The recent drop in prices on the EU’s Emissions Trading System (EU ETS) threatens to slow industrial decarbonisation and to deprive state treasures of urgently needed funds for climate action.
While the topic of prices fluctuating within the EU’s Emissions Trading System is not new, the current 31-month low of just over €50 per tonne has reignited debates on the ability of the EU ETS to incentivise green investment and achieve emissions reductions. Starting in January 2024, prices have been decreasing steeply from around €84 per tonne to reach prices as low as €52. While this is still a far cry from the very low ETS carbon price witnessed between 2010 and 2020 of under €20. As prices continue to fluctuate, we look at the drivers for this recent downward turn and explore future scenarios.
Thanks to the early establishment of its Emission Trading System (EU ETS) in 2005, the EU has long been at the forefront of efforts to put a price on carbon. As the central instrument of the EU’s decarbonisation policy, the ETS has gone through several revisions as the EU increases its climate ambition.
For years, the EU ETS has grappled with the issue of oversupply, dampening the effectiveness of carbon pricing measures. However, in the past few years, significant progress has been made with the activation of the Market Stability Reserve in 2018, which removes some of the surplus allowances from circulation. Relatively high prices helped spur greater emissions reductions. Just last year, industry stakeholders and some national governments and media outlets lamented the steep increase in carbon price, reaching record highs in 2023 of €100 per tonne. As the debate around the 2040 target heats up, it must be recognised that a carbon price high enough to trigger decarbonisation efforts will be an essential element for achieving the European Commission’s stated ambition of a 90% net emissions reduction.
A flood of allowances
Even though a high carbon price sends the right investment signals to industry, panic caused by temporary energy price hikes due to Russia’s invasion of Ukraine and other factors led the European Commission to raid the Market Stability Reserve, flooding the EU ETS with additional carbon permits to raise €20 billion for the REPowerEU, effectively taking from Peter to pay Paul. The price trajectory suggests that as the auctioning for the purposes of REPowerEU started in the summer of 2023, a steady decrease of the carbon price started, culminating in the dip of the last weeks.
This oversupply, combined with demand stagnation, inflation, and decreased emissions within the EU ETS have reawoken the spectre of oversupply.
Moreover, the positive developments of the general growth of renewables in the energy mix and the decommissioning of coal-fired power plants (with no obligation for member states to remove the associated supply of pollution permits) have had the effect of boosting supply relative to demand. The general trend of lower fossil gas prices is also a major factor in the decreased need for allowances. Gas produces fewer emissions than coal, so as less coal gets burned, fewer emissions allowances are needed.
When the price is wrong
The resulting drop in carbon prices poses some serious challenges. Lower prices diminish the incentive for industries to invest in cleaner technologies, watering down an investment signal that is already distorted by the free allocation of allowances – with more than 89% of industrial climate pollution subsidised at no cost to industry in 2022.
Lower carbon prices also hurt national budgets. Since its inception, the EU ETS has raised over €152 billion in auctioning revenue for member states but lower carbon prices mean reduced funding for urgently needed climate action.
Funding for EU level schemes, such as the Innovation Fund, which invests in innovative decarbonisation solutions, and the Modernisation Fund, which helps lower income member states green their energy infrastructure, is also reduced when the ETS price falls. This is bad news in the context of the mitigation investment gap that must be closed if we are to meet our climate targets.
Especially with the majority of EU industrial actors still shielded from the full impact of carbon pricing, it’s essential to make sure prices remain high enough to put some pressure on them to decarbonise their activities. With recent statements by former ECB President Mario Draghi highlighting the growing need for private investment in climate action, as well as shrinking national budgets due to inflation and unfavourable political circumstances, further measures (such as a floor on the EU ETS carbon price) could be considered.
Oversupply: the real issue
Policymakers must read the significance of the current extended downward trend in the carbon price and urgently tackle the oversupply of pollution permits.
Although the Market Stability Reserve cancelled 2.5 billion allowances last year, the removal of allowances from the MSR to fund RepowerEU was a strategic error.
This must not be repeated as any relaxation of the planned reduction in the supply of allowances lowers the economic incentive for investors to slash their emissions today. The energy and industry sectors will have to double down on efforts and investments if they are to meet their climate goals – they are at present severely off track, and a steadily growing carbon price provides the right investment signal.
In conclusion, while challenges persist, the EU ETS remains a cornerstone of Europe’s climate strategy – or, to quote Commission officials, its “workhorse”. Higher carbon prices will be needed to ensure the ability of the system to bring about the needed emissions reductions. Policymakers must harness the full potential of this vital tool in the fight against climate change by addressing issues of oversupply, bolstering carbon prices, and ensuring predictable long-term emission reductions.
source: carbonmarketwatch.org (Lidia Tamellini, Eleanor Scott)