Reforming the EU ETS: It's only just begun

Things may be looking up for the EU’s “flagship” climate policy instrument. But much more needs to be done from the autumn.

The EU Emissions Trading Scheme (ETS) was on its knees 12 months ago. The European Emission Allowance (EUA) price had fallen to less than €3. The European Commission’s backloading measure, a sticking-plaster to give the market a temporary fix, was mired in an EU regulatory morass. Worryingly, the German Government - in the form of the then Finance Minister (and FDP party leader) Philip Roesler - was blocking progress on the backloading dossier. The word most associated with ETS was “failure’.

From fall to (muted) rise

One year on, the backloading regulation has been passed and is being implemented. The EUA price has rebounded to a €5-6 level. The European Commission recognised a prime reason why the ETS got in a mess in the first place - its inflexibility and inability to respond to extraordinary external events (i.e. financial crisis and recession). It has therefore proposed that a reserve mechanism (the Market Stability Reserve - MSR) be established. The debate on a 2030 climate and energy framework, with the ETS singled out as a “central instrument” to drive decarbonisation, is alive. Detractors still label the ETS a failure; but it has emerged from life support.

Three things policymakers are doing right

Much of the disenchantment with the ETS, among regulated companies and market participants alike, was caused by widespread frustration with the regulatory authorities’ inability to get a grip and arrest the scheme’s slide. The launch in January of the 2030 climate and energy package, and simultaneous publication of the MSR proposal, put the Commission back on the front foot. In particular:

1. The MSR proposal is definitely a positive development. Apart, as indicated above, from making the ETS a more flexible and responsive instrument, it would align with other core principles that all market participants would expect. By setting out clearly when major situations of over-supply or over-demand would spark the reserve into action, it would be a transparent and rules-based mechanism. It would also bring greater predictability to the market, nullifying the risk of any future arbitrary interventions like backloading. There are certainly question marks about the proposed MSR parameters, but the establishment of a reserve is the right thing to do.
2. Arguments about carbon leakage are a running sore, undermining the credibility and effectiveness of the ETS. The Commission is required by the end of 2014 to draw up a new list of sectors affected by leakage. The decision to use the same criteria for this new list as for the existing list has been criticised, especially by the NGOs. However, with some research indicating that leakage may be more of an issue in the future than in the past, the concerns of energy-intensive sectors do need to be addressed if the ETS is to progress with greater buy-in.
3. Securing a detailed agreement on the 2030 framework won’t be easy to achieve without compromises and trade-offs between member states. The new Commission, which will succeed in the autumn, will have a major challenge in crafting legislation which can reach the statute books by say 2017. But the deadline of October 2014 for a political agreement on the headlines of the framework seems to be holding firm; and it’s essential it does so in order to provide context and a platform for a reformed, more credible ETS.

Here are three more things they could be doing

1. The backloaded allowances, totalling 900 million which are scheduled to return to the ETS in 2019/20, cast a shadow. Although the Commission’s MSR proposal envisages a “smoothening formula” to ease the transition into Phase IV and the post-2020 period, the supply/demand balance towards the end of Phase III could still be severely destabilised should those allowances be returned (with downwards implications for the price). There are advocates who say these allowances should be cancelled, of course. However, that could be politically and legally very difficult to push through. Which is why the idea of early establishment of the MSR, in say 2017, and the movement of the backloaded allowances straight into it in 2019, is now building some momentum.The German Government - a far cry from the days of Roesler - signalled their support for this action last week. This was a significant announcement, and it will be interesting to see if the new Environment Committee in the European Parliament, charged with taking forward the MSR legislative proposal from September, picks up on this.
2. Nothing in the Commission’s January package, either on the ETS or when considering the 2030 greenhouse gas emissions reduction target, talked about the role of international credits in mitigating the costs of emissions reductions. Nevertheless, there is a strong case for bringing back international credits (somewhat disregarded post- 2012 because of the slump in demand) into policy deliberations when thinking about the ETS over the longer-term. This is for two reasons. First, as Enerdata calculated in a recent UK DECC commissioned study which evaluated 40% and 50% reduction targets, international credits can help to reduce domestic costs (this could be extremely relevant should the international climate negotiations persuade the EU to consider a higher target - unlikely but not impossible). Second, a global carbon market in the 2020s will have to link national and regional markets if it is to drive climate action and the low-carbon transition at scale: fungible international credits, recognised by the variety of regulated markets, remain the best way to facilitate that necessary linking between markets.
3. Last but not least, EU policymakers need to take a step change in their use of carbon revenues. So far, their approach - unfocused, hampered by poor communication, hamstrung by the insistence of finance ministries in seeing some of that revenue - has been botched. It’s worth comparing with how the Regional Greenhouse Gas Initiative (RGGI) power scheme and the California emissions trading scheme in the US handle their revenues. These are allocated towards both the development of low-carbon technologies and where customers may need help with their energy bills. The regulators in these jurisdictions are clear about what they are doing and why they are doing it, which gives them kudos and also highlights in public eyes more generally the benefits of emissions trading. A reformed EU ETS, trading at higher allowances prices (and allowing for competitiveness and leakage concerns - see above), would yield major revenues which could in turn help foster European decarbonisation. 

Urgency, Imagination, Boldness

Policymakers will face a crowded agenda over the next five years. Where climate and energy will sit remains to be seen - although the evidence is that these issues are rising back up the list of people’s concerns across Europe. The EU ETS has stabilised, but urgent, imaginative and bold policy reform is essential to take it to the next level. There is still time for politicians at the national level and in Brussels to grasp the opportunity - the ETS could then, at the risk of mixing metaphors, be both cornerstone and motor.