The Case for the EUETS Market Stability Reserve Looks in Need of Further Evidence

The market stability reserve proposed for the EUETS would be a significant change to the world’s largest carbon market. It also raises wider question about attitudes to the efficiency of carbon markets over time.

In response to the continuing oversupply of EU Allowances (EUAs) in the EUETS the European Commission has proposed a “market stability reserve” to come into operation in 2021, at the start of Phase 4 of the EUETS.  The intention of the mechanism is that EUAs will be withdrawn from or returned to the market depending on the size of the cumulative surplus of allowances, which currently stands at around 2 billion tonnes.

Specifically, when the surplus of EUAs exceeds 833 million tonnes allowances are put into the reserve, with 12% of the surplus being put in each year.  When the surplus (excluding the allowances in the reserve) falls below 400 million then 100 million allowances are returned to the market each year.  The need for reporting of the volume allowances means that in effect the calculation of the surplus is based on the surplus 18 months to 2 years earlier.  The quantity of allowances put into or withdrawn from the reserve does not depend directly on the price of allowances.  The parameters and date of introduction of the mechanism all remain subject to change.

It appears likely in practice that a large surplus of allowances will persist to 2020, and that the mechanism will effectively place EUAs into the reserve from the early to mid-2020s, returning them to the market in the late 2020s and 2030s.  The size of the reserve is likely to peak at somewhere around 1 billion allowances in the mid- 2020s (with quite a wide range around this).  The timing of the return is largely due to the chosen rate of return of 100million p.a., and the time lag in the calculation of the size of surplus.   The chart below shows for illustrative purposes only one of many possible scenarios for the flow of allowances to and from the reserve, some of which would include later return of allowances.

Illustration of possible flows into and out of the EUETS market stability reserve …

Apparent lack of environmental benefits

The proposed mechanism will only affect cumulative emissions over the long term if either allowances in the reserve were cancelled, or the presence of the reserve affects future caps, for example allowing a tighter cap to be set in the 2030s.

Cancellation of allowances is excluded from the proposals, and could in any case easily be achieved separately, so does not seem likely to provide a rationale for the mechanism as a means of providing environmental benefits.

There is also no apparent intention to enable tighter caps in future as a result of the number of allowances in the reserve.  And it is not clear that the presence of a formal separate reserve (as distinct from privately held surplus allowances) would lead the EU to tighten the post 2030 cap, although this remains a possibility.

There is thus no clear reason why the mechanism as proposed would provide any additional environmental benefit.  Consequently it seems likely to be beneficial only if it leads lower total cost of meeting the same emissions reduction goals.

Will the mechanism reduce the costs of abatement?

The effect of the mechanism on total costs seems likely to depend on the expected level of EUA prices in the 2030s relative to the 2020s, and the response of the private sector in the 2020s to expected prices in the 2030s, specifically they extent to which they will bank allowances, which is not restricted under the EUETS.

It might be that in the late 2020s the costs of abatement, and thus allowance prices, are expected to be constant or lower, in the 2030s compared with the late 2020s.  This might be, for example, because the costs of low carbon technologies are falling rapidly, or gas prices are falling and fuel switching is still the marginal price setting form of abatement.  In this case the reserve would force banking of allowances (in the broad sense of holding allowances for use at a future date) that the private sector would not undertake.  This would raise prices in the late 2020s and depress them in the 2030s, but with some net increase in (discounted) average prices resulting from inefficiently mandated scarcity in the market in the late 2020s.  The reserve might thus (on expectation) increase total costs.

In contrast, it might be that in the late 2020s prices are expected to rise strongly into the 2030s.  In this case there could be extensive private sector banking from the 2020s into 2030s.  The stabilisation reserve might have little effect, as it would simply (partially) replicate the effect of private sector banking.  The total number of allowances held for future use, and thus the supply demand balance in the market, largely unaffected.  The reserve might thus match the efficiency that private sector banking could accomplish (in the case of rising prices), while sometimes proving less efficient (in the case of flat or falling prices), leading to no net benefit.

Alternatively, the stability reserve could increase efficiency if for some reason private sector banking were not happening in sufficiently large quantities, despite an expectation of rising prices.  This might be due to perceived to perceived political risk or short commercial planning horizons.  However, the presence of severe inefficiencies from lack of private sector banking does not appear very likely.  By the late 2020s the EUETS will have been in place for more than two decades, and as such will be a very well-established policy mechanism.  Credible announcements will likely have been made on the cap for Phase 5 (the 2030s).   Even now allowance prices are well above zero even though the market is expected to remain long for perhaps a decade, implying that the future value of allowances does indeed influence their current price.

A final possibility is that higher prices in the short term would stimulate greater investment in low carbon technologies, preventing lock-in and reducing abatement costs in the long term.  This would be a further effect of perceived political risk or limited commercial time horizons.

The case for the stability reserve seems to rest on either permanent reductions in supply, which are currently unintended and could be introduced in other ways, a reluctance by the private sector to bank allowances in the event of expected price increases, or increased low carbon investment triggered specifically by some increase in scarcity in the late 2020s.  Proponents of the mechanism have not as far, as I am aware, demonstrated that these market features are likely to arise, or that the stability reserve would be effective in addressing them, let alone that it would be the most effective way of doing so.  The case for the stability reserve still needs to be made.