Carbon Market Watch

For fair and effective climate protection.

Why we need to address the EU-ETS’ allowance surplus (Newsletter #18)

11 Feb 2012

Guest article by Tomas Wyns, CCAP-Europe

Europe’s climate action flagship, the EU Emissions Trading System (EU-ETS) is in troubled waters. Due to the economic crisis, carbon prices have collapsed resulting in a large surplus of allowances. If no action is taken, the EU-ETS could collapse and emission reduction efforts in the EU could be put on hold. However, it is possible to fix the surplus issue immediately and protect the efficacy of the EU-ETS. What is currently missing is the political will to do so.

The economic crisis in Europe has lead to a dramatic decline in CO2 emissions. As a result, the demand for allowances has reduced and prices have dropped. In 2011, price for EU-ETS allowances have fallen by about half, to around €7. Because the EU is also the largest buyer of Clean Development Mechanism offsets (CERs), the prices of CERs have also dropped significantly to around €4.

Emission reductions due to an economic recession do not lead to a low-carbon development path. Industries are not becoming more efficient and power producers do not switch to more sustainable fuels. Emissions will just rise again once the economy recovers. The economic recession helped Europe meet its emission reduction goals but not in a planned or sustainable way. Analysts agree that the EU-ETS is now severely oversupplied with EU allowances. Back in 2008, the European Commission projected an EU allowance price of around €30 by 2020. If prices continue to fall, the EU-ETS could collapse.

Size of surplus

The size of the current allowance surplus is the difference between the amount of allowances available and the actual emissions during phase II (2008-2012) of the EU-ETS. This difference is about 800 and 900 million tonnes. In addition, an estimated 1,700 to 1,900 million tonnes of CERs and offset credits from Joint Implementation can be used for compliance under the EU-ETS in phases II and III (2008-2020). We expect that most of these will be not be used in phase II carried over to phase III. This brings a total surplus carried over to phase III of between 2,500 and 2,800 million tonnes.

Deutsche Bank and Point Carbon have estimated that this surplus together with the amount of allowances provided for the third EU-ETS trading period from 2013-2020 is almost equal to the emissions expected in that timeframe. In other words, no emissions reductions are required to meet the goals under the EU-ETS from now until 2020.

Why is this surplus a problem?

Let’s look at the effects of the surplus and the resulting low carbon prices on EU climate action:

The short-term impact of a carbon price is most easily seen in the power sector through a phenomenon called “merit order switching”. With a sufficiently high carbon price it is possible (depending on the relative gas and coal prices) for power producers to choose to switch power production away from coal power plants to natural gas power production. A higher carbon price could lead to tens of millions of tonnes fewer emissions in the EU just due to merit order switching. Such switching is not expected to happen at current and projected low carbon prices.

The medium term impact of a carbon price relates to the effect on energy-efficiency investments by EU-ETS installations. A higher carbon price makes investments in energy efficiency more attractive because the payback time becomes shorter. The payback time is the time it takes for energy-efficiency upgrades to pay for themselves through decreased energy costs. Companies tend to invest in energy-efficiency upgrades with a payback of less than four years. If the carbon price is higher, energy prices are higher and therefore the payback for energy-efficiency upgrades is lowered. Energy-saving measures that would have been attractive back in 2008 when the carbon price was above 20 EUR/tonne, are now no longer attractive due to the large drop in the EU carbon price.

The long-term impact of the low current carbon price is far the most dangerous. The low carbon price is an insufficient deterrent to building very large carbon intensive projects with long lifetimes, such as large industrial installations and coal power plants. If the low carbon price enables new investments in new coal-fired power production in Europe we will be locked into a high carbon pathway for decades to come. With time new carbon-intensive infrastructure will lead to higher reduction costs or even stranded assets. It is even possible that the current situation, if not corrected, will make the agreed −80% to −95% reductions by 2050, technically and economically impossible.  If there is a ‘lost’ decade on climate action between 2010 and 2020 it will be felt throughout the first part of the 21st century.

Finally there is the missed opportunity of investing in low carbon breakthrough technologies. Starting in 2013 European governments will receive billions of Euros from auctioning EU allowances to the power sector. Some governments will earmark these revenues for the development of renewable energy and innovation. A low carbon price will seriously reduce the level of investments and innovation.

It should be clear by now that a sustained depressed carbon price in phase III (2013-2020) of the EU-ETS will endanger low carbon investments, energy savings and finally the cost-effective implementation of long-term mitigation targets in Europe.

What can we do about it?

We need actions that immediately increase the currently low carbon price and that sustain this price over a longer time to enable a cost-effective pathway towards −80% to −95% reduction targets by 2050.

The European Commission proposed to ‘set aside’ – withholding EU ETS allowances as from 2013. A set-aside creates a temporary scarcity in the market since these allowances would normally enter the market through auctions. To create a lasting effect, these allowances must over time be canceled and permanently withdrawn. An elegant way to do the latter is through strengthening the annual reduction for the EU-ETS cap. Such a measure, however, requires a change to the EU-ETS directive. It would also be wise to increase the EU-ETS cap ambition level in a more structural manner to make the EU ETS consistent with reaching Europe’s 2050 goal of -95% emissions in a cost-effective manner This is also recommended, between the lines in the European Commission’s 2011 ‘2050 low carbon roadmap’.

The current allowance surplus in the EU-ETS is a threat to the low carbon development of Europe’s industry and power sector. There are ways to solve this issue in the short and long term.  Right now, however, we face a surplus of EU allowances but a shortage of political will to address the crisis in the EU-ETS. The European Parliament is currently considering intervention in the EU ETS as part of the negotiations on Europe’s Energy Efficiency Directive. It will also be up to the current Danish EU presidency to give the issue sufficient political priority and hence lead Europe into fixing the EU-ETS.

The EU-ETS at a glance:

The EU Emissions Trading Scheme (EU-ETS) is a cap-and-trade system which came into force in 2005 to help EU Member States achieve compliance with their commitments under the Kyoto Protocol.  It covers approximately 10,000 energy-intensive installations across the EU, which represent close to half of Europe’s emissions of CO2. The EU-ETS is the largest mandatory cap-and-trade scheme to date and includes 30 European countries.

  • The second phase of the EU-ETS lasts from 2008-2012 and coincides with the first commitment period of the Kyoto Protocol (KP1)
  • The third phase of the EU-ETS will be from 2013 to 2020 and will likely coincide with the second commitment period of the Kyoto Protocol (KP2) – although the length of KP2 has not been decided yet.

CDM in the EU-ETS

Up to 50% of the EU-wide reductions over the period 2008-2020 can be achieved by buying CDM and JI offsets. This means about 1.6 billion credits from the CDM and JI can be used in the EU-ETS over the period 2008-2020.  The EU-ETS is the largest offset buyer to date.