EU Emissions Trading Scheme Reform: A Change for the Better?

Carlo Carraro argues that refroms to the EU’s Emissions Trading Scheme are sending the right sort of signals for those interested in reaching emission targets.

On the 23 October 2014, the European Council endorsed a binding EU target of a domestic reduction in greenhouse gas emissions by at least 40% compared with 1990 levels. This target implies a reduction in emissions by 43% from sectors covered by the ETS. To achieve this goal, the EU has proposed a reform of the EU Emissions Trading Scheme (EU ETS) largely through the inclusion of a mechanism to stabilize the market. With these improvements, the EU hopes that the EU ETS will become the main instrument for achieving these emissions reduction targets.

The main reform to the EU ETS will be the inclusion of the market stability reserve (MSR) in 2021. This instrument would automatically adjust the annual volume of pollution permits when the total number of permits in the market moves outside a pre-defined quantity collar. If there are more than 833 million permits in the market, a number of allowances equal to 12% of the total allowances that were in circulation two years previously will be removed from the market. If there are fewer than 400 million permits in the market, then 100 million permits will be released from the reserve. By controlling the quantity of available pollution permits, the MSR aims to stabilize the permit market, increase supply-side flexibility and also the resilience of the market to sudden shocks. This stability will be able to give a clear, long-term signal to investors that low carbon technologies need to be pursued.

There is pressure to have the MSR start sooner than 2021. Notably, both the United Kingdom and Germany are pushing for the MSR to become active in 2017. They hope that an earlier start date will allow the EU ETS to set aside hundreds of millions of pollution permits (in the stability reserve), which will push the EU ETS price from its current position at around 6 euros/tCO₂ to close to 20 euros/tCO₂. This signal would hopefully trigger the low carbon investment that the EU ETS has thus far been unable to catalyze.

Start time notwithstanding, the actual ability of the MSR to revive the EU ETS is debatable. In theory, including the MSR should make no difference to the total emissions that the EU ETS will be able to reduce by 2030, assuming that all available permits are used. This is because the linear reduction factor (the rate by which the cap on pollution is tightened) is the same in both the current and reformed design of the EUETS: the emissions cap tightens by 1.74% per year until 2021 and then by 2.2% per year from 2021. Nevertheless, the MSR can lead to a faster rate of emissions reductions by increasing investor certainty in the market and by changing relative prices of energy sources in the short term. This stronger policy signal may mean that the EU is able to meet its decarbonization targets sooner and more smoothly than it would without the reforms.

The reform that the MSR is able to provide may be somewhat hindered by the continued allocation of permits free of charge. In the new framework, member states with a GDP per capita that is 60% lower than the EU average are allowed to continue to give pollution permits free of charge to the energy sector up to 2030. However, the maximum number of permits that can be freely allocated after 2020 cannot exceed 40% of the allowances allocated to each member state. Even so, this free allocation is arguably giving industry the equivalent of a €190-€300 billion subsidy from 2021-2030. Such a subsidy to fossil fuel based industries sends a contradictory message to the one that high carbon prices (thanks to the MSR) do. However, the EU defends its decision as a measure to prevent the risk of carbon leakage that would negatively impact the EU’s international competitiveness. This decision also reflects the EU’s stance on ensuring affordable energy prices and avoiding windfall profits. Further, this free allocation will continue after 2020 unless comparable efforts to enact climate policies are made by other major economies. Waiting for other countries to make climate commitments is logical and it suggests that the EU correctly does not consider the carbon pricing actions currently being taken by other countries (notably China) to be of much value yet.

In addition to attempting to protect EU industries, the EU is actively trying to ensure that the carbon price burden is shared equitably between them. To this end, the policy framework includes a reserve of 2% of the EU ETS allowances that are to be set aside to meet the high additional investment needs of low income EU member states (i.e. again in countries where GDP per capita is below 60% of the EU average). These allowances will be used to improve the energy efficiency and modern energy systems in these member states. Further, 10% of the EU ETS allowances that can be auctioned by member states will be distributed among countries whose GDP per capita did not exceed 90% of the 2013 EU average. The remaining allowances are to be distributed between all member states based on their verified emissions. These measures will advance the integration of the EU energy market. This will enable the EU to reach its energy targets more efficiently and stimulate competition in the sector. This in turn should drive down energy prices. A fully integrated energy market would result in a savings of €40-70 billion between now and 2030.

In addition to the reserves set up to improve the EU ETS’ rigor and inclusivity, the European Commission has decided to renew the existing NER300 facility and even increase the initial endowment to 400 million allowances (NER400). This funding that goes towards carbon capture and storage (CCS) and renewable energy innovation will now extend to include small-scale projects as well. The increased use of pollution permits for developing low carbon technologies is commendable, but more so is the extension of this funding to include small-scale projects. Given the ability of small-scale energy ventures to stimulate innovation and development in energy technology thus far, this move shows promise for what the NER400 funding will be able to achieve up to 2030.

With all these measures being carefully taken to resurrect the EU ETS, it is perhaps surprising that the EU decided not to remove the surplus of 2.1 billion permits that have built up in the system. This surplus is one of the main causes of the significant devaluation of market price of pollution permits. Since the EU ETS does not allow for inter-period permit trading (via banking and borrowing), there is no mechanism to ease the pressure on the system that this surplus delivers. The surplus will therefore continue pushing the carbon price down. At least for Phase III (2013-2020), the EU decision to backload 900 million allowances may ease the downward pressure on the price.

Overall, while the EU ETS reforms are moving the carbon market into the right direction, the 2030 policy framework sends some mixed signals. Nonetheless, if well managed, the new MSR may provide markets with short term price incentives much more effective than those sent in the last decade. This is crucially important in the present context of energy markets.

This piece first appeared on Carlo Carraro's blog.