As environmental protection and decarbonization efforts have ramped up in the past few decades, policymakers around the world have come up with a variety of schemes to lower industrial emissions. The Kyoto Protocol in 1997 committed developed nations to reduce their greenhouse gas (GHG) emissions by a defined amount from 1990 levels by 2012. The treaty was never brought up for ratification in the U.S. Senate, which unanimously opposed it because developing nations — such as China — weren’t included. Across the Atlantic, the Kyoto Protocol was received much more favorably, with all 15 members (at the time) of the European Union (EU) ratifying the treaty in 2002. In 2005, the EU launched the Emissions Trading System (ETS) as a mechanism to help reduce emissions from power plants, industrial facilities and commercial aviation, covering nearly half of total EU emissions. In today’s RBN blog, we explain the European cap-and-trade system, examine how the ETS is affecting the EU’s refining industry as a whole, and drill down to the refinery level to discuss disparities in carbon-cost exposure from one refinery to the next.

This is the second part in our series, which dives into the complex world of oil refining and carbon regulation, and how carbon emissions are likely to increasingly impact the competitive playing field for refiners in the Atlantic Basin. In Part 1, we covered the scope of emissions from refining operations (accounting for 3% of overall U.S. GHG emissions) and how refinery complexity and crude slates play a role in emissions intensity. We delved into where those emissions come from within the refinery and some ways to reduce them, and how, due to the nature of refining, the only way to make drastic reductions to emissions was through costly carbon capture and sequestration (CCS). We also touched on some mechanisms governments can take to “nudge” refiners and other emitters to invest in carbon capture and reduce their overall emissions. Today, we dig into one of the three approaches: cap-and-trade.

In a cap-and-trade model such as the EU’s ETS, the government sets a certain threshold on a regulated activity (the “cap”) and then steps the cap down over time. In this case, annual GHG emissions serve as the regulated activity, with the cap falling by a certain amount each year, usually a couple of percentage points, until the specific emissions target is reached. “Allowances” function as carbon credits in the ETS, with each one representing 1 metric ton of carbon dioxide equivalent (MTCO₂e) emissions. They are distributed to emitters in various ways (more on that in a bit) and industries covered by the ETS must surrender an EU allowance every year on April 30 for each metric ton of emissions over the previous year. A secondary market is set up so emitters can freely trade allowances with each other to cover any imbalances between an emitter's emissions and allowances on hand — the “trade” component of the scheme.

The first cap-and-trade system in place was the U.S. Acid Rain Program, which was launched with 1990’s amendments to the Clean Air Act. It targeted nitrogen oxide and sulfur dioxide emissions and was implemented in 1995. The first cap-and-trade scheme focused on GHG emissions was implemented in 2003 in New South Wales, the Australian state where Sydney is located. It was shut down in 2012 when Australia implemented a carbon tax to avoid duplication. The ETS was implemented shortly afterwards and is currently the largest cap-and-trade system for GHGs.

Figure 1 shows long-term, historical GHG emissions for the EU (yellow line) and U.S. (black line), while the blue line shows the portion of EU emissions covered under the ETS’s current scope. (For the ETS, we use EU-27 figures — that is, those for the 27 current member nations — which excludes UK data due to Brexit. Also, during the first two phases of the scheme some emissions weren’t covered.) ETS emissions have gone from 46% of total EU emissions in 2005 (left end of blue line) to 38% in 2021 (right end of blue line) and have been falling much faster than ESD emissions — a fact that supports the view that the ETS has been effective in helping the EU reach its emissions goals. The EU lists all other emissions not included in the ETS as Effort Sharing Decision (ESD) emissions, which includes agriculture, domestic transportation, buildings (residential and commercial), waste and other combustion, likely small industries that don’t make it into the ETS. (More on those in a bit.)

The European Climate Law, which was formally adopted in 2021, has enshrined the European Green Deal target of the EU becoming carbon net-neutral by 2050, with an intermediate goal of reducing emissions by 55% by 2030 from 1990 levels. The ETS is a big component of accomplishing this goal. In Figure 2 above, you can see the overall price of carbon for the duration of the ETS, represented by EU Allowances (EUAs) that are traded in units of 1 MT CO₂e. The World Bank estimates that a carbon price of $50-$100/MTCO₂e would be required to hit the 2015 Paris Agreement’s goals of limiting the rise in global temperatures to 1.5^o C above pre-industrial levels. The ETS has only recently reached that price band. The effectiveness of the ETS as a deterrent to emissions has been hampered because the emissions cap was too high compared to actual verified emissions over the life of the scheme, which created a surplus of EUAs to be allocated and auctioned. Numerous steps have been taken in the last few years to reduce this problem, resulting in EUA prices reaching levels that should start having a larger impact on emitters going forward.

So how do emitters acquire EUAs? Figure 3 shows the total verified emissions (red bars) covered by the ETS and the EUAs issued each year. Those EUAs are broken down by auctioned EUAs (yellow bars) and allocated EUAs (green bars), along with the free EUAs (blue bars) given to some emitters each year. Allocations are given to emitters based on historical production. After 2013, allocations were only given to industries that were deemed to be potentially harmed by the ETS due to disadvantages compared to international competitors in non-regulated regions. Most industries — such as oil refineries — compete internationally and therefore continue to get a free allocation of EUAs. An industry benchmarking process is applied for these allocations, which uses the best-performing 10% of comparable installations producing a certain product. The bottom 90% of emitters within an industry sector have to go to auction or market to cover their excess emissions.

Then there’s the issue of carbon leakage, which occurs when, for reasons of costs related to climate policies, businesses transfer production to other countries with more relaxed emissions constraints. To tackle this issue, the EU is implementing a Carbon Border Adjustment Mechanism (CBAM), starting with the cement, iron and steel, aluminum, fertilizer, electricity and hydrogen industries. Importers will need to report the emissions associated with their products sold into the EU and surrender CBAM certificates just as EU industries surrender EUAs against their emissions. Certificate costs will align with EUAs. Initially, importers will only have to report their emissions during the first two years. After 2026, CBAM certificates will be phased in as free allocations are phased out for EU industries. The EU will also be developing a timetable for all other industries, including refining, not currently included in the CBAM.

Now that we have gone through how the EU’s ETS works, let’s circle back to refineries. In Europe, refining emissions (black line in Figure 4) have been consistently about 2.5% of total emissions since 1990. Domestic transportation emissions (yellow line), however, have steadily increased from 14% to 21% over the same period. Most of those emissions are from road transportation — cars, SUVs and trucks, the vast majority of which run on diesel or gasoline. This means that, similar to what we discussed previously for the U.S., for every metric ton of emissions a European refinery puts out it will create fuels that emit another 7-8 MT of emissions. Domestic transportation is the largest sector of ESD emissions that has not fallen, staying relatively flat since 2005 (along with agriculture), outside the aberration in 2020 for COVID. The EU plans to launch a trading system to tackle domestic transportation and building emissions, referred to as ETS 2, around 2028.

Now, you are probably thinking the ETS is having a pretty big impact on the refining sector in Europe — especially with EUA prices recently hitting the €100 mark! However, to some extent, you would be mistaken. As shown in Figure 5, just under 80% of European refineries’ EUAs are allocated to them, so the true cost impact relates only to emissions that exceed the allocation. That shortage (actual emissions minus the allocation) must be covered either by EUAs banked in prior years or secondary markets. The overall difference between actual emissions and allocated emissions is about 25 MMTCO₂e annually. The EU processed around 9.4 MMb/d of crude in 2021, so the cost to refining margins on average has been about €0.73/bbl with EUAs at €100. However, there are winners and losers.

While the sector as a whole only needs to pay for about 20% of its emissions, this varies greatly from one refinery to the next, as shown in Figure 6, which ranks refineries by the magnitude of their verified emissions (black bars; highest emitters to left). For a handful of refineries, their allocations (yellow bars) are higher than what they emit, while a few others emit much more than they are allocated. The refinery with the greatest EUA deficit in the chart (black and yellow bars to far left) processes 300 Mb/d and could see its margins impacted by a sizable €3.25/bbl (at €100/MT). The refineries toward the right end of Figure 6 that had allocations they did not produce against were most likely to have their allocations cut in 2022 (and some did, according to the data).

At the moment, one might argue that the impact of the ETS on refining and other industries is pretty minimal since most emissions are covered by free allocations. It might even be fair to say the ETS hasn’t been fully rolled out yet. However, as shown in Figure 6, this aggregate view camouflages the disparate carbon position and exposure to carbon costs for each refining facility. Further, over time, as the CBAM is expanded to include all industries covered by the ETS, this cost will become more ingrained and will need to be factored into operations and investment decisions. Once the free allocations are phased out, refineries in the EU — and any that wish to import products to the EU — will have to factor in, on average, an additional €3.10/bbl cost with EUAs at €100. The CBAM will also result in some importers paying a significant compliance cost. As we discussed in the prior blog, U.S. refiners already report their emissions to the EPA, so they likely won’t have additional compliance costs to sell into Europe. But refineries from developing nations that might not report their emissions would have to produce auditable emissions numbers to continue selling into the EU, on top of acquiring CBAM certificates.

After Brexit, the UK set up the UK ETS, which mirrors the EU ETS. UK Allowances have mostly traded at a premium to EUAs, likely a result of more aggressive cap reductions with the initiation of the new ETS. There are also some discussions of linking the UK and EU ETS schemes. Newer cap-and-trade schemes tend to leverage heavily on the EU ETS, so there is some possibility of various ETS schemes being linked up in the future, too. Switzerland linked into the EU ETS in 2020, allowing refiners to trade allowances across a larger market. In the next blog in this series, we will come back across the Atlantic and dive into what a carbon tax looks like in Canada.

Note: The article was authored by Alex Hardman of Baker & O’Brien and published on RBN Energy’s Daily Energy Post on May 2, 2023.

“Over the Hills and Far Away” was written by Jimmy Page and Robert Plant and appears as the third song on side one of Led Zeppelin’s fifth studio album, Houses of the Holy. Page and Plant wrote the song at Bron-Yr-Aur, a small cottage they rented in the Welsh countryside after finishing a massive North American tour with Led Zeppelin in 1970. The tune was originally called “Many, Many Times.” The intro section is played by Page on acoustic guitars, utilizing Eastern-influenced pull-offs in the key of G that Page is fond of. The midsection of the song is led by the band and guitar-driven riffs, followed by a quiet outro featuring Page on guitar and pedal steel guitar. The song was released as the first single from the album in May 1973 and went to #51 on the Billboard Hot 100 Singles chart. Personnel on the record were: Robert Plant (vocals), Jimmy Page (guitars, pedal steel), John Paul Jones (bass, piano, organ, Mellotron, synthesizer), and John Bonham (drums).

Houses of the Holy was recorded between December 1971-August 1972 with The Rolling Stones Mobile Studio at Headley Grange and Stargroves, and at Island and Olympic studios in London, with Jimmy Page producing and Eddie Kramer engineering. The album was released in March 1973 and went to #1 on the Billboard 200 Albums chart. It has been certified 11x Platinum by the Recording Industry Association of America. Two singles were released from the LP.

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