The EU’s breath of fresh air

The EU has made the right decision in sticking with its flagship climate policy, the Emissions Trading Scheme (ETS), which — following agreement by MEPs and EU member states on 5 May — will now be reformed by the end of the year.

For many years, it has been clear that the EU was facing a tough decision: either to reform the ailing scheme, or to scrap it.

Introduced in 2005, the EU ETS had one key design fault — it was unable to respond to demand-side shocks by adjusting supply.

Since the 2007 economic crisis, demand for allowances has crashed as firms need to generate less power and produce fewer commodities. So the price of allowances crashed, too, from €17/t CO2 equivalent (CO2e) in April 2011 to €5/t CO2e just two years later.

Some argued that the EU ETS could still be a successful instrument. In effect the scheme sets a carbon budget — the total amount that can be emitted in a particular period of time, known as the cap.

Because emissions were well below the cap, this meant, according to the original design principles of the EU ETS, that there was scope for extra emissions once economic growth returned. The cap had been legally agreed, and could not be exceeded, so what was the problem? Such flexibility was exactly the point of an ETS.

The problem was that policymakers wanted the function of the EU ETS to be twofold: yes, to keep EU emissions within the cap, but also to incentivise low-carbon innovation through a high short-term carbon price.

Numerous studies had shown that the faster cuts in emissions were made, the less they would cost.

Prices of over €20/t CO2eCO2e were required for even the most marginal abatement — usually coal to gas fuel-switching — to take place, but prices in the scheme have not risen above €10/t CO2e since the start of 2012.

This made reform vital because the industries involved in the EU ETS work on such long-term investment cycles. A lack of a strong carbon price in the short term might mean that further high-emitting power stations or industrial facilities are built, locking their emissions into the system for years to come.

The solution the European Commission settled on was called a market stability reserve (MSR). The MSR works by vacuuming up excess allowances and fencing them off so that they cannot be bought or sold, effectively shortening a long market.

Similarly, if the market is found short, allowances are released from the MSR. The mechanism works according to a strict formula to provide predictability.

The real beauty of the reform is that it also solves, in one fell swoop, a number of other problems that could have contributed to oversupply in the future: the return of previously removed allowances to the market by the back-loading fix; reduced buying by utilities as a result of ever-increasing renewables generation and stringently pursued energy efficiency regulation, and the re-entrance of permits that were set aside for new industrial units that never joined the EU ETS.

In one neat stroke this solved what had been one of the central problems of the EU ETS from the start, namely, how to create some long-term investment certainty in a market driven entirely by regulation. The dynamic nature of the reform has led many to think that another intervention will now not be necessary. The MSR will be reviewed at regular three-year intervals to ensure that the speed of removal and return, and the number of allowances being removed and returned are correctly calibrated. But, if all works well, no further primary legislation should be required to alter the fundamental mechanics of the scheme.

There are still challenges ahead — getting provisions around carbon leakage right, and ensuring adequate ambition in the caps — but fundamental confidence in the scheme does not revolve around these peripheral issues, whereas it was severely dented by the oversupply problem.

So, why prop up the heavily-criticised scheme rather than scrap and replace it with, say, a carbon tax?

Two main reasons. Firstly, an ETS can provide a guaranteed cap on emissions where a carbon tax cannot. And an ETS can ultimately be linked with other schemes — China already has a national ETS in development — to create a global cap on emissions and create a steady, global price on carbon.

This is not just a climate policy wonk’s dream: it was also called for by thousands of investors and businesses last year as the central tool for tackling climate change.

That’s why EU leaders were right to stick with the scheme, and that’s why other nations will now be looking to the EU ETS as the future of climate policy.

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