The Carbon Allowance Tale - Part 1: An inefficient policy making tool?

The European Union Emissions Trading System (EU ETS) is the backbone of the EU energy policy. Its main objective is to reduce greenhouse emissions. Enshrined in EU law is the target to decrease carbon releases by at least 55% by 2030 from the observed 1990 levels. The legal framework is called “Fit for 55”. 

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The scheme is unique in that it represents a blend of regulatory decisions with a free-market approach. It has started as a controlled policytool that initially appeared ineffective in reaching the fundamental sustainability objectives. Legislative amendments and the gradual opening to financial markets has created the mature scheme that the EU ETS is today. 

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Engineering the cap 

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In line with its decarbonation objectives, the European  fixes a limit, or cap, on the quantity of CO2 emissions that can be produced. This cap defines the amount of allowances that will be issued by the European Commission (EC) for a given year. For every tonne of CO2 that they emit, industrial polluters need to surrender one allowance. They obtain those allowances by purchasing them either from the EC itself on the primary market, or from each other on a secondary market. 

Therefore, there is a regulated supply (the cap is a political decision) facing a market demand (the emissions needs of industries). 

Since 2018, there are also financial players who simply buy or sell EUAs, without surrendering them to the regulators (without matching them to real emissions). 

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This market-based price discovery leads to the most cost-efficient emission reduction path by signaling to the regulated participants the marginal abatement cost of carbon. Finding the “market price” of emissions reduction incentivizes industries to invest in decarbonation solutions at a scale and pace in line with the EU’s Fit for 55 policy. 

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The cap is fundamentally built in such a way that the issuance of allowances is diminishing over time. Every year, the amount of CO2 that can be emitted is reduced by a fixed percentage, decided by the EC: the linear reduction factor (LRF). In 2013, the LRF was set at 1.74% per year. Currently, the maximum amount of emissions that can be issued declines at a rate of 2.2% per year:  the prevailing LRF. The LRF will continue to increase to 4.3% between 2024 and 2027, and then to 4.4% between 2028 and 2030. 

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Oversupply and inefficient prices 

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In the pilot period from 2005 to 2007, the cap was the sum of every country’s estimated needs. France’s economy would estimate a need to emit X tonnes of carbon in 2005, Germany would estimate Y, Poland - Z…  Thus the European cap would be X + Y + Z + the values for all member states. The number of corresponding allowances issued ended up being way higher than the number actually needed by companies to cover their carbon emissions. The meeting of an overestimated supply with a lower-than-expected demand made the price of one EUA collapse below €10 in 2006. The initial excess was combined with a record low demand. The financial crisis had made demand for allowances drop from previous years as industrial output dwindled. This resulted in the price falling to almost €0 for all of 2007. 

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Then came the first regulatory supply adjustment: the cap was no longer decided by the member states’ estimations like in 2005, but based on their actual observed emissions from 2007. However, the supply surplus was still accrued year after year. There were 2 billion unused EUAs at the end of Phase II in 2012. 

Following that, there was a second cap design alteration. Since the start of Phase III, the cap is no longer determined by aggregating individual national requirements for allowances. Instead, it has evolved to be a shared, union-wide carbon budget. The assessment of the overall demand for permits now takes into account the entire EU carbon emission production needs. Consequently, it is periodically re-evaluated to accommodate any political changes, such as the inclusion or exclusion of member states. This kind of "rebasement" took place in 2021 following the UK's exit from the EU. It no longer made sense for the cap to incorporate the emissions requirements of the United Kingdom. If the country had remained within the union, the 2021 cap would have been set at 1,780 mtCO2. However, it was adjusted to 1,572 mtCO2 to align with the political reforms that occurred. 

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Nevertheless, these measures did not seem to fix the excess issuance of EUAs, and oversupply was still dominating the market. This phenomenon was keeping the asset prices low during the initial stages of the scheme. Regulators had created a mechanism generating inadequate prices that would have never helped the EU reach its environmental ambitions: it is progressively higher prices that keep incentivizing industrial companies to invest in decarbonation solutions. Such low prices had no incentivizing effect. 

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Adjusting how the cap is decided was not enough to make the EU ETS an efficient policytool. Authorities needed to tackle other aspects of the supply side of compliance carbon markets. 

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Sources

European Council of the European Union. (2023). Fit for 55: The EU plan for a green transition

European Commission. (2023). Commission launches public consultation on financial collateral arrangements. 

European Commission. (2023). Emissions cap and allowances.

European Commission. (2023). National allocation plans.

Ellerman, D., Valero, V., Zaklan, A.. (2015). An Analysis of Allowance Banking in the EU ETS.

Marcu, A., Vangenechten, D., Alberola, E., Olsen, J., Schleicher, S., Caneill J-Y., Cabras, S. (2021). 2021 State of the EU ETS Report.

European Environment Agency. (2023). Emissions, allowances, surplus and prices in the EU ETS, 2005-2020.