Getting the balance right – reforming the European Union’s Emissions Trading System in an even way

In July, the European Commission will present its draft reform of the European Union’s Emissions Trading System (EU ETS 1). One proposal of the Commission is already on the table: to abolish the cancellation of allowances from the Market Stability Reserve (MSR). There is also discussion of auctioning allowances from the reserve for new market entrants to finance an Industrial Decarbonisation Bank. A policy brief published today by Oeko-Institut shows that these two changes would be sufficient to meet demand in the EU ETS 1 by 2040 without the need for further measures to increase supply.

Taking a holistic view of reform proposals

The study compares various combinations of reform options relating to the Linear Reduction Factor (LRF), the MSR and the use of the New Entrants Reserve (NER). It concludes that, in many scenarios, the total volume of available allowances is not only sufficient but even excessive when existing surpluses, MSR holdings and additional auctions are taken into account. This means that all changes can only be considered and decided upon collectively. Otherwise, there is a risk of a renewed surplus of allowances in the EU ETS 1 and a risk of missing the binding EU climate target for 2040. 

The analysis also shows that an overly generous supply can not only weaken the CO₂ price in the short term, but also has long-term effects: large surpluses could be carried over beyond 2040 into the trading period up to 2050 and have a lasting negative impact on the effectiveness of the EU ETS 1. 

Reforming emissions trading in a coordinated way up to 2040

According to the analysis, a balanced ETS reform scenario would provide a sufficient supply of emission allowances up to 2040 without creating new surpluses. Careful calibration of key parameters is crucial: an LRF that remains at 4.4 percent until 2036 and is only lowered thereafter would keep the emission reduction targets within reach. This prevents additional supply from entering the market too early. At the same time, allowances become more readily available when the MSR is adjusted. This is achieved by aligning the total number. ”It is a bad idea to auction additional allowances from the New Entrants Reserve. This destabilises the market and penalises plant operators who have planned and invested on the basis of the current rules,” says Graichen.

Policy Brief ‘Getting the balance right’ by Oeko-Institut 

This study was conducted by Oeko-Institut Consult GmbH.