EU governments, fearing carbon leakage, are manoeuvring to ensure their industries get access to more free carbon allowances via an MSR loophole that could see hundreds of millions of the units benefit big emitters.

Earlier this month, EU lawmakers struck a landmark deal on the supply-curbing MSR, which observers say could at least double carbon prices by 2020.

While the proposal could withhold up to around 1.8 billion EUAs from the market by the end of the decade, a clause in the agreed text may end up cutting that figure by half by ringfencing a plethora of the allowances in an effort to prevent heavy industry seeking cost cuts from relocating outside the EU.

“It’s a massive loophole and it could mean hundreds of millions of allowances return to the market,” said Emil Dimantchev, an analyst at Thomson Reuters Point Carbon.

Under the MSR deal, EU lawmakers agreed that unallocated allowances – which Ecofys analysts estimate could amount to as much as 900 million units by 2020 – should be put in the reserve at the end of the current trading phase.

But under a clause in the agreement, which still needs to be signed off by EU Parliament and ministers, the European Commission said it will consider whether any of the unallocated allowances should be used for addressing carbon leakage.

The deal also adds additional uncertainty for the EU carbon market by inviting the Commission to propose whether up to 50 million more of the unallocated allowances should be used to help fund innovative low-carbon projects.

REVIEW PROCESS

The issue is set to be considered by the Commission as part of its review of the EU ETS Directive due by July, but will ultimately need to be agreed by EU lawmakers in a process that could take at least two years.

The EC is currently reworking the EU’s carbon leakage rules, but external studies of what is needed to prevent an industry exodus vary considerably.

Point Carbon’s Dimantchev estimated the Commission could propose between 100-200 million unallocated EUAs to address carbon leakage, but said this could rise once lawmakers got hold of the proposal.

“It’s really going to be up to member states and parliament, so that figure could go considerably higher,” he said.

In theory, these unallocated allowances could either be awarded freely to industry or sold at auction. If 200 million were sold, this could raise around €3.3 billion in 2020 based on analyst price projections.

The Commission’s top climate official Jos Delbeke last week cautioned about the use of the unallocated allowances otherwise destined to be held in the MSR.

“The influence of the reserve is going to be weakened,” he told a panel debate in Brussels.

Mark Lewis, an analyst at Kepler Cheuvreux, said if the Commission proposes the return of a significant amount of allowances to the market it would cap any EUA price gains over the second half of 2015.

ITALY’S URGE

Italy wants the EU to use the unallocated EUAs to help compensate industry for ETS-related power price hikes, ICIS reported last Thursday, citing an anonymous diplomatic source.

ICIS said the call came during recent negotiations on the MSR.

Direct carbon leakage is currently addressed through the free allocation of EUAs to industries, but Italy is not one of the six member states currently opting to also give financial compensation to their heavy industries for indirect carbon leakage, for example higher power prices due to power companies passing on the cost of having to pay for their EUAs.

The Czech Republic and Spain also spoke up in the MSR talks to call for harmonised allocation measures, according to one industry source who asked not to be named due to the sensitivity of the negotiations.

In a related move, Poland and the Netherlands last Wednesday convened a meeting in Brussels to ask other EU member states and Commission officials to support them in changing the post-2020 system of free EUA allocation, ENDS reported.

They want a so-called ‘dynamic allocation’ based on current rather than historical production, and for the cross-sectoral reduction factor to be scrapped, ENDS said, citing a background paper for the meeting.

Environmental campaigners have slammed the idea because it could dampen industry’s incentive to invest to cut emissions by drastically increasing their free EUA quotas, while forcing households to pay higher electricity bills passed on by utilities.

The Commission has previously said the approach could be too unwieldy for them to administer and some observers expect the EU executive to resist.

TIERED APPROACH

Instead, the EC could be considering reworking the benchmarks used to determine the cleanest producers and allocating fewer free allowances to industry sectors deemed able to pass through some of the increased carbon costs to their customers.

Both were mentioned by Delbeke during last week’s panel debate when he was asked about carbon leakage, though he stressed that the ETS Review proposal was still being worked on.

The Commission may also be looking to stagger the allocation, with a lower maximum percentage of free allowances awarded to sectors deemed less vulnerable. This compares to the current practice of giving the cleanest facilities in each vulnerable sector all of their permits for free.

The industry source said the proposal could include giving 80% to a group of related industrial sectors deemed more vulnerable, and 50% and 30% to other sectors that are found to be at less of a carbon leakage risk.

By Ben Garside – ben@carbon-pulse.com