EPICO, in collaboration with Frontier Economics, has published a new analysis of investment conditionality for free allocation under the EU Emissions Trading System (EU ETS).
As part of the upcoming ETS review, the European Commission is considering stronger investment requirements linked to free allocation. The objective is clear: to ensure that carbon leakage protection also supports industrial decarbonisation. But applying investment conditionality too broadly risks increasing costs for European industry without necessarily unlocking additional investment.
Our analysis shows that if a decarbonisation investment is not economically viable, making it mandatory does not make it viable. Instead, blanket investment requirements could impose additional costs on companies and, in some cases, increase rather than reduce carbon leakage risks. At the same time, the Commission’s impact assessment currently provides only limited evidence to support such far-reaching conditionality.
The challenge is therefore not whether the EU ETS should encourage investment, but how conditionality can be designed to trigger additional decarbonisation while preserving effective carbon leakage protection.
Key findings
- Free allocation should remain first and foremost an instrument for carbon leakage protection. It should continue to protect European industry where companies face genuine exposure to international competition and carbon leakage risks.
- Conditionality should focus on additional support. Rather than applying investment requirements across the board to the entire free allocation, conditionality should primarily be linked to additional support or additional free allocation. Any broader conditionality in the future should depend on evidence that it generates additional investment without increasing carbon leakage risks.
- Investment requirements cannot solve an underlying viability gap. Where a decarbonisation investment is not economically viable, an obligation to invest does not change its economics. In some cases, the required investment may even exceed the value of the free allocation at stake.
- Frontrunners need targeted protection. Companies that have already invested early and at significant cost in low-carbon production can face competitive disadvantages that free allocation alone does not adequately address. Targeted instruments using ETS revenues should help ensure that moving early remains more attractive than waiting.
- A targeted approach can reconcile investment incentives and competitiveness. Linking stronger requirements to additional support offers a middle way: companies receiving additional public support can reasonably be expected to deliver additional investment, while the core carbon leakage function of free allocation is preserved.
Together, these findings point towards a more targeted approach to investment conditionality: one that strengthens incentives for industrial decarbonisation without undermining the competitiveness of the very industries Europe needs to transform.