On 14 July 2021, the European Commission published its much-anticipated “Fit for 55” package. This blog post focuses on the key implications for corporates and the financial sector – both those based in the EU and those wishing to do business in the EU.
Why the weird “Fit for 55” name?
First things first – the EU has adopted a new climate law that commits the EU as a bloc to reducing its greenhouse gas (GHG) emissions to 55% by 2030 (compared to 1990 levels) and reaching carbon neutrality (i.e. net zero) by 2050. But the climate law just sets the targets – it doesn’t actually say how the EU is going to meet those targets.
Which is why European Commission officials have been working at break-neck speed to come up with a package of proposals to ensure that EU legislation and policy are “fit for” delivering a 55% reduction in GHG emissions by 2030.
So it’s not the name for a “boot camp for the middle-aged” or a “flirty app for mature adults” as some have (rather unkindly) suggested!
Why is it such a big deal?
Basically so far no one else has ever attempted such an ambitious climate package before. What the Commission is proposing is nothing short of transformational change on a scale not seen before for most sectors of the economy – with a particular emphasis on the energy, transport and buildings sectors.
Scientists have warned that what we’ve seen so far over the past few weeks in Canada and the US in terms of heatwaves and wildfires is just a taste of things to come and that nowhere is safe from the devastating impacts of climate change.
Central banks have also been sounding warning bells that climate change has the potential to destabilise global financial stability.
Investors have been saying for a while now that “climate change = financial risk”. Even Larry Fink is a convert: “No issue ranks higher than climate change on our clients’ lists of priorities. They ask us about it nearly every day….There is no company whose business model won’t be profoundly affected by the transition to a net zero economy.”
And just ask the insurance industry how much it’s costing them to clean up the climate mess after the fact.
The EU led the way in 2019 with the European Green Deal and it is now following up with a detailed battle plan on how to achieve those objectives. As the man in charge of the European Green Deal, Frans Timmermans, says: “This is the make-or-break decade in the fight against the climate and biodiversity crises.” And his boss Ursula von der Leyen warns that “The fossil fuel economy has reached its limits.”
And it’s not just the EU saying this. The International Energy Agency in their Net Zero by 2050 report published earlier this year warned that: “Achieving net-zero emissions by 2050 will require nothing short of the complete transformation of the global energy system…The world has a viable pathway to building a global energy sector with net-zero emissions in 2050, but it is narrow and requires an unprecedented transformation of how energy is produced, transported and used globally.”
The key here is that both the EU and other major economies genuinely believe that you can build a growth strategy around the net zero transition. Although not all of the European Commissioners are necessarily singing from the same hymn sheet (see “Next steps” below).
At a sustainable finance conference earlier this week, Citi’s managing director and head of sustainable finance Jason Channell said that “We’ve totally put to bed this concept of ESG as a cost…When we think about what financial markets and institutions do, we deal with risk and opportunity. To me, that is what ESG is about.” And right now climate is one of the most pressing elements of ESG.
The financial heavyweights are right – it’s not just about the risks; there are plenty of opportunities to be had too. But there is a limited window of opportunity.
- CBAM – The Commission is proposing a new carbon levy (based on the carbon emissions associated with the manufacturing of certain products) called the “Carbon Border Adjustment Mechanism” which would initially apply to importers of iron, steel, cement, fertilisers, aluminium and electricity, from 2023 initially as a reporting obligation during a transitional period until 2025 when it will bite more fully (thus ensuring foreign competitors face the same costs as those operating within the EU). Free EU ETS allowances for those sectors would be phased out over a 10 year period after the CBAM goes live. Not surprisingly, this is deeply unpopular both with some EU Member States and with a number of non-EU countries (including China, Russia and Turkey) and may well result in a WTO challenge being brought against the EU if it goes ahead with the plan.
- EU ETS – The Commission is proposing to include shipping in the existing EU ETS (over the period 2023 to 2025) and create a parallel ETS for road transport and buildings (from 2026). Free EU ETS allowances for those sectors covered by the CBAM would be phased out after the CBAM goes live. Free allocation of EU ETS allowances for aviation (intra-EU flights) would be phased out by 2027 (subject to a linear reduction factor). International flights (those entering/leaving the EU) will be covered by the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) scheme. The overall aim is to reduce emissions from the system by 61% by 2030.
- Effort Sharing Regulation – This applies to emissions from sectors not covered by the EU ETS (including agriculture and waste). The Commission is proposing stricter emissions reduction targets based on Member States’ GDP per capita.
- Renewable energy – The Commission is proposing to increase the EU’s 2030 renewable energy target to 40% (with specific targets for renewable energy use in transport, heating and cooling, buildings and industry) and to impose stricter sustainability rules for the use of biomass.
- Energy efficiency – The Commission is proposing the 2030 target for overall energy efficiency in the EU to be increased to 36%.
- Vehicle emissions – In addition to including road transport in the EU ETS, the Commission is also proposing stricter CO2 emissions standards for new vehicles in order to cut 90% of emissions from transport overall. Average emissions of new cars will need to come down by 55% from 2030 and 100% from 2035 compared to 2021 levels - so that by 2035 all new cars will be zero-emission. The Commission also wants to ensure greater public access to charging points for electric vehicles and more hydrogen refuelling stations.
- LULUCF - The Regulation on Land Use, Forestry and Agriculture sets an overall EU target for carbon removals by natural sinks, equivalent to 310 million tons of CO2 emissions by 2030. National targets will require Member States to care for and expand their carbon sinks to meet this target. By 2035, the EU should aim to reach climate neutrality in the land use, forestry and agriculture sectors, including agricultural non-CO2 emissions such as those from fertiliser use and livestock.
- Lots more - There are plenty of other proposals in the Fit for 55 package (including on energy taxation, energy infrastructure, transport fuels, etc).
How does this fit with the EU’s sustainable finance agenda?
If the European Green Deal and the Fit for 55 package are the roadmap and action plan for where the EU needs to be by 2030 and 2050 then the EU sustainable finance package (Taxonomy Regulation, EU Green Bonds Standard, etc) is how the EU proposes to finance the transition to net zero.
The net zero transition is going to require a massive reallocation of capital – both private and public capital – to greener, more sustainable activities.
And as we have seen recently, this is starting to have a significant impact not just on how on funds are structured and branded and how stock market indices are compiled, but also on loans, bonds and wider M&A activity (including IPOs, spin-offs, JVs and SPACs).
For more information on the EU Renewed Sustainable Finance Strategy, see our previous blog post.
Implications for clients
In the coming days we will be publishing summaries of the key proposals which should hopefully make it easier for clients to decide how the various proposals affect them on a more granular level – e.g. are you caught by the extension of the EU ETS or the new CBAM and if so how; what do the proposed changes to vehicle emissions mean for the auto sector, etc.
But taking a step back, what is the bigger picture?
Firstly, if anyone was still under the impression that climate (and the wider ESG phenomenon) was just a passing fad rather than a business-critical issue then now would be a good time to shed that.
Secondly, the overall package is basically a combination of stricter regulation and emissions standards for industry, carbon pricing and taxes, as well as rules to promote investment in low-carbon fuels, technologies and infrastructure. And although the package will affect most business sectors, it’s the energy, transport and buildings sectors that will bear the greatest brunt. With energy production and use accounting for 75% of EU emissions, it’s clear that greening the energy system is going to be critical to meeting the EU’s climate targets. On top of that, the roll out of requirements in relation to agriculture and land use reflects a significant step up in expectations.
Of all of these, carbon pricing (be it through emissions trading schemes or carbon levies) is perhaps the one to keep a closest eye on. Even the G20 at their recent summit embraced the concept of carbon pricing as a key driver for reducing emissions.
Lastly, the hardening of regulation (not just in the EU but also elsewhere across the globe) should be translated into the following practical principles for business:
- assess climate risk, including transition risks posed by regulatory packages such as the Fit for 55 package;
- figure out the financial impact on your business;
- devise a robust strategy for your climate transition (opportunities and risks) including reducing your carbon footprint (and those of your supply chain and end consumers);
- get buy-in from your investors, consumers and other key stakeholders;
- communicate clearly and regularly what you are doing (using the TCFD framework where relevant);
- implement your action plan, making sure your board is able to lead from the top on this and that you’re able to report on progress against targets; and
- translate the risks into opportunities so that climate becomes a key component of your growth strategy.
This hardening of climate regulation is not just aimed at corporates. It is just as relevant to the financial sector - with banks, insurers, asset managers, pension schemes and financial advisers also roped into the growing regulatory web. And those who collate data and translate it into ESG ratings and scores will soon be the subject of regulatory attention as their services become core to this reshaped investment environment.
All this in turn is affecting how capital is being allocated – from the rapid growth and improved pricing of green and sustainability-linked loans and bonds to the reshaping of market indices and stock exchanges’ expectations, to how you prepare for an IPO, and so on.
It is also shaping investor activism (just look at this year’s AGM season) and litigation in the courts (both in terms of legal challenges brought directly against governments for climate inaction and against corporates).
The Commission’s proposals will now need to be considered and negotiated by the Council and European Parliament. This is likely to take several months (or longer) in what some have described as “epic battles” ahead.
There were numerous reports in this morning’s press (including in the FT and Politico) that the Commission itself is not of one mind on the entire package of proposals. You would have thought that perhaps the banning of petrol and diesel cars by 2035 or the CBAM might have been the hottest potato of the bunch. But apparently the biggest fall-out amongst the Commissioners is the extension of the EU ETS to road transport and buildings – which some fear will mean the costs will be passed on to households via electricity bills and at petrol pumps, potentially ushering in a new wave of “Gilets Jaunes”-type protests. Which is why the Commission is proposing the creation of a new €72.2 billion Social Climate Fund to cushion the blow, with money from 25% of revenues generated from the new ETS, as well as from the EU budget and contributions from national governments. But several Commissioners (and Member States) remain unconvinced.
So what lies ahead in the coming months is not just the usual “Council -v- European Parliament” battles but also dissent within the Commission itself.
The timing - and fate - of each proposal in the Fit for 55 package is to a large extent independent of the other proposals in the package.