How to fix Europe’s emissions trading scheme

The European Commission proposed last year the implementation of a market stability reserve in response to the large surplus of allowances that have accumulated in the European Union Emission Trading System (EU ETS, see European Commission 2014). There is a real question as to whether such a buffer stock is necessary. In a perfect world without regulatory uncertainty, fully informed market participants would efficiently hold bank surplus allowances for future compliance and a market stability reserve would not be necessary. But, in reality, there are problems with the way regulatory credibility drives businesses to focus excessively on the short term (Taschini et al. 2014). Business responses to uncertainty and complexity are imperfect, and they have limited capacity to bank allowances at low discount rates (Neuhoff et al. 2012).

To provide quantitative evidence to the debate, the research network Climate Strategies convened an international model comparison exercise to assess the relative merits and demerits of a Market Stability Reserve (MSR) (Neuhoff et al. 2015). The analysis involved 12 institutions including the London School of Economics and Political Sciences, the Climate Economics Chair of Dauphine University in Paris, DIW Berlin, and Resources for the Future in Washington DC. The research provides evidence based answers to two questions:

Can the Stability Reserve improve the EU ETS?
How should the Reserve best be designed?

All modelling teams contributing to the report found large deviations from an efficient emissions reduction pathway, a carbon price with inconsistency between expected and later materialised price, steep price gradients that offer limited credibility to investors, and limited robustness to economic, technology, and policy shocks. A well designed Market Reserve is shown to compensate for much of these problems and could therefore improve the performance of the EU ETS.

How should a Market Stability Reserve be designed?

The preference for price versus quantity-based instruments has long been debated among economists (Weitzman 1974, Stavins 1996). We found that, when well designed, Stability Reserves based on either price or quantity triggers can perform very well against key performance indicators, and they also correct some of the problems previously described (deviation from emissions reduction pathway, inconsistent carbon price trajectory, limited robustness to shocks). However, price and quantity-based market reserves offer different challenges when it comes to setting the trigger levels.

Strong performance of a price-based Stability Reserve requires accurate information on the incremental costs of emission reductions and political agreement on appropriate trigger levels. In contrast, the performance of a quantity-based Reserve requires an understanding of the hedging demand and can be severely reduced with too high or too low quantity trigger levels. However, this is relevant once surplus volumes are close to the upper trigger level, only after 2020. Hence, if a quantity-based Reserve is pursued, policymakers have some space to learn from the market and update the trigger levels based on data reported under the European Union Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) Directive.

In comparing different design choices for a quantity-based Stability Reserve, all modelling teams find that one starting in 2017 with direct transfers of the back loaded allowances performs best. It moves EU ETS closest to the efficient emissions reduction pathway and delivers the most consistent and credible carbon price signal for investors. Thus, it contributes to an attractive regulatory framework for investments in the energy and energy-intensive industry sector and for the technology supply chain.

Carbon-intensive industries will benefit from the clarity resulting from a Market Stability Reserve, which would contribute to a clear framework for investment and innovation in clean technology.

Conclusions

Combining the insights emerging from several models, it is clear that there are numerous market and regulatory failures that impede the performance of the EU ETS. According to all models, a Market Stability Reserve helps to correct some of these market failures. Its introduction in 2017 (four years earlier than proposed by the European Commission) and the back-loaded allowances placed directly into the Reserve improves the EU ETS performance, according to all models.

References

European Commission (2014), “Impact Assessment Accompanying the document concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC”, Retrieved December 2014.

European Council (2014), “Conclusions on 2030 Climate and Energy Policy Framework”, (SN 79/14) Brussels, 23 October 2014

Neuhoff N, W Acworth, R Betz, D Burtraw, J Cludius, H Fell, C Hepburn, C Holt, F Jotzo, S Kollenberg, F Landis, S Salant, A Schopp, W Shobe, L Taschini and R Trotignon (2015), “Is a Market Stability Reserve likely to improve the functioning of the EU ETS? Evidence from a model comparison exercise”, Climate Strategies Report. February.

Neuhoff K, A Schopp, R Boyd, K Stelmakh and A Vasa (2012), “Banking of surplus emissions allowances – does the volume matter?” DIW Discussion Papers No. 1193.

Taschini, L, S Kollenberg, and C Duffy (2014), “System responsiveness and the European Union Emissions Trading Scheme”, Policy Paper, Centre for Climate Change Economic and Policy, Grantham Research Institute on Climate Change and the Environment.

Weitzman, M (1974), “Prices vs. quantities”, The Review of Economic Studies 41, 477-491.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Karsten Neuhoff is Professor for Energy and Climate Policy at Technical University Berlin.

Image: European Union flags fly outside the European Commission headquarters in Brussels. REUTERS/Thierry Roge.