The cost of carbon: How will the new EU Emissions Trading System reduce emissions from buildings?

What impact on households and businesses will the upcoming EU Emissions Trading System for buildings and transport have? In the third of this series, Fabrizio Varriale, Place and Space Analyst at RICS, asks: could the ETS2 place further pressure on households and businesses?

The EU’s current Emissions Trading System (ETS) covers greenhouse-gas emissions from electricity and heat generation, energy-intensive industry sectors (e.g. steel works), aviation within the EU and maritime transport. In total, these sectors are responsible for about 36% of EU total emissions. Every year, a limited number of emission allowances are auctioned to companies subject to the ETS (although some free allowances are also issued). These can then be ‘used’ or traded with other companies. This system puts a cap on total emissions allowed (at least theoretically) and leaves the price of the traded allowances to be determined by market demand.

The new ETS2 for transport and buildings

The ETS has successfully contributed to reducing emissions from the above sectors since its beginning in 2005. However, it does not presently address the large quantity of carbon arising from the use of fuels in other sectors of the economy. For this reason, in 2021 the European Commission proposed the creation of ETS2 to cover road transport, buildings and other manufacturing industries not yet covered by the existing ETS (now called ETS1).

ETS2 was created to avoid potential disturbances of the existing system and leave room to adjust the functioning of the new one. Through their combined coverage, ETS1 and ETS2 are designed to reduce about 60% of emissions from the major sectors of the European economy (with the notable exception of agriculture and land-use) by 2030, compared to 2005 levels.

The Carbon Border Adjusting Mechanism

After substantial political discussion in the European Parliament, ETS2 was formally adopted in Spring 2023 through Directive (EU) 2023/959. The Directive also includes a reform of the existing ETS1, where free allowances will gradually be phased out while a Carbon Border Adjusting Mechanism (CBAM) is introduced. This means that companies subject to the ETS1 will no longer receive ‘free emissions’, but will not have to compete against the lower prices of imported goods that are produced in countries where no carbon pricing mechanisms exist. No free allowances will be issued under the ETS2, but the initiative will begin with an extra 30% of allowances to be auctioned in its first year to ensure a smooth start. In practice, once the ETS2 comes into force, companies selling fuels destined to road transport and heating in buildings will need to report the corresponding emissions (on the basis of established values) and purchase an equivalent amount of allowances.

Could the ETS2 place further pressure on households and businesses?

The Directive requires monitoring and reporting of emissions to start in 2025. It sets 2027 as the first year of operation for the ETS2, but allows a delay to 2028 if energy prices are considered exceptionally high. This brings us to the main potential negative consequence of implementing an ETS for transport and buildings: that companies subject to the system will choose to shift the cost of emission allowances to their consumers, therefore increasing the prices of fuels used for transport and heating. Given the current trends of rising energy prices, the ETS2 risks putting further economic pressure on European households and businesses. Therefore, it is no surprise that this policy attracted criticism across the political spectrum.

Conscious of this risk, the Commission devised a series of measures to mitigate the potential impact of the ETS2. Beside the possibility to delay its start, the Directive includes a price stability mechanism. Under this mechanism, if the price of allowances exceeds €45 for more than two consecutive months, 20 million additional allowances are released into the market. Companies are also required to report on the extent to which the cost of compliance has been passed onto their consumers. Moreover, the Commission established (in a separate Directive) a new Social Climate Fund (SCF), which is expected to be financed through a quarter of the total revenue of the ETS2. For the period 2026–2032, €65bn have been budgeted. Member States will receive access to the SCF if they invest it into measures contributing to:

• energy efficiency
• building renovation
• zero- and low-emission mobility and transport
• carbon emission reductions
• reductions in the number of vulnerable households, micro-enterprises and transport users.

These measures will also have to comply with the ‘do no significant harm’ criteria established in the EU Taxonomy for Sustainable Finance. In fact, Member States must detail these measures in dedicated Social Climate Plans, which must be submitted by June 2024. The remaining three quarters of the ETS2 revenue will be made available directly to Member States, which are required to direct these resources towards climate actions, including those detailed in their Social Climate Plans.

Social impacts of ETS2

Despite the efforts of the Commission, many organisations have expressed doubts that these measures can address the potential social impact of the ETS2, particularly with regards to the SCF. Firstly, it is argued that the size of the Fund is not sufficient to offer substantial support to the large number of EU citizens that will likely be impacted by a further rise in the price of fuels. Secondly, the SCF will apply one year before the ETS2 comes into force, while some of the allowed measures will take several years to be implemented and have an effect. Thirdly, the structure of the fund allows for a wide variety of measures. As these measures include particularly questionable ones, such as incentives for electric vehicles, the SCF does not ensure that resources will be directed to support vulnerable people and businesses. Moreover, the decision-making process of the Social Climate Plans contains minimal participation from citizens, which could have steered the Plan towards more socially-oriented sets of measures.

Addressing the split incentive for renovation and retrofit

More generally, it is also argued that the benefits of the ETS2 in terms of carbon reductions will be minimal, against a significant risk of exacerbating the economic distress of people and businesses through further rises in fuel prices. At least until 2030, the price of allowances will be effectively capped at 45 €/ton, which is considered far below the costs of reducing emissions in the transport and building sectors. Therefore, there will be no incentive to pursue carbon reduction measures if their cost remains higher than the price of allowances. Building owners are notoriously slow in reacting to energy price signals, especially when the cost is borne only by their tenants. This is the problem of the ‘split incentive’, which is not addressed by the ETS2. As noted by JLL and EPRA, the economic impact of the EST2 will be minimal on real estate owners in the short term. But in the long term, more and more occupiers will feel the burden of energy prices and eventually shift their demand towards energy-efficient buildings. This will drive down the value of inefficient properties, and it is already happening to some degree.

Overall, it is difficult to foresee whether the ETS2 will have a net positive or negative impact. It will likely raise significant revenue to be directed at climate actions but will also increase the costs of road transport and space heating. In the very likely scenario of fuel producers passing the additional cost of allowances to their consumers, the real challenge will lie in the capability of Member States to mitigate how this will impact their most vulnerable citizens and businesses. It also remains to be seen whether this increase in energy prices will drive renovation measures across the building stock to any significant extent. Sectoral experts agree that while carbon pricing can be effective, it cannot drive decarbonisation alone and needs to be complemented by regulatory and supportive measures.