Will the Emission Trading System stay on track?

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Will the Emission Trading System stay on track?

The financial crisis of 12 years ago had such an impact on the economic growth path and corresponding emission levels that the price for CO2 emission rights did not recover until recently policy changes came into effect that reduced the surplus of emission rights caused in the market. Is the EU Emission Trading System now better prepared to deal with adverse demand shocks such as the current crisis?

Initial phases of the Emission Trading System

When the EU Emission Trading System started in 2005 the price initially reached price levels of close to about 30 euros per ton of CO2 emitted. However, when it became clear that actual emissions where below the number of allocated emission allowances prices quickly dropped, especially since it was not allowed to transfer emission allowances from Phase I (2005-2007) to Phase II (2008-2012). Phase II initially started with prices levels of approximately 20 euros per ton in 2008, however as the financial crisis hit in 2009 prices started to decrease as economic and industrial activity reduced sharply. Prices maintained below 10 and even 5 euros per ton for years to follow. The low prices for emission allowances extended into Phase III (2013-2020), as this time it was allowed to transfer allowances to the next phase (so called ´banking´).

With the excess of allowances in the market it would have taken many years of yearly reductions of auction volumes (1.74% per year during Phase III) for prices to go back up to levels where they would provide a real incentive to reduce emissions. That is why the EU decided to take additional measures to bring the carbon market back on track. For the short term, the EU postponed the auctioning of 900 million allowances from 2014-2016 to 2019 and 2020. Through this measure the surplus of allowances in the market was reduced somewhat to 1.78 billion in 2015, however as can be seen in figure 1 it did not have much affect on the price for emission allowances. First because there remained a surplus of allowances in the market, but most of all because the 900 million allowances only had been backloaded to later years. Therefore, the total number of allowances to be auctioned during Phase III remained the same. Moreover, this measure did nothing to make the Emission Trading System more resilient to possible future shocks.

Figure 1: Price for emission allowances 2013 – 2020. Source: MTech

The introduction of the Market Stability Reserve

As a long-term solution and structural reform to the Emission Trading System, the EU implemented the Market Stability Reserve (MSR). The Market Stability Reserve takes part of the surplus of allowances out of the market on a yearly basis. In case of a deficit or a very small surplus, it can transfer allowances from the reserve back to the market. This way the MSR softens the impact of external shocks to demand for emission allowances and intents to ensure a more stable price required to stimulate investment in emission reductions.

As a start, the 900 million allowances backloaded to 2019 and 2020 where moved to the MSR, thereby addressing the surplus of allowances already identified earlier. This reduced the auction volumes for 2019 and 2020 and led to the price increases seen in the market for allowances from early 2018 onwards. You could say that this measure put the carbon market back on track.

To keep the carbon market on track, every year the surplus of allowances in the market is calculated and allowances are transferred to or from the MSR accordingly. Each year before the 15th of May the European Commission (EC) publishes the number of emission allowances in circulation the year before. If this number exceeds 833 million, 24% of the allowances are transferred to the MSR. In a practical sense, these auctions are ´taken out´ of the market by reducing auction volumes over the period September that year until August the next year After 2023, the percentage of surplus allowances transferred to the MSR is reduced to 12%. On the other hand, if the number of emission allowances in circulation is less than 400 million, allowances are released from the reserve. As you can see it is not the intention of the EU to adjust the number of issued allowances exactly to the amount of emissions and reduce the number of allowances in free circulation to zero. A reasonable amount of allowances in circulation is useful for market participants to be able to cover positions for future periods and hedge against price increases.

The MSR began operating in January 2019. The publication of May 2018 had indicated that (based on the number of allowances in circulation in 2017) 265 million allowances had to be transferred to the MSR by reducing auction volumes from January 2019 to August 2019. A year later, the EC published that the number of allowances in circulation in 2018 was 1.65 billion, indicating that almost 400 million allowances were to be transferred to the MSR in the period from September 2019 to august 2020. Just over a week ago the EC published that the number of allowances in circulation over 2019 was 1.39 billion. The number of allowances in circulation has somewhat decreased in comparison with the year before. Nevertheless, a surplus of allowances continues to be present in the market, and another 330 million allowances will be transferred to the MSR over the period September 2020 to August 2021.

Economic standstill

Now that the carbon market is back on track and the MSR is doing its work to absorb surplus allowances, the economy has almost literally come to a standstill. Economists have only just begun to assess the economic impact of the coronavirus outbreak. The fall in economic activity will most likely be deeper than that of the financial crisis, although the recovery might be quicker. The impact on energy markets is clear. Worries of prolonged weak demand have (together with other factors such as foreseen increases of renewable generation and large gas reserves) have brought energy prices to record lows. Emission rights fell to around 15 euros per ton as European countries went into lockdown in the second half of March but rebounded to around 20 euros per ton where it trades now. Projections such as that from Refinitiv have been revised downwards from an average price for Phase IV (2021-2030) of 26 euros per ton to 20 euros per ton, but a return to the levels of before 2018 is not foreseen at the moment. Although it is too early to draw conclusions, for now the carbon market holds up well compared to the financial crisis. The MSR is partly responsible for that. The excess of allowances created today through less economic activity will at least partly be removed from the market from September 2021 onwards. The reduction of future auction supply helps support the current price.

Consequences for the reduction of greenhouse gasses

As we move into Phase IV (2021-2030) of the EU Emission Trading System next year, the yearly reduction of emission allowances issued will speed up from the current 1.74% to 2.2%. This reduction rate is in line with the 2030 target of a 40% reduction in EU greenhouse gas emissions. All allowances absorbed by the MSR are additional reductions in emissions. The same is true for any additional surpluses in the market that the MSR does not absorb. In the end, the EU Emission Trading System and the price for emission allowances are only instruments. The goal is reducing greenhouse gas emissions and ultimately preventing (further) climate change. And with respect to the goal of reducing greenhouse gasses, I would say that meeting the 40%-target for 2030 is a lot more certain than all of us being able to go on holidays this summer or even spent Christmas as families together this year.

Rens van de Ven | Energy Consultant

 

By | 2020-05-20T09:05:10+00:00 May 20th, 2020|Categories: Energy Markets, Featured, M·Blog|Tags: , , |0 Comments

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