The economics of the EU ETS market stability reserve

The European Union Emissions Trading Scheme (EU ETS) is currently the largest carbon trading system in the world, unless and until it is overtaken by the Chinese national carbon trading scheme planned for introduction in 2017 (Jotzo and Löschel, 2014 and Zhang et al., 2014). Although the EU ETS is meeting its core objective – EU emissions covered by the scheme remain below the total emissions cap – it is sometimes described as having ‘failed’ because prices are too low to incentivise substantial short-run emissions reductions and too volatile to provide adequate long-run incentives for investments in clean technologies.

European Allowances (EUAs) – the unit of compliance – have traded below €10 from 2013 onwards (EEX 2016). The price is below most estimates of the social cost of carbon for example as used in US government regulatory analysis (Greenstone et al., 2014; Goulder and Williams, 2012; United States Interagency Group, 2015). It is also low relative to the implicit price used internally by many companies when making their investment decisions. For instance, several multinational oil companies use internal screening prices of US $40/€35 or more (Kossoy et al., 2015), even though they operate in jurisdictions that are, on the whole, subject to lighter carbon regulation than in Europe.

There are various reasons for the low EUA prices. These include the reduction in economic output and emissions following the financial crisis, the complementary EU policies on renewables and energy efficiency (Koch et al., 2014), and the volume of international credits from Clean Development Mechanism (CDM) offsets available to partly acquit emissions obligations within the EU ETS (Ellerman et al., 2016 and Laing et al., 2013). Emissions allowances issued each year began to exceed actual annual emissions in 2009 (Redman and Convery, 2014) and a large surplus has been built up through banking. EUAs trade at above-zero prices only because of the expectation that the cap will be binding at some point in the future (Edenhofer et al., 2014).

The simplest way to increase EUA prices would be to reduce the total allowances in circulation. The 2030 Climate and Energy Reform Package (European Council, 2014) decided that the annual (linear) reduction factor for the EU ETS will be increased from 1.74 to 2.2 percent per annum from 2021-2030. By reducing the allowances issued in each future year, this policy change would be expected to lead to increasing EUA prices in the long run. And, because markets are forward-looking and EUAs can be banked into later periods, an impact on current prices would be expected. However, the impact of the announcement on current prices has been limited and concern remains that current prices are not sending appropriate signals to industry.

Another direct way of raising EUA prices would be to establish a price floor, which could be implemented through a minimum (reserve) price for newly issued EUAs at auction (Roberts and Spence, 1976, Weitzman, 1978 and Hepburn et al., 2006; Wood and Jotzo, 2009). This would reduce the supply of EUAs to a level that achieves any desired minimum price in the spot market. The California, Quebec and Regional Greenhouse Gas Initiative (RGGI) trading programs all operate with a price floor (ICAP, 2016), and in each of these programs the price floor has been binding in at least one auction and the price has subsequently risen above the floor. Price floors can be combined with price ceilings to form price collars or corridors (Burtraw et al., 2010 and Fell et al., 2012).