Getting carbon markets back in order

The EU Emissions Trading Scheme (ETS) is here to stay and stakeholders share a common vision on how to fix it, that was the basic takeaway from a roundtable on carbon market reforms FleishmanHillard hosted along with SSE and Oxera last Friday.

For those whose full time job is not in the EU Energy or Climate field, the ETS is the largest multi-country, multi-sector greenhouse gas emissions trading scheme in the world and the chief instrument for the EU in meeting its emissions reduction targets. However, a huge surplus in allowances has seen prices fall from €20 a tonne in 2011 to €5 a tonne today, reducing incentives to switch from heavily polluting fuels such as coal to cleaner alternatives such as natural gas or renewables, like wind and solar power.

Given the timely nature of the event (At the time of writing, the famous backloading  dossier which through the tempera removal of allowances would prop up the carbon price has just received the backing of MEPs in Plenary) it was little surprise that over 40 participants came to FH’s offices to exchange views with the Commission, industry and NGO’s on how best to get the EU’s principal GHG reduction instrument back on track.

What was perhaps a little more surprising was how aligned participants – EU policymakers, NGOs and industry types alike — seemed to be in their thinking on what should be the next steps to fixing the ETS and getting the EU carbon market back in order.

In November 2012, the European Commission, in its ‘”State of the Carbon Market in 2012″ document, presented 6 potential options to reform the EU ETS. At the roundtable it became apparent that a loose consensus was emerging around the following three-step approach, which includes elements of the Commission’s thinking but also a number of new elements that have been introduced by stakeholders in recent months;

Step 1 – Backloading: The backloading of 900 million EUA would be a necessary but far from sufficient first step. The backloading of allowances should prop up prices temporarily above the current €5 a tonne number but will not increases prices to the €25-30 a tonne figure original envisaged by the Commission to stimulate low carbon investment and new technologies. With MEPs having given their support to backloading in a full European Parliamentary vote Tuesday, Member States should do likewise in coming weeks, by approving backloading. The first allowances to be backloaded in 2014 or 2015 depending on what timetable the Climate Change Committee decides Dec. 16.

Step 2 -Early reduction of annual linear factor: This tool is effectively an annual decrease in the amount of allowances in the system and is in line with one of the six options laid out by the Commission. Reducing the supply would push up the ETS price. Participants at the FH event suggested revising the annual linear reduction factor by -1.74% as soon as possible, most likely in 2016 or 2017. Some participants noted that it was possible to even go beyond 1.74% to a more ambitious 2.5% reduction.

Step 3 –  Supply adjustment mechanism (SAM): A supply adjustment mechanism would automatically, based on pre-determined rules, adjust the supply of allowances in case of significant deviations in the economic development. The idea of having a supply adjustment mechanism to act as a ‘shock absorber’, independent of political interventions, was first floated by IETA in reaction to the Commission’s stakeholder consultation. Support for this measure has been growing consistently since with DG CLIMA Commission also seemingly supportive.

The main difficulty with the SAM remains how the adjustment mechanism should kick in. It could be a) Emissions-based – simply identify a lower and upper threshold; b) GDP-based – reliant on economic activity and c) ETS allowance Price-triggered – seen by many participants as the simplest option to implement but more politically challenging.

Looking ahead, the Commission will most likely come forward with a proposal on structural reforms of the ETS in January, most likely as part of the large package of policy proposals to be released on January 22; this package is also expected to include a 2030 Climate and Energy framework, a study on the various factors that drive energy prices and a formal Commission view on shale gas (A Commission policy proposal on shale gas also remains a possibility).

Given the legislative timeline,  the proposal introduced in January will not be finalized in this Parliament, but will rather seek the endorsement from Member States at the European Council summit in March.

As one participant noted at the FH roundtable: given the huge oversupply of allowances in the ETS today, without the possibility of reform, the price of ETS allowances would actually be closer to zero rather than the current €5 a tonne level. The €5 a tonne price represents investors’ confidence, however thin, that policymakers can introduce meaningful reform to a collapsing market.

After the Commission shows its hand in January, all eyes will be looking at the Council in March to demonstrate that the political will exists at the highest level to reform the ETS.

Cillian O’Donoghue