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OVERVIEW | The Proposed EU ETS Market Stability Reserve: Where are we now?

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The Proposed EU ETS Market Stability Reserve: Where are we now?

The Proposed EU ETS Market Stability Reserve: Where are we now?

On 24 February, the Committee on Environment, Food Safety and Public Health (ENVI) of the European Parliament (EP) took a vote on the Market Stability Reserve (MSR) mechanism, a crucial issue as regards the functioning of the European Emissions Trading System (ETS), in view of the new targets for 2030 set by the European Council on 23rd October 2014, namely a 40% reduction in Greenhouse Gas emissions (GHG) compared with 1990 and a 27% share of Renewable Energy Sources (RES) in the EU's final energy consumption. This is to be the latest in a series of actions by the European Council and the European Parliament (EP) on this mechanism, which was first put forth by the European Commission (EC) on 22 Jan 2014. This followed the discussion in the Council (Environment) on 17th December 2014, the tabling on 7th January 2015 of a new draft proposal for a Council Decision by the Latvian Presidency and the inconclusive opinion vote of the Industry and Energy Committee (ITRE) of the EP on 22nd January 2015.

 

The MSR mechanism is the latest attempt to provide stability in the volatile market of ETS allowances which has seen dramatic price fluctuations in the past that have undermined confidence in its effectiveness in reducing emissions. The price of allowances is the driving force for companies that fall under the purview of the ETS Directive (especially power generating companies) to reduce their emissions. The price dropped from a high point around €25-30/tnCO2 during the pilot 1st Phase of 2005-2007 to around €15/tnCO2 during the 2009-2011 period. It then dropped further to a lower plateau of approx. €5-7/tnCO2 after the second half of 2011 where it has remained, with dips as far down as €3.5-4.0/tnCO2 in mid-2013. The start of the drop in June 2011 followed the release by the EC of its draft text for the Energy Efficiency Directive at a time when the EU economy was not showing any signs of recovery. In the last year, the price has varied between €5/tnCO2 and €7/tnCO2 although an interesting development is the latest 10% increase in the first week of February 2015 possibly in anticipation of the ENVI Committee vote.

 

The EU ETS is a cap-and-trade system and as such it can help ensure a ceiling for GHG emissions in a given period but not a fixed price per tonne. This is in contrast to a CO2 tax, which was almost adopted by the EU in 1994, which would provide for a fixed price but cannot ensure specific emission reduction amounts. The volatility of the CO2 allowance price does not help medium and long term planning. The observed volatility has lately been the subject of a number of studies (e.g. [1], [2]) to identify its underlying drivers. The idea would be to provide guidance to state planners, investors and company management, also in view of the extensive interest in the ETS shown by major emitters such as China. Some of the drivers that can be most easily identified and analysed include economic activity (and the ongoing recession), renewables policies, energy prices and the use of international credits but also the impact of singular events. This interest was also kindled by the initiation of energy/climate planning by the EC looking beyond the existing 2020 Roadmap to 2030, and further to the long term 2050 targets as laid out in the EC Roadmaps for the Low Carbon Economy and Energy

 

In evaluating the effectiveness of the EU ETS, the EC came to the conclusion that the price signal of the ETS had been too weak as lower demand together with considerable use of international credits resulted in an oversupply. In an attempt to fix this, the EC adopted in February 2014 a Regulation for the withdrawal from the auction market of 900 megatonnes CO2 in  the early years of the 3rd ETS Phase (2013-2020) and their release in 2019 and 2020 (backloading). Yet, its estimates continued to show a large surplus all through the 2020-2030 period as shown in the Figure above.

 

As a result, the EC proposed its Market Stability Reserve mechanism to start operation in 2021 which was based on the following:

  1. If the total surplus is higher than 833 million allowances, allowances are added to the Reserve by deducting them from future auction volumes.
  2. If the total surplus is below 400 million allowances, allowances are released from the Reserve to future auction volumes.
  3. The release of the allowances will be carried out in tranches of 100 million allowances per year.

On 11 November 2014, Mr. Ivo Belet, Rapporteur of the ENVI Committee presented his recommendations to the Committee which included the following points:

  1. The placement of the whole 900 million withdrawals directly into the Reserve which will still go into operation in 2021 or possibly earlier.
  2. An evaluation of the surplus and the deductions/releases to be carried out annually rather than every 2 years.
  3. There is a need for more in-depth review of the free allocation provisions to industries in sectors that are susceptible to carbon leakage and to ensure that they are not at risk from international competition.

The latest draft submitted by the Latvian Presidency incorporates the Rapporteur’s recommendations but changes the ceiling value from 833 Million to 12% of the previous year’s allowances in circulation. A number of Member States (UK, France, Germany, Cyprus) have already submitted their views on the MSR as have environmental NGOs and Industry associations. Climate Action Europe (CAN), an NGO umbrella organisation, proposes that the Reserve starts operating in 2016, that the backloading allowances be cancelled and that the ceiling and floor levels be tightened, whereas industrial organisations worry about the effectiveness of the relief included in sectors subject to carbon leakage and additional costs in relation to their international competitors.

 

On 24 February 2015, ENVI Committee voted to ask for the introduction of the MSR by the end of 2018 instead of in 2021. The Committee also proposed that the 900 million allowances that were to be withheld from 2014-2016 in order to be “backloaded” should be transferred into the MSR, and not returned to the market from 2019 as initially foreseen, while the profits from the auctioning of 300 million unallocated allowances should be invested in an “Energy Innovation Fund” to finance industrial innovation and low-carbon projects. On this basis, the Committee mandated Rapporteur Ivo Belet (EPP) to begin direct negotiations with Member States, with a view to achieving a final agreement as soon as possible.

 

Still, a number of questions remain, brought up in reviews of the MSR by various academic organisations (e.g. [1], [2], [3]), regarding the design philosophy of the MSR and the relative contribution of the various drivers of the allowance price. In these reviews recommendations have also been presented, for example the substitution of upper and lower boundaries of surplus quantities by boundaries on the price itself (as is the case in the US Regional GHG Initiative) which is thought to be more effective and would certainly provide clearer guidance for planning and investment purposes. In addition, if demand as well as price is strongly influenced by long term expectations, for which the results of the upcoming Paris United Nations Framework Convention on Climate Change (UNFCCC) meeting in November will be crucial, MSR is judged to be less effective in providing the reasonable stability that is needed by the markets. Finally the compatibility aspects related to future possibilities of linking the EU ETS with other trading systems should also be taken into consideration. In conclusion, MSR is a necessary fix and despite possible shortcomings, it will help in improving the effectiveness of the price signal given by allowances.