Carbon boundary may affect China's steel and aluminum exports to terminate energy tax exemption in air shipping industry

The drastic climate policy reform proposed by the European Union will have a far-reaching impact on the carbon market, aviation and shipping, energy, steel, aluminum and other industries.

In order to ensure that EU greenhouse gas emissions will be reduced by at least 55% from 1990 levels in 2030, the EU announced a thousands-page "Fit for 55" reform package on July 14th.

A wide range of reforms have been issued, covering key EU climate policies, as well as laws on transport, energy and taxation, including proposals to strengthen eight existing legal provisions and five new initiatives. The European Commission said this required a "careful balance" between pricing, targets, standards and support measures.

For electricity and industrial carbon markets, which have been around for more than 15 years, the influential change may be the goal itself. Compared with 2005 emissions, the proposal raises the 2030 target from 43 per cent to 61 per cent, equivalent to reducing covered emissions by more than 50 per cent between 2020 and 2030, and also proposes to include shipping in the carbon market from 2026.

Drafts of some of these documents were leaked at the end of June and caused widespread discussion. Some of the reforms have been strongly supported by some member states, but they have also attracted strong opposition from other member states. For example, the proposal to include building heating and road transport in a carbon trading system has drawn criticism from countries such as Poland, but it is a priority for German policy.

Johanna Lane, policy adviser to E3G, an European climate think-tank, believes it will be difficult to reach a "big deal" on the priorities of the Fit for 55 package among member states, especially since the European Parliament has a say in the process.

In addition, non-governmental organizations, activists, all sectors of industry and even opponents of climate action will discuss and lobby for the reform plan. But a recent poll by Eurobarometer (Eurobarometer) shows that Europeans are showing overwhelming support for the EU's ambitious climate action. Negotiations on the package will take several years and may involve in-depth discussions on national priorities in each area.

France opposes, while Germany supports E3G industrial transformation and industrial decarbonization policy adviser Domien Vangenechten said that the creation of a second carbon market for the construction and road transport sector is a controversial part of the European Commission's proposal, the market will be independent of the existing electricity, thermal, industrial and aviation carbon markets.

"the European Commission wants policy and economic measures to increase climate ambitions in two areas that have hitherto been considered difficult to decarbonize, such as by making electricity and heat already constrained by carbon prices more competitive than heating fuels."

However, many member States, members of the European Parliament and other stakeholders are sceptical about the idea. At present, France has come forward to question the reasonableness of the measure, but this proposal has been affirmed by Germany.

The expansion of the European carbon market to include road transport and building heating will have an impact on low-income households, according to a report released by the Cambridge Institute of Econometrics. But at the same time, the measure is not as effective in reducing emissions in these two areas as expected.

Carbon pricing itself is regressive and may have a negative impact on poorer households. Pierre Leturcq, an European policy analyst at the Jacques Delors Institute, an European think-tank, said recent research showed that the proposal could have a significant impact on the social economy, especially on low-income families in Europe that are vulnerable to energy poverty. Their purchasing power may be seriously affected by rising fuel and heating prices.

Because of the possible knock-on effects of the establishment of a carbon market for construction and road transport, Domien said: "it is not clear whether this proposal will survive the upcoming negotiations."

To make up for this, the European Commission proposes to set up a social climate fund with a budget of 10 billion euros to provide 144 billion euros in financial aid to energy poor families over a seven-year period.

Equally ambitious among the 13 legislative proposals is a proposal to increase the annual linear reduction coefficient of emissions quotas under (EU ETS), the EU's emissions trading system, from 2.2 per cent to 4.2 per cent. By 2030, this measure will reduce emissions from sectors covered by the EU emissions trading scheme by 61 per cent.

The reform package that may affect the export of Chinese steel and aluminum to the European Union has a big premise, that is, the total emission reduction is-55% less than 1990 greenhouse gas emissions. Carbon market quotas, carbon boundary adjustment mechanism quotas, new carbon market quotas and other emission reduction mechanisms such as quotas will be planned within this framework. Some carbon market analysts predict that the average carbon price in Europe in the second half of this year is about 56 euros / ton.

Sam Van den plas, policy director of carbon Market Watch (Carbon Market Watch), a carbon market research institute, said that in fact, the evolution of EU carbon prices is difficult to predict in the short term because it depends on several external factors, such as the price of coal and natural gas, the economic recovery related to the impact of the epidemic, and so on.

But in the long run, carbon prices will rise with the tightening of carbon market quotas and climate policy. After the last European carbon market reform in 2018, carbon prices gradually rose from 5 euros / tonne to 20-30 euros / tonne in a few years. Recently, the price of carbon in Europe has almost doubled again, rising to about 55 euros per tonne. Domien believes this is because European carbon market participants see the rising trend in carbon prices as part of the European green agreement.

According to Pierre, a policy analyst, this is a level of carbon price that is in line with the EU's climate neutrality target for 2050. The rise in carbon prices will affect EU industry as a whole, but it is likely to change existing rules for industries that are still reluctant to carry out decarbonization and emissions reduction activities in the EU. For example, steel and cement producers will phase out free grants.

At present, the ups and downs of carbon prices in Europe mainly affect the EU power sector, which buys carbon quotas through auctions. At this stage, the vast majority of carbon quotas in energy-intensive industries such as steel, cement and chemicals are free. Sam said the resulting market failures should be corrected. "We call for the local use of the 'polluter pays' principle to auction all emission quotas to heavy industry instead of giving them free of charge."

The European Commission (European Commission) had previously predicted in its impact assessment that European carbon prices could reach 85 euros per tonne by 2030. In fact, many market analysts in Europe are more optimistic that carbon prices will rise even higher, reaching 100-120 euros by 2030.

At present, the expected price of the proposed second carbon market is not clear. In its impact assessment, the European Commission predicts that carbon prices in the carbon market for construction and transport could reach 48-90 euros per tonne by 2030.

The continued rise in carbon prices may have an impact on China's exports of some commodities after the carbon boundary adjustment mechanism is launched. The EU plans to gradually replace existing carbon leakage measures through a carbon boundary adjustment mechanism during the 10-year period from 2026 to 2036. The Domien believes that the two main sectors affected by China will be aluminium and steel, accounting for 9 per cent and 8 per cent of EU imports, respectively. "but both industries will continue to receive free quotas in Europe until 2035."

To end the energy tax exemption for the air shipping industry, aviation in the European Economic area has been part of the European carbon market since 2014. So far, airlines within coverage have received most of the quotas free of charge, but according to the European Commission's recommendation, this practice will be abolished and all quotas will be auctioned by 2026.

In addition, the European Commission also proposes the implementation of ICAO's global offset mechanism, the International Aviation carbon offset and reduction Mechanism ((CORSIA)), which will cover all flights from outside the European Economic area, including flights to and from China, but only if both the EU and China have implemented CORSIA.

Sam believes that the additional costs that may be incurred by this proposal in the course of trade between China and the EU will be very limited and almost negligible, as CORSIA will not incur any significant costs for airlines.

CORSIA is a system of qualified emission reduction projects officially recognized by the International Civil Aviation Organization (ICAO). The mechanism is currently in the voluntary pilot phase of 2021-2023, after which the voluntary phase will be implemented between 2024 and 2026, and then the mandatory second phase will be implemented between 2027 and 2035. In 2020, the 219th Council of ICAO examined and approved the evaluation report on the CORSIA qualified emission reduction project system issued by its Technical Advisory Committee, and recognized that China's voluntary greenhouse gas emission reduction project (CCER) can be a qualified provider of carbon emission reduction targets during the CORSIA pilot period from 2021 to 2023.

On the other hand, shipping will be included in the existing carbon market by 2026, which will go beyond the aviation industry. In the European Commission's proposal, the carbon market would cover all emissions from shipping within the European Economic area, all emissions during berthing at European ports, and 50 per cent of carbon emissions from inbound and outbound voyages.

While the above reform proposals may have some cost and trade implications, these effects will be limited. According to the European Commission's impact assessment, prices of some products will rise slightly by 0.7 per cent by 2030, while demand for goods will be almost unaffected, with fluctuations of less than 1 per cent.

In addition to the carbon market mechanism, the European Commission also hopes to link taxes to the energy content and environmental performance of fuels and proposes in the package to abolish preferential tax treatment for fossil fuels. and promote the growth of sustainable alternatives after revising the energy tax rules. The regulation is part of a broader package of EU economies coordinated with stricter climate targets for 2030, which includes low taxes on car fuel, heating fuel and electricity.

After the European Union issued the Energy tax Directive in 2003, it has been using the rules at that time for nearly 20 years. The proposed reform proposal aims to ensure that the EU energy tax is more in line with the new climate targets, proposing a shift from a quantity-based energy tax to an energy content-based tax and the introduction of fuel classification.

Under the proposal, governments could raise taxes on fossil fuels, that is, carbon dioxide-intensive fuels, and cut taxes on low-carbon fuels. In addition, the proposal also proposes a new low tax rate, while the existing tax exemption for fossil fuels will be greatly limited. Navigation for the shipping and aviation industries within the EU is taken into account and low tax rates are expected to be raised during the 10-year transition period.

Domien said it could be seen that the goal of the proposal was to keep pace with the proposed reform of the European carbon market to rebalance taxes on fossil fuels and low-carbon energy, including electricity.

It is worth noting that the governments of EU member states can impose fuel taxes on international shipping, but this is not likely to happen. Sam points out that this is because ships can easily refuel outside the EU, so the proposal has little impact on international trade. The proposal to impose a fuel tax on all flights between the EU is of great significance. However, it does not include cargo flights and flights outside the EU, so it is unlikely to have much impact on Chinese companies or China-EU trade. "