A set-aside for the EU ETS

Interest in the EU Emissions Trading System (ETS) is high at the moment in the European Parliament. MEPs are being asked to support a key amendment to the proposed Energy Efficiency Directive which will see the removal (set aside) of a substantial number of allowances from the Phase III auctions. Such an action would bolster the EU carbon price. Not surprisingly, the upcoming ITRE Committee (Industry, Research and Energy) vote has polarised business groups. I have written about the need for such action in the past, but thought it would be useful to outline the case once again.

A Baseline Correction for the EU ETS

The EU Emissions Trading System (ETS) is the flagship instrument within the EU energy and climate policy framework, and is designed to deliver emission reductions at lowest cost to the economy and provide the necessary price signal for the development of low-emission energy technologies. But the EU ETS is now faced with issues of real environmental improvement and international credibility.

Compliance with the EU’s 2020 target, of a reduction of greenhouse gases to 20% below 1990 levels, is almost a given as a result of a growing surplus of allowances in the system. This hasn’t come from real changes in the EU energy mix driven by the carbon price, but from a combination of industrial downturn and compliance with an increasing number of overlapping energy and environmental policies at both EU and member state level.

The market that develops as a result of an ETS is unlike other commodity markets, in that it is an artificial construct with a fixed supply of allowances determined by the desired emissions cap. Supply cannot naturally adjust when major changes to the system take place, such as in the current economic circumstances.

The underlying purpose of an ETS is not simply to meet an arbitrary target, but to impose a certain level of ambition on the covered sectors to catalyze the transition to a low-emission economy. If those sectors undergo a macro-level change, so too should the ETS to ensure that this level of ambition is maintained. Otherwise, there is no incentive for any underlying environmental improvement, because demand reduction hits the system. A similar argument could also be made for the case of a macro change that significantly increases demand, where the economic penalty on the system would otherwise become burdensome. This is also no different to the baseline changes that companies make when measuring emissions against a voluntary target, as would be dictated by, for example, the Greenhouse Gas Protocol.

Supply-side measures to enable such a baseline change are now required in the EU ETS. The current allowance surplus (now around 1.4 billion allowances) needs to be removed from the system to restore the ambition level, or scarcity, originally intended. A set-aside of allowances from the auctions in Phase III (2013–20) is the only short-term option available. There exists an opportunity through the discussions on the proposed Energy Efficiency Directive to do this, thereby restoring value to the system. The original system design rewarded action in Phase II (2008-12), on the expectation of scarcity in Phase III; this needs to be reintroduced.

With limited experience in operating trading schemes, it was difficult to foresee that predicting emissions would be so challenging. Most systems have therefore not been designed with sufficient supply-side measures to ensure the required robustness. This is a key learning point and should feed into EU policy formation as design discussions for Phase IV get underway in the coming years.

However, this would be a one-off measure. A longer term fix to the system is necessary. There is a body of literature that argues in favour of combining certain features of both price-based and quantity-based instruments, to create so-called hybrid policies. A recent example[1] concluded that trading schemes with price-like features, such as an reserve price below which allowances are not auctioned, should be considered to support carbon prices. An auction reserve price could be established for Phase IV of the EU ETS, thereby giving a long-term carbon price signal and providing companies some certainty over the return on investment in abatement technologies. Furthermore, an EU ETS auction reserve price would remove the need for EU member states to act unilaterally in this direction, such as recently done by the UK with its introduction of a carbon price floor.

Some may argue that a period of financial uncertainty is not the time to act, with some businesses struggling and unemployment rising. However, sectors exposed to international competition are given a transition period through the allocation of free allowances up to 2020 and are aware of Europe’s requirement to move towards a competitive low-carbon economy. Taking this opportunity to adapt to such an economy is vital for the future success of EU manufacturing as other regions and jurisdictions start to see the value in this new business opportunity. As recognised by the International Energy Agency, the EU ETS is the most cost-effective way for EU companies to meet climate change targets while remaining competitive, which then ensures energy costs and goods remain affordable for consumers.

Since the EU ETS is a leading symbol of the effort to tackle global climate change and reach Europe’s environmental targets, it is critical that the European institutions take decisive action now, with a baseline correction by setting aside and cancelling allowances from the Phase III auctions, and the introduction of an auction reserve price from Phase IV. These two measures would enable the EU to achieve the dual energy mix and emission goals that it has, but importantly still relying on the energy markets as the force for change.

[1]  Fankhauser, Samuel and Hepburn, Cameron and Park, Jisung (2010). Combining multiple climate policy instruments: how not to do it. Climate Change Economics 1 (33), pp. 209-225. ISSN 2010-0078