News 2017-11-22

Commentary: The emissions trading system has been rescued but will play a less significant role in the future

After two years of negotiations, last week EU member states reached a compromise over the EU ETS emissions trading system. The reform proposal is more comprehensive than many realize. At the last moment, emissions trading has been rescued, but in future national climate policy will be far more relevant to climate change in the EU, commented Lars Zetterberg, climate policy expert at IVL Swedish Environmental Research Institute, in an article published in Aktuell Hållbarhet.

“EU ETS was intended to be a cornerstone of the EU climate policy and the key instrument for achieving the Union’s climate goals. But with the prices of emission allowances falling for many years, it appears that the system is on the verge of collapse. The forthcoming reform is therefore crucial. If the surplus of allowances cannot be cut back and the price significantly raised there is considerable risk that the system will not survive into the 2020s. After last week's negotiations, it seems that the trading system has been rescued, but it will undergo a fundamental change and become less significant compared to other policy instruments.

A necessary element of the reform was to reduce the surplus of allowances, and this has been achieved. This will jack up prices. But what is more important is that the system has been given a mechanism that will automatically cancel emissions rights. The mechanism works in two steps:

  • A portion of the surplus is deposited in an emission allowance bank called the market stabilization reserve. The negotiations resulted in a doubling of the annual transfer to the reserve, from 12 to 24 percent of the surplus.
  • The reserve may contain as many emission allowances as were auctioned the previous year. The remainder are cancelled. In a first step, allowances corresponding to three billion tonnes of carbon dioxide will be cancelled in 2023 – a significant number. Cancellations will continue in the years that follow, but at a slower pace.

The automatic cancellation mechanism means that the system ceases to be a classic ‘cap and trade’ system with a fixed emissions ceiling. The fixed ceiling in the current system means that it is possible to know in advance how high the volume of emissions will be. However, there is a problem with this, the so-called ‘waterbed effect’. The waterbed effect means that if a country – or a municipality or a family for that matter – introduces an additional measure that reduces emissions nationally or locally, emissions may increase elsewhere in the EU, as the emission ceiling has already been set. It is analogous to when you sink down on one side of a waterbed – the surface on the other side is pushed up. If additional measures do not lead to reduced emissions it is difficult for governments to receive legitimacy for these. In addition – if a country is facing additional measures, the allowance glut will be even greater, which reduces the price and makes it even less profitable to take measures elsewhere. But if the new reform proposal with the automatic cancellation is accepted, interventions at national and local levels will suddenly have a role to play.

A likely consequence is that we will see an increase in national climate measures in the form of new or sharpened regulations and instruments. One scenario is that several EU states join forces and introduce new, coordinated instruments. Will EU ETS play a role here? Yes, it will no longer be the EU flagship, as the intention once was, but it will not be meaningless either. Emissions trading will become part of a policy mix, where its main role is to function as a safety net, trapping the measures that other instruments are unable to catch. Emissions trading also ensures that EU emissions targets are met. For example, in California climate policy works in a similar way. Regulations targeting a wide range of sectors account for the bulk of California's emissions reductions, while emissions trading sucks up the remainder.

The disadvantage of the EU's reform proposals, as I see it, is that emissions trading is made even more complex and difficult to understand and predict. But in the main, the reform is good, although other measures could have been implemented, such as the introduction of a price floor. "

Lars Zetterberg, IVL Swedish Environmental Research Institute