The new logic of the EU emissions trading system (ICTSD Opinion - Lars Zetterberg)

Never before has such an important climate decision attracted so little attention. After six years of persistently low carbon prices, this post argues that a recent reform of the EU emissions trading system may put the scheme back on track. Carbon prices could rise above 25 euros as soon as 2023, thereby pushing out coal and increasing wind and solar power in Europe. At the same time, complementary policies at the EU and national level suddenly matter.

At the inception of the EU emissions trading system (ETS), industry players, policymakers, and academics were satisfied that a price on carbon covering several sectors had been successfully set. The cap guaranteed the EU would reach its climate target. The pricing assured effectiveness – reaching the target at the lowest cost. The EU ETS was said to be a cornerstone of EU climate policy and the most important policy tool to meet climate objectives.

However, there is an enormous surplus of allowances, corresponding to approximately 2.6 billion tonnes of carbon dioxide, equivalent to about a year and a half of emissions. The surplus has pushed down the carbon price to very low levels. The problem was identified six years ago, but in spite of much discussion and negotiation, the price is still low. The EU ETS has clearly not reached its full potential in creating incentives to develop and adopt cleaner technologies to reach the objectives of the Paris climate agreement.

As some member states feel the price is not doing enough to drive down emissions, they want to introduce national measures to reduce emissions in sectors that are already part of the ETS. This is problematic for two reasons. First, since the total emissions are capped and the volume of emissions allowances fixed, extra emissions reductions in one country can lead to emissions increasing elsewhere in the EU. This is sometimes referred to as the “waterbed effect.” It is like sitting down on one side of a water bed and seeing it rise on the other side. Moreover, if additional climate policies are introduced, the surplus of allowances may increase even further, putting downward pressure on the carbon price and reducing the incentive to adopt new technologies even further.

A mechanism is needed in the EU ETS to “tighten the slack,” that is, remove (temporarily or permanently) emissions allowances when emissions are reduced faster than anticipated. In the auctions in the North American emissions trading systems, allowances are not sold below a pre-defined auction reserve price. This provides buoyancy for the carbon price. But the EU ETS does not have such a mechanism.

After more than two years of negotiations, in November 2017 the European Commission, the European Parliament and the European Council of Ministers agreed on how to reform the EU ETS. The total amount of allowances will be reduced at a faster annual rate: 2.2 percent per year. But what is most interesting is the introduction of a mechanism that automatically cancels allowances. Each year, starting in 2019, a part of the allowance surplus (initially 24 percent, then 12 percent from 2024) will be moved to the so-called market stability reserve. This reserve will now be limited in size and may only hold as many allowances as were auctioned the previous years. The rest are cancelled.

ICIS, an energy market information and carbon markets analytics company, estimates that more than 2 billion tonnes of allowances will be cancelled in the year 2023. Once a large part of the surplus is cancelled, the carbon price will increase from 10 euros today to 25–30 euros or more in 2023. This is a major strengthening of the EU ETS. It is likely to push out much of the coal-based power and lead to a significant expansion of wind power and other renewables in the EU.

But at the same time the reform may open up complementary policies at the level of the EU or member states. With the automatic cancellation, the system will no longer have a fixed cap. As a result, there will be no waterbed effect and suddenly additional emissions reductions will matter.

The dynamics are as follows: if a member state introduces an extra policy reducing emissions in the trading sector, say a carbon tax or a renewables support policy, the surplus of EU allowances will increase. When the total EU surplus exceeds the maximum level, allowances will be cancelled down to that level. Since the current surplus is already way over the maximum level, an extra reduction of 1,000 tonnes would, at least in the coming years, lead to a cancellation of 1,000 tonnes in the year 2023.

Here are a couple of examples:

National tax on aviation. The Swedish government has proposed a tax on national aviation, but this has been criticised for not reducing the system’s total emissions. However, with the new rules, reducing emissions in Swedish aviation will have a direct climate benefit. Moreover, this technological change prompted by the incentive in Sweden may spill over to international flights and hence have broader positive effects.

Base materials. The steel and cement industries have developed and are developing new processes that can reduce emissions dramatically, but the costs of these emissions reductions are probably significantly higher than the 25 euros per tonne of avoided carbon dioxide. It is unlikely that the EU ETS alone will drive a transformation in the materials sectors, so complementary policies of some sort are needed. With the reform, these policies will now be possible and real reductions in these highly emission-intensive sectors can be achieved.

Will additional policies and measures threaten the EU ETS? There are good reasons to believe that they will not. The ETS is a cornerstone of Europe’s climate policy, but you cannot build a house with one cornerstone. The EU ETS is likely to co-exist with other policies, on both the EU and national levels. In this respect, the proposed cancellation mechanism is promising. It may make it easier for the EU ETS to function in conjunction with other policies and adapt to technological breakthroughs.

What are the implications for carbon markets globally? There are several interesting questions here, for instance how competitiveness concerns will be addressed and if the reform will facilitate linking and aligning with other carbon markets. Being one of the largest carbon markets, the EU ETS is of course carefully monitored by regulators of other such markets. A functioning EU ETS is therefore not only important for Europe, but also important for carbon pricing all over the world.

For years, the EU ETS has been plagued by an extensive allowance surplus and low allowance prices, but with the reform it will be saved at the last minute. After the reform, it seems the EU ETS will be an instrument to count on and a good example on which to build.

Lars Zetterberg is senior researcher at the IVL Swedish Environmental Research Institute and programme director of Mistra Carbon Exit. He thanks Dallas Burtraw for his useful comments.

Read the article at to ICTSD (original publisher)