As the debate on the reform of the EU ETS market enters its final stage with the so-called ‘trilogue’ negotiations between the European Parliament, the Council and the European Commission, it is critical to agree on the role of the carbon price signal in the context of the EU’s increased decarbonisation objective and the ongoing energy crisis.
Fabien Roques is Executive Vice President in Compass Lexecon’s Paris office and the Head of the European Energy practice. Guillaume Duquesne is a Vice President at Compass Lexecon. Florian Bourcier is a Senior Economist based in Compass Lexecon’s Paris office and a member of the European energy practice.
We argue that more ambitious reform is needed to provide a predictable and credible EUA price signal for deep decarbonization whilst ensuring EUA prices remain within a politically acceptable range. One important point to address is making the system more transparent as a prerequisite to identifying and curing the root of the EUA price instability, rather than the symptoms.
In a recent paper, we analysed the drivers of recent increases in prices and volatility of the EU ETS market. We provided a review of the options for structural reform to ensure the price signal is predictable and credible.[1]
EUA prices have significantly increased in the past years, from below €5 per tonne of carbon since 2017 to €100 earlier this year, and have proven very volatile throughout this period. Figure 1 shows the evolution of EUA prices since 2017 in relation to events regarding commodity prices, the overall European economic environment, or EU ETS market design reforms.
Figure 1: Evolution of EUA prices, 2017-2022 (€/tCO2-eq)
This surge in EUA prices and volatility have been in part driven by the evolution of market fundamentals, such as fuel switching, economic activity, and the decarbonisation objectives reaffirmed in the Fit-for-55 package and RePowerEU plans.[2]
The potential role played by excessive speculation has also come into focus, as some suspect that it could have led to an overreaction of EUA prices to market fundamentals.[3] Although the number of financial funds active with EUA trading has tripled in the past 5 years (they hold 5% of the total long positions in the market as of February 2022), the lack of market transparency makes a robust assessment of their impact on prices challenging. Such an assessment would indeed require an in-depth investigation into who holds excessive speculative positions and to what end – a task that current data availability and transparency rules prevent.[4]
Addressing policy concerns regarding the affordability of the energy transition, especially in light of the current crisis and associated policy interventions, requires a reform of the EU ETS market framework to make it more resilient to future shocks and to provide a more predictable price. This is critical to provide long-term investment signals for clean technologies.
In the current context, high volatility increases hedging costs for compliance entities, which in turn may reduce funds available to invest in the transition. More generally, the lack of predictability could undermine investments in clean technologies and ultimately the EU policy objective of fast-tracking decarbonisation. In the first phases of the EU ETS, most of the abatement was driven by efficiency gains and marginal process changes. The current and next EU ETS phases will need to drive radical technology switches in the industry towards deep decarbonisation which implies significant CAPEX and long-lasting investments. Predictability of the carbon price signal is key to avoiding lock-in effects for fossil fuel technologies and the risk of stranded assets.[5]
The EU ETS Directive[6] currently provides two mechanisms to counter large fluctuations in EUA prices caused by market destabilizing shocks: the Market Stability Reserve (MSR), a volume-based stabilization mechanism, and Article 29(a), a price-based stabilization mechanism. None of these mechanisms seems fit for purpose:
- Some design features of the MSR make it ineffective at stabilising prices and could even lead to speculation and/or market manipulation. This is because, in the presence of banking strategies, conditioning the release and cancellation of EUAs on the total number of allowances in circulation (‘TNAC’) can lead to an unintended aggravation of EUA scarcity. For instance, when anticipated scarcity increases, firms react by banking more allowances to re-establish the balance between current and future abatement costs, hedge future price increases or in expectation of a profit. Because more allowances are banked, they continue to be counted in the TNAC. Therefore, the MSR responds by absorbing more allowances, thereby actually further increasing scarcity. In such cases, the MSR-induced flexibility can be counterproductive as it increases, rather than dampens, the price impact of anticipated shocks.
- Similarly, Article 29(a) falls short of addressing EUA price instability. It has never been used so far, and given its current activation condition, it is likely to be only activated in extreme circumstances, not even met in the current market context.[7]
New policy proposals from the Council and the Parliament do not seem to fully address the structural issues that would enhance price predictability and resilience to shocks in the EU ETS market:
- The Parliament proposed to curb financial trading in the EU ETS by excluding entities that do not trade on behalf of actual emitters. This has indeed been identified as one of the possible drivers of EUA price instability. However, financial trading plays an important role in providing liquidity and price discovery in the market. Fully banning financial trading is therefore unlikely to be desirable. A range of more focused measures to limit excessive speculation could be considered (e.g., taxes on certain transactions, the introduction of a minimum holding period, or limits on financial positions for certain market participants). The costs and benefits of such interventions on financial trading limits should however be further analysed, and the case for using temporary interventions during specific periods of market shock / high uncertainty may be stronger than as a permanent structural feature.
- Both the European Parliament and the Council proposed reform of Art 29(a) to release allowances from the MSR in the case of activation. These are steps in the right direction, but Art 29(a) should be revised more substantially to make it effective. Precisely, the European Parliament’s proposal to lower the price multiplier would activate the mechanism after a twofold price increase. The predictability of this mechanism for market participants would however be best ensured by adopting the Council’s proposal for the automatic release of these allowances. That said, a more fundamental reform would make its activation conditional on the achievement of a price threshold rather than the current criterion which refers to a price increase over a period. In any case, the interplay with the MSR would however need to be carefully considered such that, for instance, EUAs released under Art 29(a) would not trigger the activation of the MSR.
Therefore, more structural measures could be considered to further enhance the resilience of the ETS market, the predictability and credibility of the carbon price signal, and ultimately complement the foreseen reform. The toolkit of measures could include:[8]
- First, measures to improve monitoring and market oversight: a “no regret” option. These could include the creation of a dedicated regulatory body for improving the supervision and adequacy assessment of allowance and derivatives trading as well as favouring the development of an integrated regulation, jointly considering environmental and financial aspects. These measures to increase market transparency and integration echo to some extent the series of policy recommendations identified by ESMA to contribute to improving the transparency and monitoring of the EU carbon market (e.g., increasing data harmonisation across trading venues, improving reporting and monitoring of transactions on various trading venues, publishing weekly position reports, clarifying counterparties classification, etc.).[9]
- Second, addressing the root causes of the uncertainty and tackling the policy and regulatory uncertainty regarding the EU 2030 policy agenda: measures that would reduce long-term uncertainties on political commitments to decarbonisation, the ETS design, and policy overlaps (i.e., other policies driving emission reductions) should be considered.
- Third, an improved MSR. Implementing a price-based MSR activation mechanism instead of the current TNAC-based threshold would improve the EU ETS market’s resilience to shocks.
- Fourth, carbon contracts for difference: In order to enhance the long-term predictability and credibility of the carbon price, carbon contracts for difference (“CCfD”) backed by EU member states could be introduced. Such CCfDs would offer assurance about the future carbon prices in the form of a fixed price for certain emissions reductions at different points in the future and thereby facilitate investment in clean technologies.
- Fifth, price limits: the introduction of a price floor (with a gradual increase over time) as in many other carbon markets would ensure a more predictable price signal for investors in clean technologies. Conversely, the introduction of a price ceiling could help prevent short-term excessive compliance costs, as currently experienced. This latter point could actually form part of the reform of Art29(a).
- Finally, and as mentioned above, the introduction of position limits for certain categories of market participants could be considered to prevent the building up of excessive speculative positions by the players who do not act on behalf of compliance entities and do not improve market liquidity or price discovery. As a result, it could help to address the issue of price volatility. The costs and benefits of such intervention should however be further analysed. In this respect, we note that the position limits currently apply to commodity derivatives and ESMA in its report invited the European Commission “to consider the arguments in favour and against the application of position limits on the open position a person may hold in EUA derivatives and economically equivalent OTC contracts”[10].
In practice, as our study shows, most other carbon markets in the world include some form of price management mechanism that provides resilience to shocks and a predictable and credible price signal. The time has come for structural reform of the ETS to make it fit for deep decarbonisation. Given the ongoing debate and the need to find an EU-wide compromise, focusing on widely supported solutions to improve market transparency could be the first step in reforming EU ETS.