Policy paper

EU Emissions Trading System: the future of the system

Published 21 October 2014

This was published under the 2010 to 2015 Conservative and Liberal Democrat coalition government

The UK believes that the EU Emissions Trading System (EU ETS), the world’s largest cap and trade system, should remain the cornerstone of EU energy and climate change policy. The EU ETS demonstrates Europe’s ambition to act as a global leader in the fight against climate change through the delivery of a functional and effective carbon market. The continued success of EU ETS is vital in helping the EU to meet its 2030 and 2050 targets at least cost, and in laying the foundations of a global carbon market.

EU Emissions Trading System: issues and reforms

The EU ETS market currently has a surplus of around 2 billion allowances (equivalent to a year’s worth of allowances under the EU ETS cap) which, if not tackled, is expected to depress the signal for low-carbon investment for at least a decade, and is likely to increase the overall costs of meeting our future emissions reduction targets.

The surplus is the result of a combination of factors, which include:

• an unanticipated shock - the economic recession
• a weak 2020 target out of line with a least cost pathway to achieve 2050 emissions reduction goals; and
• access to project credits within the EU ETS cap

In order to address the surplus allowances and move towards a low carbon economy cost effectively, the ETS must be reformed and strengthened. Currently, there are 2 EU ETS proposals to realise these aims:

• EU ETS Phase IV: wider 2021 to 2030 reform of the EU ETS addressing aspects such as overall ambition, carbon leakage, and support for modernisation of the energy sector and technological innovation; and
• Market Stability Reserve (MSR): an agreed measure to address the surplus of 2 billion allowances in the system, strengthen the investment signal and improve the resilience of the EU ETS

EU ETS Phase IV (2021 to 2030)

In July 2015, the European Commission published a legislative proposal to reform the EU ETS for the next phase (2021 to 2030). Key elements of the Commission’s proposals include increasing the rate at which the cap on emissions decreases each year, preserving auctioning as the main method of allocating allowances, reducing the number of industrial sectors considered at risk of carbon leakage, setting up of an Innovation Fund to support the development of Carbon Capture and Storage (CCS), innovative renewables and industrial innovation projects across the EU, and a fund to support energy sector modernisation in lower income member states.

The UK welcomes these proposals as a step towards creating a more robust and effective system. In particular the proposed split between auctioning and free allocation of allowances, the broad scope of the new Innovation Fund and the rationalisation of the carbon leakage list are all positives measures to strengthen the EU ETS. However, there remain issues with the proposal which must be addressed in order to create a more effective system. In order to provide the right incentives to achieve abatement at least cost, while supporting industry through the transition to a low-carbon economy, the UK supports:

• an EU ETS cap in line with the EU’s target of at least 40% domestic Greenhouse House Gas emission reductions by 2030, honouring the October 2014 European Council Conclusions
• a secure, liquid carbon market; this is critical to provide the right incentives for installations to reduce their emissions, driving cost-effective abatement and innovation
• targeted, cost-effective and risk-based carbon leakage support. In the context of a declining supply of free allocation, support should be focused on those sectors at greatest risk of carbon leakage in order to minimise carbon leakage overall, with lower risk sectors also receiving support. A strong evidence base is vital to achieve this
• the minimisation of administrative burdens on operators, especially small emitters. It is vital that costs for all operators are kept as low as possible in order to reduce competitiveness impacts of EU ETS
• transparent and cost-effective administration of the funds to support decarbonisation of UK and EU industrial and energy sectors. The Innovation and Modernisation Funds must help drive decarbonisation, which will be key to allowing the EU to meet its 2030 and 2050 targets

Further details can be found in the UK policy position paper.

Please contact the EU ETS team if you would like to contribute your comments and ideas about the future of the EU ETS at [email protected]

Market Stability Reserve

In September 2015, the EU Council voted to introduce a Market Stability Reserve (MSR) to the EU ETS; this followed approval by the European Parliament in July 2015. The MSR will be implemented from the beginning of 2019 and is a robust, predictable rule-based mechanism for adjusting the volume of auctioned allowances, with the aim of making supply respond to changing circumstances (such as an unanticipated shock), as in natural markets, and promoting market balance.

The MSR will tackle the estimated 2 billion surplus of allowances that has built up in the EU ETS by placing approximately 1.5 billion allowances directly in to the reserve before 2021, the start of Phase IV of the EU ETS. When the surplus is above an upper threshold the MSR will remove allowances from the market and place them in a reserve, and allowances will be returned from the reserve when the surplus falls below a lower threshold or if prices increase sharply.

Tackling the surplus of allowances will strengthen incentives for low-carbon technologies and provide an effective, long-term carbon price signal that develops smoothly, protecting industry against prices rising too quickly in the future. Further details on the MSR can be found on the European Commission’s website.

The UK played a prominent role in achieving agreement to a strong and effective MSR, which will help to ensure Europe can meet long-term emission reduction obligations cost-effectively.

To inform the UK position, the government carried out analysis of the impacts of a range of MSR scenarios, including carbon price analysis from market analysts. Further information on the UK position can be found in our policy paper. UK government’s analysis is set out in our analytical paper and in January 2015, we published an external research report commissioned by the Department of Energy and Climate Change and undertaken by Ecofys and London School of Economics (LSE), to assess design options for a Market Stability Reserve. The final report and associated peer review are available.

Please contact the EU ETS team if you would like more information on the MSR [email protected]

Engagement and evidence gathering

To expand our evidence base on how the EU ETS should be reformed and to inform the government’s position on structural reform in the EU ETS, the Department of Energy and Climate Change commissioned a research project on approaches to cap-setting and the importance of price certainty in the EU ETS. The report was produced by Ecofys UK Ltd and Oxford Energy Associates and peer reviewed by Dr Herman Vollebergh (Erasmus University, Rotterdam).

The European Commission launched 2 stakeholder consultations in 2014 covering the reform of the EU ETS post-2020. The UK responses to the carbon leakage and wider Phase IV reform consultations are available online.