Does the EU ETS need reviving, again?

by Inline Policy on 12 Apr 2016

Boom and Bust

The EU Emissions Trading System (EU ETS) has been up and down a rollercoaster over the last decade. Launched with considerable optimism in 2005 as one of the European Union’s prime policy instruments for tackling climate change by placing a price on greenhouse gas emissions, it has since gone through what can be most appropriately termed a “boom and bust” cycle.

At the end of Phase I in 2007, the price of an EUA effectively hit zero, as there was no provision to carry Phase I EUAs into the second phase.

During Phase 2, before the financial crisis hit, an EUA traded at the dizzy heights of 30 € a tonne, only to descend - in the aftermath of recession and the failure of the Copenhagen COP - into single figures.

Moving into Phase 3 post-2012, the EUA hit rock bottom, falling to below 3 € a tonne in January 2013, the victim of a botched attempt to prop up the struggling market.

Eventually, lawmakers in Brussels got their act together and first passed a temporary measure (in the form of backloading - removing allowances from the market) and then what was perceived to be a more enduring structural reform in the shape of the Market Stability Reserve (MSR), the flexible and responsive mechanism the ETS had long lacked to enable it to handle external shocks like the financial crisis. The MSR, although its compromise start date of 2019 disappointed many in the market, was heralded as the trigger for the revival of carbon trading in Europe when it was passed in the summer of 2015. It seemed like the EU ETS was finally back on its feet.

Momentum forward, then checked

From last summer, the market did seem to share the view that the ETS was now getting back into shape to play the role that so many policymakers have long envisaged: that it should be the cornerstone of the EU’s decarbonisation strategy, not only driving emissions reductions but also incentivising investment in low-carbon sources of energy. Prices continued to rise from the nadir of 2013 so that, by the end of 2015, the EUA was trading at over 8 euros a tonne. the trajectory was upwards, and many analysts were forecasting a climb into double figures in 2016.

Fast forward four months to now, and things look somewhat different. Since the start of the year, the EUA price has started to fall and is now back to roughly 5 euros (notwithstanding a modest rally as this article goes to press). Various factors have been put forward - the wider energy complex, a mild winter - but, whatever the reason, the storyline - even if languishing at 5 euros is a relatively short-lived phenomenon, which is not clear - is of momentum checked and questions being asked all over again about whether the EU ETS can genuinely be core to promoting the transition to the low-carbon economy in Europe.

Policy ambition is in short supply

The check in the price trajectory is disappointing for those who have worked hard to restore its fortunes. Moreover, the sombre mood has not been helped by some of the statements coming from European institutions. To give credit, the EU undoubtedly played an instrumental role in the negotiations that resulted in the Paris Agreement, especially in relation to Article 6 of the agreement on co-operative approaches towards climate mitigation and a new mechanism to contribute to mitigation action. Which is why it was disappointing that Energy and Climate Commissioner Cañete should choose to spoil the party somewhat, issuing a statement shortly after the COP that the EU was unlikely to come forward with more ambitious climate policies before 2020.

Cañete's emphasis on the need to focus on implementing existing policies incorporated a sort of logic, given that fact that heads of government had agreed the EU’s 2030 targets as recently as the autumn of 2014. But the tone and timing of his statement resonated awkwardly with the unexpectedly positive outcomes from Paris, including the aspiration to go beyond the 2 degrees threshold by trying to limit global warming to 1.5 degrees C.

Since that initial dampening statement from Cañete, the Commission has emerged with a communication - roundly criticised by green campaigners - which advised against increasing the EU’s 2030 climate targets.  EU Ministers have also met - notably at the Environment Council in early March - and, while some member states lobbied for higher European ambition post-Paris, the Council settled on a position in line with the Commission’s paper.

As so often in the past, member states at that Council seemed to divide on broad west/east lines on higher climate targets. To observers of EU climate politics, disagreements between western Europe and central/eastern Europe are all too familiar, a situation caused partly by a fundamental rupture over what the objectives of the ETS should be: for Poland and its allies it is solely to cut emissions in the most cost-effective way; whereas for Germany, France, the UK and the Nordics, it is also about promoting low-carbon investment through a progressively stronger carbon price.

Attention is elsewhere

One of Cañete’s, and the Commission’s, main points following Paris has been that they and the EU as a whole have plenty on their plate in 2016/2017 on the climate and energy agenda. There is also some justification to this point. In 2016 we can expect the following major developments in Brussels:

  • legislation on emissions from the non-ETS sectors (notably agriculture and land use);
  • a transport decarbonisation paper;
  • and proposals on renewables, energy efficiency, electricity market design and on governance/target-setting aspects.

All extremely important (and it’s particularly encouraging to see the Commission playing catch-up in the neglected area of transport), but it rather confirms the view that many in Brussels have given up about trying to do anything more on strengthening the role of the EU ETS in the short-term.

Of course, the Phase 4 proposals are on the table, and market participants look forward to seeing what European Parliament Rapporteur Ian Duncan has to say when he presents his recommendations on Phase 4 over the next few weeks. However, the fact that the Phase 4 debate has to date centred almost wholly on carbon leakage is very revealing - in the post-Paris world, as the US and China continue to take forward their domestic agendas (not to mention a bunch of others, ranging from Mexico to Canada to Thailand), this is striking a discordant note.

But what can be done with the ETS?

Against this unpromising background, it’s not easy to identify policy solutions. Free marketeers argue that the ETS is doing the job that it is meant to be doing, and that the price will rise as a result of market conditions. They could be right, and those worried about the check on the price progress of the EUA could be crying wolf too early.

But what if the recent structural reform still hasn’t got to the heart of the ETS’s problem with over-supply?  Moreover, the free market mantra rather misses the point that the ETS is an artificial market created as part of the policy response to what the Stern Report labelled “the greatest market failure the world has seen”: climate change. Self-evidently, there must be limits to how often the rules can be changed, but the Phase 4 proposals do provide an opportunity (in fact, a regulatory peg) for the EU to take another look and consider if more can be done to get the ETS right in the post-Paris world - especially if other channels, like revisiting the 2030 climate targets, are off-limits for the political reasons described above. Here are some options that the EU institutions and the other European capitals should possibly be considering:

1) Bring forward the start date of the MSR. Comment: Germany and the UK lobbied hard for a 2017 start date when the MRS legislation was going through. They were eventually forced to accept a compromise start date of 2019, primarily because of Polish opposition. There is no reason to believe they would be any more successful with another go, but keeping this question alive could continue to focus minds. At this stage, the start date could in principle be brought forward, say to 2018.

2) Address the ongoing problem of over-supply and windfalls. Despite the Commission’s honourable attempt to update the basis of free allocation through carbon leakage benchmarks, there is still substantial concern that carbon leakage protection is not focused enough on those sectors who are genuinely deserving of it. Witness the joint UK/France non-paper tabled last month on how the post-2020 allocation of free EU carbon allowances could be divided into four different tiers - wider than the Commission’s proposed two - in an effort to focus free allowance hand-outs on those sectors most at risk from leakage.

Comment: such an intervention wouldn't by itself resolve the over-supply problem, but it would be a testament of serious European intent in the post-Paris environment.

3) Border control measures, an old chestnut which has been recycled on more than one occasion by the French, as a means of imposing a carbon price on imports from countries that have no such pricing externality. Comment: favoured by economists, but not a proposal likely to fly politically inside the EU and would surely be met with stiff resistance in WTO circles.

4) A price corridor, yet another recent proposal from the hyper-active French. Basically, this would introduce a “soft collar” for EUAs, with a reserve price at government auctions and a ceiling price some 3-6 times that. The corridor would be part of the MSR, which would rise annually along a predetermined trajectory and would therefore then either soak up or surrender allowances based on prices rather than the thresholds agreed in the existing rules agreed last year.

Comment: this would probably be seen as a step too far with “market interference”. The Commission has never been keen on price guidance; and some would argue that if you are going to start setting prices, you might as well swap the ETS for a tax.

5) Unilateral cancellation of EUAs. This idea was floated by Ian Duncan at a recent Brussels gathering, and there are rumours that member states like the UK could support this.

Comment: possibly the most practical idea in play. The unilateral approach towards cancellation would not contradict the EU-wide approach on cap-setting and emissions reduction.  Crucially, it would not demand of all member states that they cancel their surpluses - and might therefore be more acceptable to Poland and its allies than anything else on this list -  but would give member states individual flexibility, e.g. not to proceed with auctions if they so choose.

In Conclusion

It might be too early to consider further changes to the ETS, coming so quickly on the heels of the MSR legislation placed on the statute book in 2015. But the longer the EUA price continues to stagnate against the background of ongoing surpluses and over-supply of allowances, the greater the risk that the ETS will look out of time and out of sync with everything else going on, whether it is international policy developments or clean energy technology prices continuing to fall.

Something fresh would require some heavy lifting, and the appetite among European policymakers seems to be lacking at present. Perhaps this would be the opportunity for the private sector to step up, take the lead and put pressure on the politicians? If the ETS is to be a meaningful policy instrument, the inertia on price can’t continue indefinitely. Otherwise, there is a risk that national governments will increasingly emulate the UK government and start introducing their own national emissions measures like the carbon price floor - a growing fragmentation that many companies, whether they are compliance entities or financial intermediaries, would not welcome. In that respect, French Environment Minister Ségolène Royal’s appointment last week of a high-level panel to develop proposals on how to implement a price floor for EUAs is a further sign that some national governments are becoming restless with the ETS; and if no action is taken at EU-wide level, the risk of fragmented national measures will only grow.

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Topics: European Union, Energy and environment, EUA price, Technology, UK business

Inline Policy

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