The Market Stability Reserve proposed by the European Commission will not be sufficient to reform the EU Emission Trading Scheme (ETS). If the ETS is to be saved, EU policymakers must instead take the bold step of establishing a price band for CO₂ emission rights, argue Brigitte Knopf of the Potsdam-Institute for Climate Impact Research (PIK) and Ottmar Edenhofer of PIK and the Mercator Research Institute on Global Commons and Climate Change (MCC). They warn that a failure to make the ETS work could wreck the entire EU climate and energy policy.

One of the pillars of European climate policy, the European Emissions Trading System (EU ETS), is currently questioned in its ability to deliver its objectives as the allowance price is persistently low at around 5€/tCO₂. In January 2014, the EU Commission put forward a legislative proposal to tackle the problem of the low price. Its proposed Market Stability Reserve (MSR) is designed to adjust the short-term auction supply without affecting the long-term cap by establishing a reserve of non-auctioned allowances. The MSR is based on pre-defined rules on (i) when to feed allowances into the reserve and when to release them (triggers), and (ii) how many allowances to reserve and how many to release. The reserve can be carried over multiple periods, ensuring that the MSR is neutral to the overall cap. The starting year proposed is 2021, but some Member States, e.g. Germany, call for an earlier start in 2017.

The European Council will be discussing the MSR proposal at its meeting on 23 October, in addition to the question of the EU’s overall CO₂-emission reduction target for 2030. It is expected that the Heads of State will give a positive vote on the MSR proposal. It will then be discussed in the European Parliament.

What is the problem of the EU ETS?

But does the MSR address the current problem of the EU ETS? What is actually the problem and are there alternative solutions?

These questions are addressed in a new policy position paper from the Energy Platform of Euro-CASE (the European Council of Academies of Applied Sciences), which we summarize here.

There is an important point that is often overlooked when the EU ETS is compared to other markets, e.g. the oil market. The difference is that the EU ETS is a market where scarcity is governed by political decisions and not by natural scarcity. Thus expectations of market participants about future political decisions are critical.

Between 2009 and 2013, actual emissions stayed below the annual cap. This means that temporarily the annual cap did not provide incentives for action (see Figure 1). However, the cumulative cap until 2020 is still binding and some scarcity is expected as reflected by the positive allowance price. In this situation – where annual caps are not the constraining factor for emissions – it is uncertain how traders in the market form their expectations. If they expect that the oversupply will be absorbed within the current commitment period (for whatever reasons), then presumably the price will increase. If they expect that the oversupply will be sustained, then the price will likely decline. Additionally, when they do not expect an ambitious cap after 2020, the price might even further decline.

Figure 1:  Historical developments of EU ETS annual cap (Cap), annual verified emissions from sources covered by the EU ETS (Emissions), annual offsets surrendered for compliance (Offsets) and average December future prices (CO₂ price). Source: adapted from Grosjean et al. (2014).

Indeed, empirical analysis shows that in the current regime demand-side fundamentals (e.g. the economic crisis, renewables, Kyoto credits etc.) only accounted for 10% of the price variation and can thus only very partially explain the weak carbon price signal. Other factors, in particular regulatory and political announcements, were found to be much more influential. They have played a key role in the price decline. As a consequence, any reform of the EU ETS has to deliver a mechanism that focuses on the expectations of market participants.

So what are the future expectations about the EUA price? The low price of futures contracts for the year 2020 (see Figure 2) indicates that traders anticipate only a modest long-term scarcity of emission permits in the market. Neither the Commission’s decision for back-loading (removing allowances now to be re-injected later) nor its structural reform proposals seem to have significantly changed long-term expectations.

Figure 2: EUA price for nearest futures contract and for December 2020 futures contract traded on the ICE ECX platform for the time span 2011-2013. Source: ICE Futures Europe.

The problem with the low price

Now one might argue that in a cap-and-trade scheme there is no problem at all with a low price. But indeed, there is.  The idea behind a cap and trade system as a system regulating the amount (and not the price) of emission allowances, is the ability to ensure attainment of its cumulative cap at least cost, by optimally incentivizing mitigation efforts, investments, and research and development (R&D) over time. A low price is – in conventional thinking – a sign of a well-functioning market. But in this case, it reflects the expectation of traders that the oversupply will be sustained even beyond the current commitment period. In other words, the EU ETS does not incentivize the search for low-cost mitigation options but reflects mainly the expectations of traders about future political decisions. It has been transformed into a betting shop for the commitment period after 2020.

Three interrelated considerations underpin the key concern of this lack of “dynamic efficiency”:

• First, modeling studies indicate that the current EU emission allowance (EUA) price of around 5€/tCO₂ is too low to induce dynamically efficient mitigation, investment, and R&D decisions. Instead a minimum price of 20€ is required after 2021.
• Second, there are significant uncertainties both on the allowance demand side (e.g. future GDP growth) and allowance supply side (e.g. future changes in the cap). This might not only contribute to the current low EUA price, but can distort private sector decisions over mitigation, investment, and R&D, which would be a reason for concern even at a higher price level.
• Third, the prospect of low EUA prices might result in EU Member States resorting to national mitigation policies, thus creating an inefficient pattern of regulation across the EU as well as adding to the factors working towards reducing the EUA price.

Introducing a price collar as an alternative reform

The proposed MSR does not address the problem of long-term cost-effectiveness and price uncertainty. The MSR is a quantity-based instrument that addresses the existence of a large allowance surplus, but oversupply does not disappear until 2030, as the Commission shows in its own assessment. Overall, the impact of the MSR on the price is difficult to assess because the rationale behind the mechanism is not transparent and rests on assumptions that are incompatible with inter-temporal price smoothing. If hedging is the rationale behind the MSR, the trigger should change over time.

Also the effect it has might be too slow and the review phase considered for 2026 gives additional uncertainty. For all these reasons, the MSR will have an uncertain impact on investment in R&D as well as on low-carbon investments. The fact that many business associations are mainly indifferent to the MSR is also a sign that market participants do not expect that it will lead to higher prices. Consequently, the MSR is very likely not the best mechanism to cure the current problem of insufficient dynamic efficiency.

But there are alternatives for a reform. The dominant problem is the low credibility of the long-term scarcity, which is reflected in the weak price signal. Given the difficulties of establishing long-term political credibility, the best approach is to directly manage expectations of market participants. Therefore, a better alternative would be to add price-triggers that establish the boundaries of political intervention. This kind of hybrid scheme would allow combining the best of the two different systems: cap-and-trade and taxation. This can be done by introducing a price band or collar to the ETS in form of a lower and upper boundary on the price, both of which increase over time. This would directly address the concern over dynamic efficiency of the EU ETS.Such hybrid instruments that combine a cap-and-trade system with price-based triggers have already been implemented successfully in California and the US RGGI region.

A price collar can immediately deliver a stable and sufficiently high allowance price. In addition, it is a useful way to manage expectations of future prices in line with the long-term cap of the EU ETS. While the floor price is justified in terms of cost-effectiveness, the argument for a price ceiling is different. It is needed because prices can also increase substantially through shocks. When a ceiling is set, this risk is reduced symmetrically, which is important for investors, as for them both directions of the risk (prices that are substantially higher or lower) are important. In addition, a price ceiling prevents costs becoming politically infeasible. A credible price collar would, therefore, directly incentivize investments in innovations that are required for cost-effective long-term decarbonization.

Moreover, while the ETS is working as a kind of lawn-mower over national preferences, a price collar would allow Member States to partially follow their own climate policies, e.g. adopting more ambitious reduction goals, or their own renewable support schemes or efficiency standards, without fear of undermining the ETS – given that the EU ETS is operating at the price floor. In general, this is the advantage of tax systems compared to cap-and-trade systems in multi-level governance settings such as in the EU.

The political feasibility of introducing a price collar

In the end, instead of a narrow reform of the EU ETS, a full-fledged reform addressing several aspects of carbon pricing is required. Besides (i) setting a price collar within the EU ETS, this includes (ii) reducing emissions in the other sectors (for example transport and heat) by also pricing carbon emissions in these sectors or by a sectoral expansion of the EU ETS, (iii) addressing additional market failures through other policy instruments beyond the reach of carbon pricing, and (iv) addressing the possible problem of carbon leakage by expanding the group of countries that participate in the EU ETS or by linking it to policies in other regions, see the example of California and Quebec.

Within this package, the price collar ensures the dynamic efficiency of the emissions trading scheme: it makes clear to the market agents when the regulator will intervene. This would be in sharp contrast to the proposed MSR system in which expectations can be easily destabilized because the regulator does not announce in advance at which price it intends to intervene. Instead, a price collar will make the EU ETS effective.

There might be some opponents who will say the EU ETS will become a tax system. However, it should be clear that this is a political framing which intends to avoid any reasonable reform debate. The political feasibility of implementing a price collar and the wider reform package might be limited.But without such a comprehensive reform of the EU ETS, the idea of a joint EU climate policy might come to an end.

The implications of this are dire. There is not only the danger that the EU ETS might not survive as a functioning instrument of European climate policy, but also that the whole EU climate policy will fail and will return to fragmented climate and energy policies across the region, such as with the carbon floor price in the UK. This could substantially increase the costs of climate policy and the EU would lose its last credibility as an international leader in climate and energy policy. By contrast, a successful reform and a well-functioning ETS would restore the credibility of the EU’s climate and energy policy domestically and internationally. 

Editor’s Note 

This article is based on a policy paper published by the Euro-CASE Energy Platform in September 2014. Euro-CASE is the European Council of Academies of Applied Sciences, Technologies and Engineering.

Brigitte Knopf is head of the research group ‘Energy Strategies Europe and Germany’ and deputy head of the Research Domain ‘Sustainable Solutions’ at the Potsdam Institute for Climate Impact Research (PIK) and has coordinated the Euro-CASE assessment of the EU ETS. She is on Twitter as @BrigitteKnopf 

Ottmar Edenhofer, Head of Research Domain ‘Sustainable Solutions’ and Chief Economist at the Potsdam Institute for Climate Impact Research (PIK), Director of the Mercator Research Institute on Global Commons and Climate Change (MCC) and Chair Economics of Climate Change at Technical University Berlin. He is Chair of the Euro-CASE Energy Platform.