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energy

In the EU, does carbon price foreshadow change?

Hæge Fjellheim  Head of Carbon Research

Hæge Fjellheim  Head of Carbon Research

We are witnessing a green shift in the European energy sector, and there are plenty of signs this will only accelerate in the years to come. But, it is far from certain that the price on carbon will be the main driver for this transition.

On April 8, a major reform of the European Union Emission Trading System, the flagship instrument of Europe’s climate policy, entered into effect. It will significantly tighten the market and could further boost carbon prices towards 2030. But will that be enough to ensure the trading system is the driver of green transition in Europe?

The entry into law concludes a nearly three-year-long process to make the EU’s main climate policy instrument fit for fight until 2030. Why is this reform important? A key concept is carbon price. Currently, it costs around 13 euros to emit one metric ton of CO2 equivalents. Even though this is a level not seen for seven years – after a rapid rally with prices climbing 70 percent since the beginning of 2018 – most would agree it is still not sufficient to fundamentally shift the economy in a green direction.

What should be the price on CO2 emissions? And how do you decide the optimal price level? The answer is: You don’t. The EU Emission Trading System covers nearly half of the EU’s total output of greenhouse gases. Every year, fossil electricity generators and heavy industry from over 11,000 installations across Europe must submit emission allowances or permits equivalent to their actual emissions. One ton of CO2 is accounted for by one European Union Allowance.

A man looks at his mobile phone amid morning smog in Pristina, Kosovo. REUTERS/Hazir Reka
A man looks at his mobile phone amid morning smog in Pristina, Kosovo. REUTERS/Hazir Reka

European emissions dropped a lot as an effect of the financial crisis. This reduced the demand for allowances and led to a huge surplus. Thomson Reuters Point Carbon has calculated it to around three billion allowances, or close to twice the annual emissions from all covered installations.

In other words, the low price is the result of a mismatch between demand and supply. While demand is dynamic – reduced activity gives a reduced volume of emissions – supply is decided politically and, as such, is static.

Are low carbon prices really a problem? Some say no. The climate target will be reached – as emissions will not surpass an ever-shrinking emission cap – and what’s more, it will be achieved at low cost. Still, many worry that low prices mean the can is kicked down the road. If the Eu is to take the goals of the Paris Agreement seriously, it needs to significantly change the way it produces and consumes its energy. A low price on emissions will not incentivize the investments that are needed.

Three years ago, the EU created a so-called market stability reserve that will become operational next year. It will absorb parts of the surplus, thereby making the supply side more dynamic. The original idea was to withhold 12 percent of the surplus every year.

The reform that has now been concluded tightens the belt even more:

  • First, the pace of the intake of allowances to the stability reserve is doubled. This means the surplus will be reduced more rapidly.
  • Second, a considerable amount of allowances (we estimate it at 2.4 billion), will be cancelled from the reserve by 2030. These volumes will never come back into circulation. While it will not be felt directly in the near term, this measure represents a real strengthening of the EU’s long term climate policy ambition.
  • Third, the annual emission cap will be reduced more rapidly than today.
The Szabadsag Bridge with the frozen Danube River seen in a veil of heavy winter smog in Budapest, Hungary. REUTERS/Laszlo Balogh
The Szabadsag Bridge with the frozen Danube River seen in a veil of heavy winter smog in Budapest, Hungary. REUTERS/Laszlo Balogh

Altogether, this will make a huge difference. We see the expectations of curbed supply already from 2019 as a main factor why prices have rallied lately. That said, a large surplus will remain. We foresee a slow-down of the current rally and currently estimate carbon prices at 14 euro per EUA in 2020 increasing to 25 euro in 2030. This price trajectory is based on a number of assumptions on economic growth, coal and gas prices, development of renewable energy, energy efficiency, Brexit and market behavior.

It is not difficult to imagine lower prices, especially now that the EU has started negotiations on whether to strengthen the targets for renewable energy and energy efficiency. More of those and an accelerated phase-out of coal power will lead to reduced emissions, less demand for allowances and lower prices.

It is not hard to imagine a further tightening of the system, either. The Emission Trading System is a political creation and it can be changed politically. Several “anchors” have been added to the legislation whereby lawmakers are committed to reassess both the level of ambition and the stability reserve parameters several times before 2030. As politicians are congratulating themselves with what they have just achieved, officials and experts in Brussels are already well-engaged in discussions on whether the reform will be sufficient, or if more will be needed.

For many countries the reform will not be ambitious enough. And seeing that it will probably be hard to tighten the screw further at EU-level, they will chose to advance alone or in smaller groups, setting their own national emission targets, deciding on strategies for phasing out coal, and supporting new renewable energy.

The reform is a compromise negotiated between eastern and western Europe and between electricity generators and industry. It concerns not only a tightening of the Emission Trading System and the carbon price, but also industrial competitiveness and the distribution of the revenues from the allowance auctions between the member states. It also touches on how member states finance innovation and the modernization of the energy system.

We are witnessing a green shift in the European energy sector, and there are plenty of signs this will only accelerate in the years to come. But, it is far from certain that the price on carbon will be the main driver for this transition.


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