On 22 January 2014 the Commission presented a legislative proposal to establish a market stability reserve for the EU Emissions Trading Scheme (“EU ETS”). This proposal forms part of the 2030 framework for climate and energy policies, and it is envisaged that the market stability reserve will operate from phase 4 onwards.

The overall purpose of the EU ETS is to lower emissions, and it is Europe’s principal mechanism for doing so. The Commission believes that by 2020, emissions from sectors covered by the EU ETS will be 21% lower than they were in 2005, and 43% lower by 2030. The Commission’s latest press release in May of this year reported that emissions of greenhouse gasses from installations participating in the EU ETS were estimated to have decreased by at least 3% between 2012 and 2013.

THE CURRENT PROBLEM

Phase III of the System – the current phase – started in 2013 and runs through until 2020. Since approximately 2009 (i.e. towards the beginning of Phase II of the Scheme) there has been a growing surplus of emissions allowances and international credits building up in comparison to emissions. This has largely been attributed to the economic crisis that has plagued European member states over recent years, which has reduced emissions, in addition to high imports of international credits, as well as over-allocation in Phase II of the Scheme. The effect of this surplus has been to significantly weaken the carbon price signal.

The Commission estimates that at the end of 2013, the surplus had grown to in excess of 2.1 billion allowances. Whilst the Commission envisages that the rapid build-up that the System has seen between 2009 and 2013 is expected to end from 2014 onwards (as the process of back-loaded started in the first quarter of 2014 – see below), it does not believe that the overall surplus will reduce to any substantial extent before Phase III ends in 2020. The Commission views this surplus as a problem for two key reasons:

The current surplus risks undermining the orderly functioning of the carbon market in the EU; and

If the discrepancy between the number of allowances and credits compared with emissions is not addressed, this will significantly undermine the EU ETS’ ability to meet the more demanding emission reduction targets that will no doubt be set from Phase IV onwards in a cost-effective way.

THE PROPOSED SOLUTION

The Commission is therefore clear that action is required. As a short-term measure to stop the surplus from growing further and to try to reduce the surplus slightly, the Commission plans to postpone the auctioning of 900 million allowances until the end of Phase III in order to create increased demand and address the imbalance between supply and demand in the short-term. It is worth noting that this “back-loading” will not result in a decrease in the total number of allowances auctioned off during Phase III , it will just redistribute when the allowances are auctioned off. This will see 400 million fewer allowances being auctioned off in 2014, 300 million fewer in 2015 and 200 million fewer in 2016.

In addition to the short-term measure of “back-loading”, the Commission’s proposal for a market stability reserve is viewed as more of a long-term, sustainable solution to the problem. The current plan is for the market stability reserve to be introduced at the beginning of Phase IV in 2021.

The reserve would improve the EU ETS’ resilience to withstand economic and other pressures which have led to the current surplus, through the ability to adjust the supply of allowances to be auctioned.

It is envisaged by the Commission that the reserve should operate entirely based on an automatic, fully rule-based process which would provide neither the Commission nor individual member states with any say as to its implementation. The reserve would therefore respond to unforeseen events by adjusting the supply of allowances based on the automatic process referred to above, and with no Commission or member state input. In practice, this would mean that, depending on the number of allowances in circulation at a given time, the reserve would either add further permits into, or release permits from the reserve, in order to ensure that the permit surplus is always maintained within certain lower and upper parameters. Where allowances are to be added to the reserve, they would be taken from future auction volumes; where allowances are to be released from the reserve, they would be added to future auction volumes.

A key benefit of the proposed reserve is its ability to deal with future unforeseen events autonomously and without Commission or member state input. The reserve’s independence and transparency should provide market participants with clear expectations in relation to short-term permit supply adjustments, whilst allowing decisions as to the level of emissions cap and climate policy in general to be made at a European level.

The proposal has also drawn a number of criticisms. Not least amongst these is the reserve’s ability (or more accurately, a perceived inability), in practice, to respond to future unforeseen events. Some commentators suggest that, as the reserve is triggered by observed data and responds with a lag of approximately two years, it follows that adjustments in the number of permits allowed into the market will always occur after the event has actually occurred, thus arguably undermining the reserve’s effectiveness and utility.

In a “vision document” published on 16 July 2014, DECC expressed the view that the stability reserve was not an adequate response to the problem of oversupply in the EU ETS. It sees the need to cancel permanently a high volume of the surplus allowances before 2020.

NEXT STEPS

The market stability reserve proposal has been submitted by the Commission for further consideration, in accordance with the usual EU legislative procedure. An expert meeting on the technical aspects of a market stability reserve was held on 25 June 2014 and the consultation process is moving forwards.