The role of ETS for the transformation and the interaction with national measures

EU emissions were reduced by 22% between 1990 and 2017, while the economy grew by 58%. One of the EU policies used towards emissions reduction is the Emissions Trading System (ETS), whose functioning was improved during the last reform, but is still lacking a crucial feature to ensure higher robustness

The EU Emissions Trading System (ETS) is a key tool for reducing greenhouse gas emissions in a market friendly way. Covering around 45% of the EU’s greenhouse gas emissions, it is the world’s first major carbon market and remains the biggest one. It establishes a cap over the greenhouse gases that 11,000 heavy energy-using installations (power stations and industrial plants) and airlines can emit each year. The system issues a fixed amount of allowances each year that companies need to buy and then surrender to the EU to emit CO2. If their emissions exceed the number of allowances they surrender, they face severe fines. Allowances can be traded between companies, hence providing flexibility to the system so that emissions are reduced where it is cheapest to do so. The ETS thus puts a price on CO2 emissions, incentivizing the regulated companies to reduce their emissions.

The ETS includes the emissions caused by airlines (credit William Hook/Unsplash)

While the theory of the ETS is clear, it will only lead to sufficiently high CO2 prices to start the transformation to a zero-emission system if emission allowances are scarce. Such a scarcity can either arise a) if in a certain year, less allowances are issued than actually needed, or b) if market participants expect a significant scarcity of allowances in the future – then they can already buy emissions today, “bank” them, and use them to fulfil their obligations in a later year. This “banking” translates a future scarcity into a scarcity today – a process common to financial markets. However, this second option requires that market actors are convinced about future scarcities – thus the prices depend on expectations of all market actors about the political will to tighten the cap in the future. As this is a highly subjective and speculative basis for price-formation, allowance prices are expected to be volatile if channel b) is the main reason for scarcity.

So how did the ETS market turn out? Upon starting of the second phase in 2008, expectations of scarcity were high, leading to EU emission allowance (EUA) prices of 30€/tCO2. Soon, however, market participants realised that the cap was set too high and that emissions would be depressed due to the financial crisis, thus EUA prices dropped to a level of 10-16€/tCO2. Over the period 2011-2013, prices dropped further to a level of 3-7€/tCO2, much too low to incentivise investment into low-carbon technologies and start a fundamental transformation of the energy system. For many decarbonisation options, carbon prices above 50 or 100€/tCO2 are required to make them competitive.

A study by Koch et al. about the causes of the EU ETS price drop indicates that market fundamentals – such as the reduction of economic activity due to the financial crisis or the increased deployment of renewables – explain only a small part of the price changes. In a later paper, they come to the conclusion that the price changes were strongly influenced by expectations about future interventions from policy-makers.

This has severe implications for the functioning of the ETS: if market actors have the expectation that future caps will continue to be unambitious, prices stay low. Without high allowance prices in the coming decade, industry will not have incentives to invest enough into research, innovation and deployment of emission-neutral fuels and technologies.

Moreover, other climate policies such as the Carbon Price Floor (CPF) in the UK, which taxes fossil fuels used to generate electricity, and the envisaged coal phase-out in Germany, ending coal-fired power generation by 2035-2038, are expected to interfere with the ETS. While the closing down of polluting power plants is good news for climate action, it will cause a lower demand for ETS allowances in the market, thus reducing scarcity and decreasing the EUA price. This may endanger the business case for other investments into low-carbon technologies and thus lead to higher emissions elsewhere. This is the so-called “waterbed effect” – under a fixed total cap, emission reductions in one country can lead to emission increases in another country.

The ETS establishes a cap over heavy energy-using industrial plants (credit Valeriy Kryukov/Unsplash)

Recognising these challenges to the ETS, the European Commission has reformed several aspects of the ETS in the new legislative framework for the period 2021-2030. The revised trading rules aim to support the compliance with the 2030 climate and energy policy framework and the EU’s contribution to the 2015 Paris Agreement. Concretely, the annual cuts in the amount of allowances were increased from 1.74% to 2.2% from 2021 onwards. Additionally, the market stability reserve (MSR) was reformed so that it now automatically cancels a share of the total certificates when their number becomes higher than a certain threshold. Also, countries have explicitly the right to cancel certificates in case they enact certain national policies, such as shutting down coal power plants.

The first reaction from the market was very positive – prices increased from the 3-7€/tCO2 observed from 2013-2017 to a range of 20-26€/tCO2. Interestingly, this increase is higher than what would be expected just from the foreseen changes to the number of allowances in the 2021-2030-period. This might be interpreted as a change in perception of market actors – the political process around the latest ETS reform and the implementation of the cancellation rules proved that there is sufficient political will to keep the EU ETS a strong instrument for achieving the EU climate targets.

While the reform managed to increase future EUA scarcity as well as optimism of market participants, it did little, however, to reduce the risk of future price crashes that might arise if political commitment to tighter targets wanes. Also the waterbed effect, which offsets the reductions from tighter national policies, remains an important weakness. A study by Osorio et al. shows that the new MSR mechanism would only partially reduce the waterbed effect of a presumed German coal phase-out, from 64% without MSR to 44% with MSR. Additional voluntary cancellations by Germany would be needed in order to counterbalance the remaining waterbed effect and keep the EUA price unchanged.

Thus, to strengthen the robustness of the ETS, further reforms are necessary. In order to reduce risk for market participants eager to invest into low-emission technologies, an EU-wide price floor would be a crucial addition to the ETS. Such a price floor would guarantee at least some minimum price on which innovative companies that develop low-carbon solutions can calculate.

By Robert Pietzcker, Potsdam Institute for Climate Impact Research (PIK), and Iker Urdangarin Meabe, World Future Council