By Carlo Carraro, Director, International Center for Climate Governance (ICCG), Venice.
(On Thursday, the Florence School of Regulation Climate and the European Commission host a day-long conference looking back at the first 10 years of the EU ETS. Webstreamed here)

The European Union Emissions Trading Scheme (EU-ETS) – the world’s most extensive carbon pricing market – has now been in operation for ten years. The EU-ETS was developed as a way of meeting the EU’s greenhouse gas emissions reduction targets in the most efficient and cost-effective manner. To do so, the EU-ETS sets a limit (a cap) on the total emissions certain EU sectors (mostly heavy industry and aviation) are allowed to use during predefined trading periods. Permits are then distributed amongst polluters where one permit equals one tonne of carbon dioxide equivalent. These permits can then be traded between market participants. As such, the total amount of pollution is set by an external authority, but market participants determine the permit allocation thereby optimizing efficiency.

The permit price is set up to reflect the scarcity of carbon dioxide in light of which market participants must choose between exchanging allowances up to the limit or investing in low carbon options, depending on difference between the marginal abatement cost and the permit price. In this form, the EU-ETS has piloted the first major carbon pricing scheme and in so doing helped to develop a sound basis from which the other carbon pricing systems that are cropping up around the world can build. For this reason, the past ten years of EU-ETS have been a positive learning experience and a success. This cannot, however, come without mistakes. I will review some of these and how the EU-ETS plans to improve over the coming decades in order to reduce the EU’s emissions more efficiently.

Misallocation of permits

Throughout all of its operating years, the EU-ETS has suffered from a notable imbalance between the supply and demand of permits. In the first period (2005-2007), too many permits were allocated because most countries had inaccurate emissions data from which their allocated permits would be based. However, since this period was a learning phase, none of the excess permits could be banked and carried over for use in the second period so they are not relevant to the current imbalance we still see. The non bankability of the permits however produced a sharp fall of the permit price, with negative consequences on the credibility of the EU-ETS and on investors’ expectations.

During the second period (2008-2012), the economic crisis, inflow of foreign investments and inconsistent renewable energy and energy efficiency policies resulted in a surplus of permits. This surplus was exacerbated by the fact that most permits were allocated instead of auctioned in the first two periods. The increased auctioning of permits in the third period improved the efficiency of the market since fewer permits were being handed out for free. In fact, the number of freely allocated permits dropped to 43% of emissions compared with almost all emissions being allocated in previous periods. Further, it was not just an internal oversupply of permits that was and is occurring. The inflow of international credits from other carbon credit schemes (including the Clean Development Mechanism and Joint Implementation) are adding to the glut. This oversupply of permits to the market drove the carbon price down and therefore removed the incentive for investors to seek out low carbon alternatives. The lasting downwards pressure was exaggerated by the supply side inelasticity that defines the regulatory nature of the EU-ETS.

System rigidity

The EU-ETS emissions cap is predetermined for each trading period. While some flexibility was introduced in 2013, the cap remains largely inflexible. For a market mechanism based on the principle of supply and demand, the EU-ETS needs to improve this flexibility for the system to operate successfully. The inability to do so thus far has contributed significantly to the over-allocation of permits now plaguing the system and driving the permit price down.

On the demand side, the banking and borrowing of permits introduces system flexibility where changes in demand between trading periods is smoothed out. On the supply side, a number of options have been discussed for increasing flexibility.

One option that has been adopted is the back-loading of allowances whereby permits are removed from the market to reduce the glut and then reintroduced later. However, this method provides only a short term solution. As such, the recently decided upon market stability reserve is being developed to control the quantity of permits in the market. This method provides a more comprehensive response to excess permits than backloading or other approaches like influencing auction levels.

However, the current parameters should probably be more stringent if the reserve is to reduce the permit glut, bring the carbon price back up and do so in an appropriately fast amount of time. Moreover, on both the supply and demand side, it would be beneficial if the rules were more clear and consistent. This would optimize the system and give market participants the certainty they seek. Having said this, we need to remember that the EU-ETS is still piloting a number of tactics and learning as it goes.

A single price

The diversity of both countries and firms participating in the EUETS is high. Certain sectors (particularly the power sector with 64% of the allocated allowances) and countries (such as Germany and Poland) have more influence in the market than others. This diversity of market participants needs to be considered to avoid problems with the carbon price formation and potential misuse of market power by dominant sectors and countries. There are whisperings of such problems with the current homogenized carbon price. The energy sectors participating in the EU-ETS currently dominate the emissions in the market. This results in the energy industry setting the market fundamentals for the whole market. This is not the optimal way of reducing emissions for less dominant market participants. A solution to this problem could be setting a carbon price that is partly determined by carbon intensity or output based goals.

On this note, combining the absolute emissions cap with a (relative) carbon intensity indicator will be very important for the future of the EU-ETS. This is because looking solely at absolute emissions reductions gives no sense of whether those emissions are being reduced as a result of the development of low carbon infrastructure or coincidental factors (such as an economic slowdown). This problem was experienced in Phase II of the EU-ETS with the economic crisis in 2008/2009. To be truly effective in the long term, the EU-ETS needs to set incentives for the introduction of low carbon alternatives. It would therefore benefit from a carbon intensity metric that can measure such progress.

Expanding the emissions covered

In line with the long term goal of managing and reducing global greenhouse gas emissions, the EU has recognized the importance of forming connections with other carbon pricing markets and methods. However, to avoid carbon leakage, it notes that this process needs to be managed properly. The EU has developed links most strongly through the Linking Directive 2004/101/ED that seeks to link developed and developing countries through the Clean Development Mechanism (using Certified Emission Reductions) and the Joint Implementation (using Emission Reduction Units). In this process, the EU has tried to reduce the likelihood of carbon leakage by attributing carbon credits to Clean Development Mechanism and Joint Implementation projects on a project by project basis. Further, with relation to the Clean Development Mechanism, only 15% of a country’s total allocated permits is allowed to be traded for Certified Emission Reductions so that – in light of the uncertainty associated with linking to non-EU schemes – the chance of carbon leakage is limited.

Looking Forward

The past ten years have allowed the EU-ETS to test options and improve not only its own ability to reduce greenhouse gas emissions, but also make it easier (with the knowledge now acquired) for other countries to do the same. Even so, the learning and development is not complete. Many plans and debates are underway on how to move forward with the EU-ETS. The main one is, of course, the market stability reserve (MSR). The MSR is being introduced to steadily increase the carbon price and, in so doing, reintroduce investor confidence in the market. The MSR is effectively a quantity collar where, from 2018, if there are more than 833 million allowances in circulation, 12% of these total allowances are removed from the market into the reserve. The MSR also ensures that if there are fewer than 400 million allowances in circulation, that 100 million are released from the reserve. With the current situation of the EU-ETS, the lower limit of the quantity collar is not as immediately relevant for rectifying the carbon price issue. Nevertheless, it is important to have it to ensure the long term stability of the system. While the MSR plans to restore a price signal that will stimulate investment in low carbon energy, there are some limits to the current plan that we need to consider so that the upcoming years of EU-ETS deliver the necessary reduction in greenhouse gas emissions.

First, it is important to note that the inclusion of the MSR in the EU-ETS will not lead to an increase in the overall emissions reduced, only change the rate at which they are. The linear reduction factor (rate at which the emissions cap is reduced) will still be 1.74% per year until 2020 and then 2.2% thereafter. As such, in the reforms to the EU-ETS, there is no suggestion to reduce the overall amount of pollution covered by the EU-ETS. Some pressure groups have suggested increasing the linear reduction factor up to 2.6%. Given the increasing urgency of stepping up mitigation efforts, perhaps this rate should be increased if the EU is truly to shoot for a long term zero carbon future.

Second, as mentioned above, with the current surplus of permits in the market, the EU-ETS will have to pull permits into the reserve at a rate of 12% per annum starting from 2018. With this extraction rate, it would take 10-15 years to clear the market of the current two billion and growing permit surplus. In other words, with the current plan, it will take the market 10-15 years to return to a state where the market can operate efficiently. It seems necessary to increase the extraction rate as this is far too long to get the market back on an even keel. Another key element that ties into this is the issue of backloaded allowances. To correct the growing surplus of permits, the European Commission took the short-term action to remove 900 million permits that were due to be auctioned during Phase III (2013-2020). The current proposal is that these permits should be reintroduced into the market at the beginning of Phase IV (2021). This reintroduction would be unwise as it would undermine the progress being made on systematically reducing the permit surplus. Aside from the problems this would pose to removing the overall excess of permits, the sudden spike in supply that would result from 900 million permits being introduced back into the market would squander the progress towards a stable market that provides clear, continuous signals to investors.

Third, after much debate, the ENVI Committee in the European Parliament brought forward the starting date of the EU-ETS from 2021 to 2018. It is encouraging that the committee decided to bring the date forward. However, since we need this glut of permits removed as soon as possible for the EU-ETS to work efficiently, this date should ideally be sooner. Germany and the UK were both pushing hard for a 2017 starting date, which would have accelerated the progress the MSR could make.

Beyond MSR

The MSR will provide some of the stability that the EU-ETS is currently missing, but on its own, it is not a long term solution because economic downturns or other external factors may occur and interfere with the supply/demand balance. The MSR therefore needs to be complemented with other measures to increase the robustness of the EU-ETS. One important consideration needs to be the flexibility of the permit supply mechanism. This is because the most serious problem facing the EU-ETS at the moment is the low carbon price. This price is regulated by the total permit cap. With the variety of possible changing external factors, this cap needs to be flexible so that the price can be stable when there are unexpected changes in supply or demand.

Another consideration is the efficient distribution of permits among market participants. In a 2014 report, Ecofys suggested the idea of a dynamic allocation of permits where permits are distributed based on actual production levels instead of historical levels. A correction factor would be applied at the end of each year to ensure the accuracy of the system. In this system, the New Entrants Reserve would be replaced by an Allocation Supply Reserve that would buffer the over or undersupply of permits associated with new market entrants. This performance based approach is certainly more efficient than a historically based one and would encourage low carbon technological innovation. However, there is the risk of carbon leakage if the actual production level targets are too tight. Keeping a check on carbon leakage risk will become increasingly important as the EU-ETS continues to develop and integrate with other carbon pricing schemes. Such development and integration is essential for the management and therefore reduction of global emissions without leakage. It also allows the EUETS to achieve its own emissions reductions more cost effectively, it increases the market liquidity and it helps make the EUETS permit price more stable.

Where we stand

On the whole, we see the EU is seeking to reform the ETS and thereby reinstate investor confidence. We must applaud this effort and persistence to provide a fully functional carbon pricing mechanism. However, a project of this scale will be in constant need of refinement to deliver effectively. As such, looking forward, we need to ensure that the MSR is running optimally (with the earliest start date and an ambitious linear reduction factor) and is complemented with other improvements (such as improved cap flexibility). While you can argue that the decisions made on the MSR and 2018 start date are first steps on which the EU can build, investors are highly responsive to even the slightest change in public policy, even if for the better. Therefore, if we are to send a clear signal to investors, it is beneficial to deliver one stringent, informed package of improvements now that will indicated to investors that this is the line of action from which policy will not veer. This firm, consistent action will encourage the investment in low carbon technologies the EU-ETS was established to incentivize.

Ten year later, the EU-ETS can be considered a success in environmental policy. This 10th anniversary should therefore be the occasion to celebrate this success. At the same time, it should be the occasion to indentify the major changes which are necessary to make the EU-ETS work more effectively. Linkages with other permit schemes, flexible monitoring of permit supply, and consistency with other EU climate policy measures (subsidy to renewables, in particular) are probably the most urgent ones.

This article was first published on Carlo Carraro’s blog.