2016 State of the EU ETS Report February 2016

Andrei Marcu

Milan Elkerbout

Wijnand Stoefs

Table of Contents

Executive Summary ............................................................................................................................. 1

1. Introduction ................................................................................................................................... 2

A EU ETS “fit for purpose” ................................................................................................. 2

2. Environmental delivery ............................................................................................................... 3

3. Economic efficiency & cost effectiveness .................................................................................. 6

EU ETS: Indirect driver of change ...................................................................................... 8

Direct impact of the EU ETS ................................................................................................ 9

Conclusions on economic efficiency & cost effectiveness ............................................. 11

4. Market Functioning .................................................................................................................... 11

5. Carbon leakage and competitiveness ...................................................................................... 15

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Executive Summary

The EU ETS has passed its first decade of operation and has proven to be an inspiration for those that promote carbon markets. But is the EU ETS delivering, is it “fit for purpose”, and what does that actually mean? As with any activity or project, it needs to be subjected, periodically, to an assessment regarding its well-functioning, and the delivery of its objectives.

The EU ETS can be assessed against a number of deliverables, which include environmental delivery and economic efficiency, as well as market functioning, and mitigation of risk of carbon leakage. While the former two are direct deliverables, the two later ones can be seen as corollary.

There is no doubt that the EU ETS is delivering, ahead of time, against its -21% target for 2020. It is a success.

As a market, the EU ETS is functioning reasonably well, even in the face of many of the liquidity providers exiting the market. Volumes have been down back to below 2009 levels. The make-up, and behaviour, of the market participants tend to amplify its downturns, while its seasonality will sometimes amplify its volatility. Auctions continue to be well covered.

Carbon leakage and competitiveness are the main EU ETS current policy issues. So far, in Phase 2 of the EU ETS, carbon costs have not had a significant impact on competitiveness, with the possible exception of electro-intensive industries. Examination of the post-2020 proposal, and a search for a solution, will need to consider a package that will optimize the free allocation cap, the increased overall scarcity, and the need to work in harmony with the objectives of the MSR. This may herald an inter-sectorial competition for scarce free allocation.

However, it must be a concern that the 2020 milestone target does not seem to be in line with the EU longer-term goal of 80-95% by 2050, and has a low probability of delivery, even at the lower end of that range. Also, current objectives are aligned with a 20C target, and do not seem to take into account the Paris Agreement (PA) call to “pursue efforts to limit to 1.50C”. Finally, the current governance, and the EU ETS Phase 4 proposal, do not account for the PA proposed periodicity, which includes a global stocktaking in 2018 and 2023, and a possible new NDC in 2025, if not in 2020.

The EU ETS is making a difference in establishing a price for carbon and incentivizing, through its resilience, and direction towards increased scarcity, significant corporate shadow prices. However, EUA prices at current levels cannot trigger operational, or medium-to-long term change, which is triggered by other, more costly measures, which have other additional objectives, such as renewable energy policies. The need to find mechanisms to incentivize innovation must be a significant concern.

This points to trade-offs between economic efficiency and the political reality of other objectives. However, this is clearly not a call for competition, or choice between different policies, but for the need for recognition of policy overlap, and effective coordination of policies to mitigate that overlap. The coordination was introduced through the Market Stability Reserve (MSR), but its parameters, which are the result of a political compromise, are simply not effective in the political delivery, and environmental challenge, timeframes. This is leading to erosion in the trust in the EU ETS, which needs to be addressed.

The lack of debate on the current market situation is being interpreted as a lack of concern on the developments in the EU ETS, and that things are accepted, and acceptable, the way they are. No matter how you cut it, as an overall statement, one can say that the EU ETS market is long, while environmental delivery requires much more to be done. This combination cannot be right.

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1. Introduction

The EU Emissions Trading System (EU ETS) is a regulatory market that was created by the European Union (EU) in order to provide a price signal for de-carbonization, and to help and meet its Kyoto Protocol (KP) international obligations.

As any activity or project, it needs to be subject, periodically, to an assessment regarding its well-functioning, and the delivery of its objectives. In this respect the EU ETS is not different from any other activity, and article 10(5) of the EU ETS Directive provides for such a yearly assessment.

Carbon pricing through an emissions trading system needs to be one of the tools deployed by the EU to help meet its GHG reduction goals. The “State of the EU ETS” Report is intended to contribute to the policy debate to help ensure that the EU ETS is “fit for purpose”, by reflecting on whether it meets the objectives that were set for it explicitly, as well as the implicit expectations of the stakeholders.

A EU ETS “fit for purpose”

The conditions for success for the EU ETS (“what constitutes success for the EU ETS“), need to be identified, followed by a determination if it delivers against those conditions. Article 1 of the EU ETS Directive outlines its broad objectives:

This Directive establishes a scheme for greenhouse gas emission allowance trading within the Community in order to promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner.

This Directive also provides for the reductions of greenhouse gas emissions to be increased so as to contribute to the levels of reductions that are considered scientifically necessary to avoid dangerous climate change.

However, the EU ETS functions in the harsh realities of everyday life. The “conditions for success” need to be more explicitly translated in terms of economic and market language. A number of DIRECT conditions can be identified, which would make the EU ETS to be “fit for purpose”:

Environmental delivery. Does it deliver against absolute environmental targets as expressed in the EU ETS Directive? The EU ETS Directive also refers to reductions “scientifically necessary”. Stakeholders may see other environmental deliveries as implied, or related.

Cost effectiveness and economic efficiency. This reference in Article 1 of the EU ETS Directive could be interpreted as referring to macro-economic efficiency and cost effectiveness for compliance. Alternatively, economic efficiency can be seen as being dynamic while cost effectiveness as a more snap shot view.

Two corollary conditions can be derived from these objectives:

Does it function well as a market, based on tests that any market is judged against? This will allow for good price discovery.

Does it provide effective, but at the same time proportional, protection against the risk of carbon leakage for those sectors of the economy, which are open to global competition, while the global climate change regime is seen as asymmetrical?

Stakeholders, have, expressed in their own language, their expectations for EU ETS:

Does the EU ETS provide a price signal for de-carbonization, is it the driver for de-carbonization, including innovation? How does it interact with other EU policies and

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measures that may result in GHG emissions? This is a relevant and legitimate question as it impacts directly the efficacy and efficiency of the EU ETS.

Do the EU ETS covered sectors really decarbonize? Do we meet targets by decarbonizing or can the lower GHG emissions in ETS sectors be attributed to other cause – and does it matter?

Does it provide for short-term as well as long-term economic efficiency?

Is the EU ETS target in line with EU domestic and international climate change commitments?

Does it help reduce the risk of exposure to carbon constraints?

Does it meet the polluter pay principle?

Some stakeholders may not always be genuine in their demands, and the issues listed above may seem like a long Christmas list. At the same time, it is difficult to find any issue listed above as being illegitimate. All these elements are deeply interrelated, and in some ways represent different angles of the same question.

2. Environmental delivery

Environmental delivery is the key delivery, if the EU ETS is to be considered successful. However, this delivery is not one-dimensional, and must be seen as being multi-faceted, in that it needs to be examined for direct achievement, as well as in relation to the overall climate change objectives to which it is meant to contribute.

This latter condition is not explicitly expressed, and can be seen as being a political decision in terms of the balance of the contribution from the ETS and non-ETS sectors, as well as the timing (milestones) of the effort to reach long-term EU de-carbonization goals.

Delivery against the trading period target. In this case the issue is simple: does the EU deliver against its trading period for 2020 of -20% vs. 1990 emissions?

Delivery against EU long-term domestic environmental commitments. This question is valid to the extent that it examines whether the short term, trading period target, leads the EU to deliver on its longer terms goals and commitments. This is relevant to the economic efficiency of the delivery of the EU’s long term climate change objective. However, how the milestones (trading period targets) are set for the EU’s long-term GHG reduction efforts is a political decision.

Delivery against international GHG commitments. The EU ETS level of ambition should match against the EU’s international commitments, as expressed in both the Cancun pledges, as well as it was recently agreed in the Paris Agreement.

EU ETS delivery

The EU ETS target for 2020 (-21% for ETS sectors when compared to 2005) is being reached, ahead of time. It is a clear and unambiguous success, which no one can argue with.

The European Environment Agency figures showed that by the end of 2014, emissions from EU ETS covered installations had already decreased by 24%, when compared to 2005.1

1 EEA. (2015), « Trends and projections in the EU ETS in 2015”, October 2015.

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Figure 1. Trends and projections of EU ETS emissions (stationary installations), ETS cap and available credits, 2005-2020

Source: EEA (2015). Trends and projections in the EU ETS in 2015. p. 30.

How much is due to a decrease in CO2 intensity, and how much it is due to a decrease in the level of economic activity, is an important issue. What is desirable is that we have low absolute GHG emissions due to a decrease in energy and carbon intensity, which points that to the fact that action has been taken to decarbonize.

Data from different sectors (e.g. electricity, cement, pulp and paper, chemicals and pharmaceuticals) seem to indicate a decrease in carbon intensity. In the case of the electricity industry the increasing role of renewable energy plays a critical role.

However, from a research and policy point of view this is difficult to verify. This points to a not-so-glamorous, but more-than-important, issue, that of data availability that will allow for independent analysis. The mismatch between data on EUTL, and on EUROSTAT, makes it impossible to undertake serious analysis, and in this case, verify information using official data. This is an important issue, and one that needs to be addressed with some priority.

EU domestic climate change targets are expressed through a number of legislative and other institutional documents, dating back to the European Council (EUCO) of February 2011, which endorsed a 80-95% reduction target vs. 1990 levels.2 In the same Conclusions, the EUCO called upon the European Commission to develop a long-term roadmap for GHG emission reductions.

This was expressed in the “2050 Roadmap for moving to a competitive low-carbon economy” (RM) which referred to COP15 where “world leaders agreed that global average temperature

2 European Council. (2011). 4 February 2011 Conclusions. EUCO 2/1/11 REV 1

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should not rise more than 2°C”. It also mentioned a number of intermediate GHG reduction targets (40% by 2030, 60% by 2040, and 80% by 2050).3

While the roadmap explicitly mentions the long-term ambition of reducing GHG emissions by 80-95%, it nevertheless considers the above trajectory to be in line with this.

The 2030 Framework for Climate and Energy Policies (2030 Framework) has a temperature target to “limit global temperature rise to below 2°C”.4 The associated Impact Assessment (IA) repeats this temperature target of “to below 2°C”. This is translated into GHG reduction targets for 2030 of 40% by 2030 compared to 1990. ETS sectors are expected to reduce emissions by 43% while non-ETS sectors should contribute with a reduction of 30% compared to 2005.5

The most recent document detailing the EU’s ambition are the October 2014 EUCO Conclusions.6 It refers to the following targets:

“At least 40% domestic reduction in [GHG] emissions by 2030 compared to 1990”

Linear Reduction Factor (LRF) of 2.2%

EUCO “will revert to this issue [contributions/targets to UNFCCC] after the Paris Conference”

The Impact Assessment of the EC proposal of July 2015 refers to 80-95% reductions, in addition to “at least 40%” by 2030. However, it resorts to the I.A. of the 2030 Framework for justifying the use of a 2.2% LRF, thereby not taking account of the change in language to “at least 40%”.7

While the I.A. of the 2030 Framework notes that a 2.2 LRF is necessary for reaching the 40% GHG reduction target (-43% compared to 2005),8 it must be highlighted that it also notes that a 2.2% LRF would not be sufficient for a 90% reduction compared to 2005 (in ETS sectors), as this would require a LRF of 2.4%. It would therefore seem that the 2.2% LRF is not putting the EU on a trajectory for reaching - 90% in ETS sectors by 2050.9

From an international commitment point of view, the Paris Agreement (P.A.)10 has a number of provisions, which are relevant for environmental delivery of the EU ETS.

P.A. Art. 2(1a) speaks of a commitment of “holding the increase …..well below 2°C” and “to pursue efforts to limit …. the increase to 1.5°C”

CP.21 para. 20 [the COP Decision accompanying the Paris Agreement]: A facilitative dialogue in 2018 will take place to take stock of collective efforts of Parties in relation to progress towards the long-term goal

3 European Commission. (2011). A Roadmap for moving to a competitive low carbon economy in 2050. Brussels, 8.3.2011 - COM(2011) 112 final

4 European Commission. (2014). A policy framework for climate and energy in the period from 2020 to 2030. COM/2014/015 final *

5 European Commission. (2014). COMMISSION STAFF WORKING DOCUMENT IMPACT ASSESSMENT Accompanying the document Communication [on] A policy framework for climate and energy in the period from 2020 up to 2030 - /* SWD/2014/015 final */

6 European Council. (2014). 24 October 2014 Conclusions. EUCO 169/14

7 European Commission. (2015). COMMISSION STAFF WORKING DOCUMENT IMPACT ASSESSMENT Accompanying the [Proposal for amending the ETS Directive]. {COM(2015) 337 final} {SWD(2015) 136 final}. P. 22

8 Supra note 5. P.105

9 Ibid.

10 UNFCCC. (2015). FCCC/CP/2015/L.9/Rev.1

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CP.21 para. 24 & Art. 4(9): communicate or update Nationally Determined Contribution by 2020 and to do so every 5 years – new EU NDC by 2025

P.A. Art. 14: mandates a global stock take every 5 years, starting in 2023

The current EU ETS contribution, together with the non-ETS sector contribution (effort sharing), could be argued, that is broadly in line with a 20C objective.

However, the P.A. implies that there will be pressure to meet a target between 1.5C and 2C, which represents a significantly higher level of effort. While the impact of the P.A. on EU policy is currently being assessed, it would seem that this more ambitious objective makes the current EU contribution to the global reduction effort insufficient, as it already has a low probability (66%) of achieving the 20C target.

This is also supported by the UNFCCC ‘Synthesis report on the aggregate effect of the INDCs’ which states that the currently submitted INDCs will not be sufficient to limit temperature rise to 20C.11

Yet another supporting element that the current LRF of 2.2% is not sufficient is expressed by the reference in the P.A. to have a level of ambition in “accordance with best available science”. This implies that EU targets will also need to take into account the next IPCCC report, which has a periodicity of 5-7 years, and is very likely to demand a higher level of effort than the current INDCs. In this context, the IPCC report on 1.50C, mandated by the Paris Agreement, is important to watch.12

As mentioned, how milestones are chosen has strong political connotations, and will influence the economic efficiency of the path chosen. It will also be influenced by what other countries, which are Parties to the P.A., will do. As such, this is a political decision, and as in other cases, some economic efficiency will be sacrificed, and traded, for political feasibility.

What is clear is that the current governance, whereby the EU ETS is on a ten-year cycle, does not match the one in the P.A. Addressing the level of ambition (expressed through the LRF, or otherwise) in the current legislative process (P4) may be challenging (or not). However, making provisions for a governance system that would be able to adapt to the cycle of the P.A., should be seriously examined.

3. Economic efficiency & cost effectiveness

While environmental delivery, with all the caveats mentioned above, is the key delivery for EU ETS, it must also be seen as a necessary, but not sufficient, condition for the EU ETS to be considered “fit for purpose”. The EU ETS should drive de-carbonization in an economic efficient and cost effective way, both inter-temporally, as well as across the economic landscape.

EU climate change policy and the EU ETS exist in the real world of policy decision-making, and its architecture and operation will always include trade-offs between pure theoretical economic efficiency, different EU objectives, as well as political realities. For illustration purposes, it is a clear political decision that the EU ETS does not allow an unlimited quantity of international credits, as well as that there is a “firewall” between the ETS and ESD sectors.

11 UNFCCC. (2015). Synthesis report on the aggregate effect of the intended nationally determined contributions. FCCC/CP/2015/7

12 CP.21 para. 21

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The EU also has other policy objectives beyond de-carbonization, and that is reflected in the other instruments, which were put in place, and interact, sometimes very strongly, with the EU ETS. The prime such examples are the Renewable Energy (RE) and Energy Efficiency (EE) Directives.

There will always be overlap, and interaction, between different policies measures, but there need not be competition, as long as there is recognition of that interaction, it is well quantified, and the tools to ensure that they are coordinated to provide for the effect of the overlap, are put in place.

If these conditions are not fulfilled, then the EU ETS could become a marginal tool that will “clean up” what other policies “fail” to deliver with respect to EU climate change goals, but not be the driver for de-carbonization. This currently is the situation in California, where the ETS is not the main driver for de-carbonization. This implies that de carbonization will be done in a less than the most efficient way, and it is a political decision to allow for a trade-off between economic efficiency, and other meeting other objectives.

The EU ETS was initially seen as a tool that could drive change in all time frames. In the short-term, it could provide the arbitrage for fuel switching in the power sector. In the medium term, it could be expected to impact investment plans for the deployment of new technologies, especially renewables, but also energy efficiency. Long-term time horizon is especially important for new plant investment, as well as providing an impulse for innovation, that is critical if we are to reach de-carbonization levels expected by 2050.

Efforts were made during the last two years to ensure that this would happen – that the EU ETS price signal would play these roles. In the absence of any officially declared price floors, or corridors, interventions targeted volumetric parameters.

During 2014, and in early 2015, the policy debate on the EU ETS focused on interventions that were intended to correct imperfections in the design of the market (i.e. supply side flexibility). These interventions were also intended to introduce measures and mechanisms to mitigate the interaction, and coordinate, between the EU ETS, and other policies that reduce GHGs, such as RE and EE. The other perceived cause of the excess length in the market, the importation of international credits from the Kyoto mechanisms, has been already eliminated.

The expected result was a lowering/elimination of the over two billion EUA overhang that has emerged in the EU ETS, with some likely, and hopefully untargeted, impact on EUA prices.

Both changes to the EU ETS Directive, back loading and MSR, were in different ways, harder fought battles, than anticipated. This did not signal a good understanding, and in some cases acceptance, of the problem to be solved by some of the stakeholders. Concerns, genuine for some, of the separation of the discussions on carbon prices (MSR) and “who pays the price” (carbon leakage), also contributed.

This resulted in the outcome being a watered down political compromise, with most analysts forecasting that the MSR will not start to have material impact (restore scarcity), and address the problem, until sometime in the mid-2020s.

Market participants saw the outcome as a signal of political commitment, which created a positive sentiment, and confidence, in the staying power and the resilience of the EU ETS. This was reflected through a slow, but steady, increase in EUA prices, also fuelled by the positive sentiment generated by the Paris Climate Change conference in December 2015. This was in spite of the realities of the demand supply curve, which signalled that the EU ETS was still significantly long for the foreseeable future.

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Figure 2 illustrates price developments over the period from late 2012 until now. However, at this time, EUA prices are essentially back to where they were in 2014.

Figure 2. Daily settlement prices for EUA’s at EEX, December 2012-February 2016, in €

Source: EEX (2016).

EU ETS: Indirect driver of change

The EU ETS has a strong impact, and plays a positive role, in changing corporate culture. Corporate investment decisions are made based on internal shadow prices, which are in many cases significantly higher than EUA prices, and what the mid-to-long-term price curve would indicate. Studies such as Carbon Disclosure Project (CDP) (2014) 13 show that significant multinational corporations such as Total (32$), BP (40$), Royal Dutch Shell (40$), and AkzoNobel (64.5$) are making decisions based on carbon prices that are higher than current prices.

This situation can be attributed to two main causes. Firstly, carbon pricing is becoming widespread and the EU ETS has played a critical role as a pioneer. It has now become one of the key demands of many in government and business. Initiatives such as the Carbon Pricing Leadership Coalition that started during the UNSG Climate Summit in 2014 and was launched at COP 21, point in that direction. Currently, nearly 25% of global emissions are under a carbon pricing mechanism,14 with carbon markets to become a countrywide approach in 2017 in China.

Secondly, while the EU ETS has been criticized for regulatory instability (see Figure 3), it is also recognized that all interventions have been in one direction: to provide political support and drive the EU ETS towards more scarcity. This is what the main regulatory changes have indicated: limitation on the use of international credits, back loading, MSR, etc.

13 CDP (2014), “Global corporate use of carbon pricing – disclosure to investors”, September, https://www.cdp.net/CDPResults/global-price-on-carbon-report-2014.pdf.

14 World Bank (2015), “Partnership for Market Readiness Annual Report FY2015“, https://www.thepmr.org/system/files/documents/PMR%20Annual%20Report%20FY15.pdf

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Figure 3. Timeline of changes in the EU ETS

Source: Based on info from: Heidelberg Cement (2016).

Direct impact of the EU ETS

From the short-term, operational, point of view, fuel switching is currently out of the range of the EU ETS price. Coal to gas switch would require an estimated EUA price of 20€, maybe lower, given current prices of primary energy sources.

For the mid-term, change, especially the deployment of renewables, is taking place. Figure 4 shows the change in installed capacity of renewable energy (solar PV and wind) in the EU between 2004 and 2013.

Figure 4. Installed renewables capacity in the EU (solar PV and wind in MW)

Source: Eurostat (2014).

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Solar PV Wind

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It is estimated that under current circumstances (which change frequently, meaning that the carbon price which triggers switching to RE is also constantly changing) the carbon prices required for the deployment of some types of RE should be in the order of 30€ (before accounting for the additional investments to cope with the intermittency of RE). The increased RE capacity is mostly due to the EU RE target driving feed-in tariffs, and other dedicated support, while costs continue decreasing rapidly.

A 2013 OECD study15 also show that the OECD average cost of abatement for CO2 through renewable policies is €169 when using feed-in tariffs and €176 when using capital subsides. It should be noted that since then, these costs have dropped significantly, although they remain above the carbon price. From a de-carbonization point of view this is extremely inefficient, but RE has also objectives other than de-carbonization.

From a long-term perspective, if this situation persists, at this EUA price level, the Innovation Fund of 450 million tons will have at its disposal significantly fewer resources than anticipated.

Under these circumstances the direct impact of the EU ETS, and its power to drive change, is marginal at best.

This is leading to measures being implemented at the national level, such as the UK price floor (over 18 £ per ton of CO2 in 2015). Other member states may follow suit. France is on the record as pushing for a price corridor, which, coupled with the current level of prices, is effectively a carbon tax. Germany has considered different approaches in order to phase out its coal-fired plants, which are now displacing gas generation.

Translated into markets, this can only be seen as a driver towards the fragmentation of the EU ETS, and an additional loss in the efficiency that the EU-wide ETS is bringing.

This does not, in any way, make a case against carbon pricing through carbon market and the EU ETS. It should also not be interpreted as the need to make a choice between different policies. There are many factors that are interrelated, and as in any market, policy making cannot guarantee any specific outcomes, especially as they relate to prices. In this context, the impact of low fossil fuel prices cannot be ignored, as it will also delay change, and also needs to be addressed.

The current situation needs to be seen as an indication that the policy measures which were put in place to address, from a systemic point of view, the overlap of policies, and the surplus that it (partially) created, may be incomplete, and not incisive, and will therefore take too long for the time horizon of politics and some economic decision-making. This includes MSR parameters that were put in place to drive scarcity to a bandwidth of between 833 million and 400 million EUAs, which is what the best judgment is under the MSR.

The second take away is the need to reflect whether relying on a volumetric bandwidth, as the only solution, is desirable, in this very politicized market.

Since the purity of economic theory was broken, and other objectives were also included in the optimization of the de-carbonization drive, serious examination should be given to other type of options, including an EU-wide price bandwidth, under certain conditions. This last caveat is critical, as a price floor that is way higher than the EU ETS market price, becomes a pure tax, and negates the credibility of the market approach.

15 OECD (2013), “Climate and Carbon, aligning Prices and Policies”, OECD Environment Policy Paper, October 2013 n°01, OECD/IEA Publishing, Paris.

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Conclusions on economic efficiency & cost effectiveness

We are currently over achieving the EU ETS short-term environmental targets at very low EU prices. Instead of overwhelming joy, there is a sense of lack of success, not from all, but nevertheless, from many of the stakeholders.

This uneasiness can be crudely attributed to the low EUA price, which is disappointing to those that wish to promote specific solutions, especially RE. Such description of the problem defies the very logic of having a market. However, it must also give pause, as this is a regulatory instrument that relies on a societal license to operate.

The second price collapse of the EU ETS, which we have been witnessing since the start of 2016, is becoming more challenging to rationalize, following a successful Paris Agreement, and the introduction of tools to rectify EU ETS design deficiencies.

The sense that many market participants have is that there is nothing wrong with the concept, or the architecture behind the EU ETS, but that the parameters that were put in place were great as a political compromise, but do not address the problem.

The lack of any public debate on the current market situation is being interpreted as a lack of concern on the developments in the ETS markets, and that things are accepted, and acceptable, the way they are.

The findings in this section point to some erosion in the credibility of EU ETS as a tool to drive change in an economically efficient manner. Targets are achieved, but are they achieved in an economical way, or has the compromise between objectives moved too far from economic efficiency?

It is a situation, which requires serious consideration regarding some of the parameters that have been put in place to ensure that the EU ETS is an economically efficient tool for de-carbonization.

4. Market Functioning

Mechanically, the EU ETS can be said to be a well-functioning market. There are a number of factors that need to be considered which include: liquidity, volatility, transparency, market participation, security of the registry, and regulations such as MIFID II.

For the short-term, analysts will have different interpretations and justifications for the current downward price. It is not the aim of this report to substitute for market analysis.

Nevertheless, it has become clear that sentiment plays a significant role in the EU ETS. With an overhang of about 2 billion allowances, and demand being mostly to hedge utilities forward sales of power in the three years ahead, fundamentals would dictate that the price should in principle be zero. However, EUAs arguably are seen as representing an option for future GHG scarcity, expected only around 2025 by analysts, which then translates into positive prices.

Until this significant overhang disappears, sentiment will continue to play a leading role, especially when coupled with other market developments, especially on the bearish side. It has always been argued that carbon should be a driver for energy arbitrage. Currently, it seems that other energy commodities, especially oil prices, play the role of driver for CO2.

Market liquidity is good, in so far as that the EU ETS clearly exhibits price discovery, at least in the short run. However, compared to other commodity markets, liquidity levels nevertheless remain modest.

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There is limited participation in auctions, with participation numbers of around 20 being normal. The average number of bidders in the spot primary market during 2015 was 18. This includes data from the main EU auctions, as well as those for the separate auctions held in Germany and Poland. The cover ratio, an indicator of the demand for the underlying asset, was 3.18, which indicates decent demand.

By contrast, for 2014 and 2013 – the first two years of the ongoing Phase 3 – the average participation numbers were 16 and 18 respectively, indicating a slight increase in participation over 2015 again. The cover ratio for these years was 6.00 for 2014 and 3.00 for 2013.

Another indicator of healthy market functioning is whether the auction clears at a price equal to the spot price on the secondary market. Large divergences between the two could indicate lack of liquidity or market manipulation. Reports of the European Commission on the execution of auctions show that the difference between auction clearing prices and the spot prices is often 1 to 2 cents, with many auctions also clearing exactly at market prices (e.g. March, June 2015 – no reports have been released since June 2015).

Likewise, for the secondary market, spreads between bid and ask prices are relatively constant in the 1-3 cents range, which indicates healthy market functioning.

When it comes to Open Interest (OI), which refers to the number of outstanding positions, data from ICE shows that the number is relatively constant throughout most of 2015, with the OI for the benchmark end-of-year future (e.g. Dec15) standing at around 570-580.000 contracts at the beginning of the year, reaching nearly 600.000 by mid April, before dropping to around 550-560.000 contracts at the end of the year.

Generally speaking, rising prices with increasing OI shows a strong market, while OI weakening in the face of resillient prices shows that the market may be weakening. In this respect it should be noted that OI remained stable over the first weeks of 2016, as EUA prices plunged, but still remained lower by a few thousand contracts than during most of 2015.

Daily volumes in the secondary market, moreover, appear to exhibit some clear seasonality. A German report summarizing the carbon market for 2014 shows volumes peaking in March (2014: around 1 billion)16 and being much lower in the second half of the year (roughly between 350 – 600 million). Data from ThomsonReuters PointCarbon, moreover, also consistently shows higher volumes for the first half of the year, compared to the second half for the years since the start of Phase 3. There may be also be a timing effect, with August less than half of a normal month, and market players closing their books from mid-December.

16 German Auctioning of Emission Allowances Periodical Report: Annual Report 2014, p. 9

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Figure 5. Phase 3 volumes in millions - Jan-Jun vs Jul-Dec

Source: CEPS, on basis of ThomsonReuters PointCarbon data (2016).

When looking at the volumes since the start of Phase 2 in 2008, total secondary market volumes have gone up steadily, but nevertheless peaked in 2013. Total volumes for 2015 were at their lowest level since 2008, and about 41% lower than they were in the peak year 2013.

It is also notable that the share of OTC volumes in the total market has changed considerably over the years. In 2008 OTC trades constituted well over half of the total secondary market, while by 2015 this share has dropped to single digits, making trades via exchanges the dominant means of trading. This drop may be due to regulatory changes in some countries.

Figure 6. EUA Secondary Market Volumes (in millions)

Source: CEPS, on basis of ThomsonReuters PointCarbon data (2016).

Higher liquidity, however, is seen by many market analysts as being a goal in itself as it would make the system as a whole – including the achievement of environmental targets – more efficient. Higher liquidity would also dampen the increased volatility that generally marks

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periods of low volumes, something which can be seen as important in a market which is expected to drive changes in decision making over different time periods (fuel switching in short run, but investment in longer run).

With the departure of Deutsche Bank, Morgan Stanley, JP Morgan, etc. few of the big banks are still present in the market. Some of the liquidity was provided by trading house such as Gunvor and Mercuria, but some of them have also now withdrawn from the market. The decision of many of these actors was not driven by carbon market related decisions alone, but include other factors, such as new market regulation.

The decline of volumes coincides with the exit of the banks, and diminishes the resilience of the market to the entry/exit of players such as speculative funds.

Figure 7. Historical Development of EUAs and implied EUA and Brent volatility

Source: Commerzbank Corporates & Markets, Bloomberg.

Another remark is that the current market participation seems to amplify downward swings. When there is increased supply, such as due to increased auctions as back loading ends, or because certain institutions sell their positions as part of a larger weakness in global (commodity) markets, for year-end reasons, or to meet financial needs, there is little underlying demand to halt this slide.

The industrial sector receives a substantial amount of their allocation through free allocation, and is in many cases over-allocated. As such, industrial operators remain largely absent from auctions, and need not access the market during rallies, or indeed, during any other time except when they have to surrender allowances for compliance. On the other hand, when it comes to adding to the (already considerable) supply in the market, some industrial operators may use their spare allowances as means of financing. Meanwhile power companies are less affected during downward swings.

Volatility varies over the year, with peaks during the first quarter compliance period as well as near the end of the year, when market activity picks up as firms try to settle their carbon positions for accounting purposes. As in other markets, low volume periods tend to amplify volatility, as is the case for other markets.

In a survey by Redshaw Advisors, industrial end-user operators acknowledged that their participation in the market is rather limited, with 44% accessing the market only once a year,

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and only a little over a quarter doing so up to 2-3 times a year. Moreover, this participation mostly takes place between December and April.

Additionally, only 17% of the operators have their finance departments manage their carbon exposure, but rather delegate this to their technical or environmental departments. The limited involvement of finance departments could be interpreted as carbon risk not being seen as a major risk element to manage. This is a concerning observation at it raises questions about the ‘trade’ component of ‘cap-and-trade’. It should be noted that industrial operators are only a minor share of the market, although this is partially caused by lack of need due to free allocation.

The skewed participation patterns in the market have certain ramifications. If the composition of market participation varies considerably throughout the year, the share of speculators in the market will also vary accordingly. This may create problems in a market with an outright regulatory aim.

If high liquidity is indeed accepted as being a necessary condition for good market functioning, then it follows that the participation in the market should not be unnecessarily inhibited. This is primarily of importance for financial regulation, where stringent rules may deter entry to the market as compliance with the financial rule books becomes too costly. In this light it should also be noted that EUAs cannot serve as collateral under the Financial Collateral Directive, which makes it less attractive for certain financial institutions to hold these assets.

MiFID II meanwhile, whose entry into force was recently delayed to January 2018,17 is one of the cornerstones of EU financial market regulation. MiFID II for the first time classifies EUAs as ‘financial instruments’, and refers to earlier problems with the security of the registry as justification for this.

Whilst operators under the ETS are not required to comply so long as they trade on their own account, a high regulatory burden may still deter certain financial institutions from participating in the carbon market. On the other hand, MiFID II is also expected to improve the transparency about the composition of the trading flow, due to increased reporting obligations on positions held.18

5. Carbon leakage and competitiveness

Competitiveness, and concerns over the risk of carbon leakage, have been important factors in shaping the EU ETS policy debates. If back loading and MSR were, and are seen (wrongfully), as addressing EUA prices, the debate on the carbon leakage list is the other side of the coin, and addresses the question of “who pays the price”.

These concerns were initially addressed through very limited auctioning (5% for P1: 2005-2007, and 10% for P2: 2008-2012). That changed with the third trading period (P3: 2013-2020) where a significant amount of EUAs are now auctioned, and free allocation was introduced as an instrument to mitigate the risk of carbon leakage. The amount of free allocation that industrial installations covered by the EU ETS are given is determined through the carbon leakage list, and a complex system that is a function of historical production levels and benchmarks.

There is a second aspect to the carbon leakage debate, which is also important. The current provisions for mitigation the risk of carbon leakage, through the use of historical production levels to determine free allocation, also have a significant impact on the supply-side flexibility

17 http://europa.eu/rapid/press-release_IP-16-265_en.htm

18 Directive 2014/65/EU [MiFID II], Art 58

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of the EU ETS. Together with the fixed auctioning schedule, free allocation based on historical production data, has contributed significantly to the current systemic EUA surplus.

The P3 provisions that allowed the EU ETS to reduce free allocation, in case of a decrease of production levels, had very significant thresholds (production level reductions of 50%, 75% and 90%), which made them ineffective, and prone to gaming. The current proposals for P4, allow for flexibility based on both an increase and decrease in the level of production, which is a step forward. However, their effectiveness will largely depend on the thresholds for triggering an adjustment to free allocation levels. In the current EC proposal, these are to be determined through implementing legislation. The current proposal can provide flexibility; it just depends on how much flexibility will ultimately emerge.

The carbon leakage debate was separated in two phases. The first phase addressed the composition of the carbon leakage list to 2020. This was completed in 2014, with a virtually unchanged carbon leakage list, essentially postponing any hard decisions for the post-MSR period, after the completion of the debate on prices. In this negotiation industry stuck together, and obtained what can only be seen as a very favourable result, which validated its strategy.

There was significant amount of research and modelling trying to predict the risk of carbon leakage for P2. There predictions varied substantially, but were in some cases apocalyptical. The post-2012 research is much more sparse, and results less dramatic.

CEPS research on the impact of the EU ETS on the bottom line of a limited number of energy intensive industries (steel, aluminium, flat glass), as well as research from Ecorys et al.,19 indicate that in P2 there was little impact from carbon costs on the bottom line of energy intensive industries. In some cases the impact was actually negative, i.e. resulting in a net contribution to the bottom line, as industry was substantially over allocated.

Table 1 below shows the impact of EU ETS prices on the steel and aluminium industries. The electro-intensive industries were impacted in a material way, with the power industry passing through its carbon costs.

This points to the current issue of addressing compensation for indirect costs, which is dealt with at the discretion of individual Member States, in accordance with the environmental state aid guidelines. The P4 proposal does not make any material changes in this area, and this continues to be a sour point for a very vocal part of energy intensive industries.

19 Ecorys et al. (2013). Carbon Leakage Evidence Project. http://ec.europa.eu/clima/policies/ets/cap/leakage/docs/cl_evidence_factsheets_en.pdf

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Table 1. ETS costs for steel and aluminium, in % of EBITDA

Phase 1 (2005-2008) Phase 2 (2009-2012)

Steel: Blast Oxygen Furnace (direct, indirect and admin costs)

0% -9%

Steel: Electric Arc Furnace (direct, indirect and admin costs)

5% 12%

Primary Aluminium (indirect costs)

average: 27% average: 49,8%

Flat glass (indirect costs)

n/available average: 3,1%

Source: CEPS (2013a20 and 2013b21) and CEPS (2014)22

The second debate, which is on-going, focuses on how to address competitive concerns resulting from carbon pricing for P4, post-2020. While the impacts of carbon costs in P2, and maybe P3, set the stage for these discussions, they are not always seen as relevant, due to the “special conditions” that existed in this period (i.e. low EUA prices, the extent of the economic and financial crisis).

These “special conditions” simply exposed existing problems. The design of the EU ETS seemed to have been premised on economic growth and GHG scarcity, and could not cope with the extent of the crisis.

The carbon leakage debate, which is at the heart of the July EC proposal for P4, needs to be seen, and addressed, as a long-term issue, in the context of increased scarcity, due to the intervention of the MSR, the increase in the LRF, currently proposed to increase from 1.74 % to 2.2%, as well as the potential revision of the EU NDC in 2020 or 2025.

Those sectors that perceive as being at risk of carbon leakage, ask for free allocation that is gauged to actual production levels, in order to ensure that their competitiveness is not compromised by what they still see as a world of asymmetrical climate change policies. While it is not the intent to analyze and compare different INDCs in this paper, it is also questionable that after COP21 in Paris the world continues to be as asymmetrical as it used to be, given the review cycles which may lead to increased ambition as time progresses.

Under the current EC proposal (and even more so if free allocation is pegged at actual production levels), with a 57-43% split between auction and free allocation, some provision needs to be put in place to ensure that the free allocation cap is not broken. Without such provisions, while the probability may be low, no guarantee can be offered that the free

20 Renda, A., J. Pelkmans, C. Egenhofer, A. Marcu, J. Pelkmans, L. Schefler, G. Luchetta, R. Zavatta, E. Giannotti, G.M. Stecchi, F. Simonelli, D. Valiente, F. Mustilli, J. Teusch, F. Genoese, F. Infelise, J. Wieczorkiewicz, W. Stoefs, L. Colantoni, J. Timini, (2013a), “Assessment of Cumulative cost impact for the aluminium industry”, CEPS and Economisti Associati, Brussels, November.

21 Renda, A., J. Pelkmans, C. Egenhofer, A. Marcu, J. Pelkmans, L. Schefler, G. Luchetta, R. Zavatta, E. Giannotti, G.M. Stecchi, F. Simonelli, D. Valiente, F. Mustilli, J. Teusch, F. Genoese,, F. Infelise, J. Wieczorkiewicz, W. Stoefs, A. Fumagalli (2013b), “Assessment of Cumulative cost impact for the steel industry”, CEPS and Economisti Associati, Brussels, June.

22 CEPS (2014) Study on composition and drivers of energy prices and costs in energy intensive industries: the case of the flat glass industry.

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allocation cap is not broken - no matter what provisions exist in other areas, such as benchmarks.

The alternative is that additional free allocation comes from somewhere else, be it from the auction share, the MSR, or some other pot of EUAs made available. That will require consideration of such measures on the functioning of the MSR. EUAs were put in the MSR to bring the market in line with what is seen as an adequate market scarcity (a volumetric corridor between 883 and 400 million).

Whatever the final outcome may be, a solution, which only proposes that additional free allocation is made available, as needed based on production, without any provisions to address the free allocation cap, must be seen as incomplete.

The discussion on competitiveness also needs to take into account its long-term perspective and resilience. It also needs to account for the fact that the international climate change regime may not be as asymmetrical as it used to be.

With EUAs at current low prices, and with an increasing number of jurisdictions covered by carbon pricing, competitiveness will cease to be a EU problem only, to be addressed domestically. In not so distant future it will need to be addressed through international cooperation.