Will the EU 2030 carbon target revive the ETS market? The ETS scheme has been dismissed for its failure to generate a carbon price high enough to stimulate investment in low carbon technologies. Today, guest authors Jan Ondrich and Martin Bebiak discuss whether the EC’s new climate proposal will remedy this perceived failure. They say that a switch from coal to natural gas will require a carbon price of 36 euros per ton.

Source: Andreas Hermsdorf | pixelio.de

The present scheme generates oversupply, which we estimate could reach some 2,545mn allowances by 2021, when the ETS reserve system probably comes into effect. This has pushed carbon prices down to the point of irrelevance. The attempt to remedy oversupply by back-loading has failed.

What about the future trading period? Has the EU learned from past failures in the CO2 market? For 2030, the EC has proposed a target of 40% emission reduction compared to 1990 levels, resulting in an annual linear reduction of the ETS cap by 2.2% after 2020. We calculate this would result in an annual cap in 2030 of 1,314mn allowances.

Assuming economic growth of 1% in the EU and constant increases in rates of efficiency, annual ETS emissions would fall to 1.5bn annually by 2030. Total ETS emissions in 2021-2030 would stand at 16.1bn.

Our calculations show that the supply of emission allowances in 2021-2030 would total 14.9bn. We must then add the current accumulated surplus (2bn), plus the estimated surplus accumulated within Phase 3 (545mn), giving a total of surplus of 2.545bn. This corresponds to the EC surplus of 2.6bn by 2020 in its 2030 proposal.

If we add this surplus, we have a total 2021-2030 supply of 17.5bn. Total ETS emissions in this period would total 16.1bn, giving an oversupply of up to 1.4bn. This would keep prices at rock-bottom, hardly motivating firms to decrease their carbon emissions.

Would the proposed stability reserve, planned to start in 2021, solve the oversupply problem? If implemented, the system would adjust annual auction volumes in situations where the total number of allowances is beyond a predefined range:

• Allowances will be withdrawn from future auction volumes and added to the reserve system if the surplus is higher than 833mn allowances. This means that in year x the decision will be made to withdraw 12% of the allowances in circulation in year x-2 from auctions taking place in two years time (x+2). 12% of the allowances in circulation are defined as the total surplus of allowances in the given year. If this number is lower than 100mn, no allowances will be withdrawn.
• Allowances will be released from the reserve and auctioned due to a temporary deficit, given the total surplus is below 400mn allowances. In this case 100mn allowances will be released in a year(x+1).

By our estimations, there would be an oversupply of 2,545mn allowances already by 2021, when the ETS reserve system comes into effect. This means in 2021 the decision would be made that 12% of the surplus allowances in year x-2 would be withdrawn from the planned auctions in year x+2. In 2019, the surplus will probably be at 2,537mn. As a result, 12% of this surplus (304mn) will be withdrawn from the auctions in 2023. This will continue every year until 2027, when the surplus falls below 833mn. By 2028 the surplus will fall below 400mn, resulting in 100mn being released from the reserve system every year until 2030.

It seems then the stability reserve system will solve the problem of oversupply. This problem could be dealt with even earlier if German efforts to introduce the stability reserve system in 2016 are successful.

What does this mean for carbon prices? Given that the EC’s measures will likely balance demand and supply in the carbon market, we believe the price will be determined by the switching costs for power plants between gas and hard coal since power generators are the largest consumers of carbon allowances. Assuming constant prices as in 2013, we calculate that gas will be more competitive than hard coal with a carbon price of €36/tonne. If we assume that gas will be the marginal power plant, then the price of carbon should reach at least €36/tonne.

The EC proposal thus has the potential to produce a price which should motivate utilities to start switching from coal to gas, leading to significant carbon abatement in Europe, though not until 2028. If Europe wants to start decarbonising sooner, it is imperative that the German proposal for starting the stability reserve mechanism already in 2016 is accepted.

Jan Ondrich is a partner and Martin Bebiak a senior analyst in market analysis and advisory firm Candole Partners.