Effects of the proposed EU ETS Market Stability Reserve

Mr Adam Whitmore, Rio Tinto

Paolo Agnolucci, University College London

Phoebe Lewis, University College London

There is currently a surplus of about 2 billion allowances in the EUETS during the current phase, largely arising as a result of the economic recession in Europe.  In response to this surplus the European Commission has put forward a proposal to establish from 2021 a market stability reserve, with allowances put into or drawn down from the reserve depending on the size of the cumulative surplus of allowances (EC 2014).  This is a significant innovation in the structure and potential operation of the world’s largest carbon market, with no precedent from similar mechanisms elsewhere. Although a number of authors in the academic literature have discussed and advocated the use of price stability reserves, (e.g. Murray et al 2009), a reserve is normally assumed to be activated by the price of allowances reaching a defined trigger level. The design of the EU ETS proposal is novel in that the operation of the reserve is triggered by quantity rather than price.

This mechanism has the potential significantly to affect price formation and the efficiency of emissions abatement in the EUETS.  It may also affect other carbon markets, which may introduce similar mechanisms, or may be linked in the future to the EU ETS.  However, the proposal has been subject to little formal analysis to date, despite its importance.  This work analyses the expected effect of the proposal on outcomes from the EUETS, and is thus highly relevant to current policy discussions.  Specifically the work looks at properties of the EU ETS with three different designs: firstly in its current form; secondly with the market stability reserve; and thirdly with a hybrid mechanism of price floors and ceilings. Hybrid mechanisms have been extensively analysed (e.g. Fell and Morgenstern 2010 and Philibert 2009), and this work draws on that literature.  The form of hybrid mechanism adopted for the assessment of the EU ETS is based on the California ETS, which is the largest hybrid scheme currently in place.

Our work assesses the properties of each potential variant of the EU ETS using a stochastic market simulation model.  It examines each design, looking at sensitivities of outcomes to structure and parameters of the mechanism design, and to the functional form and parameterisation of both demand and supply of allowances, and to the discount rate.  Outputs include the distribution of price paths of allowances (including their volatility), quantities of emissions over time, costs of abatement, and welfare effects.  Although results of the analysis are still being developed, early work indicates that the proposed market stability reserve may increase costs of abatement for no environmental benefit.  If validated by the remainder of the work this conclusion has significant implications for the desirability of adopting such a mechanism.

Keywords: EUETS, California ETS, emissions trading, carbon pricing, hybrid mechanisms, allowance reserve, market stability reserve

References

European Commission (2014) Decision of the European Parliament and of the Council concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC. Brussels: European Commission.

Fell, H. and R. Morgenstern (2010) ‘Alternative Approaches to Cost Containment in a Cap-and-Trade System’ Environmental Resource Economics, 47, 275-297.

Murray, B., Newell, R. and W. Pizer (2009) ‘Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade’ Review of Environmental Economics and Policy, 3, 1, 84-103.

Philibert, C. (2008) IEA Information Paper: Price caps and price floors – A quantitative assessment. Paris: International Energy Agency.