Buckle Up! Tighten the cap and avoid the carbon crash

Three years into Europe’s Emissions Trading System second trading period – how is it performing? This report provides a comprehensive assessment of the environmental outlook of the ETS, covering permit allocations, oversupply, companies use of offsets and projected effectiveness of the cap

Damien Morris

3 July 2011 | 10 min read

Highlights

77%

of total installations in the ETS are currently in surplus

855Mt

excess carbon permits accruing to industry by end of Phase 2 of which 672Mt will carry forward to Phase 3

1.2Gt

additional permits in Phase 3 due to industrial surpluses pushing up the historical baseline

52%

of offsets are surrendered for profit by installations holding a surplus

1.7Gt

Sandbag’s recommended set-aside to correct for the full effects of oversupply in Phase 2

4.6Gt

would be saved against businessas-usual 2008-2020 emissions if Sandbag’s recommended set-aside is permanently cancelled

About

This report finds that the huge overallocation to industry in Phase 2 has left a double legacy undermining the effectiveness of the scheme to 2020 and beyond: a carryover of permits banked into Phase 3 and an inflated baseline which affects the starting position of the declining carbon cap beginning in 2013. The result: a likely oversupply that grows to an eye-watering 1.9 billion tonnes through to 2020, equivalent of a year’s worth of carbon permits in the scheme.

Sandbag recommends a number of measure to save the ETS from redundancy: that the European Commission propose set-aside of 1.7 billion permits before 2013, as well as opening up the Directive by 2015 to adjust the cap.

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Executive summary

The ETS is currently doing very little to drive abatement in Europe

The low prices reflect a huge gulf between allocations and the actual level of emissions over the last three years owing principally to the impacts of the recession.

The EU ETS was established with broad political support as the preferred “flagship” climate policy to deliver reliable and cost-efficient abatement. However, midway through its second carbon budget, we find the system very likely to be oversupplied with permits for the second period running while the effects of complementary policies threaten to leave it oversupplied for a third. Loose caps in the first phase of the system caused prices to crash. Since then prices have been held afloat by the capacity to bank carbon permits forward, but with the prospects of carbon scarcity retreating ever further into the future and of new permits flooding the market, prices are again tumbling, falling by over 20% in the last fortnight, and the market is threatened by a repeat crash: analysis cited in a draft Impact Assessment for the Energy Services Directive predicts the carbon price could collapse to €0.

Meanwhile, as the evidence mounts that the cap has been set too high, the European Commission’s proposals for adjustment have become increasingly timid. It is time for the broad political base that first established the ETS to rally together to fix the system so it can work as it was originally intended.

Just as loosely fitted seatbelts are useless in preventing injury, a cap sitting above the emissions of the majority of the participants is also useless. It is time for the EU to buckle up and create an ETS that is fit for purpose. It is also time for those industries currently blocking progress to stop complaining and accept that regulation in the public interest is necessary and beneficial.

At its current level of ambition the ETS is doing very little to drive abatement in Europe, generating low carbon prices which scarcely reduce business-as-usual emissions. If low prices were a result of investment delivering cheaper than anticipated emissions reductions this in itself would not be a problem. However, as this report shows the low prices reflect a huge gulf between allocations and the actual level of emissions over the last three years owing principally to the impacts of the recession.

Direct and indirect effects of the oversupply to industrial installations in Phase 2 are likely to push the Phase 3 cap up some 1.9Gt higher than it should have been roughly equivalent to a year’s worth of emissions in the traded sector. To correct for this we propose the Commission set aside 1.7Gt of Phase 3 permits, guided by a “shadow allocation” derived from the historical emissions of the industrial sectors since 2005. We also propose that the Commission reopen the Directive by 2015 at the latest with a view to cancelling this set-aside, principally by adjusting the declination in the ETS trajectory to 2.4% placing it more in-line with the 2050 targets in the Low Carbon Roadmap.

Findings

Phase 2 industrial oversupply and effects on Phase 3

The net surplus in Phase 2 to date (2008-2010) is roughly 200Mt but a shortfall of 530Mt in the power sector masks surpluses of roughly the same amount in industry-related sectors. At a minimum, this finds power consumers purchasing 183Mt3 of permits from industry, cross subsidizing industry to the tune of €2.9 Euros.

Industrial surpluses threaten to grow to 855Mt by the end of 2012. As permits from Phase 2 can be banked forward into future phases, the majority of this (subtracting the 183Mt needed for power sector compliance) will likely carry forward swelling and weakening the Phase 3 budget by 672Mt. In other words, the ETS would be stronger policy mechanism if Phase 2 had never existed.

In addition this oversupply pushes up the Phase 3 baseline making it environmentally obsolete. In Phase 2, the overall ETS cap was derived bottom up from allocations distributed by EU Member States. In Phase 3, the cap is set top-down in reference to the Phase 2 average allocation, contracting by 1.74% each year. With the Phase 2 cap carrying 855Mt in superfluous industrial permits, this inflates the baselines used to set the Phase 3 cap, enlarging the budget by a further 1.2 billion permits. If we add this to the 672Mt of carryover identified above, we estimate that caps for the period 2013-20 are 1.9Gt too loose. This is a conservative estimate that ignores the effects of large volumes of additional surpluses concealed within the net position.

Fat cat sectors: steel and cement

The steel sector has accumulated surplus EUAs of 165Mt and the cement sector 143Mt over 2008-2010, worth €2.6 billion and €2.3 billion respectively. They have at the same time been amongst the most active lobbyists against stronger unilateral European climate targets, ambitious benchmarked allocations or a Phase 3 set-aside. What is more, the steel sector is taking advantage of uncertainty around the quantities of waste gases it transfers to combustion installations in order to downplay and camouflage this surplus.

Abuses of international offsets

Installations in the traded sector are able to surrender international offsets against their emissions as a means of keeping their compliance obligations affordable; however, some 2,912 installations, or 28% of those currently active within the system have surrendered offsets despite holding a surplus of free allocations. Together they have surrendered some 157Mt of offsets they did not need in order to expand their surplus even further, pocketing some €628 million from the higher asset value of the carbon permits released in this way. Alarmingly, this “offset arbitrage” accounts for more than half of the 300Mt offsets surrendered into the system so far.

We also find some 254Mt in offsets representing 85% of the total surrendered into the system to date are subsidizing Europe’s industrial competitors in emerging economies. Lastly, 131Mt, or 44% of all offsets surrendered were both bought by oversupplied installations and purchased from Europe’s industrial competitors.

Recommendations

This is a critical juncture for the ETS: a reluctance to increase its ambition threatens to either derail it completely or pitch it against other climate policies including industrial energy efficiency regulations. Meanwhile, the window is rapidly closing to introduce a set-aside before Phase 3 gets underway in 2013. For the last eight years, market-sceptics on the left and climate sceptics on the right have dominated comment on the system; now the broad political base which first established the ETS must come forward to defend and reform the policy. The excessive politicization of the European trading system has become a distorting lens through which its imperfections have been perceived, turning each technical or environmental challenge it faces into a call for its termination. These challenges should instead be perceived as opportunities for constructive engagement and reform with what is, fundamentally, a powerful policy whose major fault is that it lacks sufficient ambition. We need a coalition of political centrists from the public, private and third sectors to demand a strong cap that drives flexible and hence affordable abatement while actively discouraging lock-in to fossil-intensive infrastructure. Fortunately this is starting to happen with MEPs, household brands, power companies, NGOs and think-tanks making clear demands for tighter carbon budgets. We welcome and encourage this development, and invite them to comment on and share in the recommendations outlined below.

Recommendation 1: Adjust the ETS independent of Europe’s 2020 targets

Tighter caps in the ETS can greatly facilitate more ambitious economy wide climate targets for Europe. A lack of movement in the 2020 targets need not prevent more ambition within the system. A reduction in the supply of auctioned permits is necessary to adjust for the direct and indirect effects of oversupplying Phase 2. This will, as a co-benefit better align the ETS with the Renewables and Energy Efficiency Directives, and prepare the ETS for more ambitious European targets if and when they are agreed.

Recommendation 2: Set-aside at least 1.7Gt from the Phase 3 budget by 2013

A set-aside of 672Mt would correct for that portion of the oversupply we expect to carry forward from oversupplied installations in Phase 2, but this is not sufficient to correct for the indirect effects this oversupply had in driving up the baseline from which Phase 3 budget was drawn.

To account for this, Sandbag recommends establishing a further set-aside of 1Gt. We acquire this figure from a revised Phase 3 baseline derived from current power allocations combined with industry emissions. We have used average industry emissions from 2005 as a concession to some active abatement which may have taken place in these sectors. Taken together, this 1.7Gt set-aside should be introduced before Phase 3 gets underway in 2013. There is nothing in the Directive to prohibit such a set-aside of auctioned permits.

Recommendation 3: Reopen the ETS Directive by 2015

At the very latest, the directive should be reformed by 2015 to respond to the state of the science as published in the IPCC 5th Assessment Report, whose final instalment will be released in September 2014. A review of the reductions mandated by the system based on emerging science is implied by Article 1 of the Directive.

An opportunity might well arise before that date as the political appetite for climate ambition appears to be growing. Within the European Parliament, recent votes from both the Industry, Research and Energy Committee and the Environment, Public Health and Food Safety committee have come out strongly in support of stronger economy-wide targets and a 1.4 billion permit set-aside in the ETS. A crucial test of this Parliamentary support will be a plenary vote due to take place shortly after this report goes to press. Ambition also appears to be growing in the European Council, with Environment Ministers from 7 EU Member States signing a joint letter in March supporting a 30% 2020 target, and on June 21st all Environment Ministers apart from Poland’s supported the targets outlined in the 2050 Roadmap. Outside of the EU institutions, a growing number of corporate supporters have joined the call for greater ambition, including several prominent energy companies.

Recommendation 4: Prioritize the following changes to the ETS directive

At such a point as circumstances allow for a review of the Directive, we feel the following changes should be prioritized:

i. Permanently cancel the set-aside

Any permits set aside from Phase 3 risk returning to haunt the system in 2020 or in future trading periods unless they are permanently cancelled. This cancellation of the set-aside could be imposed on the basis of the following two recommendations:

ii. Increase ambition within the ETS with a steeper declining trajectory

The Directive currently calls for a review of the trajectory of the cap to be underway by 2020 and in force by 2025. But it is already clear that the current 1.74% annual reduction from average Phase 2 allocations, fails to deliver the abatement in the traded sector implied by the 2050 Roadmap. Research by Climate Strategies shows that a 2.4% trajectory is far better aligned. We call for this target to be reviewed by 2015 and for a 2.4% trajectory to be implemented by the following year. This would cancel some 553Mt of any outstanding set-aside by 2020.

iii. Create an ongoing cancellation mechanism to account for oversupply

The ETS currently has two legal mechanisms to prevent low supplies of carbon permits in the system from pushing up prices: generous international offsetting provisions, which allow compliance installations to purchase cheap abatement overseas towards half of their mandated reductions; and also a provision to bring forward permits from future auctions or unused New Entrants Reserve under specific criteria. There is currently only one provision, the banking of permits into future trading periods, to account for the opposite and prevailing problem, weak demand for permits and low carbon prices. To better account for this we recommend an Article 29b be established to create a clear basis for the Commission to intervene to permanently lower the supply of permits coming to the market under a predictable set of conditions (i.e. pre-specified drops in the production index, or drastic reductions in the carbon price). This would prevent a re-enactment of the problems that afflicted Phase 2.

iv. Introduce a reserve price for auctioned permits

Alternatively, or as a complement to the above cancellation mechanism, we recommend an amended directive introduce a reserve price for auctioned EUAs, whereby any permits not purchased at routine centralised auctions are permanently cancelled from the market. This would generate a reliable minimum price-signal for investors while maintaining the link between price and supply, turning the ETS from a quantity instrument into a hybrid quantity-price instrument.

v. Keep offsetting limited in volume and type

The offset provisions in the Directive for Phase 3 are currently much more limited than in Phase 2. They are linked to the overall level of ambition in the system. Under a 20% target, the cap on the volume of offsets is whatever remains unused of the 1.6bn tonnes allowed in Phase 2. No new industrial gas credits, which made up the bulk of the market, will be eligible from 2013 and new project credits can only be originated in Least Developed Countries or through bilateral agreement between countries. However, with the recession drastically reducing domestic emissions, offsets still potentially represent much more than half of the active abatement driven by the ETS. We feel this violates the spirit of the Directive.

An additional problem is that access to offsets is set as a proportion of allocations of allowances. This means that those who need them most, i.e. the underallocated power sector, are forced to buy swapped out allowances from others sectors that often have equal access to offsets but little need for them since they hold surpluses of allowances.

As highlighted in this report, there are examples of companies who complain about the impact of the ETS on their competitiveness while actively subsidising their competitors through purchasing emissions credits. This suggests that competitiveness concerns are being over-played, but also that the EU would do well to consider restricting eligibility further to prevent credits generated from competitive sectors such as iron and steel being surrendered.

We also recommend that even under a more ambitious target the restrictions of offsetting should remain in place. In light of the abuses of the offsetting provisions highlighted in this report, we urgently recommend the Commission:

prohibit companies from purchasing offsets until their total emissions exceed their free allocations since 2008;
limit access to offsets that subsidise Europe’s industrial competitors as a first recourse to address carbon-leakage concerns before limiting ambition within the system or imposing border adjustments

vi. Change rules to enable a whole economy trading system

The current Directive enables direct regulation of greenhouse gases from large point sources of emissions. This leaves around half of Europe’s emissions outside of the traded sector making the meeting of more ambitious climate targets more difficult to guarantee and potentially more expensive to meet. Other trading systems such as the New Zealand Emissions Trading System and the West Coast Initiative in the US enable economy-wide emissions to be traded by including the emissions from fossil fuels sold in the heat and transport sectors. These are regulated at the point of entry into the market e.g. the refinery. To create more demand in the system from sectors not directly exposed to international competition and to remain compatible with other international trading systems, the EU should either introduce a complementary Directive enabling the trading of indirect emissions in heat and transport sectors or amend the current Directive to make this possible.

Recommendation 5: Increase the transparency of the ETS

Several of the above recommendations rely on additional information about compliant installations and their activities being available to the Commission, to participants and, ideally to outside observers. We recommend the following installation level information be mandatorily reported to the Commission and published on the Community Independent Transaction Log (CITL):

Precise annual information on free waste gas EUA transfers between installations.
Latest information on the largest legal entity owning a majority share in an installation.
Complete “NACE code” information on the activity of each installation refined to 4-digit level.

This information will help to disaggregate electricity generators from other combustion installations, will allow better monitoring of the environmental performance of economic sectors against their annual output, and will provide policymakers, participant companies and observers better tools to evaluate the claims made by companies about the pressures they face under the system. Furthermore this information is required to implement our recommendations to prevent offset arbitrage, and to clarify the appropriate scale of a set-aside to correct for the effects of oversupplied industrial installations on Phase 3 budget baseline.

As a final note, we observe that the current presentation of the CITL is very piecemeal and makes it difficult to determine the aggregate performance of the system, or particular sectors and countries within it. We therefore recommend that the Commission develop a user-friendly and queryable data viewer, similar to the data tools that Sandbag has developed in their absence, and lastly to allow site visitors to download the latest CITL database as CSV files.

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