Is the EU ETS getting it right?

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

Michał Kurtyka, Minister of Climate and Environment.

The EU ETS is our main climate policy tool that allows for emission reductions and it has been a solid pillar of EU climate policy. One of the things we are constantly told is that you will be rewarded for emission reductions in the EU ETS. The less you emit, the more you will benefit. This is a message that we have also been spreading to companies that participate in the EU ETS. It is an obvious truth. But is it?

Michał Kurtyka is the Polish Minister of Climate and Environment.

The numbers don’t add up

We have noticed that something is not quite right. We have reduced emissions in the EU ETS, but we have been in constant deficit of allowances. Always. Maybe we were not doing enough and everyone around was reducing their emissions faster than us? Therefore, we have taken a look at historical data in the EU ETS from the beginning in 2005 till now. We have taken into account the full scope of existing EU ETS allowances, namely the total number of allowances to be auctioned by particular a Member State together with the total number of allowances received for free by installations in this Member State and its allocation from the Modernisation Fund (MF). By comparing the combined number of all those allowances in a given year to the level of reported emissions in EU ETS in the same year generated by the Member State one can easily define the level of surplus or deficit of allowances that particular Member State is experiencing in the EU ETS.

What we have found lies in contradiction to the most fundamental statement – you will be rewarded for emission reductions. While analysing EU wide EEA data, we found there to be no substantial correlation between emission reductions and the number of allocated allowances. Member States with very small reductions had an allowance surplus and some Member States with large reductions had a deficit (see chart below for the 2013-2019 correlation for Member States). Why is that?

Source: EEA data viewer.

This is all due to the allocation key for auction allowances. It is based on a principle that is not related to emission reductions that have been undertaken in recent years and encompass allowances for free allocation as part of the auctioning distribution key, despite that they are allocated separately as part of another system. One could argue for a matter of double counting, but this would be a topic for a separate article.

Seeing that the forecasts show the further growth of the deficit gap in the future for some Member States, we have raised this matter during the European Council meeting in December 2020. The European Council agreed that “the problem of imbalances for beneficiaries of the Modernisation Fund in not receiving revenues that are equivalent to the costs paid by the ETS installations in those Member States will be addressed as part of the upcoming legislation”.

So how do we fix this?

One step in a good direction is the increase of the Modernisation Fund, however, for some Member States it will not be enough to address this imbalance. In case the increase of the Modernization Fund does not fully compensate the imbalances experienced by the Fund beneficiaries a complementary instrument that would guarantee a long-term structural solution needs to be established. We, therefore, look towards a change in the Market Stability Reserve (MSR), where a  structural correction could be introduced.

Firstly, a Member State with a deficit of allowances in a given year n would have their allowances exempted from the operation of MSR in the year n+1 up to the amount of their deficit in year n. This would be done on a rolling basis. Moreover, when a Member State is in deficit of allowances, it is not contributing to the existing surplus on the market.

Secondly, if the exemption from MSR is too little to fully compensate the deficit in year n then the rest of it should be covered by using allowances already placed in the MSR to ensure a respective increase of MF allocation for this Member State in year n+1. Channelling the deficit gap allowances through the MF would ensure that funds are used for the modernisation of installations and the funds would be fully used for such purposes.

The proposed solution would be fully compatible with at least 55% emission reduction target, and would not undermine EU climate ambition guaranteed by a new cap in the revised EU ETS Directive and would not affect long-term price signal. Installations would still have the incentive to reduce due to increasing, allowance prices.

Today funds are transferred from installations in countries with one of the largest transformation needs and smallest capacities to budgets of countries, which don’t need these additional resources. This cannot be the foundation of the EU ETS. Funds should be driven to areas that need them the most and will be used in the best way, increasing much-needed investments.

Has the EU ETS become a new toy for speculation?

Recently we observed rise in the price of EU allowances which may be reaction of the market on the forthcoming EU ETS revision. However, it raised our concerns over the potential speculative nature of the volatility, which could undermine the efficiency of the system in delivering on its objectives.

Poland supports low-emission investments within the framework of the EU ETS, however, too high prices of allowances at this stage can cause a number of adverse effects, which can lead to cost pass-through and hindering the green transformation of their assets, which is particularly relevant during the recession provoked by the COVID-19 pandemic. Overall, the current trend of EUA prices may jeopardize the objectives of the EU ETS and be counterproductive to climate and social policies of the EU. This just might be one challenge too many for the EU ETS.

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