Getting Fit for 55

fifty five percent when compared with levels. So if you're looking to get up to speed on how compliance markets like the EU e t S work and what Fit for fifty five is, well, today is for you. We speak with Bo Chin and Emma Cocher, who both focus on carbon markets at B and F Compliance. Carbon markets have come in and out of vogue, if you will, and there have been years where the carbon price fluctuated very little. As a result, many people thought of it

as more of a carbon tax. But today not only does it really impact the companies that are paying for the credits, but there is a growing trader community which is closely watching and trading against these fluctuations. So while Article six and Cup twenty six last year brought carbon markets back into focus for some of the world, those of us in Europe, well, we're just continuing with something that was started way back in two thousand five. So I guess I asked the question, are you a carbon

nuby or veteran? BENFS Carbon Research can be found for subscribers at BENF on the Bloomberg terminal, on BNF dot com or on our mobile app. Speaking of subscribers, if you'd like to be aware of when we release new podcasts on Switched On focused on energy, transport and sustainability, just make sure to subscribe on whatever podcast player you're

listening to us on now. And as a reminder, B and EF does not provide investment or strategy advice, and we have a complete disclaimer at the end of the show. But now let's speak with Bow and Emma about carbon markets and fit for fifty five. Thank you both for coming on the show today. Boh welcome, Thank you, Dana, great to be here, and Emma, thank you, Danna, great

to be here. Alds. So we are here to talk about well, probably the thing that you guys spend most of your time talking about, which is the EU Emissions Trading System, and we're going to talk today about some important reforms that are being discussed and potentially progressed in the very near term. But before we go into what's changing,

let's go back. How long has this been around for and when was the last time since its origination there was a sizeable change to the EU e T S. E t S it's the scheme that has been around since two thousand and five. So it's a market based carbon market and it's a kind of that cap and trade system. So it basically has the absolute cap that all installations in the EU market there are around eleven southern they have to keep their emissions under that cap.

So basically installation or a company in new e T S they can either reduce their emissions themselves or pay for the emissions that they produce, and altogether they need to keep under the cap that is regulated by the

policy makers. So basically, the target by now is to achieve forty three percent emission reduction by twenty thirty and this is now to be changed or to be reformed, and the goal right now is to align the emission scheme to the larger European Green Deal and the fit for fifty five target, which means fifty emission reduction by

twenty thirty compared to nine nine levels. And on largest change for the market before this new reform has been the ms ARE introduction of Market Stability Reserve, which basically gave the extra boost to the European carbon price from eighteen. I think we'd say this is arguably one of the widest reforms the EU e t S has seen, and

actually globally and et S schemes. If they can pass these reforms, this will be a pretty significant change across the number of the elements of the overall European Union emission Trading scheme and this will apply to every country that is in the EU and has companies operating physically on their soil or on their soil, and overseas there

will be those that are physically on this soil. So there's also the scope for currently entr EU airlines as well, but that's also up to reforms whether this scope would be changed. So you referenced the fit for fifty five reforms, which is what we really want to delve into today. They're looking to bring down emissions by which industries is this going to impact because it appears that there are actually some new industries that will be impacted by these reforms. Indeed,

that's right, Dana. Eu E t S a carbon market in Europe has always borne bigger emission reduction burden than the rest of the sectors. So how fifty five percent will translate into EU E t S. It's going to be higher. So the proposed figures have been from permission, it's been sixty one percent emission reduction for those EU E t S sectors and now that we have seen from Parliament this suggested number is sixty three percent emission reduction.

What does this basically mean to the sectors under the EU E t S scheme is that they need to crank up their emission reduction and also investment into those low carbon technologies. For power sector will expect more fiel switching from cold to gas, as well as uptake of renewables,

more wind, more solar and batteries. And then what this means for industries is that they need to look into the technologies that they can use to reduce their emissions, so whether that is hydrogen CCS or bio fields or electrification. What do the changes in FIT for fifty five mean for some new entrance to this space, so specifically maritime

and shipping. I think the shipping space in particular has been something that people have really been focused on as a just a critical part of the economy as we are looking at supply chains and how completely international and global a lot of those are as we're dealing with, you know, inflation. As EO targets deep decarbonization and NEST zero, they have to include shipping emissions into the scope as well.

That's one reason. Another reason has been why we need to include shipping is that aviation, especially entre u aviation, has already been susceptible or they have been already been included to EU e t s and they have been mandated to pay for their emissions. So it would be fair to have owth shipping and aviation in the same scheme as well as for buildings and transport. There is

a separate market now proposed for them. The reason to have them separate is mainly that one, they're more consumer facing, so separating them would allow setting up mechanisms to protect those more vulnerable groups, especially those who are more vulnerable in terms of higher energy costs like consumers and small and medium sized companies. Another reason is that the cost

for decarbonizing buildings and transport are very high. By including them into the carbon market, we may not see significant emission reductions in these sectors immediately, so the incentive to reduce emissions in these sectors wouldn't be instant. By having a separate market, we could also introduce other supporting mechanisms

to make this happen. For example, what Spending suggested a format to kind of accelerate decrbinization is contract for a difference carbon contract for a difference to be exact, and what this means, it's basically to use the curbon market and the carbon price as much as we can, but then top up with additional amount of kind of subsidy so that we can reach the price needed to drive this emission reduction. I think, just on the fairness point, so Bo just raised it, it's fair to include shipping

alongside aviation, which has already included with buildings. If your building is current electrified, so you're using a heat pump in your home that actually has a carbon price associated with it, Whereas if your home is currently using gas, there is no carbon price associated with it, So this is in order to level the playing field for buildings alongside sectors such as the power sector, which is already included in the EU e t S. So let's go another part of this which is meant to level the

playing field and also quite contentious within the proposed changes, which is the carbon border adjustment mechanism. What is this and why is it so contentious? So the Carbon border adjustment mechanism, as we've just been discussing, the majority of industrials in the EU are within the EU Emissions Trading Scheme, so this means any ton of emissions produced they must

pay then the respect of carbon price. If goods are imported from an outside country, that country may not have an equivalent scheme to the EU Emissions Trading scheme, which means that those goods are produced without having to pay a carbon price. So what the carbon border adjustment mechanism

tries to do is effectively equate those two products. So a ton of steel produced in the EU paying an X amount of carbon price is going to be the same as a ton of steel produced outside of the EU, where they will pay effectively and input X that will be equal to the carbon price the ton of steel and the EU has had to pay. Now it's controversial, of course, because this would require the EU effectively regulating

production from outside of the European Union. Also, there's the second part of it, which is we haven't seen significant industrial decarbonization in the EU emissions trading scheme because industrials have received free allocation and so what that was is effectively free permits in order for them to produce that ton of steel but not pay the effective carbon price.

And so in order for it to be fair if outside the EU is paying a carbon price, those free allowances have to be removed, which means current production within the EU will then have to pay the full carbon price. So what about the countries that do have their own trading mechanism and how will this impact and interact with them?

So I'm thinking actually specifically the country that we're sitting in, m Au and I bow is spose in the States, but the United Kingdom, since Brexit took place, they've set up their own e t s. How does that interact with these new potential rules. Will there will be a bit of a change you expect on this side? How long will that take and how does it interact with

a carbon border adjustment mechanism. So actually the u K e T S has or emissions trading scheme has traded actually at a bit of a premium compared to the EU emissions trading schemes to actually permits are slightly higher in cost than we're seeing in the EU. That means is effectively, if you are paying more under your local scheme then the EU emissions trading scheme, you wouldn't have

to pay that carbon border adjustment mechanism. So this is going to hit countries who either don't have a carbon price at all or have a much lower carbon price than the current price of European Union allowances. It also depends on your imports emission intensity, so if your imports mission intensity is lower than the existing benchmark in Europe, you can also avoid paying that carbon levy at the border. Basically, if we kind of summarize, the main point for this

carbon border adjustment mechanism is really three. One is to ensure the fairness of competition for different industries, especially those under the EU E T scope. Then second is to reduce emissions ensure that you can achieve that the net zero goals and the set mid term emission goals as well. And then the third is to encourage also other countries

to take up emission reduction pulses. So what will take the fit for fifty proposals from more than a proposal and something that is actually going to come to pass and actually impact the way that the e ETS functions. So how this works in the European Union is effectively European lawmakers have to agree amongst themselves. So there's are three key parties that need to agree. So the European

Commission is the body who proposed for fort. The next stage as it goes to the European Parliament to either agree or disagree on all of the elements that have been proposed by the Commission. So the Parliament must agree amongst themselves whether they're happy on each of the proposals or they propose amendments. Once Parliament has agreed, this thing goes to the European Council and the European Council does

the same. Are they happy with the proposal, would they prefer to amend as both said, the European Parliament has suggested a higher emissions reduction, so sixty three percent decline and emissions compared to sixty one from the European Commission. And so the European Council either agrees with the Commission

or agrees with the Parliament. It's all of its circular and then once all three have agreed their position, it goes into trialogue negotiations they agree amongst themselves, and once that's occurred, which we were hoping to see at the end of this year early next, it will be introduced into legislative process. How long is that going to take, That's the question everyone's asking. Because of the significance of these reforms, these negotiations are set to take a bit

of time. Just recently, the European Parliament Plenary actually voted down the proposed amendments for a significant part of the EU e t S or Emissions Trading Scheme reforms. And so what that does is it sends it back to the sub committees of Parliament to renegotiate, and then it will come back up to Parliament plenary to vote. So any setbacks like this adds at least a few weeks.

This entire process usually takes around one to two years. Okay, so one to two years we're sitting here at These are supposed to impact the market for well, for goals that are actually focused on. Is there any concern that it will take too long to actually come to pass in order for these rules to have a meaningful impact on emissions reduction. The longer we wait, the shorter time frame in which participants within the market will have to

reduce your emissions. And so we're expecting in terms of those emissions productions that there will be a one off free base, effectively a one off adjustment where we reduce the number of allowances in the market and then it continues to decrease per year as it does currently. What that means is you squeeze it into a few years, and it's likely the scarcity will drive the price of the allowances even higher. Actually, the risk of postponing is increasing.

Maybe we will still be able to reach the timeline targets that we have in mind, or at least what the consensus of the market have in mind. This consensus right now is to start the reforms, our implementation of the reforms in twenty four What this risk of postponing would mean right now if short term is just more uncertainty, and this uncertainty of policy is on top of the market on centinety is that we have been experiencing as well.

Amidst inflation risks, commodity risks and also bigger economic risks. Carbon has basically been seen as the commodity that has more stability. Having this amount of policy delays and changes, are not convinced in the market at the time when the market really needs quite a lot of market confidence.

In the long term, though, what this means is that we could see drastic actually market movement because we need faster emission reductions in the later years, we may see more market volatility actually than less market molaticity, which is also maybe not what the policymakers in Europe would like. Now for a very short break, stay with us. How are carbon traders and those who are actually looking to I guess profit off of the volatility within the market.

How are they looking at this? And then also how are the businesses that are going to be directly impacted looking at it? Is there a lot of resistance and are there areas of support? Carbon market has been a keep place for traders in the last few years, and we have also seen an influx of financial intermediaries coming

to this market mainly for several reasons. Maybe the most obvious one is that this is a commodity where there's a declining supply and the demand is rather in a lastic as we said, to reduce those industrial emissions, it's really expensive. So in that way the trajectory for carbon price is well the required carbon price to reduce emissions in line with what the policymakers are saying is upwards. There are attraction for this commodity in other ways as well.

One is that it's an environmental sustainable asset, so people who want to expand their investment for photios to more sustainable products, greener products, carbon could be seen as a

good option. It can be also used as a hedge in tool or like carbon intensive investment, but also for interest risks because carbon in general track the technology that would be out the margin to abate the required amount of emissions, and that technology is usually aligned with an increase in interest risks in the market as well, so that it will be investing in carbon would naturally also

head you from interest risks. So being ear f expects the price of European Union allowances to hit one thirty six years put down nominal by So that high price presents an opportunity for traders with increased folatilely as Bo was just mentioning, But it also presents an opportunity for companies who are producing low carbon solutions. So we're starting to see low carbon industrial solutions for example c c U s start to become competitive when we're seeing prices

this high. So it's it's no longer where carbon is not heading balance sheets, so emitters it's just quite happy to just continue to burn. Fossil carbon is now becoming quite a big consideration in terms of the power sector, in particular when they're coming to retire assets or invest

in new assets. Now, as we know, everything within the energy transition is interrelated, so with high gas prices and sanctions on Russian gas and oil at the moment, and then also what was already going to be a very expensive year when it came to power prices, how has this impacted how the European Commissioned, European Union, European Parliament are all looking at these proposed changes. In part there's

a couple of interesting dynamics that are playing out. So moving away from gas in the short term has seen significant colburn, but actually it has also led to europe In countries looking at increased renewables for instance, and any investment in renewables that come on board will eventually decrease the carbon price because effectively they don't have to pay

for as many permits if those come online. In the near term, however, the European Union is looking to fund the transition away from gas, and what they have done is proposed selling the spare allowances from the market stability reserve from the European Union Emissions trading scheme to raise a figure of twenty billion out to six in order to facilitate this move away from gas. This has some

pretty significant risks. As both said, we're already seeing increased volatility in the carbon market from the reforms, and so any additional quite sporadic policy announcements like this moves the price significantly. The other part of it is that they haven't specified the number of allowances. They've only specified the monetary amount, so as you can imagine, if you start selling allowances into the market and adding additional supply, this is likely to be bearish for the price. A low

low of the price so become quite circular. You didn't have to release more allowances in order to raise the amount of funding that you need, which again carries on the spiral downwards. Yeah, exactly, and it adds to the amount of uncertainty in the market right now because if we look at this plan what the magist described, it is called repower EU. So a part of this plan is to increase the supply to the market through ms

Market Stability Reserve. Another is to double the Innovation Fund auctions this year and also another the third part is to also increase the contract for a difference budget for the EU Innovation Fund. How this would impact the market is that if we the the technologies to reduce emasines would get funding from elsewhere then the carbon market. That's also bearish for the market. But we have to also look at the market outside of this only reform, but

all of the reform packages. So now we have four before we are we had three packages, so fifth for fifty five carbon Border Adjustment Mechanism and MSR reform. So this add one layer of additional answer attempting. So we would have now fit for fifty five RA power you see them an MSR. So the collected impact on the

market is becoming more and more unknown. Meanwhile, for like for carbon investors more from the financial financial markets, they are also in a difficult situation because one is all this uncertainties and another is that part of this reforms also proposed that they may be exempt from this market if reforms get moved forward. So all in all, a lot of uncertainties in the market. Well within the uncertainties and within some of the industries that are actually going

to be impacted. Let's talk a little bit about the hard to abate space. So we already discussed maritime and shipping and buildings, which are new entrants to this, but how about some of the spaces that have had pre easily had very generous allowances. So let's talk about cement, fertilizer, aluminium or aluminum depending upon you who you are. What are we seeing there and is that where a lot of the uncertainty really lies and how they will be impacted.

For hard to abate sectors, they know that EU has emission reduction requirements from them and they can now see more or less the trajectory because the sixty one sixty three is different but still quite similar in terms of where we're going. But for them, the answertainty is how much the air free allowances will be actually reduced. The

rate has been suggesting rate has been quite different. There's the Commission hosts at ten percent annual free allowance reduction from and now at the Parliament suggested also another figure, more easier one, so they would have more free allowances towards. So for industrials in the European Union emissions trading scheme, it's an interesting question. They've been included for a number of years, but the free allowances have effectively insulated these industries.

That's currently proposed that these free allowances would be phased out as you know, a carbon border adjustment mechanism is faced in What this means is their industrials are now looking at what their decombanization options are, So for instance, in aluminium or steal, they're looking for electrification, they're looking for hydrogen, they're looking for ccus. The question is a lot harder than the power sector, where wind and solar

became the dominant technologies of choice. Industries have had a lot longer to consider solutions. But in fact what that's meant is actually the price of these emissions allowances has also grown, so they're going to start feeling that or realizing the carbon price at a much higher rate than

the power sector was previously. So the power sector was included and the phase out of free A and for the passing to Heppen the number of years ago when the average price was setting a lot lower being Eve predicts the average price to be eighty four euros per

ton this year, so already significant. So if industries are getting phased out around the mid twenty twenties towards and beyond, by this stage we're expecting the carbon price to be significant, So they're going to get hit with either really high carbon prices or are probably still pretty high de carbonization options. I think how the hard to bid industry could see this like either as an opportunity or as a risk.

In terms of a risk, M already measured quite well that the current price is increasing and the free allocations decreasing, so the effective carbon price for industries is also likely to increase and potentially quite drastically. But it could be also an opportunity in a way that by investing before the other competitors globally, they could achieve a carbon advantage, and this carbon advantage could be beneficial globally as well.

Outside of Europe, there are already customers who are looking for green products feeding into this demand could brain additional revenue streams now investment into cleaner technologies in order to aid in decarbonization. Therefore, you know, emissions reduction from a lot of the companies that are participating in this and located in the EU, that is one of the desired outcomes. That's what the European Union is trying to accomplish with

these reforms and actually with the existing system. Is it really visible to them to all of us, what technologies are really indirectly linked to the pressure being put on them by a high carbon price? Or do we really only see it when a technology makes it Because invariably R and D and development of technology doesn't always end up working out. Timelines can be very different than what was initially anticipated when somebody sets out on creating solutions.

And as we increasingly get to the space of industries that have a limited number of options and solutions available to them today, do you think it will be clear and easy to link back a lot of the progress that we hope to see over the next few years and how that actually the EU e t S impacted that.

I think it's a really interesting question and it's something that the EU e t S or Emissions Training Scheme is not new, right, It's been going since two thousand and five, and what we have seen is it's been hailed as a pretty big success in terms of pushing the power sector to decarbonize. And so what we've actually seen is a pretty significant decline in power sector emissions and the uptake of low carbon solutions such as solar and wind. It's the cornerstone policy of the European Union

to drive emissions reductions. It doesn't mean it's the one solution so Bo mentioned earlier. It may well be that this is combined with upfront subsidies or carbon contracts. For difference, the Innovation Fund, which is a scheme that's funded by the European Union allowances, actually then recycles that revenue and invests in early stage projects. For example, we've seen a number of hydrogen projects received funding. So the carbon price might be the stick, but there is a carrot that

is being dangled because of revenues generated. Yeah, exactly, So yes, it's not a simler bullet to solve this energy transition questions. But it brings transparency to the narrative. It gives the industries an actual number at price signal that shows that the cost for emitting it's going up. So there's a crisis and there is a driver for them to do

something about it. So if you had to summarize what are the main stumbling blocks that you think stand between it being approved tomorrow and going into practice and what they're actually discussing over there in Brussels, I think what's

interesting is that actually we're fighting over technicalities. So the carbon border adjustment mechanism was originally seen as the most controversial and incredibly hard to get through lawmakers, But what we've seen actually is the debates are surrounding the timeline, not the carbon border adjustment mechanism. The same goes for the wider reforms of the EU emissions trading scheme. We're seeing lawmakers fight over percentage reductions, not increasing the ambition.

So I think the positive thing to take out of the reforms as they stand today is the big and the bulk of the changes are going to make it through the current negotiations around a bit more about what form they're going to take, but actually the direction of travel is emissions reductions and movement towards net zero for

the European Union. Think, the main then that EU needs to agree on is how to get from today to tomorrow at the same time resolved the same questions in a way that energy security, that cheapness of the energy, and also the clean ness of that energy. And this includes both power sector and industrial sector and potentially other sectors that are under the like European Larger European Economy

and European Emission scope. And what you has been saying is that it doesn't just want to maintain the status quote for this three angles, but they want to push hard on the decarbonization part. And what that means is that at the price need to be even higher to show this direction of change and to drive this direction of change. So we will have to watch and see what happens as they're looking at the fifty five measures. Emma and both, thank you so much for joining and

explaining to us in more detail today. Thank you very much, Thank you, day night, It was pleasure. Today's episode of Switched On was edited by Rex Warner of gray Stoke Media. Bloomberg any F as a service provided by Bloomberg Finance LP and its affiliates. The recording does not constitute, nor should it be construed, as investment advice, investment recommendations, or

recommendation as to an investment or other strategy. Bloomberg. An e F should not be considered as information sufficient upon which to base an investment decision. Neither Bloomberg Finance LP nor any of its affiliates makes any representation or warranty as to the accuracy or completeness of the information contained in this recording, and any liability of this recording is expressly disclaimed.