The 6th Assessment Report of the IPCC presents a clear message: we need to act fast or fail to avoid escalating and more destructive extreme weather events. The only safe scenario looking towards the future is when world governments, including the European Union, are ready to act swiftly to transition to carbon-neutral technologies already in the 2020s. The question of how investments in carbon-neutral technologies will be mobilised equitably, at the scale required to meet this massive challenge, is still to be answered. Ahead of COP26, these questions are quickly rising to the top of the agenda.
Just a month before the launch of the IPCC report, the European Commission revealed a legislative package for a massive overhaul of the current EU climate and energy legislation. In doing so, the European Commission put forward a financial proposition for the next decade that warrants careful analysis. The so-called ‘fit for 55’ package presented by the European Commission on July 14th is an opportunity to bring the EU Member States, industry and citizens on the right pathway to climate neutrality. However, whether it will have buy-in from the European Parliament and Council of the European Union will depend to some extent on the perceived appropriateness of the proposed financing mechanisms to support the package implementation.
The Fit for 2030 package builds on some pre-existing pillars of the EU Climate’s architecture and introduces new ones. The Innovation Fund (IF) and Modernisation Fund (MF) already existing in the EU ETS are retained and increased, while a new Social Climate Fund (SCF) is introduced. Financed by both the EU Member States and the European Commission, with the help of a new carbon pricing scheme, the Fit for 2030 package creates the new Emissions Trading System covering buildings and transport. This blog will describe the IF, MF and SCF composition and how they work throughout the next decade.
Financing climate action through the ETS
Figure 1. Composition of the Modernisation Fund, Innovation Fund, and the Social Climate Fund. EU ETS 1 means the current ETS, while EU ETS 2 refers to the newly proposed ETS for buildings and transport.
Figure 1 shows the composition of the three funds and how each ETS contributes to them. The following text will go into more detail on all three funds, starting with the Social Climate Fund.
The Social Climate Fund
The SCF has been proposed to mitigate the effects of a newly proposed ETS for buildings and transports. The SCF is implemented under the direct management of the Commission, responsible for all steps in implementing the SCF. The SCF provides a total of 72.2 billion euros, and the proposal distinguishes between two periods (Figure 6): 23.7 billion euros from 2025 to 2027 and 48.5 billion euros from 2028 to 2032 in current prices. The latter is subject to availability under the annual ceiling of the Multiannual Financial Framework (MFF)1. The share that member states can receive is limited to their maximum allocation share. This is based on gross national income (GNI) per capita, population size, the population at risk of poverty living in rural areas, CO2 emissions from fuel combustion by households and percentage of households at risk of poverty with arrears on utility bills. Figure 2 shows the maximum amount per capita member states can receive.
Figure 2. Maximum share per capita of the SCF member states can receive.
To access the funds, member states have to submit Social Climate Plans (SCPs), which include measures and investments to mitigate the social impacts of carbon pricing. These SCPs have to be approved by the Commission. The assessment is based on relevance, effectiveness, efficiency, and coherence and takes up to 6 months but can be extended if agreed upon. The SCPs must include milestones and targets, and funding shall only be delivered when these have been achieved. Member states have to submit requests for payment once or twice a year by 31st July. If rejected, part or all funding shall be suspended. The suspension only ends once the milestones and targets have been fulfilled. If, after six months of the suspension, this is still not the case, the EC will reduce the amount of funding proportionally. Within 12 months of the date of the conclusion of relevant agreements, no real progress has been made to reach appropriate milestones and targets. The EC will end the applicable agreements and de-commit the amount of the financial allocation. Member states always have the opportunity to present their observations. Funding from the SCF can only contribute a maximum of 50% of the total costs of the SCPs. Member states must contribute at least 50% to the total costs, including through revenues from auctioning allowances under EU ETS 2.
Figure 3. Overview of the tasks of the European Commission and member state. SCF = Social Climate Fund, SCP = Social Climate Plan, EC = European Commission.
The Innovation Fund
As mentioned above, there is a proposal to establish a new ETS for buildings and transport (EU ETS 2). This new ETS will also contribute to the already existing Innovation Fund by auctioning 150 million allowances under the new EU ETS 2. Emission sources covered under this ETS are: 1) combined heat and power generation (CHP) and heat plants that produce heat for commercial, residential, and institutional buildings (directly or via district heating) and 2) road transportation excluding the use of agricultural vehicles on paved roads. All allowances under this system will be auctioned, and there will be no free allocation. The EU ETS 2 will start in 2026 in parallel with the current EU ETS, though a permit is required from 2025. The base year is 2024, with the base amount defined as the 2024 emissions limits, calculated based on the reference emissions under Article 4(2) in the Effort Sharing Regulation. Each year after 2024, the cap decreases by 5.15% per year (the linear reduction factor or LRF). This will be followed by a rebasing in 2028 and an increase of the LRF to 5.43% unless the average 2024-2026 emissions are more than 2% higher than the 2025 cap, which would see the LRF be revised accordingly. The auction revenues will be used to finance climate action.
It is not just auctioning that is separate from EU ETS 1. In the Market Stability Reserve (MSR), there will be a separate section for the EU ETS 2. In 2026, 600 million allowances will be put in that MSR section, and if any of those 600 remain in 2031, they will become invalid. The upper and lower thresholds are 440 and 210 million allowances, respectively. A buffer of 100 million allowances is either released or absorbed depending on whether the total number of allowances in circulation falls below or above the lower and upper thresholds, respectively.
The IF is funded via many other sources, as well as shown in Figure 1. First, allowances from the free allocation (365 million) and auctioning pot (85 million) are used to fund the IF, up from 325 million and 75 million EAUs, respectively. Secondly, the proposal adds allowances to the IF that could become available if aircraft operators close. Thirdly, the introduction of a carbon border adjustment mechanism (CBAM) will coincide with a reduction in free allocation for sectors covered by CBAM (iron & steel, fertilisers, cement, and aluminium) as both aim to address carbon leakage and co-existence raises concerns of double protection and risks being incompatible with WTO rules. The reduction occurs gradually by 10% each year from 2026, resulting in a 50% reduction by 2030 and a complete phase-out by 2035 (for covered sectors). The EUAs that would have been given for free in the absence of a CBAM will be made available to fund the IF.
Fourthly, the proposal also keeps two funding sources mentioned in the current directive unchanged: 50 million allowances from the Market Stability Reserve (MSR) and remaining unused revenue from the NER300. NER300 was funded by the auctioning revenue of 300 million emission allowances from the New Entrants’ Reserve (NER) during phase 3 (2013-2020). It was intended to fund CCS and renewable energy technologies. There were two calls for proposals, with the first one consisting of 200 million allowances (1.1 billion euros) and the second one 100 million allowances (1 billion euros). However, some projects had issues attracting additional financial support and had to withdraw, resulting in unspent funds. Those from the first call are used for the InnovFin Energy Demo Projects (EDP) and Connecting Europe Facility (CEF) Debt Instrument, financial instruments managed by the European Investment Bank. The unspent funds from the 2nd call of the NER300 (735 million euros) are used to fund the first call of the IF (one billion euros)2.
Lastly, the IF can also receive funding from The FuelEU Maritime initiative. This initiative aims to support emission reductions in the maritime sector by increasing the share of renewable and low-carbon fuels in the fuel mix through mandatory emission intensity reductions and the obligation to use an onshore power supply or zero-emission technology in EU ports. It applies to ships above a gross tonnage of 5000 and covers their stay in EU ports, intra-EU voyages and 50% of voyages coming from or departing to a port outside the EU. It aims to reduce emissions by 75% by 2050 relative to 2020 (Figure 4). Each year, ships shall have a verifier issue certificates of compliance. If a company has a compliance deficit, it shall pay the penalty.
Figure 4. Emission intensity reduction targets under the FuelEU Maritime Initiative. 100% = the fleet average greenhouse gas intensity of the energy used on-board by ships in 2020 determined on the basis data monitored and reported in the framework of Regulation (EU) 2015/757 and using the methodology and default values laid down in Annex I to that Regulation. This will be calculated by the Commission at a later stage.
The company also has to pay the penalty for each non-compliant port call. These penalties are known as ‘external assigned revenue’. These will be used to finance the IF to support the rapid deployment of renewable and low carbon fuels in the maritime sector through stimulating the production of more significant quantities of renewable and low carbon fuels for the maritime sector. They will also facilitate the construction of appropriate bunkering facilities or electric connection ports in ports and supporting the development, testing and deployment of the most innovative European technologies in the fleet to achieve significant emission reductions.
The Modernisation Fund
The Modernisation Fund is completely financed by auctioning allowances (EUAs) from the current EU ETS. The current directive foresees to auction 2% of the total amount of allowances and allocate the revenue only to member states with a GDP that is 60% below the EU average. The ETS revision proposes to increase this from 2026 by auctioning an additional 2.5% of the total amount of allowances between 2026 and 2030 and allocate that revenue to member states with a GDP that is 65% below the EU average. This includes the same ten countries as before, but now Greece and Portugal can also receive funding from the MF (Figure 5).
Figure 5. Share of the revenue from auctioning 2.5% of total allowances from 2026 to 2030 as part of the Modernisation Fund (Greece and Portugal in green to highlight them as new recipients).
The proposal also eliminates all support from the MF to investments related to any fossil fuels, not only solid fossil fuels as is the case now. It also proposes an increase of the percentage of the fund, which must be invested in priority investments (as defined in Article 10d(2) of the ETS Directive from 70% to 80%). Examples of such investments are renewable energy, the support of households to address energy poverty concerns and a just transition in carbon-dependent regions of the beneficiary Member States.
Figure 6. Timeline showing the available funding sources for the Social Climate Fund, Innovation Fund, and Modernisation Fund.
Other notable changes in the ETS proposal
There are several other notable changes in the ETS directive regarding funding. First, member states must use not just 50% but all their auctioning revenue for climate action. Second, installations that must conduct an energy audit under the energy efficiency directive can only receive free allocation if the recommendations of the audit report are implemented (if the pay-back time for the relevant investments does not exceed five years and the costs of those investments are proportionate). If not, their share of free allocation is reduced by 25% unless they implement equivalent measures.
Meeting the ambitious objectives established in the Paris Agreement will depend on how quickly and profoundly our technology transformation can occur in the next decade. The EU stands as an example for the rest of the world on how to mobilise the necessary climate finance for this goal, given that its jurisdiction covers a broad spectrum of economic and industrial conditions across its Member States. So far, the direction of travel proposed by the Fit for 2030 package relies intensely on carbon pricing, social equity and innovation. Can this serve as a model for the rest of the world? While that remains to be seen, elements of this proposal will undoubtedly figure prominently at COP26.