Reforming the European Emissions Trading System: the proposal for a Market Stability Reserve

The European Commission has proposed a major reform of the European emissions trading system (EU ETS). It released in January a proposal for a non-discretionary mechanism that would reduce the amount of pollution allowances available to emitters in cases of exceptional drops in emission levels. The proposal calls for a “market stability reserve” which will effectively limit how many surplus permits can be in the market at any one time. What does it mean? If adopted, the mechanism will likely bring a higher predictability for low carbon investments and an enhanced credibility of the carbon market.

Why a market stability reserve

In the current form of the ETS, the number of pollution allowances available to emitters is determined for each phase of market operation well in advance of the phase’s beginning. During the course of a market’s phase, however, emissions levels may end up far below the cap, as they did in the wake of Europe’s financial crisis. This systemic quirk of the carbon market, whereby supply is rigid but demand is fluid, is the reason why emitters have accumulated a hefty surplus of allowances and why the European carbon price has deteriorated substantially in recent years.

The low carbon price has hurt the credibility of the emissions trading system and this has in turn prompted politicians to intervene in the market. Member states recently approved a “backloading” of allowances, which would delay some allowance auctions from the next few years to 2019 and 2020, in order to raise the carbon price in the short term. But while this move signals the continued political backing for cap-and-trade in Europe, it is not a long term solution. Discretionary interventions reflect poorly on both the credibility and predictability of climate policy.

The proposed market stability reserve will be non-discretionary. It will therefore steer clear of the politics of the day. Instead, the mechanism will provide a predictable framework for how the carbon market will respond to exceptional market surpluses.

The mechanism will be based on data regarding the market’s cumulative surplus, which will be published annually. The cumulative surplus is defined as the difference between the market supply – allowances issued and credits surrendered – and historical emissions, accumulated since 2008. When the cumulative surplus exceeds 833 million tons in any given year (say, year 0), the mechanism will withdraw 12 percent of this surplus from the auctions scheduled to take place in two years’ time (in year 2). The withdrawn allowances will be placed in a reserve. They will be gradually released to the market at a later date, when the surplus of allowances has decreased to below 400 million tons.

Towards enhanced policy predictability and credibility

While the proposal remains to be adopted, the legal proposal will likely trigger a much needed debate in Europe about the stability of the bloc’s carbon market. A market in which supply is fixed in advance and demand fluctuates widely with GDP can be expected to lead to oversized fluctuations in the carbon price. A drastic drop in the carbon price in the short term lets investors continue to support high-carbon energy infrastructure. Such investments, however, are inconsistent with Europe’s long term ambitions of decreasing emissions by 80-95 percent by 2050.

Short-term fluctuations in the carbon price can thereby create inter-temporal inefficiencies which lead to the lock-in of high-carbon infrastructure and potentially stranded assets. In this context, the proposed market stability reserve will provide a more consistent and predictable carbon price signal. Such a signal is likely to strengthen the incentives for competitive low-carbon technologies. It will also enhance the credibility of the emissions trading system by preventing a carbon price collapse that may be followed by discretionary interventions by politicians.

The choice of trigger levels

Assuming a consensus is reached on the need for flexibility in EU’s carbon market, attention will likely turn to the threshold levels at which the reserve is triggered. The upper threshold – which the Commission proposed should be 833 million tons – provides an implicit support for the European carbon price. Against the backdrop of the current market oversupply, expected to reach 2.6 billion tons by 2020, the threshold of 833 million tons substantially tightens the market supply and demand balance. This is expected to result in a significant increase in the carbon price compared to a scenario reflecting the current market design.

Just as important to the carbon price are the implications of the lower threshold of 400 million tons. By choosing this threshold, the Commission is proposing that allowances should be released from the reserve at a time when the market is still oversupplied. Using this threshold, the market stability reserve will likely return allowances to the market relatively quickly after they have been withdrawn. The choice of a lower limit of 400 million tons therefore weakens the potential of the proposal to bring about long-lasting change in the market’s surplus.

But regardless of the final design of the stability reserve, the Commission’s proposal exemplifies the evolution of carbon markets. Regulators who seek to put a price on carbon are increasingly recognizing the importance of price stability in enhancing the predictability and credibility of climate policy.

This article was originally published on The Energy Collective on January 23, 2014. Link to the original article:

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