Hold Tight! Chancellor Merz Adds to EU-ETS Policy Noise with Confused Intervention

As we have explained in our two most recent blog posts,¹ policy noise around potential reforms to the EU-ETS has ramped up over the last two weeks. This evening, German Chancellor Friedrich Merz has raised the volume of this noise with a confusing intervention at a summit with the EU industry in Antwerp, as reported by Bloomberg. The Bloomberg story hit the wires almost immediately after the market closed this evening, with Chancellor Merz quoted as saying the following:

• “This system is not the system to generate new revenues,” Merz tells energy-intensive companies at an industry summit in Antwerp on Wednesday.
• “This system is implemented to reduce CO2 emissions and at the same time to enable the companies to come to CO2-free production lines,” he says.
• “So if this is not achievable and if this is not the right instrument, we should be very open to revise it or at least to postpone it as we did with ETS2 for consumers.”
• “I‘m fully in line with all those who are saying we have to do more on climate change.”
• “I’m fully in line with all those who are saying we are looking for the right instruments, but at the cost of our industry, at the cost of the working places in our industry, this is unacceptable.”
• And that’s the reason why I’m in line with everyone who says, if this is not the right instrument, we have to talk about that and we have to change it.”

There are three confusing points in Chancellor Merz’s comments, in our view.

First, there is his point that the EU-ETS is not “the system to generate new revenues”. Presumably, what he means here is that the move to phase out free allowances – which is a source of great concern to much of the EU industry and hence a key issue for his audience in Antwerp today – should be looked at again, as raising extra revenue by auctioning more allowances should not be the priority and instead should be about protecting EU industry. For context, free allowances are EUAs that are granted at no cost to industries at high risk of carbon leakage to safeguard industrial competitiveness.

However, raising extra revenue is not the main purpose of phasing out free allowances; rather, the point of phasing out free allowances is to internalize the cost of carbon in EU industry such that the incentive to reduce emissions is increased. If the cost of carbon is not internalized, where is the incentive to reduce emissions?

The experience of the power sector is very instructive in this respect. The power sector has had to pay for all of its allowances at auction since 2008, thereby ensuring that the cost of carbon has been internalized in the power-generation sector since 2008. And in 2024, emissions from the EU power sector were down by ~65% (~750Mt) versus 2008.

Of course, the steel, cement, and other industrial sectors covered by the EU-ETS do not have the same fuel-switching opportunities as the power sector, nor the benefit of surging electricity production from renewables. However, the point is that once the incentive is created to reduce emissions by cost internalization, emissions can fall dramatically.

Moreover, phasing out free allowances is not being done in isolation, but rather hand-in-hand with the introduction of the Carbon Border Adjustment Mechanism (CBAM). And the phase-out of free allowances is happening at a very slow pace, in any case, over a nine-year period (2026-34).

Second, what does it even mean to say “we should be very open to revise it or at least to postpone it as we did with ETS2 for consumers”? Again, presumably he means the EU should be open to postponing the phase-out of free allowance rather than the postponement or suspension of the EU-ETS itself, but this would by definition also require postponing the introduction of CBAM, which already came into effect on January 1 this year.

Third, all of this raises an incredibly important point: what about the moral hazard of changing the rules on free allocation and CBAM? Companies that have been preparing diligently for the introduction of CBAM and the phase-out of free allowances would risk being penalized for following the incentives created in the Fit-for-55 package passed in 2021 if the rules on free allocation and CBAM are changed in a blanket way that takes no account of the efforts made by good-faith industrial actors in recent years. Accordingly, any extension of or increase in the free allocation of allowances that is ultimately agreed on in the EU-ETS Review should be tied strictly to investments in low-carbon technology.²

In short, and as we have emphasized in our last two blogs, the EU-ETS Review and the MSR Review scheduled for Q3 this year will undoubtedly cause more market-moving headlines in the coming weeks and months, but we were not expecting such a confusing message from such a pre-eminent figure in EU politics so soon after the comments of Jos Delbeke last week and Peter Liese yesterday as covered in our blogposts of February 5 and 10, respectively.

The market will likely sell off further from the open on Thursday morning (February 12) as participants try to make sense of Chancellor Merz’s comments against the backdrop of an already feverous political, regulatory, and media clamour around these issues combined with what is still a very high level of net speculative length in EUAs (94Mt as of Friday, February 6, per today’s latest Commitment of Traders report from ICE).

However, when the dust settles and the commotion of all these recent policy comments dies down, we think the EU-ETS Review later this year will in the end make reasonable and sustainable changes both to the timeframe for phasing out of free allowances (balanced with a commitment to invest in low-carbon technology) and to the Linear Reduction Factor from 2031 onwards, and that this will ultimately ensure the long-term integrity of the program.

In this respect, Ursula von der Leyen’s comments urging EU member States to spend 100% of ETS revenues on decarbonization today were a more constructive and coherent contribution to the ongoing debate around ETS Reform than those of Chancellor Merz, and a reassuring counterpoint.

Nonetheless, in the short-term we can expect more volatility and a probable further testing of prices to the downside.

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1. See our posts on Climate Market Now of 10 February (Cool Heads Required as EUAs Face Increased Volatility from Political Risk) and 5 February (EUAs Drop on Bloomberg Story, So What is Going On?).
2. To be fair, Jos Delbeke made exactly this point in his comments last week, and so did Ursula von der Leyen earlier today in urging EU member States to spend 100% of ETS revenues on decarbonization (see the Carbon Pulse report on Von der Leyen’s comments here).