The European Parliament and Member States have reached a historic deal on the first half of a two-part reform of the EU Emission Trading Scheme (ETS). This is the introduction of a “market stability reserve” (MSR) that will mandate EU officials to add or remove allowances from the market according to pre-set rules. The MSR is supposed to wick away the enormous 2.1 billion “surplus” of carbon allowances that has accumulated in the market over the last few years, equivalent to one full year of EU ETS emissions. The CO2-price did not immediately respond, but analysts expect it to go up considerably in the future if the reform process is completed.
“The future of the EU ETS has been decided,” said a senior EU official at a debate organised by the Cologne Institute for Economic Research in Brussels, the first German economic research institute to have opened a permanent branch in Brussels. Peter Zapfel, head of policy coordination at the European Commission’s climate department, called the MSR deal “courageous” and confirmed that it paves the way for the Commission to issue further proposals for reform before the summer.
The European carbon trading scheme, the largest in the world, has been in the doldrums for years. A large “surplus” of allowances, caused by overallocation, lack of demand thanks to the economic crisis and energy efficiency gains, and an influx of international carbon credits, has kept the carbon price in the single digits since 2011.
The MSR deal is a historic first in that it sees MEPs and Member States agree to make a Commission proposal more ambitious (usually MEPs fight to beef it up and Member States succeed in watering it down). In this case, the biggest bone of contention was when the MSR should start: the Commission had proposed 2021 (for fear of interrupting the current trading period from 2013-20) while the Parliament wanted 2018. Several member states (e.g. France, Germany and the UK) wanted 2017 while other member states (a blocking minority led by Poland) insisted on 2021. The 2021 blocking minority was dissolved in the Council when the Latvian EU presidency brokered agreement on a formula that will see richer member states contribute more allowances (and therefore give up more auctioning revenue) to the reserve than poorer member states. This paved the way to a deal: the MSR will start on 1 January 2019.
More important than the start date however, is that a whole batch of allowances currently parked outside the system will go straight into the reserve rather than (re-)entering the market. This includes 900 million “backloaded” allowances – temporarily airlifted from the market in 2014-16 to boost the carbon price but normally due to re-enter it in 2019-20 – and up to that many again in “unallocated allowances” – allowances set aside for new entrants or arising from plant closures that would otherwise also re-enter the market in 2020. Without the MSR, the current allowance surplus could have nearly doubled by 2020, saddling the EU with an irrelevant carbon price for years to come.
One step further
NGOs such as UK-based Sandbag also hailed it as a “landmark” agreement and estimated it could remove as many as 2.2bn allowances from the market by the end of 2020. Sandbag – along with other NGOs – went one step further though and called on Member States to now permanently cancel a “significant” volume of carbon allowances. Dutch Green MEP Bas Eickhout said: “The oversupply of allowances needs to be permanently fixed. This implies permanently retiring 2 billion emission allowances. Failure to do so, combined with an un-ambitious [40%] greenhouse gas reduction target for 2030, would mean EU climate policy will come to a standstill.”
The EU steel industry has lost a fifth of its workforce since 2008
The problem with permanently retiring allowances has always been that it amounts to changing the EU’s greenhouse gas emission reduction target for 2020, a political no-go. Eickhout called the MSR deal a “band-aid”, not a landmark. And several delegates at the Cologne Institute for Economic Research debate seemed to agree. Energy consultant Mike Parr pointed out that investment bank UBS reports that 70GW of coal- and gas-fired plants have been shut down in the last five years – with more to come. Is the MSR a solution on the scale needed? he questioned. Dr Hubertus Bardt, Managing Director and Head of Research at the Cologne Institute for Economic Research, also said that the MSR will do “not a lot”.
Certainly the carbon price did little on the day of the deal, sticking around its preferred €7 a tonne. Nevertheless, analysts such as Philipp Ruf from ICIS Tschach called the deal a “strong outcome”. He expects the carbon price to exceed €20 by 2020, €30 in the next decade and to hit €40 by 2030.
In any case, the MSR was only ever meant to be part I (or indeed part II if you count backloading before it as Zapfel does) of EU ETS reform. A lot depends on what comes next. The Commission’s proposals for deeper reform will be shaped by what EU heads of state and government decided last October: 1) a new carbon leakage regime (to compensate industries at risk of leaving Europe for regions with weaker carbon constraints) 2) low-carbon funding mechanisms (including an innovation fund, a modernization fund, and extra support for power plants in poorer countries) and 3) a ratcheting up of the annual rate at which the EU ETS cap declines to bring it in line with a 40% greenhouse gas emission reduction target for 2030.
With a shrinking pot of free allowances, policymakers – and industry – face tough choices over who is most deserving of them
The most controversial of these issues is carbon leakage. “We need 100% free allowances for our [10%] most efficient installations,” said Wolfgang Weber from chemicals giant BASF at Wednesday’s debate. European steel industry association Eurofer also put out a press release on the back of the MSR deal warning of a likely significantly higher carbon price before 2021 and “tougher times” for EU steelmakers vis-à-vis their international competitors. The EU steel industry has lost a fifth of its workforce since 2008, Eurofer pointed out. Director-General Axel Eggert echoed BASF’s call for 100% free allowances for the top 10% of installations.
What the Commission intends to do is study in much more detail to what extent energy-intensive industries pass on the cost of carbon to their customers (and are therefore not actually exposed to carbon leakage). It has traditionally been assumed that they cannot – because they compete internationally – but looking back over the last ten years, the Commission has found evidence of at least some pass-through in all sectors, Zapfel said. In contrast, it has yet to see evidence of carbon leakage.
With a shrinking pot of free allowances, policymakers – and industry – face tough choices over who is most deserving of them. Who contributes most to the European economy, growth and jobs? Jesse Scott, an electricity policy analyst at the International Energy Agency (IEA), argued that industries also need to manage their expectations: there will never be a global level playing field for energy simply because resources are spread differently across the world.
Note that what is not on the Commission’s EU ETS menu going forward are demand-side measures to expand the scope of the scheme. These did feature in an original list of reform ideas back in 2013. Expansion could be to other sectors – transport and heating are typical favourites – and/or linking to other emerging emission trading schemes. There are economic arguments in favour of making the EU ETS as big as possible – maximum emission reductions at minimum cost – but the regulatory perspective is less appealing.
“Carbon markets are thriving globally”
The challenges of extending the EU ETS to transport are significant – if international, remember the aviation saga; if domestic, think of incorporating millions of individual drivers or redesigning the scheme to target up- not down-stream entities. Member states have the option of including transport but none has done so, so far. Similarly, the notion of linking to other schemes has generated excitement in the past, but is far from happening today. There were originally plans for a link to a US federal scheme and then a link to Australia – neither partner market materialised and the issue is off the agenda for now, with the exception of a link to Switzerland. This last is causing NGOs such as Carbon Market Watch worry, since the Swiss plan is to keep the door open to international carbon offsets and what does this mean therefore for the EU’s 40% domestic greenhouse gas emission reduction target?
Looming large behind all these European debates is COP21 in Paris and an anticipated new global climate deal. For Bardt, it is this that will really make the difference because it will provide that all-important predictability (for business) that climate action is here to stay. Scott meanwhile points to the pervasiveness of carbon markets worlwide: they currently cover nearly a quarter of global emissions and this will go up to half if all the plans underway are realised. “Carbon markets are thriving globally,” she told the Cologne Institute debate. China in particular is one to watch – it plans to launch a national carbon market next year, which would be twice the size of the EU’s.
In Brussels, stakeholders now await formal approval of the MSR deal by Member States and the European Parliament in the weeks to come. The MSR makes the EU ETS more resilient to external economic shocks and the impacts of overlapping policies, and gives the scheme a second chance of being the flagship climate policy Brussels intended it to be.