Fixing the EU-ETS?

02 Aug 2012

Gina Hanrahan

A short-term draft proposal to revive the ailing EU Emissions Trading Scheme (EU-ETS) was announced by EU Climate Action Commissioner, Connie Hedegaard, on 25 July 2012. The bigger question of how credibility will be restored in the market over the medium to long-term remains unanswered, however.

The Commission’s proposal aims to address the major oversupply of emissions allowances in the ETS system, which has led to a depressed carbon price of as little as €6 or €7 per tonne in recent months, from initial highs of around €20 per tonne. Speaking as she launched the proposal, Commissioner Hedegaard said, "The EU ETS has a growing surplus of allowances built up over the last few years. It is not wise to deliberately continue to flood a market that is already oversupplied.”

Why Has Oversupply Arisen?

The oversupply in the EU-ETS has arisen as a result of a number of factors. First amongst these is the ongoing economic crisis, which has seen a fall off in industrial activity and related energy use. The consequent decrease in emissions has in turn led to reduced demand for allowances. Other factors depressing demand include: the impact of overlapping renewable energy and energy efficiency policies; the transition to Phase III of the ETS from Phase II (in January 2013), which will lead to a temporary increase in allowances; and the ongoing uncertainty about future EU climate ambition post-2020.

The difficulty with the oversupply is not oversupply per se – as the amount of allowances in the system is consistent with the EU’s 21% reduction target to 2020 in the sector – but rather the fact that it is leading to such low carbon prices. The argument for one-off intervention in the ETS centres on the idea that the price signal has been insufficient to drive the kind of low-carbon investment and innovation necessary to lay the foundations for the much steeper emissions reductions that will be required in the post-2020 period. As the price of carbon is so low, it is argued that companies are investing in carbon-intensive capital stock, which will have implications over a long time horizon. Critics of intervention, however, counter that the low price is reflective of low demand and therefore shows a well-functioning market. They also maintain that even a one-off intervention is a slippery slope, raising the spectre of repeated market intervention. See an excellent paper by CDC Climat Research for an overview of the key arguments for and against intervention.

The Commission’s Plan

The Commission’s plan involves back-loading (i.e. delaying) the auctioning of allowances for Phase III of the ETS (2013-2020). The plan explores three options for delaying auctioning for the years 2013-2015 - either 400 million, 900 million or 1.2 billion allowances will be auctioned at a later date. It is estimated that oversupply will amount to 1.8 billion allowances in the 2008-2020 period.  The Commission argues that back-loading is designed to “improve the functioning of the market, and not to increase the price.” The intervention is anticipated to raise prices in the short-term, but lead to a steadier price in the long-term. As the allowances will eventually be auctioned, it is thought that there will be a limited impact over the 8 years of Phase III (2013-2020). The Commission is clear that the proposal does not constitute market intervention, as the mechanism for changing the timing of auctioning is provided for in the Auctioning Regulation to allow flexibility in exceptional circumstances.

Implications

Analysts Thomson Reuters Point Carbon have estimated that the impact of delayed auctioning of 800 million allowances (what they see as a likely political compromise) will bolster the price of allowances by €6 per tonne on average in Phase III compared to current prices and caution that a failure to “make good” on the back-loading proposals delay could see carbon fall to as little as €4 per tonne.

Next Steps

The Commission’s draft proposals have now entered a period of stakeholder consultation and have also been sent for consultation to the Climate Change Committee, acting by qualified majority. As a second step the final proposals will be sent for three-month scrutiny by the European Parliament and the Council, before the Commission finally adopts it.  In addition to the proposals for back-loading, the Commission will bring forward proposals for a longer-term structural remedy for the EU-ETS by the end of 2012.

Reaction

Reaction to the Commission proposals has been mixed. Environmental groups have called for a rapid conclusion of the auctioning fix and for ambitious structural reform. European industry is divided on the issue, however. While the European Association of Metals has stressed the potential negative impacts for industry and have criticised any moves towards cancelling allowances as a “de facto increase of the CO2 target,” an alliance of energy companies including Dong, Alstom, Shell, EnBW, GE and Statoil have called for at least 1.4 billion allowances to be withdrawn from the system. Reacting to the proposals, David Hone, Chairman of the International Emissions Trading Association and adviser to Shell, maintained that the back-loading plan simply buys time to reach agreement on structural changes to Phase IV - which might include increasing the cap on emission more rapidly, or introducing a reserve price for auctions. The reforms, and new post-2020 targets, would have to be agreed to give investor certainty before the delayed auctioning could take place in Phase III.

Conclusion

Whatever the short-term decision on the quantity of allowances to be back-loaded, the key long-term question remains – what will be required to restore market credibility for the EU-ETS? The market has shown itself to be insufficiently robust to deal with the impact of external factors and market actors remain uncertain about whether EU climate ambition will lead to a real allowance scarcity over the long-term. The recent draft proposals announced by the Commission concentrate on the supply side of the equation by delaying the auctioning of permits and the Commission is likely to build more automaticity into future structural market reforms, which would improve market functioning. But to truly tackle the weaknesses of the ETS, clear signals will be required about future scarcity to drive investor demand. This would be beneficial from a climate perspective also. The political barriers to agreement on a step-up in ambition post-2020 remain large, however, and it is unclear whether they will be surmounted in the short to medium term.

 

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