Bursting the Bubble

The unclear future of EU-ETS: is there still a chance of success?

5 February 2016 | by
eu ets

The EU-ETS has been a cornerstone tool for combating rising greenhouse gas emission levels since its inception. It began to embody the “polluter pays” principle, which pointed out that emissions create external costs (damage to air, water, soil etc.) that should be paid for by those who produce the emissions. This will make polluting a costly affair and gently nudge the industry towards cleaner production methods.

Fast forwards to 2015 and the current situation is bleak. The price of carbon is less than ‎€7 per permit, way below an impactful threshold. Only around 45% of emissions in EU are currently covered by the ETS, with a number of exceptions, and up to half of all the permits are being given away for free. The result is plain and simple – it is cheaper to pollute. Not only that, but the low carbon price makes it hard, if not impossible, for certain new technologies to emerge, such as Carbon Capture and Storage. For CCS to be competitive, the carbon price should shoot pass €30 mark and we are a long way off from that. With over 10 years in existence, the EU-ETS is still more of a suggestive  than an assertive force to the industry. To understand why we arrived here, let us take a look at the history of EU-ETS.

The EU-ETs came to be in 2005 as more evidence began to tie climate change with man-made emissions. By setting a cap on the total emissions to be released from the participating installations (such as power plants and factories), the ETS would stop the growth of emissions and then reduce them by shrinking the total amount of permitted emissions on a yearly basis. To create accountability, permits were given to the participating installations that would have to be returned for every tonne of carbon (and later other substances) emitted at the end of the year. Additional permits can be bought from other installations, if they have not used up their allocation, and are willing to sell them. This way businesses that find it more feasible to modernise will do so, while others will instead purchase additional permits when needed. This allows emission reductions in areas where it is most cost efficient. The money generated through this system is then used to fund innovative low-carbon technologies and projects in EU and abroad. This description explains EU-ETS in a nutshell, but while the theory seems sound, experience shows there is plenty to work on.

Phase 1 of EU-ETS (2005-2007) saw the price of carbon collapse to €0. Because the mechanism necessary for monitoring and accountability were not in place yet, the total cap on the emissions was decided using best estimates, which led to too many permits being available in the market. In addition, neither aviation nor maritime transport was included in the scheme, and the installations that were included consisted of just power generations and energy-intensive industrial sectors (with plenty of exceptions). Granted, this was a deliberate test phase emphasizing learning through doing, and many of the issues, were fixed.

Phase 2 (2008-2012) experienced some adjustment: additional installations were now covered by the ETS, fewer permits were available, the emissions cap was reduced, and only up to 90% of permits could be distributed for free. The system’s bolts were being tightened, but it was not bullet proof and the 2008 economic crisis proved it. As the industrial output of Europe fell, so did the emissions, reducing the need for permits and their cost. The lack of a balancing mechanism, a buffer for economic ups and downs, wasn’t present, and the consequences of it are still felt today with the price of carbon permit swinging below €7.

Fast forward and we are currently in Phase 3 of EU-ETS with little respite in view. It was probably expected that as the economy recovers, the need for more permits will grow, and so will the price. However three elements were underestimated: the speed of economic recovery, EU’s green agenda, and the number of excess permits. The industry did not recover as quickly as envisioned, depressing the carbon permit price further, and making the excess number of them even a bigger issue, since the surplus is not shrinking and there is no mechanism in place to pull out the permits mid-phase.

Granted, 900 million permits were temporarily withheld from being traded but that did little to improve the permit price. Also, after over a year of deliberations, we finally have the Market Stability Reserve, which will serve the purpose of pulling out permits from future auction volumes if the total surplus is above 833 million allowances, and returning them if the surplus falls below 400 million. However, the market reserve will be established in 2018 and the allowances will be moved from 1st of January 2019. This means the already depressed prices will continue at least for another 2-3 years, and even then it does not mean the mechanism will achieve its goal.

The issues of EU-ETS are as much political as they are technical. Some of the Member States will fight tooth an nail to keep within the active market as many permits as possible to retain competitiveness in the market. Think Poland and its dependence on coal to generate 85% of its electricity needs. It will be crucial for a substantial amount of permits to be removed in order for there to be a noticeable price boost. This will be made difficult by the third issue – the current EU environmental policies.

The EU saw an opportunity in the economic downturn. While the energy needs were lower and production was down, renewable energy and stricter emissions regulations took centre stage. Instead of firing up old fossil fuel plants and building new ones, more and more of our energy needs are being met with clean power. This is coupled with the tightening of emission regulations to air, soil and water, and lower energy requirements through improving energy efficiency regulations. Even at full capacity, the economies of Europe will no longer produce the same amount of emissions that the cap of the Phase 3 was calculated for. Unless the math is correct, and the increased annual reduction in total number of permits available and the stability mechanism size matches the pace of  development of low carbon economy, the price will not rise much, if at all.

This is what the currently ongoing EU-ETS related Directive review is trying to avoid. The goal is to cut the size of the cap put on the emissions, increase the speed of the yearly cap size reduction, backlog some of the permits using Market Stability Reserve and set up the Innovation Fund, that will use the money made through EU-ETS to fund low-carbon technology development and demonstration.  However if our previous experience is anything to go by, the slow pace of legislative process and the need for often eye-watering compromises may produce a system that would be a good fit for the decade that passed, not for today’s world.

What do you think?