The European carbon market put to the test by Covid
The current economic crisis has caused a drop in the price on the European carbon market (or EU ETS for European Union Emissions Trading System) and will contribute to the increase in the surplus of allowances. This highlights how necessary it is to reform the mechanism for managing this surplus or even to implement a floor price. However, for Charlotte Vailles from I4CE and Nicolas Berghmans from IDDRI, this crisis should lead us to consider the EU ETS no longer as the “cornerstone” of decarbonisation in Europe, but as a safety net.
The current economic crisis highlights – once again – the weaknesses of the EU ETS in the face of external shocks, which have been only partially resolved by the latest reforms. While the crisis has so far only had a measured effect on the carbon price – apart from a brief episode of falling prices in mid-March, it is expected to have a very significant impact on 2020 emissions and thus create a new surplus of allowances, while the surplus accumulated since 2009 has still not been absorbed. This historical surplus caused by the economic crisis, the increase in supply with international credits, and the unanticipated effect of other European energy-climate policies still amounts to 1.4 billion allowances in 2019 according to the Commission’s recent calculations.
The implementation of the Market Stability Reserve (MSR) last year helped to raise the carbon price to around €20-25/tonne, but its current parameters will not be adapted to regulate the new surplus of allowances due to the current economic crisis. Indeed, analyses by I4CE and Enerdata or ERCST and ICIS already showed before the crisis that the MSR would not be sufficient in the medium term to neutralise the effect of other energy-climate policies on the supply-demand balance of the EU ETS, such as renewable energy development policies and the coal phase-out plans of some Member States. The impact of the crisis on the EU ETS will therefore materialise in the medium term, and calls into question the rather positive results of the EU ETS in 2019, when the rise in prices led to a historic drop in coal-based electricity production.
In order to avoid another chronic depreciation of carbon prices and an increase in coal-fired power generation in Europe, the parameters of the MRS must therefore be strengthened during the review scheduled for 2021. Another solution would be the implementation of a carbon floor price, as it exists in other ETSs, for example in California, Quebec or the Regional Greenhouse Gas Initiative (RGGI) ETS. Such a mechanism would counterbalance the fall in the price of fossil fuels while providing visibility for investments by economic players. This measure was recently recommended by the French High Council for the Climate as a way out of the crisis and proposed (again) by France to the other European states at the end of April.
This crisis should provide an opportunity to rethink the role of the EU ETS, especially since the European Commission is currently assessing the impact of an increase of the 2030 emissions reduction target to 50 or 55% below 1990 levels as part of its Green Deal. This increase in the 2030 target is necessary to put the continent on the path to climate neutrality by 2050 and requires a review of the policies and instruments mobilized to achieve it, in particular the EU ETS. While the EU ETS was presented as the cornerstone of European climate policy when it was implemented, this may be an opportunity to (re)define its role, drawing for example on the experience of California, where the ETS’s role as a safety net is accepted. The ETS would thus guarantee the achievement of the climate objectives in case the reductions expected from other policies are not sufficient, but would no longer be considered as the main driver of decarbonisation.
Historically, the EU ETS has had little effect on emissions from the sectors covered. If we take electricity generation as an example, the vast majority of emissions reductions between 2005 and 2018 cannot be attributed to the EU ETS: it came primarily from the deployment of renewable energies and the policies that supported this deployment (see Figure below, an update from an I4CE report). Over the period, the EU ETS has contributed only marginally to emissions reductions, by favouring gas-fired power generation over coal-fired power generation in the last two years. Coal phase-out is of course necessary, but carbon neutrality cannot be achieved by simply switching between fossil fuels. In particular, it requires massive investments in low-carbon technologies, something that has never been achieved by the EU ETS alone.
For their part, the industrial sectors covered by the EU ETS have so far made little progress towards decarbonisation. And the existence of the EU ETS may have slowed down the use of other levers, which are necessary to accelerate decarbonisation in sectors where today’s investments will still be there in 2050. We need specific instruments for the decarbonisation of industry, such as the integration of carbon criteria in materials markets, or the establishment of contracts-for-difference for innovative low-carbon projects. These tools must be designed in line with the upcoming revision of the EU ETS to implement genuine sectoral decarbonisation strategies, one of the priorities of the new EU industrial strategy unveiled in March 2020.
Let us not choose between the EU ETS and other policies to decarbonise electricity and industry in Europe. We need both. And we must not fall again into the trap of expecting everything from the EU ETS. This is especially important to remember as the Commission considers extending the carbon market to the transport and building sector. While a single carbon price is attractive from the point of view of economic efficiency, there is a great risk in reality that this price will be aligned to the level which is politically acceptable for the sector with highest constraints, to the detriment of the decarbonisation of the other sectors. The extension of the EU ETS, if it really were to take place, should therefore be conditional on keeping existing policies – or even implementing new policies – necessary for the decarbonisation of the sectors in question. Otherwise, it could become a brake on their necessary transition to carbon neutrality. For the transport sector in particular, it is essential to preserve and strengthen the instruments which currently make a real contribution to decarbonisation, first and foremost European emission standards for new vehicles.