In January 2020, the German government proposed legislation on phasing out coal in power generation. The government plans to implement the full coal exit law within the first half of 2020. This is by far Europe’s largest coal phase-out plan.
Regarding brown coal (lignite), a shutdown schedule and compensation payments have been negotiated on a plant by plant basis. For hard coal, the law foresees reverse auctions for capacity taken off the market according to a timetable set by the authorities.
Germany’s decision has international implications. Carbon dioxide emissions from burning brown and hard coal in Germany amounted to 160 million tons in 2019, corresponding to about 20% of the total German emissions. The German share of the total emissions covered by the European Emissions Trading System (EU ETS) was 20–25% during 2013–2019. Any national policy overlapping with ETS by such a large participant in the EU ETS has the potential to jeopardize the whole European system.
Coal phase-out and voluntary cancellation combined create a strong impact
It is encouraging that the German coal law proposal states the intention to cancel the unused emission allowances corresponding to the coal phase-out. If these are not removed from the market, this will do nothing but shift the emissions to other operators in Germany or in other EU ETS member states.
However, the details of the legislation are vague. The legislation does not specify the cancellation methodology nor volume, which creates uncertainty in the market. According to the law proposal, important details such as cancellation volumes will be decided later, based on independent studies.
Cancelling allowances also means a financial loss for Germany in the form of lost auction revenue. The cost can be high, in single-digit billions, but it simply reflects the true cost of an overlapping policy. Without any cancellation the same cost would be spread to other member states through lower auction prices.
But why is the cancellation so crucial? In order to answer this question, one must dig deeper into the functioning of energy and carbon markets.
The EU ETS is a carbon budget
EU ETS is a market-based cap-and-trade system. This means that the system has a fixed amount of emissions allowances, which are gradually released to the market. The amount of allowances decreases annually at a predictable pace set by the Linear Reduction Factor (LRF).
Each year, installations (such as power plants, factories etc.) in the system must acquire and surrender emission allowances corresponding to their verified emissions. As the banking of allowances between years and trading periods is allowed, in practice the EU ETS caps the cumulative emissions of the system exactly like a carbon budget.
As the carbon budget is common to the whole system, reduction of emissions in one country or in one installation tends to lead to emissions rebounding somewhere else in the system. This phenomenon is called the "waterbed effect" or internal carbon leakage.
For example, the decision to end use of coal in Germany is a national overlapping policy with the ETS. Therefore, it leads to freeing up these allowances, which will then be used by other emitters in Europe.
The same applies to other overlapping policies in the sectors covered by the EU ETS (e.g. national taxes, subsidies, etc.).
Market stability reserve brings complexity into ETS
The introduction of the Market Stability Reserve (MSR) into the ETS in the beginning of 2019 made the system more complicated.
The MSR cuts the supply of allowances available to the market if the system is oversupplied. An oversupply is indicated by the total number of allowances, an indicator published by the EU Commission once a year.
In an oversupply situation, an amount corresponding to 12–24% of the oversupply is removed from the market and transferred into the MSR. On the other hand, the MSR increases supply when the system has a deficit of allowances.
From 2023 onwards, the allowances in the MSR will be permanently cancelled according to predefined rules. Consequently, the ETS cap is no longer entirely independent of market development.
MSR cannot prevent the waterbed effect
Some recent public comments have stated that the MSR eliminates the waterbed effect almost entirely, and therefore the MSR is able to tackle any excess allowances resulting from overlapping policies.
However, this claim misrepresents the way energy markets and the MSR operate.
While the MSR operates based on a figure published once a year, the power market is optimised on a continuous basis. For example, when coal-fired power generation is closed down, it will be replaced by generation that can ramp up at will, namely generation that also consumes emission allowances, such as other coal- or gas-fired plants.
For the EU ETS, this means that demand for emission allowances will rebound immediately elsewhere in the system. As the operation of the MSR is based on an annual indicator only, it fails to catch the excess allowances.
The rebound happens in two main ways: firstly, coal and gas plants elsewhere in Europe will ramp up. Secondly, gas loses some of its competitiveness against coal, meaning carbon emissions “leak” from gas to coal. This is because the emission allowance market is a key driver in the competition between gas and coal.
If the allowance market loosens while other factors remain unchanged, coal stands to benefit.
Germany’s decision sends an important message
Based on Fortum’s own analyses and surveys of external market analysts, the MSR is not equipped to prevent the waterbed effect, as it operates too slowly and absorbs too few unused allowances from the market. We estimate that 80–90% of the waterbed effect still exists after the introduction of the MSR, depending on certain market assumptions.
Germany has in any case sent an important signal to other member states by deciding to cancel the unused emission allowances due to the coal phase-out. This is of high European political importance for the further development of the EU ETS and an example of making responsible and sustainable climate policy that results in real emission reduction.