EU ETS
An emerging asset class
The European Union (EU) Emissions Trading System (ETS) has been defined by the European Union as a cornerstone of the EU's policy to combat climate change and its key tool for reducing greenhouse gas emissions cost-effectively. It is the world's first major carbon market and remains the largest.
In operation since January 2005, the EU ETS covers the most carbon-intensive sectors of the EU economy. The goal of this program is to reduce the total volume of carbon emissions from multiple sectors. The EU ETS is a cap-and-trade system: the supply of European Union Allowances (EUAs) in this market is capped and declines each year, and participants can buy those EUAs at numerous regular auctions. Demand comes principally from compliance entities having to deliver EUAs to match their prior calendar year verified (i.e., audited) emissions every 30th of April.
On 1 January 2020, Switzerland became the first country to successfully link its greenhouse gas emissions trading system with the EU ETS.
More than 45% of the total emissions from participating countries are now covered under this program, including emissions of power generation, oil & gas, steel, cement, chemicals, glass, and pulp & paper. Aviation and maritime look set to join this scheme in 2024. The verified carbon emissions output from these sectors are the source of demand for European Union Allowances (EUA).
Demand (i.e. emissions) under the EU ETS oscillates from year to year, driven by, e.g., more efficient electricity production (gas instead of coal), more efficient industrial processes, new or closed businesses, weather (more or less renewables requiring less or more back up from conventional thermal carbon-emitting electricity). What was a declining trend of power emissions has now reversed as coal has had to come back into the fray as Russia has reduced the supply of gas to EU on the back of their Ukraine invasion. When the EUA price gets to a meaningful level and/or free allowances are reduced, there will be a financial incentive for companies to change their business practices/production runs to become more carbon efficient. But that will take time and money. In short, emissions/demand oscillates over time but the swings are modest compared to the reductions in supply.
The EU is committed to reduce emissions by 55% by 2030
There is no doubt that the EU is committed to reducing carbon emissions in order to save the planet. This has been a goal spearheaded at the 1997 Kyoto summit, at a time when the rest of the world gave little credence to the climate urgency. On 14th July 2021, the EU upped its game, revising its prior 40% reduction of 1990 emissions levels by 2030 target to 55%. It also now targets climate neutrality by 2050.
The EU ETS is clearly a cornerstone in this policy: it will take a larger burden off on the 2030 emission targets. Although accounting for only 40% of European emissions, the ETS will have to reduce its emissions by 61% i.e., exceeding the 55% general target.
Auction revenues are a significant source of funds to member states
Auction revenues are a hugely important source of revenues to both the EU and member states.
At a price of €80/t, EUA auctions represent c€50bn of revenues. These revenues are distributed to the 27 member states. To put that into context, it is greater than the UK’s €40bn Brexit bill. Except that was a one-off payment; EUA revenues are recurrent. The only stipulation on the use of revenues is that at least 50% should be utilized for climate-related spending. These revenues form part of the EU’s recommended toolbox to protect consumers and industry from high energy bills (predominantly due to soaring gas and coal prices) by making social payments to those most at risk.
Although the EU does not share in these revenues today, it is keen to have a slice in future years. As part of the Green Deal discussions, the EU has said it wants a share of the EU ETS revenues as well as the revenues from the proposed Carbon border Adjustment Mechanism (CBAM) going forward in order, in part, to finance the €800bn COVID-19 rebuild spend.
Regulatory changes take time
Although the EU ETS began life in January 2005, it achieved very little for the better part of 14 years: the carbon price was simply too low to incentivize carbon reduction. Higher carbon-intensive processes need to be made more expensive than lower carbon-intensive processes by factoring in a sufficiently high carbon price.
Since 2013, the EU has tried several ways to increase the EUA carbon price. Ultimately these were all unsuccessful until the introduction of the Market Stability Reserve (MSR) in January 2019. That was a game-changer. It is a mechanism which, under certain triggers, reduces the supply of EUAs and has resulted in a more meaningful and impactful carbon price.
Current proposals:
As part of the Green Deal/Fit for 55 package, there are a number of proposals being discussed to tighten up the EU ETS. The most important of these are highlighted below.
Reduction in the annual cap
In order to reach the EU ETS 2030 61% target reduction (ie more than the 55% EU-wide target), the supply (i.e., cap) of EUAs has to reduce at a faster rate than the existing 40% target, equivalent to 2.2% pa. This reduction rate is known as the Linear Reduction factor (LRF). The unknown is when this step-up will be enacted. If enacted for the year of 2024, we estimate this will step up to 4.2%, but it could be enacted one year earlier. There is also the possibility of a one-off booster taking out 117m (as well as a 200m proposal) permits in the first year (which, of course, would reduce the subsequent annual LRF).
MSR threshold to be retained at 24%
The MSR (Market Stability Reserve) is triggered based on the total number of allowances in circulation (TNAC). TNAC is simply the EUAs that have been issued but are yet to be utilized for April 30th compliance, i.e., the float of EUAs held on balance sheets or by individuals. Simplified, if the prior year TNAC is greater than 833m, then the MSR kicks in. In 2019, for example, the prior year TNAC was 1955m, exceeding 833m and, therefore, multiplied by 24% resulting in an MSR withdrawal of 397m. This is the amount by which the regular auctions (c1bn, pre-MSR) would be reduced. There is also a lower limit of 400m: should TNAC fall below this level, 100m additional EUAs will be auctioned. In between 833m and 400m, the MSR is not triggered.
The current proposal is to keep the MSR withdrawal rate at 24% replacing the exisiting drop to 12% in 2024. There is also discussion of reducing the 833m upper threshold to 700m.
Tightening the definition of Article 29a
Article 29a is in place to combat any surge in the EUA price. As it stands, Article 29a is triggered if the average carbon price of the last six (6) months is three (3) times greater than the preceding two (2) years. If triggered, the committee will be automatically convened. At that meeting, a decision will be made as to whether the price has gone up because of speculative or fundamental reasons. If the decision is that it has gone up because of speculative reasons, 100 million allowances will be added back into the system via auctions. If the decision is that it has gone up because of fundamental reasons, then there will be no additional supply, i.e., the status quo prevails. The current proposal is to reduce the three (3) times threshold to two (2) times the preceding year.
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