The effect of the EU ETS free allowance allocation on energy mix diversification: the case of Poland's power sector

Abstract

Since 2013, power plants in the EU have been obliged to buy carbon permits instead of receiving them for free. However, in order to ease their energy transition, some Member States that meet certain conditions (mainly a high share of fossil fuels and low income) are allowed to continue to receive free allowances for existing power plants (Article 10c of the EU ETS Directive). In exchange, they must invest in modernizing their electricity sector and diversifying their energy supply. However, up to 70% of the conditional investments have been made in upgrading coal-fired units, which casts doubt on the effectiveness of the measure to increase energy diversification. This paper evaluates the effect that the so-called rule 10c has had on energy diversification. A synthetic control method is applied to aggregate data from Poland, one of the countries eligible for free allowances, to investigate how the lignite and wind share in electricity generation would have evolved had Poland not used the rule 10c derogation. Our results indicate that Poland's energy diversification would have been the same if allowances had been auctioned instead of allocated for free. Therefore, the policy is only relevant in political terms and involves unjustified revenue loss for affected governments in favour of installations, i.e. subsidies. Our results suggest that rule 10c, as defined, does not incentivize investment in low carbon alternatives. The use of this transitional free allocation will continue to be available in phase IV (2021-2030) of the EU Emission Trading System (EU ETS). Key policy insights ¿ Application of the rule 10c derogation under the EU ETS, granting emission allowances for free to fossil fuel-reliant member states, has not achieved the intended goal of energy mix diversification in Poland. ¿Using a synthetic control method, we show that the lignite and wind share of electricity production in Poland would have followed almost the same trajectory if full auctioning, instead of free allocation, had been applied. ¿Because most conditional investments were used to retrofit coal-fired plants, the policy's main contribution was to subsidize continued use of coal power. ¿ The policy also deprived affected governments of auction revenues.