Fixing the EU ETS for the long haul

What are the long-term aims of the EU emissions trading scheme in an increasingly carbon-constrained world and can it be made fit for purpose? Paul Hatchwell investigates emerging elements of a revitalised carbon market beyond 2020

A more consistent, long-term carbon price signal is needed to encourage heavy industry to cut emissions (photograph: Brian-Whittaker/123RF)The EU emissions trading scheme (EU ETS) is the world’s first and largest mandatory carbon market, and it is set to play a key role in Europe’s low-carbon future up to 2030 and beyond.

It is a flagship policy regulating almost half of the bloc’s emissions from power stations and energy-intensive industries, a crucial part of the three ‘20/20/20’ targets negotiated in 2008 (endsreport.com/19980). These aim to deliver a 20% emissions reduction by 2020 relative to 1990, a 20% reliance on renewable energy and a 20% improvement in energy efficiency by 2020.

But by 2050, the bloc is committed to a far more ambitious 80-95% reduction in emissions, in line with the UN’s objective of limiting global warming to 2°C.

Figure: The changing fortunes of the EU ETSTo have an effective long-term future the EU ETS will first have to banish the ghost of a difficult and fractious past. But the cap-and-trade scheme has yet to fully emerge from a series of bruising crises due to chronic oversupply of allowances, aggravated by the onset of recession and industrial distress selling from 2009 (endsreport.com/39612). From €30 per tonne of CO2 equivalent in 2008, prices now struggle to reach €6/tCO2e (see figure, p35).

Acrimonious discussions, beset with concerns over industrial costs, finally resulted in agreement earlier this year to ‘backload’ further allowance auctions to later in the scheme’s third phase, which runs from 2013 to 2020 (endsreport.com/42934).

But the measure has led to only a modest lift in flagging carbon prices. The reintroduction of these allowances later in the decade is set to cause another market crash. This threatens to undermine the EU ETS’s effectiveness in setting a carbon price to drive low-carbon action at least until the 2020s. 

Midlife crisis?

But as a hoped-for climate deal looms at the 21st conference of the parties to the UN climate convention (CoP21) in Paris next year the stakeholders of the EU ETS are also being forced to look beyond their immediate problems (endsreport.com/44367).

Searching questions are being asked about the scheme’s long-term domestic and international aims, how it could be made fit for purpose and how it fits with other energy and climate policies.

One certainty is that it will now continue beyond 2020, despite reservations over cap and trade compared with other measures such as a carbon tax. The debate has moved on. And the EU ETS will be expected to do more towards emissions abatement, not less.

But exactly what emerges from ongoing discussions on the scheme’s future will depend on a wider discussion on ambition and form of the bloc’s new climate and energy targets up to 2030 (endsreport.com/44367). These targets will be a crucial stepping stone to the 2050 objective. They will be influenced by the level of ambition on emissions mitigation at the UN Paris talks.

In January, the EU proposed an ambitious 40% economy-wide greenhouse gas reduction target by 2030 relative to 1990 as an unconditional offering for the Paris talks. It also proposed a minimum 27% contribution from renewable energy and later a 30% voluntary energy efficiency target.

The commission aims to finalise its position on 2030 goals in October, when EU leaders have pledged to reach an agreement. But there is strong opposition to both higher ambition, led by Poland, and to a new energy efficiency target, led by the UK (endsreport.com/43964).

Under the current 2008 climate and energy package, the EU ETS cap needs to shrink by 21% relative to 2005 by 2020. But if the 40% economy-wide target is approved this would be adjusted after 2020 to achieve a much sharper 43% reduction by 2030. That would mean adjusting the linear reduction factor from 1.74% annually up to 2020 to 2.2% thereafter.

But a change in the reduction factor will mean a fundamental change in the EU ETS Directive, involving complex co-decision processes between the European Parliament and the European Council. Any such change is unlikely to be agreed before CoP21.

And if a steeper economy-wide target were agreed next year – say, the 50% that the UK has called for – then a steeper downward trajectory would be likely for the EU ETS. A proposed ban on the use of UN offset credits after 2020 would need to be reconsidered to keep mitigation costs down.

Grand designs

One painful lesson from the first two phases of the EU ETS is that it is not only the rate of decline of the cap that drives mitigation though behavioural change and investment. The market is also looking for a more consistent, long-term carbon price signal to be at least partly reflected in shorter term trading.

Without this, the risk of high-carbon lock-in from new fossil fuel generation remains. In the January proposal the commission stressed that the EU ETS would still be “unprotected against future unexpected and sudden demand shocks” such as another economic crisis or less likely a boom, leading to price crashes or spikes.

With an oversupply of EU allowances now standing at more than two billion tonnes of CO2 equivalent, and political risk from backloading and other planned interventions, efficient operation of the market in providing low-carbon incentives has been severely compromised.

Stig Schjolset, head of carbon research and forecasting in the Point Carbon team at Thomson Reuters, estimates that the market oversupply may not be cleared until 2030. The resultant delay in mitigation incentive could lead to much higher costs later.

One solution, notably advocated by the UK, would be to cancel the 900 million tonnes of CO2e in backloaded EU allowances.1 These are currently set to flood the market in the last two years of phase 3 in 2019 and 2020. But this would require a change to the EU ETS Directive, and there is strong opposition from other member states and industry.

To address the longer term problem, the commission unveiled its pièce de résistance in the form of a market stability reserve (MSR) mechanism in January (endsreport.com/42931).2 The legislative proposal, following consultation with analysts, traders and other stakeholders, aims to bolster carbon prices and reduce volatility from 2021, the start of phase four.

The MSR would work by releasing allowances onto the market, or retiring them, when thresholds are reached. It would see 12% of market surplus withdrawn into the reserve each year, slowly reducing it until no more than 833MtCO2e remains. This figure is within the liquidity range that power firms say they need to buy allowances for forward hedging. Hedging is typically carried out three or more years ahead.

After the excess surplus has been eliminated, allowances would be released from the MSR slowly, at a rate of 100MtCO2e a year once the number of allowances in circulation drops below 400MtCO2e. That is about 5% of total EU ETS emissions.

A further proposal in the same document aims to tackle the risk of build-up of a large surplus in the last year of phase three and later phases, avoiding a repeat of the crisis at the end of phase two in 2012. This would remove any excess auction volume that is more than 30% greater than the volumes expected in the first two years of phase four. Two thirds of this excess would be split equally and auctioned across those two years.

There is broad support for the MSR in principle, but the devil will be in the details yet to be hammered out by the commission. DECC is supportive in principle, but is studying the implications. It believes other measures, such as early cancellation of backloaded allowances, are still needed.

Trevor Sikorski, head of natural gas, coal and carbon for market analyst firm Energy Aspects, is confident the reserve will eventually increase prices but less confident they will achieve price stability and lasting behavioural change.

“This kind of intervention is quite difficult to structure.” The commission wanted something “very formulaic so that the market can understand the rules and trade around them”, he says.

“The more complicated, the more likely you are to scare people out of the market”, reducing liquidity. But “in being formulaic and simple, you can end up introducing rigidity”.

Sikorski points to the difficulty of assessing market sensitivity, particularly given high-volume hedging behaviour by the power sector. “There’s going to be lots of debate around the trigger levels. Does the market get tight at 800MtCO2e? Does it get tight at 400MtCO2e?”

But there is a time lag problem too. The MSR will work on actual market data, which could be very significant, says Sikorski. For example, a decision to take out allowances in 2026/27 would not take effect until 2028, but by then “the market might be in a different place”.

Miles Austin, executive director of the Carbon Markets and Investors Association, strongly supports the reserve in principle: “The way it calculates the oversupply is extremely good. [They] have anticipated very well where the potential problem could be.”

Austin does not believe that withdrawing 100MtCO2e tranches annually or delayed action will cause significant volatility. “You would expect it to some extent to be priced in.”

But he is scathing about the detail, particularly the 12% annual reduction in surplus up to the end of phase four in 2030, which he sees as a “back of the envelope” decision. “We think the 12% is completely hamstringing it. It completely lacks ambition, [and] it needs far sharper teeth than 12% gives it.”

He adds: “The problem with that is the system will not be reset for a decade and a half, which is way too long [for effective decarbonisation].” 

Early introduction

Point Carbon’s Schjolset agrees it would take too long to take effect. Reaching the new equilibrium could take six to seven years, so starting in 2021 would not see the surplus cleared until as late as 2027, he says. “That’s why we see countries like Germany calling for early introduction of the MSR by 2018. If you would want to get rid of the oversupply, why would you wait until 2021?”

There is also the risk of a long delay if the MSR is linked to EU ETS reforms, with final agreement on changes to the directive unlikely until late in phase three.

The commission told ENDS it is open to possible early adoption of the reserve proposal, but it is currently still planning for 2021. Co-decision could delay it.

Despite opposition from heavy industry, Poland and other coal-dependent member states, most analysts agree that a 2018 start date would help smooth the transition from phase three to four, providing greater certainty for investors.

But an early move would only really be a game-changer if it were to coincide with a parallel agreement that the backloaded 900MtCO2e (equivalent to almost half the EU ETS surplus) should be transferred into the reserve.

There is indeed strong opposition from industry. Alexandre Affre, director of industrial affairs for trade body Business Europe, told ENDS his organisation strongly supports a long-term role for the EU ETS and a single, carbon-based target for the bloc.

But it does not support any changes before 2020. Affre argues that ad hoc interventions such as backloading open a Pandora’s box of political risks and delays. “This is creating more problems than solutions,” he says.

Three targets better than one?

The EU ETS does not work in isolation, but as one of the three 20/20/20 targets, although there has only been patchy progress on energy efficiency and renewable energy (endsreport.com/41129).

So would carbon price alone achieve the investment needed for decarbonisation? Schjolset is sceptical: “I don’t think we are moving towards a scenario with one measure for all to drive low carbon.” There will be several policies, he says, otherwise “you would need much higher prices and that is not the case at the moment”.

He says that at least €50-100/tCO2e would be needed to drive carbon capture and storage or offshore wind but Point Carbon estimates suggest that carbon prices are unlikely to exceed €50/tCO2e before at least 2030.

Sikorski believes the carbon market would suffice if the only aim is to reduce emissions, with clarity beyond 2020 likely to increase investment. But he accepts that if more fundamental change is needed, such as large-scale renewable investment or increased security of supply, then other policy tools are required.

For its part, the commission’s January proposal argues that the reserve “has the advantage of capturing changes in demand not only due to macroeconomic changes, but also impacts of other factors such as complementary policies, as well as changes on the supply side like the inflow of international credits”.

The real proof of the pudding must surely be in terms of tangible low-carbon investments. At present, allowance prices are so low that even early fuel switching to less carbon-intensive gas generation seen up to 2008 has been reversed in favour of coal-burning.

Even in the UK, the House of Commons Environmental Audit Committee has warned there is currently less than half the investment needed to decarbonise the economy and meet domestic and international emissions obligations to 2020 (endsreport.com/43281). As a result, much now rides on electricity market reform.

In phases two and three, the only tangible sign of mitigation investment came through a commission-funded competitive scheme based on revenues from sale of 300 million allowances from the new entrants reserve (NER300). This has had limited success. The commission told ENDS it remains open to similar schemes in future phases, but automatic hypothecation of all EU ETS auction revenues is unlikely. 

Carbon leakage

Since 2013, the power sector has faced 100% auctioning, while other non-vulnerable sectors will see free allocation drop from 80% in 2013 to 30% by 2020. The directive states that free allocation should gradually reduce “with a view to reaching no free allocation in 2027”.

On 9 July, the EU Climate Change Committee extended arrangements giving 100% free allocation to two thirds of EU ETS sectors at risk of foreign competition up to 2019. But it did so on the basis of the much higher €30/tCO2e price in 2008. The allocations depend on performance benchmarking and reduce with the cap, but are still controversial (endsreport.com/20970).

There is no clarity yet on arrangements after 2020, with much depending on the outcome of the Paris talks.

But the issue of free allocation to organisations deemed to be at risk of carbon leakage is just as important to efficient future market operation as it is to industrial competitiveness. With such a large proportion of industry able to access and sell free allowances, there is continuing potential for instability. As a result, there will be less pressure for prices to increase from diminishing auction volumes.

Almost all parties recognise that the EU ETS, with allowances currently trading for as little as €6/tCO2e, is not delivering low-carbon investment and behavioural change in its current form. Most agree that fundamental changes, rather than tweaks, are necessary but there is less agreement on timing and details.

If implemented together and early, the commission’s proposed measures should help boost carbon prices, and could smooth the transition to phase four. Without them, the EU ETS will remain moribund for a decade. But early adoption of the MSR may prove legally fraught, many of its details will be fought over and it will not necessarily remove volatility.

The main concern is that allowance prices are not likely to break €50/tCO2e by 2030 and will remain too low to stimulate low-carbon investment. That fact will only fuel the intense debate over whether to go for a single emissions target or three separate ones for 2030 more akin to the current 2020 regime.

Ultimately, all eyes are on the forthcoming CoP21 in Paris to deliver a much needed impetus to international greenhouse gas mitigation. Backed by a robust global climate deal, EU ETS reforms should be politically and economically easier to implement, helping restore market credibility up to and beyond 2020. Without it, higher ambition will be very difficult. At present, the outcome is too close to call.

paul.hatchwell@haymarket.com

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