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Dr. Brigitte Knopf The EU ETS: Ex-Post Analysis, the Market Stability Reserve and Options for a Comprehensive Reform Seminar on the EU Emissions Trading System Helsinki, 13 November 2014 Presentation of the Euro-CASE policy brief Dr. Brigitte Knopf (PIK)

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Primary Energy in 2050

The EU ETS: Ex-Post Analysis, the Market Stability Reserve and Options for a Comprehensive ReformSeminar on the EU Emissions Trading SystemHelsinki, 13 November 2014

Presentation of the Euro-CASE policy brief Dr. Brigitte Knopf (PIK)

Dr. Brigitte Knopf1Scientific Background: New IPCC Report 2014There are multiple mitigation pathways that are likely to limit warming to below 2C relative to pre-industrial levels. These scenarios [] are characterized by 40% to 70% global anthropogenic GHG emissions reductions by 2050 compared to 2010, and emissions levels near zero or below in 2100.In the majority of lowconcentration stabilization scenarios [] fossil fuel power generation without CCS is phased out almost entirely by 2100.www.mitigation2014.orgIPCC Synthesis Report (2014)

#Dr. Brigitte KnopfPolitical Background: The EU 2030 FrameworkDecision on headline targets by the European Council (23 Oct 2014)At least 40% domestic GHG reduction by 2030Binding EU-wide target for renewables of 27% Indicative EU-wide target for energy efficiency of 27%

Reform of the EU ETS: January 2014: Legislative proposal for reform of the EU ETS with a Market Stability Reserve to start in 2021 Council conclusion refer to a reformed ETS with an instrument to stabilise the market in line with the Commission proposalChange of linear reduction factor to 2.2% p.a. compared to the current 1.74% p.a. (accepted by the EU Council)Timing: ENVI Committee is set to vote on 24 Feb. 2015 #Dr. Brigitte Knopf Chairs of the Euro-CASE Energy Platform: Ottmar Edenhofer, Bo Nordmark, Bernhard Tardieuhttp://www.euro-case.org/images/stories/pdf/position-paper/Euro-CASE-policy-paper-ETS-reform.pdfEuro-CASE Policy Position PaperReform Options for the European Emissions Trading System (EU ETS)

European Council of Academies of Applied Sciences,Technologies and Engineering

Dr. Brigitte Knopf4The EU ETS: ex-post analysisCarbon pricing is essential for climate policyStrong decline of the CO2 price

#Dr. Brigitte KnopfEx-post analysis of environmental effectiveness

Emissions stayed below the cap In fact, annual cap did temporarily not set a constraint and did not provide incentives for action (non-binding cap)Grosjean et al. 2014Phase 1Phase 2Phase 3#Dr. Brigitte KnopfPrice formation in a market with non-binding cap: Empirical evaluation of EUA price driversOnly 10% of price changes can be explained by market fundamentals (renewable deployment, economic crisis, CDM, ). The price formation in a market where scarcity is governed by political decisions crucially depends on expectations of market participants about future scarcities and future political decisions

Koch et al (2014)

#Dr. Brigitte Knopf

Expectations about future scarcities are crucial:Dynamic cost-effectiveness of ETS is lackingEUA nearest contract and Futures 2020Currently: decreasing CO2 price

8Dr. Brigitte Knopf

Expectations about future scarcities are crucial:Dynamic cost-effectiveness of ETS is lackingEUA nearest contract and Futures 2020Currently: decreasing CO2 priceAlso in the future, no substantial price increase is expected (only little spread between nearest contract and future contract for 2020)9Dr. Brigitte KnopfExpectations about future scarcities are crucial: Dynamic cost-effectiveness of ETS is lacking

EUA nearest contract and Futures 2020Cost-efficient CO2 price from modelingKnopf et al. (2013)Also in the future, no substantial price increase is expected Models show cost-efficient price path with increasing prices of more than 20/tCO2 by 2020

10Dr. Brigitte KnopfThe problem with the low priceA low price is in conventional thinking a sign of a well-functioning market. But in this case, it reflects the expectation of traders that the oversupply will be sustained even beyond the current commitment period.

In other words, the EU ETS does not incentivize the search for low-cost mitigation options but reflects mainly the expectations of traders about future political decisions.

The EU ETS has been transformed into a betting shop for the commitment period after 2020. #Dr. Brigitte KnopfSummary of problem analysisThe EU ETS is a market where scarcity is governed by political decisions and not by natural scarcity. Expectations of market participants on future political decisions are crucial

Environmental effectiveness of ETS is given. But the cap did not set a constraint as emissions stayed below the cap

Dynamic cost-effectiveness is not given; prices are not expected to increase significantly until 2020

Key question and requirements for ETS Reform to address: How to stabilize expectations of market particpants?

#Dr. Brigitte KnopfReform proposal by EU Commission: The Market Stability Reserve (MSR)In the course of the debate about the ETS reform, the EU Commission changes the wording from too low price to too high surplus of EUA certificatesJanuary 2014: proposal of MSR as a quantity based instrumentTrotignon et al. (2014)

13Dr. Brigitte KnopfMarket Stability Reserve - Impact

Does the MSR stabilise expectations?Contributes to decrease surplus (due to exogenous shocks) of allowances in phase IVBut oversupply does not dissipate until 2030Effect of MSR on price is unclearSource: European Commission (2014)Millions#Dr. Brigitte Knopf14Market Stability Reserve - EvaluationThe MSR does not address the problem of missing long-term cost-effectiveness and price uncertaintyChoice of quantity instrument is questionableIt addresses the existence of a large allowance surplus, but oversupply does not dissipate until 2030If hedging is the rationale behind the trigger it should change over timeThe impact is difficult to assess because the rationale behind the mechanism is not transparentMSR will have an uncertain impact on low-carbon investmentTiming of the effect might be too slow; review phase in 2026 gives additional uncertainty#Dr. Brigitte KnopfAlternative reform proposal by Euro-CASE: Instead of a narrow reform of the EU ETS, a fully-fledged reform addressing several aspects of carbon pricing is required:Setting a price collar within the ETS as a hybrid instrument

Sectoral expansion of the EU ETS to enhance the cost effectiveness of EU climate policy

Policy instruments in addition to carbon pricing are required for stimulating innovation

Addressing carbon leakage

#Dr. Brigitte Knopf1. Setting a price collarReliable framework for investment decisions; price collar will stabilize expectations; dynamic cost effectiveness is assured

#Dr. Brigitte KnopfAdvantages of a price collar within the EU ETSGeneral: price collar will stabilize expectations and lead to dynamic cost-effectiveness

Price ceiling is motivated by the fact that prices can also increase subtantially through shocks. With setting a ceiling this risk is reduced symmetrically, what would be important for investors

Price floor (auction reserve price) would allow addressing national preferences, e.g. more ambitious domestic mitigation goals, without undermining the environmental effectiveness of the additional national policies

Hybrid instrument of ETS and floor price also installed in California and other US Regions; might support possibility of linking

#Dr. Brigitte KnopfCan Linking of International Emission Trading Systems deliver Momentum for UNFCCC Climate Change Negotiations?19

IPCC WGIII, Fig 13.4Dr. Brigitte Knopf192. Sectoral Expansion of the EU ETSThe ETS currently covers about 45% of all GHG emissions, but all sectors need to significantly reduce GHG emissions.

There are different options on how to add further sectors, but upstream inclusion is the most favorable.

Revenue recycling (auctioning vs free allocation) important for sectoral expansion:Possibility of lowering costs to particular industries by exemptions and revenue-recycling

#Dr. Brigitte KnopfExample of sectoral coverage of carbon markets worldwide

Worldbank 2013http://www.worldbank.org/en/news/feature/2013/10/02/carbon-markets-world-view-infographic#Dr. Brigitte Knopf3. Instruments in addition to carbon pricingIn addition to carbon pricing, other policy instruments for innovation and diffusion of low carbon technologies might be required

There are indications that especially the innovation spillovers are high

R&D policies could therefore support innovation and should be part of the portfolio if market failures can be observed

#Dr. Brigitte Knopf4. Tackling carbon leakageCarbon leakage only affects a few sectors

It can be addressed by expanding the group of countries that participate in the ETS or by linking it to other regions

Within the group, free allocation of some emission permits as well as tailor-made trade policies should be considered

Lowering costs to particular industries by exemptions and revenue-recycling

#Dr. Brigitte KnopfIncreasing the number of ETS worldwide is the best way to address carbon leakage

Worldbank 2013http://www.worldbank.org/en/news/feature/2013/10/02/carbon-markets-world-view-infographicDr. Brigitte KnopfSummaryPricing carbon is essential for climate policy. In the EU ETS emissions stayed below the cap, but the EU ETS lacks dynamic efficiency to ensure long-term cost-effectiveness.

The MSR does not address the current problem. It might turn out to be a toothless tiger.

Instead, Euro-CASE proposes a reform package with setting a price collar as the foremost element and includes a sectoral expansion, policy instruments in addition to carbon pricing and addresses carbon leakage.

Without a comprehensive reform of the ETS, there is a clear danger of a revival of fragmented climate and energy policies across Europe which have the potential to increase the costs of climate policy substantially. #Dr. Brigitte Knopf