to a non-EU port or vice versa. Over time, these percentages will increase to 100% of emissions.

“The scheme will also start tightening in terms of the vessels covered, including to offshore vessels. And the commercial consequences are significant – there are various estimates flying around of the additional cost to the industry of ETS – some have said it could be up to $100,000 for a US Gulf Coast to EU round trip in the tanker sector. Cruise ships will be hit particularly hard because their energy consumptions needs tend to mean higher emissions.

“There are significant implications for the chartering market – how does it all work in the complex contractual structures and who is going to pay?”

“EU ETS 2 is going to dwarf the size of the current system”

In addition to expanding the scope of regulations to take in the maritime sector, last year legislation was passed introducing the next phase of the EU ETS extension.

Vaughan who specialises in environmental law, explained: “The upcoming bolt-on “EU ETS 2” is going to dwarf the size of the current system due to its broader spread of activities. EU ETS 2 will start out as a parallel but separate system in order to avoid disrupting the stability of the existing EU ETS market. EU ETS 2 is however not scheduled to go live until 2027 and could be delayed to 2028.

“The primary distinction lies in the sectors it encompasses. EU ETS 2 addresses emissions from combustion of fuel supplied for road transport and for heating buildings, including commercial facilities, manufacturing, and other business operations not previously covered. Given the impracticality of enforcing this against individual vehicle operators and building owners, the onus is being placed instead on businesses which dispense the fuel to buy and surrender the allowances – i.e., suppliers of gas for heating in housing, terminal operators and refineries. The categories are aligned with the entities who are required to pay fuel duty. Those entities are then entitled to pass the cost of the allowances on to their customers who purchase the fuel.”
Source: Reed Smith