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The long-term outlook for the ETS2 carbon price is tethered to heat pumps

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Europe’s second emissions trading scheme (ETS2) is set to begin in less than two years. ETS2 covers buildings, road transport, as well as those manufacturing industries not included in ETS1. The launch of the cap-and-trade scheme will mean that an additional 1Gt CO2e of emissions across Europe will be subject to direct carbon pricing.

Market participants - primarily fuel suppliers, distributers, and resellers - don’t have long to wait until they can start managing their carbon risk. ETS2 futures contracts are expected to launch in early May on ICE Endex, the energy and commodities exchange. It will give us the first indication of where the price of physical EUA 2’s will trade when the scheme comes into force at the start of 2027.¹

The marginal abatement cost (MAC) - the cost of abating the last tonne of emissions - is one way that investors (and policymakers) can get a fix on where carbon prices need to be in the future. Sloping upwards from left to right, the MAC curve gradually steepens as additional tonnes of carbon emissions get increasingly more difficult, and hence more costly to abate.

The MAC facing buildings and transportation sectors is typically much higher than industrials and power generation, and sits at the steepest part of the MAC curve. This suggests that the ETS2 price should be significantly higher than the ETS1 price (the EU’s current carbon market covering power generation and industrial emissions).

The challenge in correctly determining the ETS2 MAC reflects the potential impact of complementary policies. For example, while most countries have directives as to the energy performance of buildings, some have specific policies tackling the barriers to more carbon efficient buildings. The Canada Greener Homes Affordability Program (CGHAP) for example helps fund insulation and heat pumps for lower income households. Policies such as these act to push down the MAC curve, and in turn dampen the carbon price required to incentivise behaviour change. (see ETS2 carbon price could rapidly breach €100: Europe's second carbon market is expected to be very sensitive to emission allowance scarcity).

More than just hot air

Heat pumps are one of the most important decarbonisation technologies. They can slash the energy required to heat buildings and dramatically cut their carbon intensity. Unlike conventional electrical space heating systems that convert one form of energy (electricity) to another (heat), heat pumps work by transferring heat from one place (a “source”) to another (the “sink”). Under ideal conditions heat pumps can transfer 300% more heat than they consume. In comparison a high efficiency gas furnace might achieve 95%.

In contrast to ETS1, which places the compliance burden at the point of consumption, the obligated entity under ETS2 are the fuel suppliers, distributers, and resellers. The European Commission (EC) estimates that 11,400 of these companies will count as regulated entities under ETS2. These companies are likely to pass on the full cost of carbon to their customers - Europe’s households and small businesses - increasing the incentive to install a heat pump.

Fossil-fuel boilers continue to dominate the sale of heating of appliances, accounting for 78% of units sold in the EU during 2024. Meanwhile, heat pumps account for 17% of new appliances sold. Although heat pump installations surged during the height of the energy crisis, sales have since slowed to 2021 levels. Heat pump’s share of the market differs markedly across EU member states, from less than 10% in Italy to almost 30% in France.

The rollout of heat pumps is going to be vital if Europe stands any chance of meeting its climate targets, and time is of the essence. The average lifetime for a fossil fuel-fired boiler is 15-20 years. The longer it takes to phase out sales of new boilers, the larger the carbon lock-in across Europe’s building stock. How much carbon lock-in? The delivery gap in 2040 - the aggregate of each Member States building sector emission projections, minus the European Commissions 2040 target impact assessment - is estimated to be around 165 Mt CO2 according to Agora.²

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