The EU drives forward on its emissions trading scheme

Teething trouble

The European Union’s Emissions Trading System (EU ETS) allocates pollution permits among heavy energy using installations in 31 European countries. These permits are tradeable; meaning that companies that can reduce pollution at lower costs can pick up the slack for companies for which it is more costly. Theoretically, this reduces pollution by the desired amount at the least overall cost.

Policy has been developed to reach deeper into and further across European polluters during the scheme’s implementation ‘phases’; currently the EU ETS covers around 45% of all EU greenhouse gas emissions making it the world’s largest tradable pollution permit system (Bayer, Aklin, 2020).

The key to the systems long term success is a sensible and stable price so there is sufficient financial incentives for firms to invest in carbon reducing and offsetting schemes.

In phase 1 (2005-2008) it became apparent that allocations greatly exceeded actual emissions and so the price collapsed. In the second phase (2009-2012) the rules of the market were changed so that permits can now be held to be redeemed at a later date, this stimulated demand briefly before the global financial crisis.

The ensuing reduction in demand for carbon intensive activities meant that a large surplus opened up in the market; allocations traded at well below 20EUR/tCO2e and approximately 1.8 billion permits were left unused by the end of 2012 (Muûls, Colmer, Martin, Wagner, 2016). So, despite concerted efforts to maintain a price sufficiently high to incentivise decarbonisation, allocations have traded at relatively low prices for much of the scheme’s existence.

Nonetheless, the EU ETS has led to an estimated 11.5% reduction in emissions from regulated industries between 2008 and 2016. This is partly attributable to the fact that the scheme, as part of the wider political narrative, implies that polluting will come with increasingly high costs in the long term. Industry is therefore keen not to waste time in decarbonising (Bayer, Aklin, 2020).

Volatility is not over

As the system enters its next implementation phase at the end of 2020, regulators must remain committed to the long term aims of the system in order to further increase the speed of decarbonisation. There has been considerable price volatility following the reduction in emissions from aviation in particular as a result of lockdowns across Europe this March. Allocations slipped from the relatively high and stable price that had been enjoyed throughout much of 2019 to a 16-month low.

Polluters and speculators alike are becoming increasingly cautious of the wider shift in public opinion that will likely lead the EU to tightening market rules at the end of the current phase (Hatherick, 2020). This has led to a recent rallying of the market that has placed allocations at their highest price in well over a decade.

Following intense lobbying from the International Emissions Trading Association and a revision of the EU’s 2030 emissions target to a more ambitious 40% reduction on 1990 levels;   the EU is expected to reduce the quantity of free permits it allots the aviation industry and increase the number of surplus permits it effectively removes from the market with its market stability reserve.

Allocations are already auctioned off in annually decreasing quantities, however in the schemes newly revised next phase (starting 2021) the total quantity of allocations will be reduced by 2.2% annually rather than the previous 1.74% (European Commission, 2020).

A meaningful next phase:

With the application of such policies, the price of carbon is expected to average at around 32 EUR/tCO2e across the next decade. Despite being a large improvement on the systems performance over the past decade this may not be high enough; it has been suggested that a price of around 55 EUR/tCO2e in 2020, increasing to as much as 180 EUR/tCO2 by 2050 is required to force industry onto a trajectory leading to net carbon zero by the mid-century (Holder, 2020).

The uptake in the market is spurred on in part by the prospect of a tightening of the supply side. This is a promising sign that if the correct policies are implemented, the system may be able to reach a steadily increasing and meaningfully high price within the next phase and proves that the continued commitment of the EU to the ETS is crucial if the scheme is to remain the cornerstone of European decarbonisation policy.

By Ed Cox

References:

Bayer, P, Aklin, M 2020, The European Union Emissions Trading System reduced CO2 emissions despite low prices, Proceedings of the National Academy of Sciences of the United States of America, <https://www.pnas.org/content/117/16/8804#sec-4>

European Commission 2020, EU Emissions Trading System (EU ETS), <https://ec.europa.eu/clima/policies/ets_en>

Hatherick, V 2020, EU mulls ETS aviation changes, Argus Media, <https://www.argusmedia.com/en/news/2121349-eu-mulls-ets-aviation-chang es>

Holder, M 2020, How best to solve a problem like carbon pricing, BusinessGreen, <https://www.businessgreen.com/news-analysis/4016807/best-solve-carbon-pricing>

Muûls,M , Colmer, J, Martin, R & Wagner, U.J 2016, Evaluating the EU Emissions

Trading System: Take it or leave it? An assessment of the data after ten years, Imperial College London, <https://www.imperial.ac.uk/media/imperial-college/grantham-institute/public/publications/briefing-papers/Evaluating-the-EU-emissions-trading-system_Grantham-BP-21_web.pdf>