The case for a price floor in the EU ETS

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French President Emmanuel Macron (C) poses with World Bank President Jim Yong Kim (center-R), and President of the Comores Azali Assoumani (4R) pose with children after the closing speech of the Plenary Session of the One Planet Summit at the Seine Musicale event site on the Ile Seguin near Paris, France, 12 December 2017. [Etienne Laurent / EPA-EFE]

The recently adopted reform of the EU Emissions Trading Scheme (EU ETS) is insufficient to trigger cost-efficient decarbonisation of the economy, argue Christian Flachsland and Anna Leipprand. A carbon floor price that starts at a significant level and rises over time would address the problem, they write.

Prof. Dr. Christian Flachsland is head of the working group Governance at the Berlin-based Mercator Research Institute on Global Commons and Climate Change (MCC). He is also the assistant professor of Climate and Energy Governance at the Hertie School of GovernanceAnna Leipprand is a Fellow and PhD Student with the Working Group Governance at MCC. 

The Mercator Research Institute on Global Commons and Climate Change (MCC) was founded in 2012 by Stiftung Mercator and the Potsdam Institute for Climate Impact Research (PIK)

The EU’s long-term climate targets are acutely at risk. The price for emission allowances has been sagging at a very low level between €5 and €8 per ton for years. And despite the launch of new reforms in the European Emissions Trading Scheme (EU ETS) it will most likely remain just there.

The recently adopted reforms bring some improvements, but miss the core problems and will not lift the price to the level that would be required to trigger cost-efficient decarbonisation. They neither create sufficient incentives for short-term mitigation options such as a shift from coal to gas, nor for long-term investments into low-carbon capital stocks and into research and development.

This wait-and-see strategy holds severe risks. At some point in time, the allowance price will have to increase suddenly and steeply (‘hockey stick curve’) if the cap for emissions in the EU ETS decreases as currently foreseen. The available budget for emissions is shrinking, but today’s low prices do not prepare the capital stock for complying with it.

Currently, the cap is set to reach zero by 2058, tightening by 48 megatons per year. In the case of a sudden and rapid price increase industry and business actors can be expected to put strong pressure on policy-makers to alleviate it – for instance by relaxing the cap.

Industry would likely argue that they could not adjust to a sudden price rise given the long-time horizons for the necessary investments. If the cap were then relaxed by courtesy to economic concerns, the EU’s long-term climate target would be missed.

The possibility alone that this scenario might materialise damages the credibility and effectiveness of the EU ETS as the core instrument for European decarbonisation. In a recently published policy paper we argue that a floor price would greatly reduce this risk.

The EU ETS suffers from three major problems.

  • First, the short-term time horizon of traders prevents the formation of a market price that reflects the scarcity of allowance supply in the long term.
  • Second, the allowance market reacts in a very sensitive way to climate policy announcements in the EU that are interpreted as cues regarding the future stringency of the cap. Empirical scientific research suggests that the allowance price is thus pushed below the level that would be necessary for cost-efficient decarbonisation.
  • Third, all additional climate mitigation policies in EU ETS member states dampen the price as long as the corresponding allowances are not permanently deleted (the so-called ‘waterbed effect’).

The EU ETS reform that was recently adopted does not sufficiently address these problems. Although the cancellation of allowances in the Market Stability Reserve (MSR) from 2023 on will restrict allowance supply, a significant effect on the price is not to be expected. Market forecasts by some consultants that do predict such an effect are based on models that lack transparency.

And while member states are now permitted to delete allowances to compensate for emission reductions resulting from national measures (such as a coal phase-out), there is no guarantee that all countries will actually use this option. Moreover, additional mitigation efforts by subnational private and public actors – for instance cities – are not accounted for at all.

A floor price that starts at a significant level and rises over time addresses all three of the problems sketched above. The long-term price formation is no longer left to the market. Policy-makers can communicate their level of ambition directly in the form of a price that is relevant for the market, rather than by taking the detour over announcing long-term and eventually uncertain quantity targets.

With an auction reserve price and non-auctioned allowances being permanently deleted, lower allowance prices will directly translate into higher emission reductions. Thus, a floor price would substantially strengthen incentives for investments into low-emission capital stocks and into research and development, and it would provide long-term planning security for investors by indicating that a continuous but smooth price increase is desired by policy-makers.

In the paper we outline three options to implement a floor price.

  • An auction reserve price (like at Ebay), where allowances are not sold as long as bids do not reach the reserve price, is a first option that has already been implemented in California and in other North American Federal States.
  • The UK has introduced a price floor of €18 per ton CO2 for power plants that is additional to the EU ETS. Plant operators are obliged to pay the difference between the current price in the EU ETS and the domestic floor price to the tax authorities. However, no allowances are deleted, which means the UK mechanism does not lead to emission reductions at EU level. The use of the allowances is only shifted in space and time.
  • A third option is a floor price that only applies to a certain share of the overall volume of allowances. This past summer the Regional Greenhouse Gas Initiative (RGGI), an emissions trading system in North-Eastern USA, has adopted an “Emissions Containment Reserve”. Ten percent of the overall amount of allowances to be auctioned will be subject to a floor price of 13 US Dollar per ton, with the price rising by seven percent per year. ECR allowances that are not auctioned will be deleted.

If EU member states are serious about decarbonisation and the Paris Agreement, the level of ambition of their short-term policies needs to be aligned with the challenging long-term targets. For Germany, modelling studies show that a price of €30 per ton for EU ETS allowances can trigger emission reductions of approximately 30 Megatons of CO2 in 2020. This would contribute significantly to achieving the country’s short-term climate target, which are currently at risk of being missed.

Even more importantly, an EU-wide minimum price would send a credible signal to investors, both for the mid and long term, that European countries are seriously committed to climate protection.

Emanuel Macron has already made it clear that he would be willing to cooperate on introducing a price floor. Other member states – most of all the next German government – should seize his outstretched hand and make this a priority for European climate policy.