Allocation and Pricing

So this is a diagram that explains how the cap has applied in the Emissions Trading System since its beginning. The coloured columns are the different phases of the Emissions Trading System and you can see a dotted line which are actual emissions covered by the system and there’s a few things to explain in this diagram. Most notably, it’s those straight lines at the top of the columns that run from 2013 through to 2020 and the two straight lines that are at the top of the columns from 2021 to 2030.

Now, those are reflecting the Linear Reduction Factor in the Emissions Trading System in Europe, which is the linear reduction that is made annually to the total number of allowances issued under the Emissions Trading System. Why is this important? Well, first of all, as explained, this is ensuring that the cap is coming down and the environmental stringency is improving over time. And what’s important for companies covered by the Emissions Trading System is that they know by how much emissions will reduce every year. It’s predictable, they can plan accordingly. And so what’s happened is that, as of 2013, the emissions trading had this Linear Reduction Factor feature introduced and it’s been operating since then.

From 2021, it was decided that the Linear Reduction Factor would increase to 2.2% a year, having previously been 1.74% per year, and the law was changed to make it 2.2%. But then, in the light of the European Green Deal, the European Union has wanted to increase ambition on climate change through to 2030 and so the obligations under all of the legislative instruments have to become more stringent and the Emissions Trading System too will become more stringent and, most notably, the proposal that has being made is that the Linear Reduction Factor would be 4.2% per year and that is still to be confirmed in law, which is why there is a question mark on the graph next to it.

It’s suggesting that the reduction achieved by the Emissions Trading System as a whole will reach 61% by 2030. That’s a big reduction. You can see that sort of reduction getting significantly more ambitious over time. That ambition is the ambition of the European Green Deal and the emissions trading, like every other part of legislation, will be coming more ambitious in that time. The most remarkable thing about the Linear Reduction Factor, however, is that if you look beyond 2030 it will squeeze emissions down to zero in the early 2040s.

Now, as I say, this is a proposal not yet enacted in law, what’s enacted in law is the green line that is above it that shows emissions wouldn’t get to zero till about 2055-58, something in that region. So, you can see that this is squeezing emissions down, but doing so in a predictable way. It’s clear if you see that the law is reducing the number of allowances by a fixed amount each year, if you’re an operator you must be thinking what can I do to reduce my emissions so that I can comply with these obligations that are being put on me.

And, of course, buying allowances in the market is always possible, but you’ll see in a few slides what the price of these allowances is doing in the meantime. So, I’ve explained in previous that allocation is a key issue in any Emissions Trading System. Economists generally prefer that allocation be made by auctioning because it’s more economically efficient and what Europe has been doing is that having started with no auctioning at the very beginning of emissions trading, there is now a majority of emissions that are auctioned to, in particular, the power sector, the power sector receives no free allocation at all now.

So, the share of auctioning has gradually increased and correspondingly the free allocation is still given to industry sectors that are exposed to competitiveness pressures from third countries, the European Union doesn’t want those industries to relocate outside Europe and that relocation outside Europe is called carbon leakage, we are trying to avoid that happening and so there is a free allocation given to industry. However, it’s not given on the basis of historical emissions anymore, it’s given on the basis of benchmarks and this is to ensure fairness among the different operators.

So, there is a benchmark per industry sector, so there is a benchmark for steel, a benchmark for cement, a benchmark for lime, different energy sectors have different benchmarks and how is it set? Well, the Commission aggregates or collects the data from all the operators in the field in that particular sector and the 10% best-performing installations in Europe set the standard at that 10% best-performing. So, those best-performing installations receive all the free allowances they need, but those, the 90% who don’t reach that level receive less and the further away you are from that benchmark, the fewer you get in relation to your actual needs.

So, it’s fair, it’s done on the on the basis of performance, benchmark performance and it’s something that’s been in place now since 2013 and is continuing for the moment.

Now, allowances, I described these as being needed by companies in order for them to fulfil their legal obligations. They can actually be traded by everyone who opens a Registry account and everyone can do that. There is a charge for having a Registry and in many Member States but, in principle, everyone can trade allowances.

Now, operators have obligations under the scheme, as I described, and many of these operators wish to reduce the risks of either having to go to the market and buy allowances at unknown, perhaps high prices, or in some cases they also want to make an investment and sell allowances, make a new investment and hope to buy in the future fewer of these allowances but they want to cash in. So, this is there is a market going on and that market is facilitated by intermediaries like financial institutions who help provide liquidity, all of which helps efficiency, economic efficiency. It’s also possible for NGOs to buy allowances in the market and cancel them.

So, in practice, this carbon market, as it’s called, the emissions trading market is a very big sophisticated market now. Most of the trades are forward contracts because companies want to fix the price at which they are buying or they are selling allowances and then they can, they know that that’s the price they are going to get to remove the uncertainty and so it’s a market that has developed in Europe very considerably. And this is the price evolution of EU allowances since 2008.

You can see that the price, first of all, varies which is why companies are little bit unsure what to do and hedging and making forward contracts is a way of them limiting risks, but the big picture that you can see very clearly is that, as of around 2017. the carbon market price of allowances went up very considerably.

And this is due to the fact that stringency is increasing and there is also a sense that climate change is something that’s going to need more and more ambition over time and businesses are prepared to pay more to have allowances, you know, so that they can, some companies are buying allowances for the next 10 years so as to be sure that they can afford to keep operating over the next 10 years and other companies don’t do that, but these are decisions companies make. But you can see the price is really beginning to make an impact.

At 50/tonne of CO2 companies have to ask themselves, can I reduce our emissions by less than 50, in which case it’s worth me making that investment or would I, could I or is it the cheapest way of me complying to buy allowances at that high price. As the price goes up, more and more companies are thinking I better do something in order to make my investments and reduce my emissions, which is exactly the sort of behaviour that this instrument is designed to obtain. The sorts of improvements that have been made over time are that more auctioning, as I say, is being done, including in particular for the power sector, the electricity generation sector.

The Linear Reduction Factor was introduced from 2013 but the laws were passed in 2008-2009. And the second wave of reform, as I described earlier, has further increased the Linear Reduction Factor and it has also created another sort of market correction mechanism which is called the Market Stability Reserve because there was a long period during which the price was rather low, there were too many allowances in the system and there were also credits that were allowed into the system that came from the Kyoto Protocol’s Clean Development Mechanism.

All of that combined with an economic slowdown in the period 2009 through to 2011-12 meant that there were more allowances and the price then fell quite significantly and the Market Stability Reserve automatically absorbed that surplus allowance, surplus of allowances and it’s a reserve from which allowances are sucked into when there’s an abundance of allowances and where the reserve releases allowances again into the market if ever there is a scarcity of allowances. So, they are not allowances that are cancelled, they go into a reserve and they stay there for a while and they might come out again but so far the inflow into the reserve has made the price improve very much in terms of its value.

Ensuring fairness is essential in any instrument of climate change. In the case of the Emissions Trading System, the first thing that’s ensured fairness is that there’s an openness of it in and equality of treatment among operators wherever they are located in Europe. There is a single European carbon market, there is a single European price which is the same if you are a cement producer in Portugal or Poland. Auctions are open to all. So, you know, if you don’t have enough free allocations you can get them from an auction, more allowances can be obtained from an auction. And the benchmarks, as I mentioned, were harmonized again so that sectors are treated fairly within the sector.

One company isn’t being given a more favourable outcome than another company, there’s a consistent methodology for free allocation. And, of course, if you think about an Emissions Trading System, what tends to happen is that reductions are made in the countries where it is cheapest to make those reductions and those have tended to be the Central and Eastern European countries that joined the European Union from 2004 onwards. And they have tended to receive a larger money flow because they’ve tended to sell allowances, make reductions of emissions in those countries, sell the surplus allowances to more expensive operators located in more expensive countries.

And then there’s also a very explicit redistribution of auctioning revenues that are channelled to the Central and Eastern European Member States which have a poorer GDP per capita ratio. There’s a specific Modernisation Fund indeed for the 10 least wealthy Member States designed to give them the funds to reinvest in their energy systems. So, fairness, if you like, between Member States and between operators has been a feature since the beginning of the Emissions Trading System, and certainly it’s very important and becoming increasingly so as the scope of emissions trading is extended.