Reforming Carbon Trading

Postponing the auction of some 900 million carbon allowances is necessary in order to stabilise the carbon trading system, says the Commission.
 
The recession that started in 2008 led to lower-than-planned carbon output, which, combined with an increasing allotment of allowances, led to an over-supply of allowances and hence prices dropping to unacceptably low levels.

According to a new report, allowances for the 2013 to 2015 period should be ‘back-loaded’ until the next phase of the EU emissions trading system, which ends in 2020. Other structural measures are also recommended.

This means that fewer allowances under the EU’s Emissions Trading System (ETS) would be offered in the short term, while demand remains very low. More would be available later, when demand will most likely have recovered.

State of play

The EU ETS functions in the following way. Allowances are regulated and issued to Member States on a case by case basis, based on their industry needs. More allowances can be obtained via funding of green projects in developing countries to obtain international credits to meet the 2020 GHG reduction targets.

Allowances are tradable to set the carbon price on the market in the short, medium and long term according to market rules (supply-demand interplay). The volume of allowances issued is annually decreased by a linear factor of 1.74%.

The key changes in the phase three of EU ETS, agreed upon in 2008 and applicable as from 2013 until 2020, have largely been implemented. However, the economic crisis of 2008 has caused a drastic imbalance between the supply (issued allowances and used international credits) and actual demand from the industry (based on reported emissions) during the ETS phase two.

 An accumulated surplus of 955 million allowances in 2012 caused large carbon price volatility, and rendered the EU ETS inefficient in stimulating investment in clean technologies. This imbalance could negatively affect planned reductions in greenhouse gas (GHG) emissions, which is vital if Europe is to achieve its EU 2020 targets.

Analysis

The report estimates that the supply of allowances is expected to increase in the short-term, mainly through forward selling for ETS phase three to generate funds for:
• Carbon capture and storage (CCS) and innovative renewables (RES)
• Early auctioning to meet power sector demand
• Selling of left-over allowances in national phase two reserves

The surplus is to be expected to increase in 2013 potentially, but will slow down beyond 2014. However, the surplus is not expected to decline significantly, creating accumulated structural surplus of around 2 billion allowances in the ETS phase three.

Recommendations

To tackle this negative trend, the Commission proposes the so called ‘back-loading’ of volumes of allowances during the phase three to rebalance the supply and demand and reduce price volatility.

However, the accumulated surplus will maintain affecting the EU ETS even beyond 2020. Therefore, a structural measure may be needed to correct this over supply. Here the Report provides six recommendations.

Increase the EU reduction target to 30% in 2020

Should this 2020 target be increased from current 20% to 30%, the quantity of allowances in the EU ETS will need to be adjusted accordingly. This could be done either via permanent retirement of allowances or a revision of the annual linear reduction factor.

The Commission calculates that the amount of allowances to be adjusted is on the level of 1.4 billion. This step would also have implications on the targets under Effort Sharing Decision.

Retire a number of allowances in phase 3

This option would require primary legislation and could be implemented by a separate decision rather than a revision of the EU ETS Directive.

This measure would address the overall supply-demand imbalance over phase three and ensures that the ETS contributes to RES and energy efficiency targets. But it would not affect the framework after 2020. The concrete volumes and timeframe would need to be outlined in detail.

Early revision of the annual linear reduction factor

The current linear reduction factor of 1.74% annually applies also after 2020. The original review is planned beyond 2020.

An early review of this factor could address the supply-demand imbalance and restore 2020 targets ambitions with impact beyond 2020. This option combined with increasing the 2020 reduction target to 30% would achieve the 80-95% reduction in the ETS cap by 2050 compared to 1990.

Extension of the scope of the EU ETS to other sectors

This option foresees the inclusion of other, less prone to cyclical economic changes sectors in the EU ETS. This extension could increase the overall reduction ambition. More analysis is needed to address the issues of reporting and surrendering allowances in these sectors.

Limit access to international credits

The quantity limit on international credits has been generous so far being the main contributor to the accumulated surplus in allowances. Without international credits the EU ETS surplus by 2020 would constitute only 25% of currently expected surplus.

In phase four, such regulatory framework could allow for more investments in clean technologies, instead of technology transfers in the EU ETS. Additional shocks on the carbon market could be addressed via remaining surplus.

Discretionary price management mechanisms

The Commission proposes creation of carbon price floor, setting a minimum price to allow for investor certainty on the market.

Alternatively, the supply-demand imbalances may be addressed through price management reserve influenced by allowances. This reserve could be funded by reducing phase three auction volume, which would decrease the surplus in the EU ETS. This volume may be retired permanently.

However, these measures carry a risk of being administratively and politically decided rather than being supply-demand outcome.

Conclusions and next steps

To safeguard the technology neutral, cost-effective character and harmonised component of the internal market, the Commission proposes action in two areas:
• Amendment to auctioning timetable in terms of volumes and amounts. Draft proposal has been published by the Commission along this Report
• Structural measures to be discussed and adopted in order to tackle the structural surplus in allowances in phase three

The Commission welcomes stakeholders’ views on proposed structural measures, and will launch a formal stakeholder consultation process shortly.