OREANDA-NEWS. March 17, 2015. What happens when an irresistible force meets an immovable object? One answer to this paradox is “nothing” since irresistible forces and immovable objects can’t co-exist. At least not in the real world.

But what happens when the irresistible force is the political will of the European Union to reform its carbon market ahead of global climate talks later this year, and the immovable object is a group of EU member states who are resolutely opposed to higher carbon prices?

Of course, the answer is simple: something has to give. There must be compromise. The real question, then, is what sort of compromise is possible, and how long will it take to agree?

This is the major uncertainty that carbon traders and other energy industry professionals are grappling with, as lawmakers and EU member states work to thrash out new legislation to shore up European carbon prices amid a long-running surplus of permits.

EU Allowance prices have fallen from as high as Eur7.88/mt on February 24 to a four-month low of Eur6.28/mt on March 13, amid concerns that a group of member states are ready to form a blocking minority in the EU Council to weaken a plan to create a Market Stability Reserve to curb the oversupply.

Some participants are forecasting a doubling of carbon prices by the end of this year if reforms are enacted, while a failure to curb oversupply would almost certainly crash the price.

The long road to reform

Here’s the background: The “cap” on Europe’s CO2 emissions under the EU Emissions Trading System was set at a time of healthy economic growth. It is fixed under legislation, and cannot easily be changed. It is set to deliver a 21% reduction in CO2 emissions by 2020 from 2005 levels, among power generators and heavy industrials. Europe’s regulated CO2 emissions are on track to meet that target.

A combination of worldwide recession, an influx of cheap United Nations carbon offset credits and the effects of overlapping EU climate and energy policies pushed carbon allowance prices down from more than Eur30 per metric ton of CO2 equivalent in 2008 to less than Eur3/mt in 2013, with prices edging back to around Eur7/mt in early 2015.

For every mt of CO2 emitted by Europe’s power plants and factories each year, plant operators must hand over one allowance.

A large chunk are given out for free to trade-exposed sectors, but since 2013, most power generators must purchase most or all of their required permits at government auctions or in the open market through brokers and exchanges.

That’s consistent with the “polluter pays” principle that lies at the heart of efforts to put a price tag on industry’s CO2 emissions. Without such a carbon price, those responsible for CO2 emissions can avoid taking on responsibility for their environmental damage.

The EU, for its part, says its long-term goal to decouple CO2 emissions from economic growth is on track: Between 1990 and 2012, the EU succeeded in cutting its greenhouse gas emissions by 18%, while GDP grew by 45%, according to the European Commission.

And the EU is on track to meet its 2020 target of reducing economy-wide emissions by 20% below 1990 levels, the EC says.

But in the wake of the economic crisis of 2008, lower industrial CO2 emissions meant plant operators needed fewer allowances than originally expected, allowing a surplus of around 2.1 billion mt of permits to build up (around a year’s worth of CO2 emissions across the 31-nation system), pushing permit prices sharply lower.

Low prices — what’s the problem?

The 2020 CO2 cap under the EU ETS has been met several years ahead of schedule, and the resulting lower carbon prices underline this point.

Carbon market purists say low emissions permit prices don’t matter, since the environmental benefit is delivered by the CO2 cap, not the price.

Sure, the CO2 cap is being met, but a cap that was once considered ambitious was made easy by the global recession and other factors mentioned above.

The excessively low price for carbon allowances simply reflects the fact that little work is left to do to meet the 2020 cap.

A carbon price that can automatically fall during times of economic hardship is seen as a plus, relative to more rigid approaches like a carbon tax. Nevertheless, low carbon prices have little effect on operational decisions and long-term investments.

Some environmentalists say the obvious solution then, is to set a tougher CO2 cap under the EU ETS, in light of a radically changed economic landscape, which would clearly deliver a stronger price signal.

But tougher CO2 caps for 2020 are politically impossible: the legislation has already been agreed for that time period.

If the EU ETS and other policies are delivering the agreed CO2 reduction, why not leave the system alone and accept the resulting low prices?

As a colleague at Platts recently asked: “If the EU ETS is a free market for pollution rights, why do they keep tinkering with the market in order to engineer a higher price? It’s starting to look more like a CO2 tax, so why not just use a tax instead?”

Fair questions, perhaps. And the scope of this post cannot do proper justice to the complex debate about carbon tax versus cap-and-trade.

Suffice it to say, tax has some compelling arguments, such as delivering more certainty on the price. But a carbon tax also suffers from a critical weakness: polluters might simply pay the tax and carry on polluting — great for raising revenues for governments, but not so helpful for the environment.

Cap-and-trade, on the other hand, guarantees the environmental outcome by capping CO2 emissions from the start, irrespective of where the price goes.

Aside from that, industry is overwhelmingly against new forms of taxation and will almost always lobby against them.

Furthermore, EU top-down taxes are legally problematic. Generally speaking, EU member states are free to chose their own tax systems, provided they respect EU rules.

So the carbon tax approach would end up being fragmented into a patchwork of different rates in each country, which would create unwelcome distortions in the energy markets.

The market is here to stay

For good or for ill, a unified carbon market is the legal reality in Europe.

But herein lies the problem: a combination of recession and other EU climate and energy policies have done the hard work in cutting CO2 emissions (like the Renewable Energy Directive, Energy Efficiency Directive), by prompting EU governments to incentivize those activities, while at the same time pushing the carbon price down.

Arguably, that makes a mockery of the market-based approach: why put a price on CO2 emissions while at the same time incentivizing reductions using other more expensive policies?

This mix of EU policies simply means Europe is cutting carbon emissions at an unnecessarily high price, using state-sponsored subsidies, while at the same time hampering the carbon market’s ability to do the same job at a lower cost to the economy.

Part of the answer to this conundrum is that renewable energy and energy efficiency deliver other societal benefits besides reducing CO2 emissions, such as improving energy security and creating new sectors of employment.

EU governments have understood the need for subsidizing renewables and energy efficiency, at least in the short- to medium-term, even if doing so had the unintended negative effect of undermining the carbon price signal delivered by the EU ETS.

Academics and economists say the carbon market, if left free of other overlapping policies, could do the heavy lifting by cutting CO2 emissions at the lowest cost to Europe’s economy as a whole, without the need for renewable energy and energy efficiency targets.

It can do this, they argue, by always incentivizing CO2 reductions where they cost the least — harvesting the so-called low-hanging fruit. The private sector is better at deciding where to allocate capital than politicians. So let companies buy and sell allowances from each other, so that CO2 reductions take place only where they cost the least. Or to use the economists’ lingo: delivering marginal CO2 abatement.

Policymakers, on the other hand, need to operate in the real world, and they must balance pressures from opposing lobby groups, voter preferences and all manner of other political realities, including dealing with more immediate and pressing issues, like boosting jobs and growth.

Accepting this rather-less-than-optimal outcome, EU policymakers used all the tools at their disposal in order to achieve multiple climate and energy goals for 2020.

So the EU ETS and other policies are working, cutting CO2 emissions in line with the 2020 cap, even if the underlying economics are less than ideal.

But excessively low carbon prices don’t spur Europe’s power generators and heavy industrial companies to make operational decisions like switching from coal to gas, let alone make long-term capital investment decisions on low-carbon plants.

That risks a lock-in of a carbon intensive plant now, which could compromise cost-efficient CO2 reductions down the line.

One of the carbon market’s failures so far is that the price signal it delivers does not align well with longer-term CO2 reduction goals (the EU wants to cut CO2 emissions by at least 80% by 2050).

The regulator intervenes

Recognizing this problem of low carbon prices, the European Commission proposed delaying or “backloading” 900 million carbon allowances from auctions in 2014 to 2016 as a stop-gap measure to avoid a price collapse, and also proposed a Market Stability Reserve to curb the oversupply starting in 2021 as a longer-term structural reform.

Backloading took effect in March 2014, and the MSR has already gained the support of the EU Parliament in February 2015, and needs the backing of member states in the EU Council before becoming law.

Several Western EU member states including the UK and Germany want the MSR to start in 2017, while a group of eight Central and Eastern European countries want a start date of 2021.

The start date matters for carbon prices because it will start biting into the surplus at a rate of 12% of the oversupply each year, under the EC’s proposal.

Countries who oppose the early start are worried about higher carbon prices and their impact on electricity prices, particularly in coal-dependent countries like Poland.

Those supporting an early start say waiting until 2021 will waste several more years before the carbon market can send a meaningful price signal to drive Europe’s industry forward toward a low-carbon economy.

Deadlock at the EU council

All of which brings us up to date: EU member states are seemingly stuck in deadlock in the EU Council, and neither group wants to back down on the start date for the proposed carbon Market Stability Reserve.

As one carbon trader recently put it: “A movement of the start date on either side will be a compromise that no-one is happy with, so the Council will not want that.”

“If they end up with this deadlock [continuing], the delay alone will smash the carbon price, because people will wonder whether the whole proposal can be agreed at all,” he said.

Adding complexity to the proposal is uncertainty over the treatment of the 900 million backloaded allowances that are set to return to market via auctions in 2019 and 2020, and several hundred million other allowances that will be left unallocated by 2020 and which will also be sold back into the market unless a decision is taken to put them into the reserve.

The effort to create a carbon reserve under the EU ETS comes against a background of longer-term reforms as well as a wider context of global action to cut emissions.

The EU wants to go into United Nations climate talks in Paris in December with a full set of credible and complementary tools that can deliver CO2 reductions in the most economically efficient way.

The EU released its so-called Intended Nationally Determined Contribution to the UN climate process on March 6 (details here).

Adding to that, Latvia, the current holder of the six-month rotating EU Presidency, wants to broker agreement on the MSR before its term ends on June 30.

Furthermore, EU Commissioner for Energy and Climate Action Miguel Arias Canete has made it clear that the EC will not propose any further EU ETS reforms until the MSR is agreed, adding further pressure on lawmakers and Member States to find agreement this year.

Tough negotiations

Negotiations in the Council could be tough, but ultimately some kind of compromise is almost inevitable.

As one Brussels-based policy observer put it: “The point is that countries rarely try to railroad each other because it can have ramifications in other areas.

“So they all have to compromise, and my feeling is the ‘early start’ people have more to lose if the process is delayed, and so will give concessions to get the backloaded allowances out of the market in return for a 2019 or even a 2021 start.

“Remember, the objections from those against are financial, not ideological. So the ‘early start’ people always have the option to give the ‘late start’ people some kind of financial reassurance that they won’t be left out of pocket. That might be by convincing them they’ll make more money auctioning the allowances if they have a higher price, although that doesn’t seem to have worked so far,” the source said.

“And also, finding compromises and reaching agreements is the day job for all these people. I suspect it’s not nearly as bruising as you might think,” the source added.

With so many moving parts and possible outcomes to the reform process, trying to predict future carbon prices is problematic for analysts until more clarity emerges from the EU Council.

If no compromise is achievable on a middle ground start date of 2019, one possible outcome is that Latvia manages to oversee a compromise in which the MSR starts in 2021 as first proposed by the EC, while backloaded and unallocated allowances are placed directly into the reserve.

That way, the CEE countries opposed to an early start date can have their demands met, while the Western countries also have their concerns about surplus allowances allayed.

In the negotiations in the EU Council, what will it cost to get the CEE countries to support tough carbon market reforms? Money for carbon capture and storage research? Help with efficiency improvements to coal-fired power stations?

In the inevitable political horse-trading that will ensue, one can only speculate on the topics that could come up behind closed-door negotiations, and all sorts of concessions and compromises are possible, including on matters entirely unrelated to the EU carbon market, in the overall effort to secure agreement.

What is beyond doubt is that the EU as a whole is serious about cutting greenhouse gas emissions and it wants the effort to be global and fair.

From Latvia’s point of view, and the wider EU in general, even a weak deal on the MSR that is somewhat compromised is vastly better than no agreement at all, so negotiators can be expected to pull out all the stops to make sure that happens before the end of June.

Carbon price impact

EUAs for Delivery in December 2015 have averaged at Eur7.13/mt so far this year, based on the daily closing price. Today’s carbon price includes the perceived probability of some kind of future supply constraints.

Certainly, without proposed reforms, carbon prices would be far lower than today’s level, because the system has an accumulated oversupply of at least 2.1 billion mt, suggesting a price of near zero.

So what do proposed reforms mean for carbon prices going forward? Some analysts have forecast that carbon prices could double to Eur15/mt later this year if the most bullish reform scenarios materialize.

Well, Platts doesn’t do price forecasts.

But in the humble, personal view of this author — and this is not a forecast, but merely a consideration of a possible compromise — one outcome could go as follows:

  • Agreement is found this year to start the MSR in 2021.
  • A decision is made to transfer the 900 million backloaded EUAs into the reserve.
  • Only 300 million EUAs from the unallocated pool are sold back into the market (possibly from 2018 to 2025) for the proposed Innovation Fund, with the remainder being transferred into the MSR.

Under this scenario, a realistic price range for EUAs for December 2015 delivery by the end of the year might be Eur7.00/mt to Eur9.00/mt.

Any agreement that fails to transfer into the MSR all of the backloaded EUAs or unallocated EUAs left after the 300 million are sold would likely see prices fall to lower levels.

Swiss bank UBS has recently called for a doubling of the carbon price by the end of the year, based on an assumption that strong MSR reforms will be agreed in trilogue talks in the EU Council, Parliament and Commission by summer 2015.

However, UK carbon analysis group Sandbag has said even a strong MSR with an early start will leave the carbon market with a 2 billion mt surplus until 2020, based on a view that electricity demand will fall more than other analysts have assumed.

“It is clear that if a strong, early MSR would maintain a constant 2 billion mt surplus from now until 2020, prices are unlikely to rise significantly higher than today,” the group warned.

In a market entirely born of regulation, the EU ETS continues to be characterized by deep uncertainty, until Europe’s politicians lay down clear rules on supply.

Such rules may indeed be imminent, but until they are written into law, the market must grapple with huge uncertainty on the carbon price.

Recent work by Platts and its market analysis unit Eclipse, showed that even a Eur15.00/mt carbon price later this year will have little effect on fuel decisions by European power generators, barring in the UK where the underlying economics are affected by a domestic carbon tax.

That’s largely because even with a Eur15.00/mt carbon price, coal remains the most profitable fuel for power generation, based on underlying coal, gas and power prices in most of Europe.

For the EU ETS to become a major driver of CO2 reductions, deep policy changes would probably be necessary, and they may be beyond the scope of the current discussions on the MSR.

The MSR, if agreed, will very likely avoid a future carbon price collapse. But it might not, on its own, deliver the high carbon prices some people want or expect.