By Adrien Assous, executive director, Sandbag Europe

The EU is in the process of reforming its carbon market (EU ETS) in line with raising the bloc’s emission reduction target up to 55%, from 40% currently. Amongst the many features of the reform, one is raising little attention, despite contradicting a higher ambition: a proposed increase in the number of surplus allowances in the system. But if the EU is serious with meeting its cap, the surplus should and could be reduced down to zero during this decade.

Meddling with the cap

An allowance gives the right to emit a tonne of CO2, so any surplus of permits at a given time (left unused after all compliance needs have been met) allows emissions to exceed the cap in the future. The current surplus was inherited from previous phases of the scheme (as far back as 2008), when the cap was unambitious, and while emissions were consistently below the system’s cap, a design flaw allowed two billion offsets to be imported into the market (worth about a year’s emissions), which caused the surplus to balloon to absurd amounts.

As the allowance price crashed to under €3-a-piece in 2013, measures were introduced to salvage the market, including the Market Stability Reserve (MSR). The MSR consists of reducing the auctioning of new permits as long as the surplus, called TNAC for “Total Number of Allowance in Circulation”, is above a certain threshold of 833 million.

So the MSR aims to reduce the TNAC but only down to 833 million allowances, which still let emissions exceed the cap significantly. For comparison, EU ETS emissions in 2021 were 1.37 billion tonnes of CO2e. Actually, things are not that bad because a calculation trick in the reported TNAC ignores the permits purchased by airlines (about 150 mln so far), so the surplus effectively tolerated (subtracting aviation purchases) is slightly under 700 mln. This amount will keep falling over time as airlines buy more permits, probably down to about 500 mln in 2030.

A reform against ambition

And this is where the proposed reform is going the wrong way. The Commission is proposing to stop excluding aviation purchases from the TNAC calculation, so the tolerated surplus (below which the MSR stops reducing auctions) will spring back up to 833 mln, loosening the constraint on emissions and dampening the system’s real ambition.

There is no good reason to tolerate more surplus in the EU ETS. The reason why an MSR threshold was created in the first place, leaving some surplus in the system, was to help power utilities hedge their fossil-based electricity sales. Power utilities secure the price of emission permits alongside coal or gas as they sell power up to three years in advance, which creates more demand than strictly needed for the current year’s emissions. This extra demand was estimated at 833 mln when the MSR was first implemented in 2015.

But while the power sector becomes less carbon intensive, and the needs for power hedging are gradually decreasing. Moreover, since Brexit, all UK plants have left the scheme, further reducing hedging needs. So it would make sense to adjust the MSR threshold accordingly, downwards instead of upwards.

Spot vs. future confusion

The Commission’s proposal has raised little concern so far, and the tacit consensus is that the market needs some surplus – just not too much. But are we sure of that? In the UK, a carbon market started last year, replicating nearly every feature of the EU ETS except for its surplus – and it works!

The thing is, contrary to public belief, hedging doesn’t involve any allowances at all. When power utilities “buy carbon”, they don’t usually buy actual allowances. Instead, they enter into long futures contracts, i.e. agreements to buy allowances in the future, which is very different. All they need is not the existence of surplus allowances in the market, but just entities willing to sell in the future at a given price, i.e. taking short positions. In case there isn’t enough short selling appetite, actual emission permits can also be used for hedging, but basically the two can be used interchangeably.

The surplus as a crash accelerator

Problems could arise when there is both significant short-selling appetite and a surplus. Appetite for short selling is a question of price: an overvalued asset attracts short sellers. What makes it perceived as over- or under-valued is its scarcity over the years.

As hedging needs decrease with the power sector’s decarbonisation, if the surplus shows no signs of dramatic reduction, the perceived scarcity of carbon allowances might falter and some short selling might happen, making the “hedging” surplus redundant. As short positions grow, even a smaller surplus won’t be useful any more for hedging, which could make an otherwise balanced market blatantly oversupplied.

What should be done?

To avoid a crash scenario, a simple solution is to reduce the market’s surplus drastically, or even remove it completely. Some might argue that this latter option could create the opposite risk, of a market squeeze if the hedging is not matched by enough short positions.

However, two design features of the ETS would prevent this risk. The first one is called borrowing: as the compliance date of each year falls in April of the next year, next year allowances auctioned or allocated until that date are available to hedge future power sales.

The second one is Article 29a. Through this article, if prices reach a certain level, the auctioning of allowances covering future years can be brought forward. In absence of surplus, a mechanism of this type could complement borrowing to allow a perfect match between auctioning and hedging needs. The trigger mechanism of Article 29a would need a few tweaks to allow this perfect match, but the essential is there.

As a precaution, it should be clarified that emission permits released by early auctions through Article 29a are not counted in TNAC calculations to prevent their withdrawal by the MSR. We could even imagine that, to avoid any confusion between current permits and ‘early’ permits, early auctions are carried out through future contracts rather than actual deliveries of permits. In the US, a carbon market called the Western Climate Initiative does exactly that – maybe something to think about.

Sandbag Europe is a non-profit climate change think tank which uses data analysis to build evidence-based climate policy.