Will the EU ETS have a happy endgame?

This article is published in the context of the LIFE COASE project

What will happen when the last EU Emission Trading System (EU ETS) allowance is issued? What will the price be? When will the last banked certificate be used, and what will happen afterwards? These and other questions pop up when we think about the full decarbonisation of the EU ETS. The problem is not that they remained unanswered, the problem is that there is little time to answer them. If the EU ETS cap, currently defined until 2030, is extrapolated linearly, the last allowance would be issued around 2040 – and the rules for the trading period 2030-2040 will have to be defined well ahead of 2030.

Questions arise regarding the efficacy of the ETS in managing a net-zero emissions cap efficiently. The 'ETS endgame' presents uncharted territory for market behaviour and design. Despite the urgency, there is a notable gap in research and understanding surrounding ETSs nearing their terminal phase.

In this post, we provide a snapshot of our paper, where we elaborate on the main challenges stemming out of the EU ETS ‘endgame’. Delayed (re)action could be costly and endanger the path to climate neutrality.

Unveiling Market Dynamics: The MSR Conundrum

To address the unique challenges posed by an ETS approaching zero supply, our paper employs the numerical model LIMES-EU to analyse market dynamics induced by the 2023 reform, shedding light on anticipation effects, price formation, banking, and investment dynamics across sectors and technologies (see complete paper). We first perform a numerical analysis using LIMES-EU to assess the impact of the current EU ETS policy (assuming a continuation of the main EU ETS parameters, e.g., extending the emissions cap and keeping Market Stability Reserve (MSR) parameters constant after 2030). Cumulated allowance invalidations would reach 7.8 billion EU allowances and prices would increase from 125 EUR/tCO2 by 2030 to 205 EUR/tCO2 by 2040. These figures are substantially higher than those of a scenario with less ambitious targets, highlighting the impact of future scarcity anticipation. Besides providing insights on the efforts required by current climate policy, our analysis addresses more general questions on the suitability of the current EU ETS policy framework to face future challenges.

Our findings raise questions about the adequacy of the MSR design in the face of ever-stricter emissions caps. The feedback effect between banking and the MSR creates inefficiencies, as the MSR reacts to increases in banking as if they unconditionally signal decreased demand, ignoring potential future demand increases or supply decreases. This not only distorts intertemporal efficiency but also indirectly constricts cumulative supply beyond decided cap paths, accelerating the transition to zero supply in an opaque manner that is dependent on market developments, especially the foresight of market actors. Additionally, our sensitivity analysis reveals that while the reform has fixed some issues with the MSR, it also tends to amplify its implications by maintaining its core design and parameter values. Furthermore, as the market transitions to long-run net-zero equilibrium, the shift from a power sector- to an industry-centric system around 2030 drastically alters abatement options and price fundamentals. While decreasing allowance supply may not pose significant issues if demand decreases concurrently, uncertainties surrounding technology development and infrastructure deployment could significantly impact market outcomes. Managing the evolution of supply relative to demand will be crucial in transitioning to a net-zero environment.

Navigating ETS Evolution: Banking, Thin Markets, and Frictions

As the EU ETS marches towards net-zero emissions, a host of challenges emerge, notably concerning allowance banking and market thinness. In the long term, the market size (banking + allowance supply) will be small, posing risks of market thinness and illiquidity. These constraints can also be prevalent in the short to mid-term if limited foresight or financial barriers (amplified by the energy transition) hinder trading and banking behaviours.

In the realm of information frictions and regulatory uncertainty, the ETS faces a shifting landscape. Market fundamentals increasingly need to reflect the nuances of industrial abatement technologies, complicating price formation and information aggregation. Moreover, long-term price dynamics are clouded by uncertainty surrounding the deployment of removal technologies, raising questions about the role of regulatory clarity in mitigating market noise and ensuring price coordination.

Continual increases in carbon prices underscore the need to address distributional concerns and equity. As auction revenues shrink and allowances become scarcer, policymakers grapple with the challenge of maintaining fairness amid increasing costs. Adjustments in ETS design, such as implementing holding limits or exploring central carbon banking, offer potential solutions but necessitate further research and careful consideration of their implications.

Looking ahead, the efficacy of carbon pricing post-transition to net zero comes under scrutiny. Net-zero management requires us to revisit the adequacy and composition of the policy mix at large.

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LIFE COASE is co-funded by the Life Programme of the European Union. The views and opinions expressed in this post for LIFE COASE are solely those of the author(s) and reflect neither those of the European University Institute nor those of the European Commission.

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