The EU Emissions Trading System (ETS) for carbon dioxide (CO2) is the largest worldwide. Since its inception in 2005, it has experienced allowance price volatility and low overall prices. Generally, the fact that it costs less than anticipated to reduce CO2 emissions would be good news. Instead, these price dynamics are bad news for many because they suggest the program may fail to spark a significant transformation of the economy away from fossil fuel use.
To bolster allowance prices, EU authorities are taking steps to introduce a market stability reserve (MSR). The MSR regulates the volume of allowances issued at any point in time depending on the volume in circulation and not yet used for compliance. Importantly, the MSR varies when allowances are issued but it does not vary the total number.
How this remedy will work and whether it will affect market prices are the focus of new research by three teams commissioned by RFF to provide an analysis of the EU’s MSR proposal.* Their findings are now available in the following RFF discussion papers and accompany related research by European-based teams. Read on below for highlights of key points:
- What Ails the European Union’s Emissions Trading System? Two Diagnoses Calling for Different Treatments, by RFF Visiting Fellow Stephen Salant
- Comparing Policies to Confront Permit Over-allocation, by Harrison Fell of the Colorado School of Mines
- Price and Quantity “Collars” for Stabilizing Emissions Allowance Prices: An Experimental Analysis of the EU ETS Market Stability Reserve, by Charles Holt and William Shobe of the University of Virginia
What have we learned? The news, in my view, is mixed. Theory and some evidence suggest that, so far, the MSR will have a limited effect in fixing the problem directly. However, to the credit of EU regulators, the MSR signals that the doctor has not given up on the patient. The European Union has a long-term commitment to emissions trading—the MSR may buy enough time for prices in the ETS to recover as the economy recovers. If that does not happen, I believe the European Union may ultimately replace the MSR with a more direct and simpler instrument—a reserve price in auctions for emissions allowances that will instill a minimum price in the market.
Why Do We Observe Low Allowance Prices?
The EU has identified ambitious climate goals in the long run. Model forecasts suggest these goals will require high allowance prices that should be reflected at a discount in today’s prices. However, the allowance prices today are a concern because they do not appear sufficient to trigger the innovation and investment that will be necessary to achieve the long run goals.
It is important to understand the cause of the problem in order to design an effective remedy. But, there does not appear to be a single explanation for the low demand for emissions allowances and the resulting low allowance prices. One cause might be the economic slowdown in Europe, which has reduced the demand for emissions allowances. Another is overlapping policies by EU member states to promote renewable energy and energy efficiency, which also reduces the demand for emissions allowances.
One group of authors has argued that low prices result because the current supply of allowances exceeds the demand of the electricity industry to hedge emissions associated with existing power contracts going out three to four years. When the demand of the electricity sector is satisfied, allowance prices fall. In this view, moderating the short-run availability of allowances by adjusting their flow through the MSR will affect the near-term price without having to change the volume of allowances that are issued in the long run, a point that has been criticized by others.
In one of the new RFF papers mentioned above, RFF Visiting Fellow Steve Salant explores whether the limited demand to hedge power contracts explains low allowance prices and the observed jumps in those prices. In the current market environment, investors outside the electricity sector should be buying low to be able to sell high in the long term, when allowances are expected to be scarce. Such behavior would drive up short-term prices—but this has not occurred. Salant suggests one reason may be that investors are uncertain about the survival of the program in the long run and hence require a premium to compensate for that risk. Changes in this “regulatory risk” might also explain the jumps in allowance prices that have occurred. If regulatory risk is the problem, the MSR would help boost allowance prices only if it were to change investors’ expectations. The European Union’s commitment to the trading program, as reflected in the MSR debate, may provide such a signal. Paradoxically, however, the MSR may reinforce uncertainty to the degree that it signals that market outcomes will depend on additional future administrative action.
In another of the new RFF papers, Harrison Fell of the Colorado School of Mines uses simulation modeling to illustrate how arbitrage across time relates prices in the present to prices in the future. One would expect economic agents to adjust the timing of buying and selling allowances based on the path of prices over time—and, in turn, prices to adjust to that behavior. Fell finds that the MSR can reduce price volatility—but that its performance is especially sensitive to underlying economic parameters.
Charles Holt and William Shobe, of the University of Virginia, round out our analysis. They examine market behavior in an experimental setting, finding that subjects in the laboratory do a good job of arbitraging across time periods. And so compared to a policy of doing nothing, they find little benefit (and possible cost) associated with adjusting the quantity of allowances based on privately held inventories of unused allowances, such as would be the case with the MSR. However, their research indicates that a “price collar” (when a price floor and a price ceiling are both in effect) may enhance the efficiency of the program.
The Challenge of Managing Carbon Prices
The analyses indicate that if the reason for low allowance prices has to do with satiation of demand to hedge power contracts and if other investors require a premium, the MSR may be effective in bolstering prices in the near term. But if other factors contribute in an important way to interact with the program and depress prices, different remedies may be necessary.
Whatever the cause, the low price of allowances is perceived as a negative feature of the EU ETS. Another remedy that I’ve written about previously is a reserve (minimum) price in the auction for emissions allowances. All three North American programs—in California, Quebec, and the Regional Greenhouse Gas Initiative (RGGI) in the Northeast United States—include this feature. The design looks just like the minimum acceptable bid option that one finds on eBay. Bids for emissions allowances below the reserve price in an auction are not filled. If sufficient demand does not exist above the reserve price, some allowances are not sold, restricting supply and helping to stabilize the price.
These allowances may be available in a subsequent auction but ultimately should be withdrawn. For example, in RGGI, the backlog of unsold allowances was permanently retired. In each North American program, the reserve price has been binding for at least one auction—and in every instance, the price has subsequently moved off the implied price floor. And so these market-based programs have continued to function. Without such a mechanism, however, allowance prices may have fallen to zero, spelling a program’s demise. We saw near-zero prices in the trial phase of the European Union’s program in 2007.
For the EU ETS today, an auction reserve price was only briefly considered to remedy the issue of low allowance prices. Instead, policymakers in the European Union have opted to introduce the MSR—a somewhat complicated rule to modify the timing for introducing emissions allowances into circulation. It will be interesting to see if this approach achieves its desired effect. Meanwhile, the option of a reserve price is an idea that may still gain appeal for its simplicity. Its time may yet come.
*This work was coordinated with DIW Berlin, a leading economic research institute in Germany. Funding was provided by Mistra Indigo, DIW Berlin, and RFF’s Center for Energy and Climate Economics.
