Last year I argued in a post that the EU-ETS price was fine (at that time it had slipped to some €8 in the depths of the recession) in that it reflected the market circumstances of the day and needless to say the system would still deliver the targeted reduction by 2020. At that time it even appeared that there was still a considerable shortage of allowances in the intervening years so we could expect quite substantial infrastructure investment, even including CCS, by 2020.

A year is a long time in a recession and although the price has recovered somewhat and in any case the 2020 target will be met, the current circumstances of the ETS may not be right at all. It is now pretty clear that by the start of Phase III there will be a considerable banked surplus of allowances in the system. The actual number varies depending on who calculates it, but it would seem to be somewhere between 800 million and 1.4 billion allowances. It means that not a great deal of effort will have to be expended to meet the Phase III targets and that it is unlikely any transformational change in power infrastructure will actually take place – save for meeting the renewables target. The Netherlands is even seeing 4 GW of unabated coal come into the mix.

This isn’t exactly what the Commission had in mind when it set out on the ETS journey back in 2001. Rather, their goal was much more ambitious. The expectation was for a radical departure from business as usual, including the commercialization and early deployment of technologies such as CCS. Although there should at least be the EU demonstration CCS facilities up and running by then, it is not looking like there will be much more. The real change may not be seen until the 2020s, which may be fine from the perspective of the EU meeting it’s reduction targets but certainly isn’t fine from the perspective of seeing a new generation of power technologies enter the market and be available globally, particularly in countries like China. Such an outcome isn’t compatible with the global need to quickly reduce emissions.

The result of all this is that we are starting to see a reaction from policy makers. The Commission has proposed shifting the EU target to 30% even though the formal international agreement trigger for this has not been achieved. The new UK government has proposed both a UK only ETS price floor and an Emissions Performance Standard (EPS) for the UK power sector. On the face of it none of these are particularly welcome, in part because their implementation further undermines the carbon price. But they are understandable. This is hardly an undercurrent discussion either, not so long ago The Times weighed into the debate with an editorial discussing a carbon floor price!

The Times

22 September 2010

Even though they wear yellow ties, green is still the colour most associated with Liberal Democrats. So Chris Huhne was on comfortable territory at his party’s conference yesterday, telling the audience that the coalition Government would be “the greenest ever” (see page 15). The Energy and Climate Change Secretary’s remarks about nuclear power were less popular. But his statement that “I’m fed up with the stand-off between renewable and nuclear, which means we have neither” was persuasive.

Like many thoughtful greens, Mr Huhne has come to accept that nuclear power has to be part of the energy mix if Britain is to decrease its reliance on imported fuels, reduce carbon emissions and reduce volatility. While rightly opposing any direct subsidy for nuclear power, Mr Huhne has understood that investment will only be unlocked for such long-term projects if there is some certainty in pricing. His commitment to create a “floor” price for carbon helps to provide that certainty for all low-carbon technologies, as well as nuclear.

It will be an essential spur to the expansion of the low-carbon industry that Britain needs to create if it is to meet its climate change commitments.

In the case of the 30% target, this is a tool that the Commission has available and they could argue that the actions by nearly 100 countries as a result of the Copenhagen Accord represents a sufficient trigger. But the issue is more complex than it looks. The EU is comprised of two sectors, one part that is under the ETS and one which isn’t. Any shift in the target would require an adjustment in both sectors, yet in the non-ETS part of the economy it is difficult to see what actions can deliver a further reduction in the limited time now available.  Vehicle efficiency standards are now in place, renewable fuel targets set and various national policies aimed at buildings are underway. Changing them all would be problematic. In the traded sector a new target would support the carbon price and at least speed up technologies such as CCS.

The approach proposed by the UK targets the power sector, but there is a significant side effect. Because of the ETS carbon cap, any additional UK only action will simply be offset by less action in the EU. That means the UK is taking an additional and arguably unnecessary fiscal burden in the overall delivery of EU reductions. The problem here is 100% policy leakage.

So the problem remains, what to do with the ETS? There are potentially two ways forward.

  • The first is to change the cap in the EU-ETS for Phase III, in effect withdrawing some one billion allowances from the system. This would correct the overhang from the recession and support the price going forward, driving the sort of transformational investment which was wanted from the outset. What isn’t clear is how this would be done. Recallibration may require the reopening of the Directive, perhaps not a politically desirable step. The action is equivalent to changing the overall EU target to 23-24%, but of course with all the change in the ETS and no further change in the other sectors.
  • A second approach would be to design a more structural change to the system. This could be picked up from Phase IV onwards and would involve the implementation of a reserve price in future (starting in 2019, say, for Phase IV) allowance auctions. The reserve should always be announced well in advance, but it’s existence would allow long term support for the carbon price, thereby enabling the investment environment that was the original intention of the system. Such a design feature allows the ETS to be corrected from to time in the event of unexpected shocks such as the recent recession. Implementing a reserve price for Phase IV and beyond would give new value to existing allowances in that any current surplus could be banked forward into the future period and benefit from the known higher price.

It could be that both steps need to be taken, in part because there may be a reluctance to announce a reserve so far in advance, although even its existence would potentially send a price signal. The implementation of a reserve would also force the definition of the broader Phase IV architecture and target now which in turn would offer more predictability for system participants and potentially support longer term carbon market development including projects in developing countries which can be linked via the CDM. The ideal situation would be to see the CDM extended through to the 2020s, but that would require a bold political agreement in Cancun or South Africa in 2012.

The EU-ETS has become the poster child for a carbon market based approach to greenhouse gas mitigation. As such it needs to work, not only delivering compliance but also the step change in type and scale of investment that policy makers are looking for. If it doesn’t do this we can hardly expect others to pick up and implement this approach, which in turn means other less attractive and more costly policy measures.