As some of you will have seen this week, MEPs in the European Parliament have voted in support of backloading 900 million EU Emissions Trading Scheme (ETS) allowances to the back end of this decade.
This is a positive and important step for strengthening the EU ETS, however in isolation it does not give a significant enough boost to low carbon investors over the long term. The EU ETS needs reform. Without it investments in low carbon generation, fuel switching and energy efficiency will continue will need supported by additional policy mechanisms and the required carbon abatement that we need to undertake as a society will be squeezed to later on in the century.
I was in Brussels last week speaking at a roundtable of interested parties and policymakers. I have come back more optimistic about the future of the EU ETS than when I went as I saw genuine effort and support for reforming the EU ETS to perform the twin roles of capping the emissions we can emit as a society, and providing a robust carbon price signal for investors. There are different opinions about what reform of the ETS should include, but hopefully the European Commission can bring forward proposals for all stakeholders to coalesce around.
Any reforms to the ETS must rectify a fundamental flaw within the design of the ETS - there is no link between the supply and the demand of allowances. As a result, as the European economy has collapsed in recent years and demand for allowances has dropped away, the supply has not. This has flooded the market with surplus allowances, which has in turn caused the carbon price to bottom out.
Without this link, the ETS price will remain volatile, exposing the market to increased risk and expectation of political interventions. The carbon price will then continue to be driven by political noises rather than the economic need to decarbonise – as it is now.
To ensure that there is real structural reform, we view that backloading is just the first step of four to a functioning EU ETS. To describe our four steps, I’ll use a simple household plumbing analogy; backloading has only reduced the flow of water – it hasn’t mopped up the spillage or crucially, fixed the leak. Therefore whilst it’s an important first step, it doesn’t stop your carpets getting wet in the future.
The second step is to fix the fundamental flaw that I outlined above, by linking the supply and demand of allowances in the form of a Supply Adjustment Mechanism or a SAM (which I also blogged about previously). We’re pleased to hear the Commission is coming forward with proposals in the New Year. However, there are a number of details around the SAM and we have expanded them in more detail in the following discussion paper. On a SAM design, the key question for us is how you release allowances from the reserve so that market participants don’t treat the reserve as an extension of the market and price it in, ensuring that the reserve is exactly that – a reserve.
The third step is to correct an obvious flaw by lining up the linear reduction factor, or the annual rate at which the ETS cap tightens, to the expected 2030 and 2050 targets. Once the carbon target is set within the 2030 Climate and Energy Package, it’s a no brainer to align the linear reduction factor to the agreed targets.
Once you have fixed the structural problems (or the leak in this analogy), you need to clean up the mess in the fourth step – dealing with the surplus allowances. This will be much of the focus of the debate in Brussels. There are two realistic options here: cancelling allowances; or putting surplus allowances in a strategic reserve once you’ve set up your SAM. The additional third option, to do nothing, will leave the surplus hanging over the market, depressing the EU ETS price into the next decade. I don’t see this as a viable option if you want the ETS to incentivise carbon abatement in the next decade.
However, as I said before, I’m optimistic that with the clear majority support for the backloading we saw in the European Parliament vote this week, the Commission can feel emboldened to bring forward real structural reform for the EU ETS. So to summarise if I was the Commission President I would:
Step 1) Get backloading through – all but confirmed
Step 2) Align EU ETS linear reduction factor to 2030 and 2050 targets
Step 3) Introduce a Supply Adjustment Mechanism (or SAM)
Step 4) Deal with the surplus
Simplistically, my take away message for European policymakers and legislators would be: thanks for turning the tap off, now fix the leak and get the mop out.