The case for a set-aside in the EU ETS

One of the big issues that has been debated in the EU since before the ink was even dry on the 2008/2009 Energy and Climate package (EU ETS Directive, CCS Directive, Renewable Fuel Directive etc.) is whether the EU emission reduction target should be adjusted up to 30% from the base 20% originally agreed. Formally, the shift to a 30% target is linked to the nature of an international agreement on climate change. For example, had Copenhagen delivered a new framework within which real and meaningful reduction targets were agreed, there would have been a fairly swift move on the part of the EU to 30%. But of course that didn’t happen.

Rather, we are almost nowhere on the international discussion and in the meantime the EU, like most of the rest of the world, has suffered the impact of the global financial crisis. As is widely recognized, this has resulted in a significant dip in emissions in 2008-2010 because of a real drop in industrial output, resulting in a likely surplus of Phase II ETS allowances and a much lower carbon price going into Phase III (2013-2020) than was ever envisaged. Of course this means that delivery on the 2020 target has become much easier for the EU, but also that much less of the emissions reduction through major change hoped for in the power and industry sectors would actually take place. Put simply, this wasn’t the plan that EU governments had signed up to. They wanted real and visible change, not just compliance with a 2020 target.

The first reaction by many has been to look on the policy shelf, see the 30% option sitting there and propose that this be implemented. The debate over such a move has been vigorous, splitting the ranks of businesses, governments and even non-government organisations. But arguably, there are reasons to consider a change, although a more focused approach is probably what is needed.

The real problem lies in the ETS itself which covers about half the EU emissions, but most of heavy industry and power generation. With a depressed carbon price and the EU ETS stuck at its -21% target (its share of the EU’s overall -20% goal) two things have happened – apart from the lack of emission reduction projects;

  • Some member states have begun to take unilateral action to ensure more happens in their domestic sectors and notably power. The most current example is the proposal by the UK Government to introduce a floor price in the ETS, i.e. a UK carbon bubble. Apart from the impacts that I described in a recent post, a recent report from CDC Climate Research points out that the move also shifts auction revenue from continental EU member states to the UK. This may result in similar policies being developed in other jurisdictions, further undermining the ETS itself. The more the ETS is stifled, the less economically efficient is the reduction pathway in the EU and the more it will cost both business and the consumer.
  • The Clean Development Mechanism (CDM) of the Kyoto Protocol has started to dry up in terms of demand for CERs. It isn’t just the low price doing this, but also the EU limits on CER intake in Phase III while the target remains at 20%. With the CDM being the only substantive component of the nascent global carbon market, problems with it mean big problems for the further development of carbon trade and the carbon market more generally. Of course this isn’t helped by the lack of action in the UNFCCC discussions, but the situation in Europe is just adding to the misery for the CDM.

A potential solution to both these problems is to remove some of the EU-ETS allowances in Phase III and set them aside, either permanently or in a carbon bank for Phase IV and later. This would bolster the carbon price and potentially make mechanisms such as the UK floor price irrelevant which in turn lowers the pressure for other Member States to reciprocate. A set-aside could also be delivered with some changes in allowed CER in-flow, thereby supporting the international carbon market as well.

The set-aside is the proposal on the table today and one which is worthy of real consideration, rather than just a knee-jerk “no” that might be expected from some business groups and Member States. Exactly how many allowances need to be removed, when and by what mechanism have yet to be defined. At a minimum, we should better understand the nature of the economic recovery that is now getting going (albeit significant problems remaining with Member State debt), but by early next year the situation should be much clearer and in any case there is plenty of work to do this year building the case.