European Union’s Emissions Trading System : An Analysis

European Union’s Emissions Trading System : An Analysis

European Union’s Emissions Trading System : An Analysis The European Union’s Emissions Trading System (EU ETS) aims to incentivize businesses to reduce their carbon dioxide emissions. It is the first exchange of its kind and  has endured  a volatile journey since its founding in 2005–both in returns and market design–to achieve its current state. The overarching idea of ETS is to allow trading of metric tons of carbon dioxide emitted, giving a free market solution to negative externalities. 

Of course, these carbon credits (allowances) hold some value. Each credit is a certificate that allows the holder to emit one ton of carbon. These credits may be traded as they appreciate in value when a scarcity appears– derived from the credits’ depleting nature–and when there is an increased or stagnant demand from corporations to emit CO2. 

Every year the EU distributes allowances to nations who then auction them off or give them away to their domestic corporations. The total number of allowances distributed decreases each year. This means that   corporations would need to develop technology for reducing their carbon footprint or purchase carbon credits. If corporations continue to emit CO2 without taking either action, they will face severe fines.

The depletion of the number of allowances distributed is a phased-out process. In this way, it  gives corporations time to develop technology and to make the necessary adjustments in their production processes to limit pollution. It prevents carbon leakage, where corporations leave the EU because of regulation. The final phase, Phase 4, was set to begin in 2021, and comes with major adjustments to the market design of the ETS. The primary concern dealt with the surplus carbon credit produced as a result of the 2008 financial crisis and an overestimated amount of allowances needed. 

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To remedy this, the Market Stability Reserve (MSR) was developed and put into effect in 2019 to act as a supply stabilizing entity for credits in circulation. This measure made Phase 3 credits untransferable into Phase 4 credits and thus effectively remedied the over-abundance of credits in circulation, which would deplete the per credit price and reduce the incentives of corporations to cut back on emission.  

The effects of the MSR became apparent in 2020 as the number of credits in circulation fell from 1.65 billion to 1.39 billion. During this time the price of December 2021 ETS futures saw a 37.8% increase. This regulation method will continue until credits in circulation reach a predetermined point. If the surplus allowances in circulation is indicative of the price per credit, the continued depletion into 2022 may cause an influx of demand. 

In 2020, overall demand for allowances decreased as a result of two major factors: the COVID-19 pandemic and  an increased use of renewables in power production by utilities companies. This substitution led to a 15% decline in emissions by the stationary installations sector, where 51% of the emissions come from power production while industrial installations make up the other 49%. 

In comparison to power production, industrial installations have had a much more difficult time reducing their total emissions. In fact the amount emitted  has slightly increased  since 2011. To counter the growing emissions by the industrial sector, freely allocated allowances will be reduced to 43% which will be allocated mostly to the industrial sector to prevent carbon leakage. 

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Although overall emissions are declining at a rate faster than the cap depletion rate put in place for Phase 4, this is mostly due to the large improvements by the power industry, and other sectors are reducing emissions at a rate slower than the required rate of 2.2%. Since 2013, industrial heat emissions have been declining at an annual rate of 2.8% while the average industrial emissions have been declining only at a rate of 1.4%. 

However, if the same proportion of power related producers were to switch to gas-fired power plants in 2021, and assuming that industrial emissions decline at the current average annual rate, the total emissions from stationary installations would reduce from ~1,354,000,000 tons to ~1,301,690,000. The natural gas substitute used in power plants reduces emission from ~200 pounds per million Btu to ~117. 

Therefore, as 118 million tons of emissions were reduced in 2019, it would necessitate the transfer of 200 million units to natural gas, reflecting 25% of the total power production emissions.

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If the same portion(25%) of the power sector–or ~168 million units–switches to using natural gas in 2021, the emissions efficiency would then see  a ~100 million units decrease, leading to a projected total emission of ~575 million units for the power sector. Assuming this trajectory while considering reversion to the mean by the industrial sector (due to the pending Covid-19 recovery), the total emissions for stationary installations would amount to ~1,301,690,000 tons. This reflects .83 of the total emissions cap. Throughout 2021, 57% of the total allowances are expected to be auctioned off to help alleviate carbon leakage in the industrials sector.

This means free allowances will constitute 43% of the total cap of 1,571,583,007 making up 51.9% of the projected demand. In comparison,  freely allocated allowances made up 49% of the total emissions in 2020. The increase in freely allocated allowances as a proportion of total emissions may lead to a decline in credit price. This has not been the case thus far and potential reasoning could be stockpiling.

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Stockpiling is a potentially influential reason for the increase in price. Companies may be stockpiling because of the MSR, which plans on removing from circulation 24% of the surplus annually. Another reason may be the newly implemented 2.2% annual decrease in allowances, which especially impacts the industrial sector, which has experienced emissions growth whenever there has been abundant GDP growth. 

The remaining half of 2021 will be especially deterministic in the future of the EU ETS. The reaction to the MSR and contracting surplus may have a continued impact on price. If there is abundant GDP growth, industries may see an increase in emissions from 2019 levels, forcing technological advancements in the sector, as they will be forced to combat rapidly depleting caps.

Regardless of the per credit price, the EU ETS has proven itself effective in reducing emissions and has done so in a creative market-centric way. However, the system may begin to show stagnation in emissions reduction and even greater returns as it becomes exponentially harder for companies to reduce their carbon footprints.

European Union’s Emissions Trading System : An Analysis

Written by Hakil Haxhiu

Profile photo of Hakil Haxhiu

Edited by Hantong Wu, Jay Devon & Vivian Fang

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