How to boost CO2 prices in the European carbon market

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photo Daniel Patman

photo Daniel Patman

If the EU is serious about raising the carbon price in the EU Emission Trading System (ETS), the best option for the short term is to strengthen the Market Stability Reserve by increasing the amount of “surplus allowances” taken out of the system, according to Hæge Fjellheim, Head of carbon analysis  at Thomson Reuters Point Carbon. Fjellheim discusses progress on the ETS reform in light of the recent vote in the European Parliament’s Environment Committee, and sets out which elements in this deal need to survive in order to prevent the EU’s “flagship climate instrument” from sinking into irrelevance.

On 15 December the Environment Committee in the European Parliament (ENVI) voted in favour of a significant strengthening of the EU ETS. ENVI wants a much more ambitious framework for phase 4 of the system (2021-2030) than the reforms proposed by the European Commission so far.  If these ideas survive the legislative process, they will lead to a tighter market balance and support carbon prices both in the short and long term.

There is no guarantee that this will happen of course: the Environment Ministers from the Member States who met on 19 December were unable to reach agreement as yet on how to go forward with the EU ETS reform. In addition, there will be a plenary vote in the European Parliament, scheduled for 13-16 February.

Shift in sentiment

Although the position of ENVI has not yet won the day, it does illustrate how sentiment around the EU ETS review has shifted. The “phase 4 review process” was supposed to focus on long-term reform proposals for the period 2021-2030, but it is increasingly focusing on how to increase carbon prices, the sooner the better.

This was not what the review was originally intended for. In 2014, measures were adopted by the EU that were supposed to address the issue of the permanently low carbon prices in the system, the result of overallocation of allowances in the past. The two key measures that were taken are: “backloading” (postponing the auctioning of allowances) and the establishment of a Market Stability Reserve (MSR). This MSR, which will start operating in 2019, will be filled with “backloaded” allowances and other unallocated allowances, and continue to soak up oversupply in the market with the aim to restore the EU ETS market balance. These two measures were expected to lead to a gradual price uptick.

“We are considering a more proactive way of dealing with the surplus that is currently in the market” – European Commission

At the same time, the EU embarked on a long-term reform process, which was kicked off on 15 July 2015 with a proposal from the European Commission. They include a plan to ratchet up the annual rate at which the EU ETS cap goes down after 2020 from 1.74% to 2.2%. In addition, the Commission proposal sets out detailed rules for issues like the free allocation of allowances, how industries vulnerable to international competition (‘carbon leakage’) should be protected and how auctioning revenues should be shared among the member states.

The Commission’s initial proposal is still part of the debate around the ETS review that is going on today. But rather than just looking at more technical changes to the EU ETS and how the system can be improved in the long-term, the debate is increasingly centring around how reforms can boost the carbon price in the short and medium term.

An important reason for this change in sentiment is the superfast adoption of the Paris Climate Agreement. This has put strong pressure on the EU to “align the EU ETS with Paris” – i.e. to make it more ambitious. Another reason is that the market, disappointingly, did not respond to the backloading and MSR measures. On the contrary, carbon prices in the EU ETS crashed right after Paris, declining 40%. They have remained in the doldrums since, at around €5/ton.

Many are worried that the MSR will be too weak to really restore the market balance and boost prices, and that national or Union-wide overlapping policies will prevent carbon prices from recovering. The emission reductions from alternative policies, e.g. in energy efficiency, will help the EU reach its overall climate ambition, but they will also reduce demand for allowances in the EU ETS, unless counteracted.

Fair share

In order for the EU ETS to deliver its fair share of emission reductions under the EU’s 2030 climate and energy framework, all details have to be agreed between the co-legislators in one concerted package of amendments to the Commission proposal. A common Parliament position may be getting closer, as the Industry and Energy Committee (ITRE) reached agreement in October, and the Environment Committee (ENVI) adopted a common position on 15 December.

The ITRE opinion directly addresses the depressed carbon price levels, explicitly linking the success of the ETS as a policy instrument to carbon price levels. The committee proposes that member states can voluntarily account for the effect of certain overlapping policies through cancelling the equivalent number of EUAs (emission allowances), and also suggests cancelling 300 million allowances from the MSR in 2021. (To compare: there are 15.5 billion allowances available in the entire period 2021-2030 under the current cap, i.e. on average 1550 million per year.)

The ENVI position consists of a number of proposals that will have significant price impacts, including the following:

  • ENVI wants the linear reduction factor to be increased to 2.4 percent. This would imply that the total cap in the EU ETS will be reduced by almost 53 Mt/year from 2021 onwards. In comparison, the Commission proposed a reduction factor of 2.2 percent, equal to 48 Mt/year.
  • It wants to strengthen the MSR. Under current rules, 12 percent of the surplus allowances will be transferred to the MSR from 2019. ENVI wants to increase the intake rate to 24 percent during the four first years the MSR operates.
  • Rather than 300 million, ENVI wants 800 million allowances in the MSR to be cancelled in 2021, while another 200 million could be cancelled in 2030 (if not needed as additional free allocation to industry).
  • ENVI wants the so-called New Entrant Reserve (NER) – designed for new business activities – to be filled with 400 million allowances from phase 4. By contrast, the Commission proposed to use unallocated allowances from phase 3 to fill the NER (essentially just adding allowances to the phase 4 cap).

ENVI also proposed other potentially important measures. For example, it holds that the cement sector should not be eligible for free allocation anymore in phase 4. To offset the risk of carbon leakage, ENVI suggests a new import scheme which would imply that importers of cement and clinker have to cover emissions related to their products – adding new demand for EU carbon allowances. In addition, ENVI wants the allocation for the aviation sector to be tighter, both by lowering the sector cap in 2021 and by setting the same linear reduction factor for aviation as for the other sectors in the EU ETS. Under current legislation, the aviation sector will have a flat cap throughout phase 4.

The policy signal of increasing overall ambition should not be underestimated, however, and could give a more prominent price impact  in the short to medium term than what our model predicts

As to the Member States, the latest progress report  from the Slovak Presidency – Slovakia holds the EU presidency until the end of the year – outlines three outstanding issues which will have to be resolved politically: ensure adequate protection to industry at risk of carbon leakage, strengthen the ETS (such as by doubling the MSR intake rate) and get the low-carbon funding mechanisms targeted towards low-income member states right.

Laszlo Solymos

László Sólymos, Slovak environment minister

The latest meeting of the Council of Environment Ministers on 19 December failed to reach any firm agreement, let alone agree on measures that would go further than the Commission’s proposals. The Slovak Environment Minister Lázló Sólymos said that “we wanted to reduce … uncertainty and give the market a clearer signal, but unfortunately we were not able to do that because of political differences.”

According to press reports, a group of ten countries, including France and Germany, found themselves in opposition to a bloc of Eastern European countries plus Spain, Italy and Croatia. The east-west divide became particularly clear when ministers discussed the MSR. Any strengthening of this mechanism during the ETS review process will have to be balanced against concessions on industry protection and low-carbon funds.

Patience

Although the review proposal is currently in the hands of Parliament and Council, the role of the Commission in the legislative process is still important, as it acts as mediator in the trilogue negotiations.

The Commission was for a long time firm in its opposition to reform proposals directly targeting the price, such as the price floor proposal put forward by France this Spring. It has consistently called for patience, asking for time to see the MSR in action from 2019. However, after Energy Commissioner Cañete during the June Environment Council opened the door to discuss further volume-based approaches, Commission representatives have been more vocal. For example, the Commission’s climate chief Jos Delbeke was recently quoted saying that the Commission “…would like to have higher prices because it would facilitate the take-up of renewable energy, for example, or encourage energy efficiency improvements, so we are considering a more proactive way of dealing with the surplus that is currently in the market”.

The €20 price level that is needed to get fuel switching from average coal plants to modern gas plants in the base load power production is only reached in the second half of phase 4, according to our price model

That’s a pretty clear way of saying that the Commission will be open to discuss the MSR and other elements not mentioned in its initial phase 4 review proposal. In the impact assessment accompanying the recent proposal for a revised energy efficiency directive, the Commission addresses the interaction between the EU ETS and more ambitious efficiency targets. It recognises the potential shortcomings of the current MSR for “very ambitious levels of 2030 energy efficiency targets”, and that a review of the MSR withdrawal rate might be justified as part of the regular review of this mechanism by 2021.

Moreover, during the press conference following this week’s Environment Council, Climate and Energy Commissioner Cañete said that he considered topics related to the MSR to have overall support as a main tool to deliver reasonable carbon prices, adding that strengthening the ETS was a general concern – the question remained how to do it.

Price model

Thomson Reuters Point Carbon has a sophisticated long-term price model that shows the impacts of various proposals on European carbon prices until 2030. The policy options are modeled against our base case, which assumes, among other things:

  • Overall targets by 2030 at 40 percent reduction of greenhouse gas emissions, 27 percent renewable energy share, 30 percent energy efficiency improvement.
  • Phase 4 review parameters as in the Commission proposal.
  • GDP annual growth rates from Oxford Economics: 1.8% until 2020, 1.7% 2021-2025, 1.4% 2026-2030.
  • Fuel prices: Latest forward curves until 2020, World Bank commodity price forecast until 2030.
  • Market participants look 3 years ahead for hedging and 5 years ahead for abatement planning.

In this base case the MSR will withdraw volumes until 2025 and enter into sleep-mode for the remainder of phase 4, while the release of allowances from the reserve starts in 2035. The MSR retrieval lifts the price in the early 2020s, before it flattens when the MSR goes into hibernation. We expect a further uptick towards the end of phase 4, as market participants will start to anticipate that the market turns short after 2030.

We modelled the effect of a strengthened MSR by assuming a doubling of the MSR intake rate from 12 to 24 percent. In this scenario, the supply overhang is reduced more aggressively with an average of 305 Mt/yr (million tons per year) transferred to the MSR in the first four years of operation (compared to 181 Mt/yr on average in the base case). The MSR will be in hibernation from 2022 with the oversupply lingering between the upper and lower threshold levels.

In this scenario, we found that the price increase will be sizable in the near-term. As illustrated by Figure 1, the price lift starts to materialize already from 2017, as market participants will prepare for the more aggressive MSR in advance. Average prices under a strengthened MSR will be 10% higher in phase 3 and 4% in phase 4 compared to our base case.

What we also found is that the proposal to cancel allowances from the MSR in 2021, as has been propsed by both ITRE (300 Mt) and ENVI (800 Mt), would have limited impact on prices in phase 4 (2021-2030). Allowances are released from the MSR only when the oversupply in the market falls below the lower threshold (oversupply below 400 Mt), at a rate of 100 Mt per year. The effect of cancelling allowances will thus come when the MSR is close to exhaustion, probably post-2040, while it will not change the market balance in phase 4. Under the Commission proposal a New Entrance Reserve (NER) will be set up with approximately 400 million unallocated phase 3 allowances, effectively adding this volume to the phase 4 supply. As described above, the ENVI proposal in contrast suggests to fill the NER with phase 4 allowances, which would imply a tightening of the phase 4 cap.

According to our modelling, the effect of sourcing the NER from phase 4 rather than phase 3 allowances will increase prices with 10 percent in average over phase 4 (as illustrated in Figure 1).

As the UK will be unable to take its normal leadership role, Germany will have to join France and step forward with a very clear position to swing the Council

We have also modelled a combined scenario, both strengthening the MSR and sourcing the NER from phase 4. In this scenario, we see a consistent price uptick from 2017. Prices are lifted on average 11 percent in phase 3 and 15 percent in phase 4. The stronger MSR causes the lift in the near term, while the price effect of sourcing NERs from phase 4 kicks in from 2021 and gets stronger over time (see Figure 1).

Finally, increasing the linear reduction factor from 2.2 percent to 2.4 percent would increase overall ambition and be more aligned with the path towards 2050. However, since the delta between the two reduction factors is only about 5 Mt/yr, the price effect will hardly be noticeable in the first few years of phase. Our model shows rather a price spike towards the end of the period as market participants start to factor in the prospect of market shortage post-2030.The policy signal of increasing overall ambition should not be underestimated, however, and could give a more prominent price impact  in the short to medium term than what our model predicts.

Haege Fjellheim article

Figure 1 Aiming for a smooth increase of EUA price levels towards 2030

Leadership role

Thus, our analysis suggests that if the main aim is to strengthen the price signal in the near term, strengthening the MSR in combination with sourcing the NER with phase 4 allowances seems to be the best option at hand. In contrast to increasing the linear reduction factor or cancelling allowances, it would most likely have a significant impact also in the near term. However, even in this more ambitious scenario we do not see a dramatic price increase before 2030. For example, the €20 price level that is needed to get fuel switching from average coal plants to modern gas plants in the base load power production is only reached in the second half of phase 4, according to our price model.

In theory, it should be easier to get an agreement to change more technical and “cap-neutral” elements of the MSR and the NER, than to get both Council and Parliament support to increase the reduction factor or to cancel allowances. Our assessment is when voting in February, the Parliament Plenary is likely to support the overall compromise deal reached by ENVI, thereby agreeing measures to tighten the market balance and increase prices. While it is still too early to say to what degree this will be mirrored in the Council, we think there is a good chance a stronger MSR will be part of the final deal. As the UK will be unable to take its normal leadership role, Germany will have to join France and step forward with a very clear position to swing the Council discussion towards stronger ETS support. The alternative could be another decade with irrelevant carbon prices.

Editor’s Note

Hæge Fjellheim is the Head of carbon analysis, Thomson Reuters

 

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