November 10, 2021

EU “Fit for 55” proposal and what it means for the industry

written by Franz Mildner
EU “Fit for 55” proposal and what it means for the industry

With the “Fit for 55” package, the European Union (EU) is taking an ambitious global leadership role in fighting climate change

Intense and deadly droughts, increased temperatures, heatwaves, storms, floods, insect outbreaks – the forecasted consequences of anthropogenic emissions are devastating, and it is scientific consensus that lowering the global carbon footprint is the key challenge for the 21st century.

The EU is therefore getting ready for a major revamp of its climate and energy legislation. In mid-2021, the European Commission presented a package of proposals called “Fit for 55”, outlining a path to reduce EU carbon emissions by 55% by 2030 compared to 1990 levels. This goes beyond current EU ambitions and will be debated by member states and the EU Parliament in the coming months. Irrespective of the exact outcome of the debates, there is no doubt that a fundamental transformation of the way the global economy works is required to protect quality of life for the human species.

With the proposal, the European Commission is pushing Europe to take a global leadership role in fighting climate change by becoming the first climate-neutral continent by 2050. The hope is to not only achieve this goal for a decarbonised economy, but to do so whilst also gaining a competitive and innovative edge relative to other continents.

In this article, we will outline the contents of the “Fit for 55” proposal, analyse its impact on different industry sectors and explain how economic – especially game theoretic – concepts can help companies to prepare for this new era of environmental policies.

The package combines market mechanisms and selected regulatory targets

The new EU climate package includes an extensive set of legislative tools that “transform our economy and society for a fair, green and prosperous future”.

Some of its key elements are:

  • Larger scope of EU Emissions Trading System (EU ETS) will increase the price of carbon: the already existing certificate trading system puts a price on carbon and caps total emissions in certain sectors. The system will be extended to additional sectors (e.g., shipping industry) and the number of available certificates is supposed to decrease faster than planned. In addition, a new emissions trading system will be set up for fuel distribution for road transport and buildings.
  • Revised Renewable Energy Directive (RED) requires increased use of renewable energies: the proposal sets a new target to produce 40% of energy from renewable sources by 2030.
  • Stricter CO2 emissions standards for cars and vans: average emissions of new cars need to go down to 55% from 2030 and all new vehicles registered in 2035 must be zero-emission. In line with that, member states need to expand charging capacity.
  • New Carbon Border Adjustment Mechanism makes import of carbon-intensive products costly: a newly introduced tariff on imports of selected energy-intensive products from countries with more environmentally lenient policies ensures that EU’s emission reduction efforts do not simply push carbon-intensive production outside the continent.

The measures principally affect the whole industry – but with varying degrees

The variety and scope of the proposed measures show that this revamp of policy will affect all types of industries and households across Europe. The laid-out plan of extending the scope of the EU Emissions Trading System, combined with a faster reduction of certificates, will lift carbon prices further. This will affect all industries relying on input factors that have a carbon footprint.
Hand in hand with that, the energy efficiency directive will align the taxation of energy products with EU energy and climate policies and increases pressure on companies to invest in carbon-neutral production technologies.

Interestingly, the new carbon border adjustment rate will introduce a new phenomenon. The mechanism introduces tariffs on the import of certain carbon-intensive products (e.g. steel) from countries with less stringent environmental policies. Companies with global supply chains in energy-intensive sectors in particular will face increased Procurement costs and are incentivised to reorganise their current supply chains. But even companies with more local supply chains may be indirectly affected by price increases.

The automotive industry is “forced” to move away from the combustion engine

Despite the generality of the proposals, some industries are targeted more by “Fit for 55” than others. For example, average emissions of new cars need to go down to 55% from 2030 and 100% from 2035 – thus, all new vehicles registered in 2035 will have to be zero-emission. In recent years we have seen that more than halving the 95 grams of CO2 per km today until 2030 is not achievable with combustion engines. In the past, automakers have decided to concentrate on improving already existing engines and have invested massively in electric cars. Billions of Euro have been and will need to be invested in innovative and sustainable technologies, including (in the short run) more efficient internal combustion engines, hybrids, electric, and hydrogen vehicles. The success of supplier selection processes will hinge on carbon footprint differences being adequately considered in the decision-making process. This step up in policy comes in addition to tightening automotive-specific emissions (see our article ‘The death of cars as we know them?’).

The aviation and shipping industry are key targets of “Fit for 55”

However, the aviation and shipping industry are especially in scope for the “Fit for 55” proposal. The Commission is proposing to phase out free emission allowances for aviation and to include shipping emissions in the EU ETS moving forwards. Shipping operators would be required to obtain ETS allowances for a part of their emissions for intra-EU shipping from 2023, subsequently they will need to obtain them for all emissions after 2027. In addition, fuel suppliers are required to blend increasing levels of sustainable aviation fuels in fuel provided at EU airports. Similarly, the uptake of sustainable maritime fuels and zero-emission technologies is stimulated by setting a maximum on the fossil content of energy used by ships calling at European ports.

Getting on the path to carbon-neutrality is urgent and requires an innovative approach: solutions from the game theory toolbox

Managing the carbon balance and prioritising it requires profound organisational changes which are costly and require time to kick in. At the same time, the many unknowns and general complexity make the standard management toolbox inefficient. Game-theoretically designed incentives can be pivotal in transforming companies to carbon neutrality and sparking innovation. Game theory has been used to optimise markets and negotiations, but also when solving the carbon puzzle, its relevance should not be underestimated.

Solution #1: Company-internal carbon trading mechanisms help save carbon emissions at the lowest cost

With increasing carbon prices induced by “Fit for 55”, financial pressure on companies to become carbon-neutral rises by default. However, this transition takes time and companies are at risk of lagging behind regulatory and market developments. In addition, the complexity of the topic makes central management planning difficult. It is nearly impossible for a company’s management to determine which carbon reduction target is optimal for which unit and sub-unit within a company. Simply going for the most polluting units (oftentimes production) may ignore easy and cheap ways of saving carbon (e.g., employee travel). Thus, companies should urgently start to implement a market logic on an internal level that is similar to the one behind the EU Emission Trading Scheme. By introducing company-internal carbon markets, carbon can be saved at the lowest possible cost.

Internal marketplaces for carbon provide just the right solution to water two plants with one hose. It allows organisations to:

  1. Identify and save the cheapest tonne of carbon, reducing the overall cost; and
  2. Steer incentives within an organisation towards the larger mission of carbon reduction, making carbon reductions more and more efficient over time.

Solution #2: Introducing a carbon Total Value of Ownership reduces emissions across the supply chain

The EU’s plan to introduce a carbon adjustment rate highlights the importance of supply chains for the carbon topic. Game theory can help companies to be ahead of legislation and have smart Procurement mechanisms early on.

Many of the emissions from production cannot be directly influenced by a company, as they happen elsewhere in the supply chain. Carbon, therefore, must be considered in awarding decisions and this is done most effectively by using a carbon emissions Total Value of Ownership (TVO) approach to consider carbon in nomination decisions. The basic idea is to translate the stock of carbon emissions of different suppliers into monetary values. This allows a like-for-like comparison of suppliers, taking into account cost and traditional quality measures, plus the carbon profile.

Solution #3: Carbon Innovation Management is needed to unfold game-changing reduction potential

In many cases, technological solutions are necessary to achieve unexpected and large-scale CO2 reductions. The aim of Carbon Innovation Management is to establish direct incentives for engineering innovations that tackle CO2 reductions. One easy-to-implement first step could be the creation of a central innovation budget pot. Different departments as well as suppliers are encouraged to develop and submit ideas for carbon reduction that would be financed by a central innovation pot. This is further strengthened by using competitive mechanisms as incentives, a classical area for the application of game theory. The ideas with the best cost-benefit ratio are then carried out and their progress is governed with KPIs, ensuring the actual delivery of what was promised.

Solution #4: Behavioural Economics has powerful instruments to reduce emissions in daily life and to achieve buy-in for transformation

Sometimes economic incentives to save carbon emissions may not be sufficient – simply because we are all still human at the end of the day.

Behavioural Economics and Social Psychology are powerful instruments in the economics toolbox to achieve buy-in for transformations on the one hand, and to practically reduce carbon emissions in  daily corporate life on the other hand.

It is scientifically proven that people react strongly to ‘default’ settings. An automatic car sometimes comes with three different settings: ‘regular’, ‘sport’ and ‘green’ modes. Usually the ‘regular’ mode is set as the default, resulting in only few consumers actively switching to the ‘green mode’ to reduce carbon emissions. Changing the default to the ‘green’ mode would be a very small change, but with a strong effect – most people will not deviate from the default and therefore drive in a more environmentally-friendly way.

Use Game theory to achieve carbon neutrality

The “Fit for 55” proposal is a pivotal step towards the carbon neutrality of Europe. For all industries, especially the automotive and other mobility-related industries, this package will create major challenges, even if it may not be fully implemented. Companies should not lose time – it might take years to be fully prepared for this enormous task. Improvising late and on the spot to address the challenge may turn out to be economically disastrous. Game-theoretic approaches, such as internal carbon trading mechanisms or TVOs including carbon emissions, can help companies to be prepared for the key challenge of the future. It is time to act now.