Making EU ETS (and Europe) more resilient

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

Promoted content

Wojciech Dąbrowski [PGE]

This article is part of our special report EU carbon market reform and price stability.

The EU is currently at the midst of a debate on its energy policy and translating the Fit for 55 packages into concrete legislation. The European Union Emission Trading System (EU ETS) is the cornerstone of European climate efforts and its changes will be crucial for the future of energy transition and energy security. The reforms of EU ETS are even more urgent due to Russia’s invasion on Ukraine. While the EU cannot quickly address the issue of energy dependency on Russia, a well-crafted ETS reform will protect the EU’s utilities against price shocks and support their energy transition.

Wojciech Dąbrowski is the CEO of the PGE Polska Grupa Energetyczna.

The European utilities and industry were recently hit by both the rising fuel prices and the carbon allowance price surge. While the EU cannot do much on the fuel supply side in the short term, it can effectively reform ETS, so it is more resilient to price shocks. A well-crafted reform of the EU ETS will also make the prices more predictable, allowing the emitters to focus on investments that advance energy transition.

Why the EU ETS reform is essential?

There is a wide discussion about the causes of the rising European Union Allowance (EUAs) prices. Some experts and analysts claim that the rising prices are caused by the market fundamentals, while others point out at the speculative activities. The latter was analyzed by the European Securities and Markets Authority (ESMA), but its recent and final report doesn’t offer a definitive answers.

ESMA confirms there was high-frequency trading and activities by financial institutions (even originating in Cayman Islands), but on the other hand it did not have significant impact on the market. To make it even more complicated, ESMA supports better transparency and market data access. One might say that the glass is half full or half empty. But there’s more than that in ESMA report – the regulator offers some proposals to consider which might improve EU ETS functioning.

The list includes better transparency, market oversight and considering limiting the number of positions for financial transactions on EUA derivatives (ESMA invited the European Commission “to consider the arguments in favour and against the application of position limits”).There are also other voices, pointing out on ETS’s price volatility and uncertainty. Jos Debelke, former EC official in charge of EU ETS, warns against ETS price volatility; the Centre for Climate and Energy Analysis, points out that EU ETS design flaws allow the speculators to influence the prices.

On the other hand there are also some different opinions to simply increase the climate ambition. With such lively debate we are still convinced that finding a common ground is possible and that ESMA’s recommendations set a stage for the future discussion on ETS reform. We should focus on what can be done to improve the system and protect against volatility, whether it is caused by speculators or not, in order to achieve the climate targets.

The recent report on the EU ETS reforms prepared by Compass Lexecon for PGE identifies the main weaknesses of the system’s design and explores the best options to reform it, so the ETS is more resilient to prices shock, whatever their cause might be. In order to address the issue, we must limit the access to the market for the speculators, while keeping the financial institutions which contribute to market liquidity on board. Without sorting this issue out we cannot move on with another important reforms, which are currently at the center of the debate: of Market Stability Reserve (MSR) and the Article 29a of the EU ETS directive.

MSR currently uses the Total Number of Allowances in Circulation (TNAC) mechanism. This solution is problematic: the allowances banked by financial institutions (bought and held to in a hope for financial gains in the future) are not available on the market.

With such design, MSR is vulnerable: the allowances banked by non-compliance entities are still calculated as TNAC; MSR responds by absorbing more allowances, thereby actually further increasing scarcity and driving the prices up. This is because the famous “surplus of allowances” is artificial as the two thirds of the TNAC is hold on account of financial actors accounts due to their buy-and-hold strategies. In fact these allowances are not available for compliance entities.

This demonstrates that the functioning of one of the tools which aims to stabilize market could be distorted by the speculative activities. The design of another mechanism – Article 29a – is also ineffective. According to the Article, it is triggered when for more than six consecutive months EUA prices need to be more than 300% the average price in the two preceding years. This make it anything but effective tool, it is not surprising that despite the rising prices the Article 29a has never been used so far.

How to change EU ETS?

There are plenty of options, but they all come down to solving one general issue: making the market and prices more predictable. The European Commission assumed average prices of emission allowances equal to €50 per tone for the entire 2021-2030 period, while the current prices remain well above €80. The aim of the reform is not to directly control the prices, but rather to guarantee at least some certainty for companies, which make long-term investment to decarbonize their assets.

Preventing the speculations doesn’t necessarily mean getting rid of the financial institutions, that play an important role as the intermediaries and help i.a. in the price discovery and facilitates market liquidity. But the activities of those of them that do not act on behalf of the emitters should be limited.

The financials not acting on behalf of  the emitters should be either excluded from the market or at least some limits on their activities should be imposed. A possible option is to set a limit on the EUA volumes they can buy. This can be done by imposing individual or general (applying to all financial institutions not acting on behalf of emitters) limits of positions. It must be pointed out that even if the issue of speculators is addressed, we must have the tools to prevent price volatility, which of course would still be possible.

The issue of the prices and excessive speculation was already raised by Spain and Poland. The debate is also gaining momentum in European Parliament, where Jerzy Buzek proposed to exclude the financials (not acting on behalf of emitters) from the market and the specific measures are now more widely discussed. To succeed, it is crucial to reform The Market Stability Reserve and the Article 29a of the EU ETS directive.

MSR with its current TNAC-based trigger mechanism must be changed, so it reacts quickly to the market reality. The decision to release allowances from the reserve should be based on the certain threshold of the EUA price. The specific thresholds might reflect e.g. EC’s price projections or be based on them in some way.  The Article 29a of the EU ETS directive must also become an effective price stabilization mechanism.

Similarly to MSR, it should be based on the specific price level, instead of price multipliers explained above – the current design made it impossible to invoke the article 29a. Furthermore, the recent compromise proposals from ENVI committee on the so called EU ETS 2 (ETS system for the transport and buildings) support introduction of the specific price limits, which would trigger MSR, as well as less strict price “multipliers” than those of art. 29a after which additional allowances would be released.

Similar measures should be introduced not only on the new, developing market (like EU ETS 2), but also on a mature one (like EU ETS), which faces price volatility challenges. Additionally, it is necessary to introduce a mechanism which would supply a set amount of allowances automatically to the auctions, without prior intermediary and politically-based steps.

Summary

The above is just a few examples of the necessary reforms, but these are of crucial importance and should not be postponed. Meeting EU’s climate targets requires huge investments . The ETS market encourages to invest in energy transition, but at the same time the EUA surging prices should not drain money spent on the energy transition. The better market transparency will give us some answers about the main drivers behind the price volatility, but before it happens, we must urgently address the structural problems of EU ETS design.

Subscribe to our newsletters

Subscribe