Will the Market Stability Reserve do the trick?

In February 2015 the European Parliament’s Environment Committee voted for reform of the European Union’s flagship Emission Trading System (ETS). To address the chronic problem of an oversupply of carbon allowances, and to signal that it is serious about fighting climate change, the committee approved a proposal to park millions of carbon allowances in a Market Stability Reserve (MSR), starting on 31 December 2018.

Source: europarl.europa.eu
At the end of 2013, the surplus allowances amounted to 2.1 billion. The MSR is designed to make Europe’s Emission Trading System more responsive to economic circumstances by balancing supply and demand for carbon allowances through annual auctions that 'make the polluter pay'. It is expected that MSR should place in reserve the existing allowance surplus by 2023, thereby raising their price to between €30 -€35 per tonne by 2020, a level that should provide incentives to reduce their emissions for the 11,000-12,000 factories, businesses and utilities covered by the scheme. As Dutch MEP Gerben-Jan Gerbrandy; commented, 'The ETS should start working again to facilitate the transition to a ‘low-carbon’ economy'.

The start date at the end of 2018 is itself a compromise between an early start in 2017 supported by Germany, the UK and Europe’s power sector and a later date of 2021 favoured by Poland , Lithuania, Cyprus and former east-European communist states.

However, all are agreed that the current carbon price of around

'The current carbon prices provide virtually no incentive to switch away from coal and decarbonise
€7-€8 Euros per tonne is hardly an incentive to reduce emissions in support of Europe’s climate change policy. As Stuart Murray, energy analyst at Pöyry Management Consultants observes, 'The current carbon prices operating in the emission trading system provide virtually no incentive to switch away from coal and decarbonise.' However, evidence by the European Commission - JRC Joint Research Centre CO2 Report 2014 would suggest that there has been a slowdown in the growth in emissions.

Market effectiveness

The impact of the Market Stability Reserve on energy consumption and behaviour is inevitably going to be incremental rather than big bang. As Murray notes, 'The one thing that is for certain it is aimed at increasing the carbon price. It should gradually encourage low- hanging fruit solutions such as the switch away from coal to gas and potentially investment in low-carbon technologies to be brought forward'. Certainly, if nothing had been done to reform the ETS, its effectiveness as a driver to encourage energy efficiency and investment in decarbonisation, would continue to have little impact. The transfer of surplus carbon allowances alongside the 900 million 'back loaded' allowances into the MSR pool together with annual auctions should balance supply and demand and introduce flexibility to respond to market conditions more promptly. As Barnaby Wharton, senior policy adviser, CBI Brussels confirms, 'It should give the ETS an ability to better respond to economic developments and reduce volatility in the system'. Moreover he adds, 'It should provide greater predictability and transparency in the market, since stakeholders will know exactly how much has been removed or returned to the market by auction in any given year'.

However, there is no certainty as to how effective the MSR will prove in practice since it is based on current conditions and projections and 'this has resulted in the European Commission deciding to review the parameters of the operational market reserve parameters at the start of each phase', suggests Stuart Murray. In hindsight, if the Market Stability Reserve had been produced at the start of Phase 2 (2008-2012) of the ETS, it would have been better able to manage the effects of the economic downturn and the over-allocation of allowances in previously years. Instead, the recent financial crisis and subsequent economic recession caused carbon prices to fall from a peak of €30 per tonne in 2008 to just €7 per tonne at the end of February 2015.

Opposition to MSR

The proposal for the MSR and the start date of 2018 has yet to be approved. Agreement still needs to be given by Plenary of the European Parliament, as well as a qualified majority at the of EU Council of Ministers, which is expected by July 2015. Despite significant opposition, Kelly Brown, Corporate PR, RWE Generation, remains optimistic acknowledging that 'While there is a risk of a blocking minority, if just a few additional member states came on board on an early MSR start, a majority could be secured.'

Poland leads the opposition, which includes Cyprus, Bulgaria, Croatia, Czech Republic, Hungary, Lithuania, Romania, as well as energy intensive high carbon emitting industries,

Poland’s opposition could be weakening
ranging from chemical producers to operators of coal and lignite power stations. Poland’s opposition is not surprising given its dependence on coal generation. At present, Poland is Europe’s second biggest coal producer after Germany, and coal and lignite power generation provide over 88 per cent of the country’s electricity needs, reports Agora Energiewende energy consultant’s report on The Polish Power System 2014.

Nevertheless, Poland’s opposition could be weakening. More than half of Polish power stations are over 25 years old and a quarter more than 30 years old. These ageing power stations are due for replacement. Polish dependence on Russian coal and the need to build replacement power stations presents both the opportunity as well as an urgent need to diversify away from coal power.

Impact on investment and innovation.

A report by the LSE’s Grantham Research Institute on Climate Change and the Environment, February 2015 finds that delaying the MSR until 2021 'risks undermining investment in clean technology'. Therefore, the proposed early start is good news as it brings some certainty to energy businesses.

given the scale of the challenge, it is unlikely to be sufficient
'This intervention by the European Union on ETS is an attempt to make investors think about the medium to long term. It should encourage the drive for investment in lower carbon generation, but given the scale of the challenge, it is unlikely to be sufficient', admits Murray. Wharton is optimistic noting, 'drawing on some of the revenues of the EU ETS, as proposed by the renewed NER400 scheme, and focusing it on decarbonisation projects, products and innovation, could deliver the technology needed to make the EU the global leader in a low-carbon economy'.

Nevertheless, will it work and is this reform sufficient to spur investment and innovation? 'To support the efforts of the energy sector to cut emissions, the EU needs a cohesive strategy to develop innovative solutions as well' states Wharton. Theoretically, the introduction of the MSR should contribute to the drive for greater energy efficiency and innovation but it is difficult to be sure since factors like the oil price, national renewable policies and the cost of subsidies for renewables complicate matters. As Bloomberg, the financial news service pointed out on 16 February 2015, the rise in renewables has 'suppressed carbon prices […]. The carbon market is being undercut by a patchwork of national subsidies for renewables'. It is hard to avoid the conclusion that the ETS, even with the MSR, is a necessary but insufficient tool, to get the significant carbon emission reductions required in the race to limit climate change. More policies and support across the energy sector, in infrastructure, for example, will be needed to stimulate the significant investment needed.

Prospects for a global ETS

BP’s Energy Outlook, February 2015 predicts an increase in demand for energy of 40 per cent by 2035 leading to a 25 per cent increase in carbon emissions - well above the level required to provide a chance of stabilising global temperatures at 2 per cent above pre-industrial levels. 'A meaningful global carbon price would provide the right incentives for the most cost-effective decisions and investments to be made', claims the report.

Merging the existing 40 carbon trading schemes around the world would face numerous challenges
The EU’s ETS has been expanded to include Iceland, Norway and Liechtenstein. However, Murray provides a word of caution to further enlargement since 'the arrival of MSR adds to the difficulties of Europe’s ETS joining with other country’s systems'. Merging the existing 40 carbon trading schemes around the world - from the US and Canada to Chinese municipalities and provinces - would face numerous challenges. From a European economic perspective a global carbon price, 'could help sustain European competitiveness and ensure the 2030 package is affordable to EU consumers. However, we are more likely to see a global economy where various ETS systems operate and trade with each other, in the same way the world trades in different currencies', says Brown. Reducing a tonne of carbon emissions does not cost the same everywhere just as a Big Mac does not cost the same worldwide, as the Economist Big Mac Index, January 2015, illustrates.