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Symposium 2015

Solution for The EU’s Emission Trading System: More Than Hot Air?

The Challenge

The EU's emissions trading system (EU-ETS) is the largest existing emissions trading scheme. This scheme is the main economic climate policy instrument of the EU, and it also serves as a blueprint for ...

The EU's emissions trading system (EU-ETS) is the largest existing emissions trading scheme. This scheme is the main economic climate policy instrument of the EU, and it also serves as a blueprint for other emissions trading schemes world-wide.

In 2014, the EU agreed on new and ambitious emissions reduction targets for 2030. While the EU-ETS is considered a key instrument in reaching these new targets, its effectiveness has been impeded by low carbon prices that fall short of providing the necessary incentives for urgently needed technological changes. So far, attempts to change this incentive structure have failed. The Reform proposed by the European Commission, the so-called Market Stability Reserve, will probably not go far enough for various reasons.

A Long-Term Approach for the EU’s Climate and Energy Policies

Background to the proposed solution:

The main challenge that the EU ETS has had to address is the structural oversupply in the market. Two legislative proposals were put forward to tackle this: one is a short-term “emergency measure,” known as backloading; and one is to change the design of the ETS by introducing a market stability reserve (MSR).

The backloading proposal was adopted in 2014 after unforeseen political objection. Under this plan, the Commission withholds 900 million allowances from auctions in 2014–16, and they will instead be sold towards the end of Phase 3 of the EU ETS, in 2019–20. The market stability reserve (MSR) creates a reserve of allowances in the EU ETS whereby at times of oversupply, surplus allowances would be placed in the reserve instead of auctioned; and at times of insufficient allowances in the market, these additional allowances would return to market via auctioning. The MSR has a dual objective: to tackle the existing surplus in the market, and to introduce some flexibility in the supply of allowances to allow the EU ETS to function like other markets, i.e, when demand for allowances decreases, so would the level of supply. The MSR also proposes to place the backloaded allowances into the reserve, as well as unallocated allowances by the end of Phase 3 of the EU ETS, instead of returning them to market through auctioning.

Additional modifications to the ETS Directive were published on 15 July to translate the “ETS elements” of the political agreement reached on the EU’s 2030 climate and energy package into a legislative text. These include changes to the EU ETS cap in order to meet the 2030 objective of reducing emissions to 43% below 2005 levels for ETS sectors, as part of the EU’s effort to reduce its overall GHG emissions by at least 40%, compared to 1990 levels. They also include the creation of new “funds” that European Heads of States agreed to in the political document they unanimously endorsed in October 2014. The idea is to use some of the allowances for a particular purpose, such as encouraging innovation in new technologies or modernizing the EU’s energy sector.

The most controversial part concerns the new rules to address the risk of carbon leakage, and which sectors will benefit from free allowances and to what extent. The current carbon leakage provisions run out in 2019 and European policy-makers have come under huge pressure to propose rules to ensure such protection continues in the next phase of the EU ETS as long as the EU’s main competitors do not have comparable climate efforts in place.

One big unknown remains the interaction of the EU ETS with global climate developments. The EU’s proposed GHG target focuses on domestic emission reductions only, without the use of international credits from UN-backed flexibility mechanisms such as the Clean Development Mechanism (CDM) and Joint Implementation. However, the CDM has been successful in driving technology and financial transfers to developing countries, and in encouraging interest in carbon market solutions around the world. It has also helped European businesses to reduce the costs of EU ETS compliance by using emission credits from projects outside of Europe.

Despite these benefits, the current challenges facing the EU ETS have led policy-makers to focus solely on domestic emission reductions. It is difficult to square the current supply-demand imbalance in the EU ETS with the long-term need for market linkages and global participation in reducing GHG emissions. But allowing the use of international credits is in the EU’s long-term interest, because it can broaden the impact of the ETS by offering market access for high-quality trading systems and carbon offsets. It is a classic “win-win” strategy, since it encourages global participation while keeping compliance costs low for European companies.

Proposed solution:

A longer-term approach for the EU’s climate and energy policies is needed.
Businesses support the EU ETS as the central policy instrument for the EU’s climate strategy for the following reasons:

  • It ensures that the most cost-effective abatement options are developed as the policy does not pick and choose the technologies to develop but lets the market decide.
  • It provides flexibility to businesses about investment timing.
  • It guarantees that the environmental objective (emissions reductions) will be met or exceeded.
  • It is a European-wide system that minimizes intra-EU competitiveness distortions that national policies cause. It is an instrument that enables linking with other jurisdictions, which can help avoid international competitive distortions.
  • It allows price discovery through market forces.

 

Some of the recent legislative amendments to the ETS Directive have focused on the short-term challenges. They are absolutely necessary to tackle the structural imbalance in the market and restore the political credibility of the EU ETS. However, simply banning international credits removes a flexible and cost-effective tool that compliance entities need in order to reduce emissions. Moreover, a ban would mean the EU is less willing to engage in global carbon market solutions, which is problematic at a time when we need heightened cooperation, including market linkages, to address the climate challenge.

Why is flexibility to link with other markets important?
Cost-effectiveness is one of the main reasons to justify international market flexibility. Carbon markets limit total emissions but provide industry and governments with flexibility to adopt the lowest cost abatement options to meet their targets. Keeping costs down can inspire greater action. It means doing more, faster, and cheaper—especially with carbon offsets in the mix.

As emission reduction targets become more stringent over time, European businesses will need access to international markets to decarbonize cost-effectively and maintain international competitiveness. As costs of abatement differ from country to country over time, access to international market mechanisms and linking to ETSs can reduce overall costs to industry and governments alike.

It is especially important for companies in smaller countries, which can do their part through international business partnerships that can form around carbon projects. It is hard to imagine how they can participate in global efforts to reduce GHG emissions without access to climate finance and markets.

Another major argument is the need for international efforts and cooperation in climate change mitigation if we are to keep global warming below 2°C. Focusing on emission reductions only in the EU will not be sufficient to achieve the level of reductions needed globally. Providing access to the EU ETS will incentivize other economies to meet climate mitigation goals using market mechanisms, improving the cost-effectiveness and quality of their systems, and seeing the benefits of market-based measures to reduce emissions.

A proposed solution to the current domestic-focus strategy in the EU is to leave the door open to the use of offsets for meeting future targets, as this will be an important cost-containment option to meet the EU’s long-term goals.

  • International credits should be available for use by installations covered by the EU ETS, if there is support by EU Member States to go beyond the agreed 40%
GHG emission reduction target by 2030.
  • They should be available for use by governments to achieve reduction goals in non-ETS sectors (i.e, under the Effort Sharing Decision). Member States could use a portion of the revenues raised through auctioning to purchase high-quality offsets. This would create an opportunity to keep the system of offsets alive by creating a source of demand, without impacting the level of supply of allowances in the EU ETS.
  • Offsets could provide an additional economic safety valve to the MSR. Once the MSR is empty or once allowances in circulation in the EU ETS have fallen below the lower threshold, offsets could become a valuable means of cost containment. However, in such a situation, the credits used should meet strict quality standards that would have been defined at the EU level, and measures need to be put in place to ensure double-counting does not occur.
  • Offsets should be available for use by airline operators as part of the future ICAO market-based mechanism.

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