Using supply-side policies to raise ambition: the case of the EU ETS and the 2021 review

Produced as part of the Competitiveness in the low-carbon economy CCCEP research programme theme

The carbon price on the EU emissions trading system (ETS) witnessed a fourfold increase in the wake of the 2018 market reform and has been hovering around €25 per tonne of carbon dioxide ever since. This has been driven by a sizable tightening of the cap on emissions, achieved through a strengthening of the linear reduction factor (LRF) by which the cap declines annually and the implementation of a market stability reserve (MSR) with a companion cancellation mechanism. The 2018 reform has increased and brought back scarcity to the market earlier than originally anticipated – if anticipated at all – by market participants.

This situation notwithstanding, further regulatory amendments are still on the horizon, essentially as part of the 2021 review. The underlying motivation of the review is to align the ETS with the EU commitments under the Paris Agreement, the objectives of the upcoming Green Deal and the achievements of the other pieces of European climate and energy policy.

In this paper the author evaluates and compares the impacts of realistic regulatory changes within the ETS to inform the 2021 review and raise ambition. The two main policy levers are an increase in the LRF and enhancement of the MSR via changes in its parameters. Crucially, these levers are not equivalent in terms of increased stringency over time as perceived by market actors, and they interact as policy complements or substitutes. The paper explores synergies to minimise the regulatory costs of an ambition ramp-up.

Key points for decision-makers

  • The author develops an emissions trading model tailored to the EU ETS and calibrates it to reproduce annual price and banking developments over 2008–2018.
  • The calibration exercise shows that market actors tend to focus on the short to mid term and do not fully account for the scheme’s long-term ambition target; only the years ahead with greater political credibility and visibility in terms of supply-demand conditions matter for their decisions.
  • This has important implications for policy design and outcome. Policy should be designed to accommodate and compensate for bounded foresight to alleviate detrimental outcomes, e.g. inefficient price developments and higher regulatory costs.
  • The MSR has the potential to make the long-term ambition embedded in the cap trajectory more tangible in the short to mid term by frontloading emissions abatement efforts. Coupled with the cancellation mechanism, the MSR also increases long-term ambition.
  • The 2018 price rally is largely attributable to market actors expecting a sizeable MSR-induced supply cutback in the coming years rather than to the companion LRF increase. This shows that transitional stringency can be as important as cumulative stringency for policy design and outcome.
  • Combining MSR thresholds that are declining over time with a higher intake rate can keep induced oscillations in check, thereby leading to higher prices and ambition. However, even after changes in its parameters, the ability of the MSR to improve the market resilience to shocks is limited and one-sided by design.
  • Ramping up ambition by increasing the LRF (direct ramp-up) or enhancing the MSR (indirect ramp-up) will have different impacts in terms of perceived stringency and they can be complements or substitutes.
  • In exploring the hitherto unexplored LRF–MSR interaction, the paper shows that declining thresholds are always less costly than constant thresholds for a given ambition target, especially when coupled with an increase in the intake rate for ambitious targets.