Welcome to my mini-lecture series on why the EU emission trading system's stability mechanism
needs a new design.
My name is Krisha Perino and I am a Professor of Environmental Economics at the University
of Hamburg.
Another one, the EU emission trading system has a broken autopilot.
Why the market stability reserve destabilizes the EU ETS and undermines other climate policies.
The EU emission trading system is the backbone of EU climate policy.
It imposes a binding carbon emissions from large stationary emitters and inner EU flights.
Each year it issues a predetermined and decreasing number of emission allowances that can be
used to emit one ton of carbon dioxide immediately or at some point in the future.
After about a decade of low prices, in 2018 a reform increased ambitions and changed its
design.
This re-established confidence in the market.
Emissions have risen from €5 per tonne in 2017 to €40 in early 2021.
This is a great achievement.
Before the 2018 reform, the cap on emissions was fixed and hence additional climate policies
only reduced the price of allowances but not total emissions.
The 2018 reform changed the basic design of the EU ETS.
Now due to the market stability reserve, total emissions are no longer fixed.
They respond to market outcomes.
The market stability reserve is like an autopilot.
It is supposed to stabilize the market by reducing the supply of allowances when there
are plenty and increasing it when the market is tight.
It does so by adjusting the cap on emissions based on the number of allowances firms store
for future use.
The more allowances firms transfer to the next year, the smaller the number of allowances
made available in the future and vice versa.
The hope was that this automatic cap adjustment would reduce total emissions in response to
climate policies targeting the same industries as the EU ETS, such as renewable support schemes,
energy efficiency measures and code face-outs.
If firms abate more today, they also transfer more allowances to the next year and the market
stability reserve in turn reduces the number of newly issued allowances.
So far, so good.
Unfortunately, the design of the market stability reserve has a fundamental flaw.
The number of stored allowances is a good measure of what happened in the past.
However, it tends to be systematically off with respect to the future.
The market stability reserve responds to anticipated future changes in market fundamentals in exactly
the wrong way.
If, for example, a larger member state announces to phase out coal-fired power plants over
a decade or two, this implies that in future years there will be less firms competing
for allowances.
The price of allowances drops.
Firms emit more today, hence they will save fewer allowances for future use.
The market stability reserve responds by increasing the cap compared to a situation without the
coal phase-out.
Hence, announcing to shut down a coal-fired power plant in ten years has the perverse
effect of increasing total emissions.
This is clearly not a desirable property for a climate policy instrument.
Moreover, it destabilizes the allowance market.
A coal phase-out reduces the demand for allowances, triggering a drop in prices.
A stabilizing intervention would reduce supply and thereby dampen the price effect.
The market stability reserve might do exactly the opposite.
By raising supply, it increases the supply-demanding balance in the market and magnifies the price
drop.
To summarize, the way the market stability reserve is designed, it steers the E-VTS well
based on past events.
It does a bad job for those events ahead of us that we already know about.
The autopilot of the E-VTS has a good picture of where it is and where it came from, but
the map of what lies ahead is distorted.
It urgently needs a software update.