The EU Emissions Trading System needs a new autopilot: a proposed reformParadoxical effects: additional climate protection increases emissions

30 March 2021, by Prof. Dr. Grischa Perino

The EU Emission Trading System (EU ETS) is the backbone of EU climate policy. It imposes a binding cap on emissions from large stationary emitters and inner-EU flights. After about a decade of low prices, in 2018, a reform increased ambitions and changed its design. This re-established confidence in the market. Prices have risen from 5€ per ton 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. Now, due to the Market Stability Reserve, total emissions are no longer fixed. They respond to the market outcome.

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 adjusts 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 coal phase-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.

Plan to shut down coal-fired power plants in ten years increases total emissions

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 large 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 installations competing for allowances. The price of allowances drops. Hence, today, polluting firms will save fewer allowances for future use. They emit more. 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 station in ten years has the perverse effect of increasing total emissions.

This is clearly not a desirable property of a climate policy instrument. Moreover, it destabilizes the allowance market. A coal phase-out reduces 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-demand imbalance in the market and magnifies the price drop.

Today's emissions trading destabilizes the market

The way the Market Stability Reserve is designed, it steers the EU ETS 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 EU ETS 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!

The reason for this malfunction is that the number of allowances stored by firms for future use is an unreliable measure for anticipated future changes in market conditions. However, there is a measure that does not suffer from this problem, is readily available and has been acid tested in hundreds of thousands of other markets. It’s the price of the good. In virtually any other market, the quantity supplied responds to changes in prices. If the price increases, firms are willing to produce more, if it drops, they produce less. This process stabilizes markets.

The Market Stability Reserve would achieve its objectives of reducing supply-demand imbalances, increasing synergies with other climate policies and raising investment incentives in low-carbon technologies much more reliably, if it would respond to changes in the allowance price rather than to changes in the number of stored allowances.

Additional climate protection backfires

Replacing the current Market Stability Reserve that navigates based on the number of allowances stored by firms by one that adjusts the cap based on the price of allowances is the software update that would fix the autopilot of the EU ETS. We need it for a safe journey into a carbon-neutral future.

The fear of the unanimity requirement has so far prevented serious consideration of price-based regulation in the EU ETS. However, both economically and legally there are crucial difference between a tax that fixes a price and a price-based cap adjustment used to stabilize a market.

The current design of the Market Stability Reserve is fundamentally flawed. It uses a distorted indicator of changes in market conditions. This risks undermining market stability and causing additional abatement efforts by Member States to backfire. The solution is to replace the current design by one that adjusts the number of allowances issued based on the price of allowances. This is how all other markets work. It is no more a fiscal measure than the current design.

The Market Stability Reserve is up for its periodic review this summer. The time for the update of its autopilot is now.