ForTheDoers Blog

Has the EU carbon market entered a new era?

Vesa Ahoniemi 27 August 2018, 11:21 EEST

Why is the Emissions Trading System the EU’s flagship policy to combat climate change?


The European Emissions Trading System was long considered something of a failure, as the post-2008 recession along with certain policy decisions brought demand for emission allowances – and prices – to the doldrums. Now the situation has changed. The price of a European emission allowance (EUA) has risen from 7.81 euros per ton at the start of the year up to 20.90 euros at the time of writing, a 170-percent gain. This is the highest price in ten years.

The ultimate reason for the stronger price is the Market Stability Mechanism (MSR), set to begin operating at the start of 2019. The MSR will effect a 40-percent reduction in the number of EUAs coming to the market compared to the current year, a dramatic shift to which the market is now reacting.

Overlapping policy measures undermine the steering effect of emissions trading

One has to remember that deep down, the EU ETS is a political tool for limiting CO2 emissions and a perennial threat to its potency comes from the same political sphere that gave birth to it. Of particular concern are overlapping policies. By these we mean, inter alia, national bans on particular fuels, targeted at production facilities already covered by the EU ETS. Overlapping policies do not lead to emission cuts on a net basis. Instead, the emissions saved at one location simply move to another inside the ETS, making these policies a poor method of fighting climate change.

A look into history reveals that the EU carbon market is extremely sensitive to overlapping policies also at the EU level. For example, the draft energy efficiency directive, published in the summer of 2011, started a chain of events during which the European emission allowance price fell from 16.50 euros per ton all the way to 6.50 and did not substantially recover in almost seven years.

Sometimes it is argued that overlapping policies are not as detrimental to the ETS anymore as they were before due to the existence of the MSR. According to this train of thought, the emissions saved by national policies will simply be withdrawn from the market into the MSR and therefore will not be emitted somewhere else.

This understanding is erroneous, however, as the time horizons of the bans on thermal coal use, for example, and the MSR, are fundamentally different. In reality, the MSR will only withdraw allowances up to the point when the total number of EUAs in the market is above 833 million tonnes. According to consensus forecasts, this limit will be reached by 2025, the earliest year when the first coal bans, now in planning, are set to take effect. Hence, as feared, the emissions abated by these overlapping policies would simply result in emissions being increased somewhere else inside the ETS, with no net emission reductions.

Overlapping policies – both at the EU level and nationally – still represent a major threat to the EU ETS. This is not to mention the political bandwidth wasted on “climate policies” that have no positive effect on the climate.

How does emissions trading help the climate?

Why is the Emissions Trading System the EU’s flagship policy to combat climate change? One perspective is that almost all resources, including those available for reducing greenhouse gas emissions, are limited. For example, in power generation we trust the market mechanism to ensure that customers only pay for as much as is needed to satisfy demand at any given moment, and not a cent more, leaving resources available for other uses.

In the context of combatting climate change, the market mechanism can make sure that emissions are cut exactly where it is most cost-effective. This is achieved by setting an emissions cap and selling allowances to the highest bidders and forming a market price of CO2 below which it makes sense for market actors to start reducing their emissions.

In practice, how does a carbon price reduce emissions? One of the most important mechanisms is the effect of the EUA price on the European power generation. As a rule of thumb, one euro in the price of carbon translates into 87 cents in the cost of producing electricity using coal but only 41 cents in the equivalent costs in gas-fired generation. This way, a more expensive EUA benefits a relatively low-carbon gas at the expense of high-carbon coal. Obviously, EUAs have no effect on the generation costs of renewables or nuclear at all, thus boosting their competitiveness against fossil fuels.

Overall, then, there simply is no particular price level at which the EU ETS starts having an impact. The impact of the price of carbon is visible at all price levels, all the time, and a higher price always pushes the EU economy in a more climate-friendly direction.

Potential for emission cuts inside the ETS exists in myriad places and as a whole is difficult to estimate, but to give a sense of the scale, in the power and heat generation the potential from coal-to-gas switching alone is to the tune of 10 percent. Although, as a caveat, this requires high volumes of gas available in Europe – otherwise price gains in EUAs will simply spill over to the price of gas and switching from coal to gas becomes more difficult. Admittedly, the causal chains are complex, but at any event, a stronger ETS will always direct power generation in a climate-friendly direction.

In addition to power and heat, the EUA price is now felt more widely also in other industries covered by the EU ETS. This is because allocations, the other main supply source of EUAs, cover a smaller and smaller part of total emissions, forcing more and more market actors to come to the market to cover their needs, exposing them to the carbon price and extending the impact of the EU ETS wider and wider inside the European economy.

Despite the rapid price movements and a tightening market, it ought to be remembered that the ETS is still a political construct and as such vulnerable to political interference. The benefits of the mechanism nevertheless overwhelming; the emission reductions achieved using the ETS take us closer to our climate goals in the most cost-effective way and can also serve as a useful model for the rest of the world.

Vesa Ahoniemi
Market Analyst