The EU Emissions Trading System (ETS) is facing tough times. Last week saw the price fall to below €3 after the European Parliaments’ Industry & Energy (ITRE) Committee voted against the Commission proposal to amend the ETS Directive to allow for backloading of ETS allowances (a compromise mechanism which will shift the auction profile in Phase III to remove allowances in the short term). At such a price level the system isn’t really functioning, rather it is little more than a short term compliance accounting system for reporting on CO2 emissions.

In effect, this means that the EU doesn’t currently have an explicit carbon price to drive change in energy and infrastructure investment, despite 10 years of policy in place designed with that single goal in mind. The very low price level also implies that there is no expectation for a real carbon price ever developing. In theory these allowances could be bought and banked through to Phase IV. Assuming a cost of capital of 5% (and of course availability of capital to do so), a €3 allowance would only need to fetch €7 in 2030 to cover this, which would be well below the price of a market which is presumably driving investment in carbon capture and storage, surely a technology being seriously considered by then. So what is the thinking that might lead to an ~80% discount in market value? Three possible scenarios could lead to such an outlook;

  1. The ETS has been stopped and the market doesn’t exist in the 2020s. In this case Phase IV would never be agreed and although there is formally no sunset clause in the system, it would effectively cease if no allowances for the 2020s were ever issued.
  2. The surplus cannot be removed by then, even with tougher targets. New crediting mechanisms continue to flood the system.
  3. Other policies will be doing the heavy lifting, leaving the ETS as a ”do nothing” policy instrument. The dominant policies will be ongoing renewable energy targets, CCS mandates, Emissions Performance Standards etc.

All of these are plausible, but I tend to think that the third one will be the ongoing problem. It is the problem today, as shown in the abatement curve chart below (an indicative CO2 price is shown on the vertical axis and the cumulative sum of reductions is shown on the horizontal access). The Renewable Energy Directive has brought projects forward which probably would not have happened until much later in the 2020s. This has had multiple effects within the EU energy system because of the presence of the ETS and its allowance based compliance. Whereas the 2020 goal might have been met through improvements in efficiency, fuel switching and the initial phase in of mature renewable energy technologies (all driven by the CO2 price), it has instead been met through a much less cost effective approach which forces the implementation of renewable energy projects first (including the less cost mature technologies), delays energy efficiency implementation and has the effect of pushing fuel switching and CCS into the 2020s and 2030s. The visible carbon price falls as a result, but the hidden carbon price operating in the economy is much higher.

 Low EU Carbon Price

 On top of this there was also the reduction in emissions as a result of the recession. This has had no real impact on the implementation of the renewable energy projects, but it further delays energy efficiency and pushes fuel switching and CCS into the 2030s and beyond. The resultant short term visible carbon price is near zero, but the same high hidden carbon price remains.

 Low EU Carbon Price - with recession 

With a near zero carbon price, no visible sign of CCS and delays in implementing energy efficiency, policy makers may then turn to further mandates, such as the case with the Energy Efficiency Directive. This, in combination with yet another round of renewable energy targets, exacerbates the situation, leading carbon market traders to take the view that their allowances will have minimal value no matter how long they wait.

Very little of this is being discussed in the context of the backloading proposal. Rather, an emotive discussion about trade exposure, the cost of carbon for energy intensive industries and the right or not of the Commission to intervene in the market is dominating the airwaves.

The real discussion needs to be around the role of mandates when an emissions trading system is in operation. As the charts above show, backloading will have very little impact if the mandate issue is not addressed as well. Nevertheless, structural reform needs to start somewhere, so let’s hope the EU Parliament Environment Committee and the Member States will take a more positive view of the importance of the ETS and therefore the backloading proposal, when they vote in February and April respectively.