The EU Emission Trading Scheme (EU-ETS) is bound to play a major role for ratcheting up climate policies in both the EU and its member states. After a prolonged period of low prices that questioned the ETS’s viability, the recent price run upwards in the wake of a major reform has sparked confidence that from now on “everything goes in the right direction”. But this confidence is misguided and ignores major risks for the scheme, argue Michael Pahle and Oliver Tietjen, both at the Potsdam-Institute for Climate Impact Research. A carbon price collar, as implemented in many other schemes worldwide, is needed to safeguard against these risks in the future. The fact that Germany recently endorsed the implementation of an EU-ETS price floor has created a critical mass in support for this measure, which – if followed through politically – can enable its adoption. Implementing a complementary price ceiling is a logical parallel step. And rethinking the national shares of allowances can help those struggling most with the transition and get reluctant EU member states on board.
In September the German Government adopted the Climate Action Program 2030. Escaping the attention of most commentators and partially hidden between lines, it lays out a fundamental shift in the country’s climate strategy by paving the way for Europe. In close cooperation with the European Commission, Germany will work towards expanding the European Union (EU) Emission Trading System (ETS) to cover all sectors eventually. As a first step, a carbon floor price (CFP) is to be implemented in the EU-ETS.
To proponents of the idea, this came as a big surprise: in the past, the CFP had been relatively unpopular in government circles. Arguably, sound scientific advice has contributed to the acceptance of the CPF amongst policymakers.
Support for a Carbon Floor Price has been mixed
But getting it into place is not without challenges. Germany only backs a “moderate” floor price. This wording may reflect opposing views within the government about the issue, and that it was necessary to compromise in vague words rather than concrete numbers. Hence a working definition needs to be found that translates “moderate” into a concrete price level. Similarly, the EU member states are divided on this issue, implying that consensus about a CFP requires multinational consensus. What is more, the new climate Commissioner Frans Timmermans is “not a fan of the idea”.
In spite of these challenges, taking a twofold course of action would greatly improve the chance of implementing a CPF in the near future. Firstly, if Germany follows through on its intention, it can tip pre-existing momentum in other member states supporting a CPF. In December 2018, ministers from nine European countries – Germany was then not among them – published a joined statement to strengthen and extend carbon pricing in Europe, naming a CPF as one measure. Meanwhile, the Netherlands is preparing legislation to introduce a CPF for electricity production, and Finland is exploring options for an EU-wide, or at least Nordic, minimum price. With Germany also on board, a critical mass of member state support can be reached. Albeit this will need leadership and a structured process, for which Germany’s EU presidency in 2020 offers a window of opportunity.
…but prices might drop again
Secondly, the belief of policymakers that the price can only go in [one] “right direction” must be corrected. Policy-wise, the main impediment to a CPF is the belief that after the recent reform – intended to “improve its functioning and resilience to future shocks” – the EU-ETS is now indeed “bullet-proofed” against shocks. Therefore, the argument goes, a CPF is not required. In the words of Frans Timmermans: “the price is going in the right direction, and I’m pretty confident it will continue.” But the 2018 price rally exhibits explosive behaviour, which might well be an overreaction of the market to the reform. European Emission Allowances (EUA) prices recently declined to a level of around 25 €/t – down from the 2-year high of 30 €/t in July 2019. Funds and banks that helped fuel the 2018 price rally have again left the EU ETS, and, in the case of a hard Brexit, prices could even slump to 15 €/t. Moreover, coal phase-outs planned for the coming decades are bound to depress prices if allowances are not cancelled, as would reduced hedging pressure. A sufficiently high CPF could thus guard against another plunge, and prevent history from repeating itself.
U.S., China have price floors
The EU would be in good company by instituting a CPF. North America and China have designed price collars into their systems to guard against price uncertainty. Indeed, both California and China looked to the EU as an example when designing their programs, to avoid flaws that drove carbon prices too low by adopting price collars. In California’s program, it became an instrumental design element in the first years, preventing the price falling below the auction reserve price. This floor price will continue to exist through 2030. The northeast U.S. Regional Greenhouse Gas Initiative (RGGI), which caps emissions from the electricity sector, will supplement its current CPF in 2021 with an additional price step. The new step will provide a minimum price for the sale of about 10% of the allowances to be sold in the auction, and the lower price floor will apply to the remainder of the allowances.
…and price ceilings
Yet, price control in both schemes also includes a limit on how high prices can climb. This provision becomes relevant under tighter future allowance allocations. In particular, sharp price increases could pose a challenge. Back in 2016, a veteran observer of California’s program stated:
“So, can California’s cap-and-trade program be saved [from the risk of becoming insignificant]? Yes. But it will require moderating the view that there is one single emissions target that the state must hit. Instead, the program should be revised to have a price floor that is substantially high [to] significantly change the behaviour of emitters. And the program should have a credible price ceiling at a level that won’t trigger a political crisis. The current program has a small buffer of allowances that can be released at high prices, but would have still risked skyrocketing prices if California’s economy had experienced more robust growth.”
Designing a collar, with tiers
A price collar thus acts as a symmetric safety valve against the risk of triggering push back (price ceiling), and the risk of the becoming insignificant (price floor) as illustrated in Figure 1:
Indeed, California adopted both a price floor (auction reserve price) and ceiling for the post-2020 period. Furthermore, it added price tiers at which allowances in a cost-containment reserve become available in the market. The price tiers serve as a speed bump to slow down potential sharp price increases (Figure 2). In so doing, regulators effectively shape emitters’ expectations about carbon prices in the coming decade. In particular, California’s 2030 climate target is far more ambitious than its 2020 target. However, the predicted rise in prices will be managed through price tiers and not surpass the ceiling price. It is a strategy of expecting-the-unexpected.
EU collar design: coping with policy impacts, market uncertainty
In the EU, this strategy would mean anticipating the price impacts of current policy contingencies and the uncertainty around the new Market Stability Reserve (MSR). First of all, it is very likely that the planned tightening of the EU’s climate target from 40% to 50% or 55%, , would require a more stringent ETS, thus driving up prices substantially. Furthermore, it is still unclear if the strengthening of the MSR through the recent ETS reform can improve the ETS’s resilience to future shocks, as policymakers intended. New research on the MSR points to oscillatory intake-outtake behaviour when market surplus reaches the intake threshold, and increasing volatility in the face of future demand shocks. Consequently, this could lead to repeated interventions and in turn, increase regulatory uncertainty.
Forecasts by analysts (Figure 3) point in the same direction. The range for near-term forecasts is large; projected price uncertainty is already considerable. Surprisingly, projections for the more distant future converge, in particular for the years 2028 and 2029. How can the more distant future be less uncertain than the near future? This question is for analysts to answer, but following the above line of reasoning, it seems more than likely that prices in 2030 will be very different from how we imagine them today. Accordingly, assuming that prices will only go in the “right direction” is overconfidence at best.
A Market Stability Reserve (MSR) “collar”
Against that background, it is arguably vital to persuade policymakers to adopt their US counterparts’ strategy of expect-the-unexpected – and anticipate that in the future prices may slump (again), or skyrocket to politically problematic levels. If they do, the 2021 review of the MSR offers a short term regulatory entry point to advance price collars. More specifically, by triggering intake in, and out-take from, the MSR through EUA price levels instead of allowance volumes in the market, the MSR would de facto become a price collar. What is more, cancellation could be put on hold since allowances would only be reinjected in the market when the price ceiling becomes binding. An MSR-morphed-into-price-collar would thus mean lower foregone revenues for EU member states in the short term, and more stable revenues in the long term.
Rethinking national allowances
In terms of finding political consensus for such a measure, a compromise would need to be found for the specific price levels. A “moderate” price could mean to preserve the current level, which is sufficiently high to drive coal out of the market. A CPF starting at this level – and rising at a fixed annual rate – could thus induce the coal phase-outs already decided by several EU member states, rendering additional national action and costly compensation measures obsolete. To ensure political success, the distributional implications require a better understanding. Given the current allocations of allowances to EU member states and the conditions of their energy systems, it is clear that there would be winners and losers for such a measure. Reconsidering the shares of allowances – and the revenue from auctioning that comes with it – would be a key lever to compensate losers, and help get reluctant EU member states on board.
Michael Pahle is Head of the Working Group “Climate & Energy Policy” at the Potsdam-Institute for Climate Impact Research
Oliver Tietjen is a PhD student at the Potsdam-Institute for Climate Impact Research