Sara Stefanini provides a written summary of our panel discussion held on 31st March 2022, “Options to Reform the EU ETS”. It’s a full summary of the 90 minute discussion (with a link to the video), but it begins conveniently with a summary of the highlights, leading with the role of financial players, who they are, the causes of price volatility, what reforms can create stability, and the cost of decarbonisation. The main concern is speculation on the price of emissions allowances. Should the pure financial actors (i.e. not those firms obliged by the ETS to reduce emissions) be restricted from trading? Many are not even based within the EU. Allowances were forecast to be around €30/tonne today, but they’re now around €100. Are decarbonising firms spending money on expensive allowances when they could be spending it on decarbonisation? It’s all discussed by our panellists along with their recommendations for reforming the EU ETS (and audience questions at the end). Taking part were MEP Jerzy Buzek, EPP, Poland; MEP Ondřej Knotek, Renew, Czech Republic; Fabien Roques, FTI Compass Lexecon; Wanda Buk, Vice-President for Regulatory Affairs, PGE; Liv Rathe, Director, Climate Office, Norsk Hydro; Robert Jeszke, Director of CAKE, The National Centre for Emissions Management (KOBiZE); Andrei Marcu, European Roundtable on Climate Change and Sustainable Transition (ERCST); Michael Pahle, Potsdam Institute for Climate Impact Research. [Event sponsor: PGE]
- MEP Jerzy Buzek – EPP, Poland
- MEP Ondřej Knotek – Renew, Czech Republic
- Fabien Roques – FTI Compass Lexecon
- Wanda Buk – Vice-President for Regulatory Affairs, PGE
- Liv Rathe – Director, Climate Office, Norsk Hydro
- Robert Jeszke – Director of CAKE, The National Centre for Emissions Management (KOBiZE)
- Andrei Marcu – Founder and Executive Director, European Roundtable on Climate Change and Sustainable Transition (ERCST)
- Michael Pahle – Potsdam Institute for Climate Impact Research
- Matthew James – Managing Director, Energy Post (moderator)
The role of financial players
- Around 100 active investment funds were in the Emissions Trading System (ETS) in 2018 and more than 300 in 2022.
- Speculation is important because it helps to build liquidity and match-make positions. But it can also amplify underlying uncertainties and prices that work against the objective of emissions reduction.
- Nearly two-thirds of allowances are held by these institutions with a clear intention to monetise them, and many aren’t based in the EU.
- Speculation is not limited to financial institutions. Almost all actors on the market speculate to a certain extent.
- Financial players are needed for hedging. The role of the ETS includes price discovery and risk-hedging.
- According to the European Securities and Markets Authority (ESMA), investment funds make up 5-10% of the market, and about 50% of positions are held by non-financial players as commercial undertakings. So companies are buying from banks and investment funds.
- Approximately 33% of the market share is held by entities outside of Europe – USA, Cayman Islands, Australia. Also, exchange traded funds (ETFs) are buying physical allowances which they can’t use in the EU.
ETS reform proposals
- Buzek has proposed an amendment in the European Parliament to limit access to the ETS for players that don’t have compliance obligations (i.e. financial institutions).
- Other ways to regulate financial trading: set taxes on certain transactions, or a minimum holding period to reduce short-term speculation, or limits on financial positions.
- Be careful of accelerating the phase-out of EU allowances, in case the carbon border adjustment mechanism (CBAM) fails to avoid carbon leakage or protect economic competitiveness.
- We need better monitoring, market oversight and transparency.
- End policy uncertainty.
- The perfect regulation of markets is not possible: you can’t predict everything (Covid, war, etc).
Price volatility and stabilisation
- EUAs (EU Allowances) today were forecast to be around €30/tonne, but they’re around €100.
- Measures are needed to protect against overly high or low prices.
- For example, set a corridor with minimum and maximum prices that grow in time or reduce allowances in the Market Stability Reserve (MSR) according to the price.
- Other measures to improve stability include compensating obliged entities when there is excessive volatility.
- The carbon price has gone from below €10/tonne a decade ago to €20-40 in 2019, to higher now.
- Volatility is due to: the expectation of more ambitious EU climate policies, the post-Covid economic rebound, the increase in gas and coal prices, and more financial institutions and speculation in the market.
- In the ETS, supply is fixed by policies so is not elastic, which can amplify price volatility.
- The MSR was agreed when prices were around €8/tonne to tackle a historical oversupply. Now it’s taking out a lot of allowances but doesn’t add in many.
- Raising the MSR’s intake rate to 24% could in extreme cases lead to an extreme increase up to €200/tonne. The prospect of such high prices would encourage speculators even more.
- The underlying cause of current volatility is the combination of constant regulatory changes, and the expectation of changes in ambition.
The cost of decarbonising
- PGE’s renewable energy targets for 2030 will cost €18-19 billion. In 2021 it spent €2 billion – 10% of its investment needs – on compliance with the ETS.
- The average carbon footprint of an aluminium bar imported into Europe is 16.7 tonnes of CO2 per tonne. If it’s produced in Europe it’s much lower at 6.7 tonnes.
- A high CO2 price will burden companies with a high operational cost in the 2020s, the period when companies need the money to transform.
- There’s a time lag between when companies spend money on the ETS, immediately, and when they get some of it back through funds like the Modernisation Fund.
- Companies buy allowances on the secondary market because they don’t have to pay in cash.
The European Union’s latest reforms of the ETS could determine the bloc’s ability to meet its 2030 climate targets – or risk over-burdening industries under pressure to transform.
The volatility of EU carbon prices in recent years is driven by a combination of factors, including an increase in emission reduction targets, policy uncertainty as the EU negotiates the “Fit for 55” package, the economic hit of Covid-19, the subsequent rebound, and Russia’s invasion of Ukraine.
But there is concern from industries obliged to trade on the ETS that the volatility is also driven by the growing number of financial players trading on the market, sucking up the supply and pushing up prices for companies that need allowances to cover their pollution. The more companies spend on overpriced allowances in the ETS, the less money they have to invest in their own decarbonisation.
Some are calling for the ETS reform to limit the participation of financial institutions, many of which are not based in the EU, or impose measures to limit their activity.
Others counter that excluding them from the market will eliminate hedging, which every market requires. The bigger concern, they say, is the policy uncertainty that has consistently plagued the ETS in recent years, and the need to give traders a long-term view of the market.
This is a summary, not a verbatim transcript, of the key points made during the online panel event.
MEP Jerzy Buzek
We are entering the decisive phase of the EU ETS revision in the European Parliament. In less than three weeks we will vote in my committee – Industry, Research and Energy – at a time when the Russian war in Ukraine has triggered discussions on energy security, energy costs and how to reconcile the accelerated phase-out of coal and reducing EU demand for Russian gas by two-thirds by the end of the year. This is at the centre of the deliberations.
We have to think about the main aim of the ETS. It is to promote the reduction of greenhouse gas emissions in a cost-effective and economically efficient manner. It is with this in mind that I proposed an ITRE amendment to limit access to the EU ETS market for entrants that do not have EU installations and do not have compliance obligations for carbon. I believe this could lead to a decrease or even an end to price speculation in the ETS.
MEP Ondřej Knotek
Renew, Czech Republic
It is natural that the more ambitious 2030 goals lead to a revision of the EU ETS. On the other hand, we are in a situation of economic and social tension because of the pandemic, the war, inflation of interest rates and energy prices. So a revision of the ETS must be done smartly and sustainably.
The European Commission’s proposal generally goes in the right direction, but I have recommendations, also on behalf of Czech energy-intensive industry. I see potential risks in the extension of the ETS, especially to road transport and buildings. Even though it comes with a social climate fund to reduce social impacts, there could be issues.
Competitiveness is another issue. There are those calling for a fast implementation of the carbon border adjustment mechanism, and therefore a fast phase-out of free allowances. We must be very careful of accelerating this phase-out, because if the carbon border adjustment mechanism doesn’t work we will have real issues with carbon leakage and economic competitiveness, as well as climate impacts. We have to give special care to EU exporters who are exporting to countries without carbon limits.
Then there’s the predictability of the price. Today’s price was predicted to be around €30/tonne of CO2, but we have already reached €100/tonne. We need to have effective and operable measures to deploy if the price is too high or too low. My preferred choice is to have a corridor with a minimum and maximum price that could grow in time, or at least use the Market Stability Reserve (MSR) to reduce allowances in the market according to the price.
The war in Ukraine underlies the need for the Modernisation Fund to support gas development as well, and potentially also nuclear.
FTI Compass Lexecon
We are finalising this study, commissioned by PGE, and I will present the key highlights.
Over the past 10 years, there was a long period in which the carbon price traded below €10, then with the reform of the ETS we had a period in 2019 when the price ranged between €20 and €30. During lockdown we had a small period with a drop in the price, but in the past couple of years the price has trended upwards. This is driven by factors including changes in the underlying market fundamentals, but also the growing role of speculation and financial players in the market.
The study considers these recent developments and tries to understand the fundamental drivers and identify policy responses.
Not only have prices gone up, but the volatility has increased substantially in the past couple of years. This is driven by a number of things. The expectation of stronger decarbonisation and “Fit for 55” negotiations in Europe. Then there’s the economic rebound post-Covid, and the substantial increase in gas and coal prices.
It’s important to also consider financial trading events. There were around 100 active investment funds in the ETS in 2018 and there are more than 300 in 2022. We’ve also seen an increase in long positions from some of these financial players.
Speculation is important because it helps to build liquidity and match-make positions. But it can also amplify underlying uncertainties, so we need to be careful about how we regulate and supervise the role of financial players in a market like the ETS.
For example, recently with Russia’s invasion of Ukraine, we saw a more than €20 drop within a few days. That illustrates the role that short-term speculation is starting to have on the ETS.
The ETS is a different market from other commodities, it’s very driven by policy-making. The supply and cap are fixed by policies so are not elastic, which can amplify price volatility. There is also a lack of clarity on long-term policy commitments and regulatory uncertainty.
We have a mechanism – the MSR – in the ETS to provide long-term stability. But if you look at the design of the MSR it can be a source of destabilisation in the market.
What’s at stake is not just the functioning of the ETS: the ETS is an important tool of EU decarbonisation. So predictability is important.
We identified different measures for reform of the ETS. Having clarity of carbon price signals, and predictability, will be crucial as we accelerate electrification.
We need better monitoring and market oversight. That’s no-regret.
One could investigate the use of measures to regulate financial trading, for example taxes on some transactions, a minimum holding period to reduce short-term speculation or limits on financial positions.
The time has come to resolve long-term policy uncertainty. At the moment we lack a clear vision of the EU’s long-term and medium-term decarbonisation pathway.
We need measures for price stabilisation. This could include reform of the MSR to make it more efficient and predictable. We also have to be careful of the side effects of these measures, so they need to be implemented carefully.
There could be measures to compensate obliged entities, because when there is a lot of speculation and volatility the increase in the cost of trading affects them. In other markets, profits from tax could be distributed to reduce the burden on obliged entities.
Vice-President for Regulatory Affairs, PGE
PGE is the biggest Polish energy group and has committed to climate neutrality by 2050. By 2030 we aim to have 2.5 GW of offshore wind, 3 GW of photovoltaics and at least 1 GW of onshore wind, and we’re decarbonising district heating.
These investments up to 2030 will cost €18-19 billion. At the same time we will be obliged to surrender EU ETS allowances. In 2021 we paid €2 billion, which means we spent 10% of our investment needs on compliance with the EU ETS.
It’s questionable whether the ETS is helping companies like PGE decarbonise. We are responsible for 5% of demand for new ETS allowances every year. Excessive carbon prices and price volatility directly affects our ability to finance and carry out our green transition.
MD, Energy Post (moderator)
Wanda, what is your reaction to the findings Fabien has highlighted?
The FTI Compass Lexecon report, and also the European Securities and Market Authority (ESMA) report, show our key concerns with the EU ETS, market monitoring and the impact of certain trading activities. The findings show that investment funds and other financial players using this buy-and-hold strategy may lead to a reduction of allowances available to compliance entities.
Nearly two-thirds of allowances are held by these institutions with a clear intention to monetise them. We perceive this as a structural problem.
Many of these financial actors are not in the EU – for example they’re in the Cayman Islands – and don’t have a direct interest in decarbonisation in Europe.
Companies like PGE are victims of the system, but they’re also supporting it. We are buying allowances on the secondary market with a long future position. We’re forced to do this by the situation.
The conclusion that monitoring of the market should be improved is a step in the right direction, but we need to act now. Otherwise we will have blackouts in Europe.
Director, Climate Office, Norsk Hydro
I’m defending the industry’s interests today. European industries know we need to decarbonise and deliver our role in the transition. We need to find technologies, test them and implement them. But we won’t see the results until the 2030s.
Meanwhile the EU is cutting its cap in the ETS faster and deeper than other regions in the world. At the same time production in Europe is decreasing and we’re importing more. The average carbon footprint of an aluminium bar imported into Europe is 16.7 tonnes of CO2 per tonne. But if it’s produced in Europe it’s only 6.7 tonnes.
Now we have this reduction in the cap, and we have a deficit of allowances. This may be the most volatile market in Europe, because it’s politically driven.
So competitiveness is declining in Europe. We want green growth in Europe, but our production is declining. How can we make this transformation if we don’t have industries developing along a low-carbon pathway?
Many say we need a higher CO2 price. That’s wrong. A high CO2 price will burden companies with a high operational cost in the 2020s, the period when companies need the money to transform. So the cap is a good enough signal that companies need to do something.
We must remember that the MSR was agreed when prices were around €8, and it was going to tackle a historical oversupply. Now it’s taking out a lot of allowances but doesn’t add in many, only 400 million allowances. ICIS has predicted that by 2025 3.1 Gt will be invalidated – that’s equivalent to a two-year annual cap in the ETS.
Article 29 is not structured well, it’s too stringent because it was agreed when prices were very low. There are different variables in the MSR that describe when Article 29 should come into force. We think the six months should be three months, and the two years should be six months or two years. We think the decrease in price trigger should be much lower.
This is a very volatile market, and we can’t make this price paragraph so rigid that it cannot enter into force.
Regarding Fabien’s presentation, it’s very difficult to improve the situation and the predictability of the ETS, and the Market Stability Reserve. How do we resolve long-term policy uncertainty, considering the pandemic, the war, the European Green Deal? It’s very difficult.
Is my amendment to limit access to the ETS for entrants that do not have EU compliance obligations enough? The European Commission has said “no price speculation on the market” but something is not working.
Potsdam Institute for Climate Impact Research
It is right to be concerned about financial players. But I also want to caution against acting too hastily.
There is still a widespread belief that by excluding financial players you exclude speculation, but this is wrong, because it’s not limited to financial institutions. Almost all actors on the market speculate to a certain extent. Don’t simplify but try to get a better understanding of what’s happening in the trading.
I think there is too much cherry-picking, we need a joint understanding of the proper material.
If we take most of the measures that Fabien proposed – except for transparency, which really is no-regret – all the others very much depend on our understanding of the problem. So we have to find a minimum agreement of the problem.
Founder and Executive Director, European Roundtable on Climate Change and Sustainable Transition (ERCST)
The important thing to look at first is the Commission’s overall package proposal, which goes in the right direction.
The ETS provides the most efficient way to decarbonise – that’s why we’re doing this.
What is the balance between regulation and markets? If you start slapping regulation as a band-aid on markets, the question is why do we have a market?
The role of the ETS is two-pronged – price discovery and risk-hedging. If you take the financial institutions out of the market, how are you going to hedge? We have to think deeper about the problem.
We have financial regulation against market abuse, but then there’s climate regulation to provide the most efficient way for decarbonisation.
The main concern is about the speed with which the price goes up and the variability of the price in the short-term.
We introduced the MSR because there was a deficiency in the market design: elasticity of demand but no elasticity of supply. We’ve all been obsessed with creating a rules-based market, but we forgot about the Maginot Line – we cannot predict everything. We’ve had an economic recession, a financial crisis, Covid, war in Ukraine – how much can we predict?
Total regulation of markets is not possible. Liv gave a good example – we invalidate everything that goes in the MSR, but why? Some of it legitimately should be taken out of the market, some of it should not.
Running a rule-based market is not going to happen. You need an intimate relationship with the market, otherwise you’ll continue to apply band-aids.
Director of CAKE, The National Centre for Emissions Management (KOBiZE)
I would like to focus on findings ESMA published recently.
The key message of the report is that the share of the investment funds in the market is limited, about 5-10%, and about 50% of positions are held by non-financial players, as commercial undertakings. It’s companies buying from banks and investment funds.
There is not enough information to draw a conclusion on who these commercial undertakings are operating on behalf of.
According to ESMA, approximately 33% of the market share is held by entities outside of Europe – USA, Cayman Islands, Australia – and this is a true problem. There is also a growing number of assets flowing from exchange traded funds (ETFs).
For example, there is one ETF – SparkChange Physical Carbon EUA ETC – that is based in Australia, but it can buy physical allowances. That can be especially dangerous for EU competition. It’s buying the same allowances physically that operators in the ETS need too. This is an opportunity for individual investors to buy allowances through this kind of ETF, and they’re not even citizens of Europe.
Speculation is a dangerous phenomenon that can lead to especially high prices. We have to be particularly careful in introducing rules for the ETS market, because the prices on the market will set future fundamentals. Continuously raising the European Commission’s reduction target means there are fewer and fewer allowances on the market.
The MSR reforms will be crucial to the direction of ETS prices. For example, raising the intake rate to 24% could in extreme cases lead to an extreme increase up to €200/tonne in 2030. The prospect of such high prices would encourage speculators even more. Companies need a stable, predictable price.
The existing Article 29a is already a good option for a market safeguard, but it’s not working – analysis shows it’s dead policy at the moment.
The EU ETS has never been an effective or successful tool for decarbonisation. At the very beginning, say in 2017, when prices were very low, the ETS did not incentivise decarbonisation. Then the prices rose again and again and the market became unstable and unpredictable.
In 2021, we spent 10% of the total renewables investment for this decade – which would bring 7 GW of renewables to Poland – on the ETS. We should admit that the EU ETS is not doing its best.
We support MEP Buzek’s proposal to limit the role of financial institutions in the ETS; we could achieve that goal in other ways, for example by introducing general or individual limits for financial institutions on what they can buy. We also think MSR reform is inevitable.
According to impact assessments, the average price for EU allowances in this decade was €50/tonne. That’s not in line with the market; it’s not in line with reality.
Most of the actors in the European institutions were wrong, and this is the time to admit it. If the EU really wants a transition, it should make it doable. With the current shape of the ETS it’s not doable.
Wanda, some of the money PGE pays on the ETS comes back through funds that you are eligible for to help you decarbonise your energy system. What’s the balance?
The problem is that we need to spend money on the ETS now, and we have to wait to receive money for example from the Modernisation Fund. So we’re struggling with access to capital. We’re supporting the financial institutions by creating the demand. We’re forced to buy on the secondary market because we don’t have to pay in cash there.
Audience Question from: Robert Pietzcker, Potsdam Institute
My question is to Ondřej and Jerzy. It sounds like you want to take all non-compliance actors out of the market. But without non-compliance actors you don’t have hedging, because compliance actors would have to pay the full capital upfront. I’ve never heard of an industry company that wouldn’t want to hedge, so how does that match up?
My motive is clear: if we have too many stakeholders in the system, it reduces the availability for those who need it. It’s up to the experts in the Commission to come up with a sustainable solution that secures both finance and the supply of allowances for those who need them.
The fundamental issue is that if you don’t have anyone on the other side to hedge with there’s no hedging. You need a counterpart. Eliminating them completely won’t fly, but more transparency is needed.
You need to look at the reason we have this volatility – a combination of constant regulatory changes, and the expectation of changes in ambition. We’ve gone from an emissions reduction target of 40% to 55% by 2030, we might have more ambition after the UNFCCC’s stocktake. That will drive people to speculate even more on regulatory developments. This is going to worsen because the market will grow increasingly liquid.
There is also a time-lag between the cost of the EUAs that I bear today and the money I receive in the future, as Wanda pointed out.
I have a question for Fabien. We see the volatility in the market, we know there is only so much politicians can do with regulation. If we can’t solve the MSR and Article 29, have you looked at the Western Climate Initiative, which has a price corridor, and compared the advantages and disadvantages of this for industries?
Audience Question from: Saleh Obadi
Fabien, what is the share of speculation impact on present high energy prices in the EU?
On the issue of banning financial players: there are costs and benefits to allowing them. It’s not in or out. We should look at whether there should be regulation or taxation to limit the role they can play.
On top of that, the costs and benefits of having financial players may evolve over time, so we need to think dynamically. There may be periods of uncertainty and crisis in the ETS, like now, where speculation doesn’t have great benefits for price discovery because no one knows the fundamentals.
On price stabilisation, we have made comparisons with other carbon markets in the US and Asia. I think all carbon markets to some extent have a price stabilisation scheme. We have found that having a price corridor provides a long-term perspective for investors and acts as insurance against high prices, which has a positive effect on the cost of capital.
We are in a situation of regulatory changes and uncertainty. We have made a fundamental change in the ambition of the ETS, which would bring changes. The only surprise is the pace of the change. The market has responded to the stronger political momentum we’re currently undergoing.
The question is whether this regulatory change will ever come to an end, or will it be constant in the next decade? We must address the root cause, not the symptoms, and identify the mode of governance that brings stability to the market – rather than blaming the market itself.
We have to separate the role of the ETS, market price development and speculation from the need for price stabilisation. The proposals in the “Fit for 55” package – the MSR, carbon border adjustment mechanism, an ETS for transport and buildings – will all drive the price up. That’s why we need safety measures.
I think it’s necessary to rethink the ETS shape and admit that it has not been driving the energy transition, rather it’s a tool for driving financial benefits for financial institutions.
Governance is going to be critical. If you want temporary limits it requires quick reactions; who is going to do that? The current governance will continue to be a problem.
And this will become a bigger problem as time passes, as the market liquidity increases.
Let’s not throw out the baby with the bathwater. There are examples of regulations, like in California, where allowances are released only to compliance buyers during price fluctuations.
Scandalising different developments and elements is not helpful. We all want a stable system and we should take this as a starting point.
We should look at California, because we need to eventually be able to link and be equally ambitious. If we can’t stabilise the market the situation will escalate when allowances are running out. We can benefit from aligning our systems.
We should not forget that the ETS price signal is fundamental to the economy’s decarbonisation. That means that it needs to be socially and politically acceptable. What is new today is that the level and volatility we have means we need a decision.
We need a stabilised market and price development that drives emission reductions. ESMA has the competence to look at the data that is still lacking to monitor market behaviour.
Summary compiled by Sara Stefanini
Produced by Energy Post