The impact of the Post-2020 EU ETS reform

Transcription

1 European Union White Paper The impact of the Post-22 EU ETS reform The Impact of Parliament, Council and Commission positions Published: 1 May 217 Analysts: Philipp Ruf, Stefan Feuchtinger Snapshot Contents This EU ETS White Paper provides insight and analysis regarding the Post-22 EU ETS reform. Under discussion since summer 215, the reform is currently taking its final shape during trilogue negotiations in Brussels. This White Paper intends to shed light on the market implications of the different proposals currently under consideration. Key Elements In the Council and Parliament positions, prices increase significantly up to 35. until 224 the main driver for this development is the proposed temporary doubling of the MSR intake rate to 24% In turn, the increasing prices incentivise compliance companies to reduce emissions, which eventually leads to price drops in the Parliament & Council position in the second half of the Phase 4 The Commission proposal instead leads to prices of 35. only by 228/29 The Council s controversial invalidation of the MSR stock would cut 2,5m EUAs in 224 and 3,m EUAs over the entire third trading period This, as well as the Parliament 8m one-off cancellation in 221, has little relevance for price developments in phase 4 as the supply-demand picture is not affected A CSCF application is highly dependent on the benchmark adjustment rate which can vary between.2% and 1.75% yearly reduction, according to the positions Several measures adopted in the positions change the balance between the amount of free allocation and the maximum available allowances for free allocation (industry cap) Introduction Single important elements 1 The cap and its distribution 2 Allocation system 6 Market Stability Reserve The impact on prices Conclusion Annex If all benchmarks were to be reduced with 1% annually, the CSCF would not be triggered in any of the three positions Director EU Power & Carbon Analytics Philipp Ruf +49 () philipp.ruf@icis.com ICIS accepts no liability for commercial decisions based on the content of this report. Unauthorised reproduction, onward transmission or copying of the EU ETS White Paper in either its electronic or hard copy format is illegal. Should you

2 Introduction In February 217, after one and a half years of internal negotiations of the European Commission s proposal to reform the carbon market after 22 (Phase 4), the European Parliament and the Council of the EU (the Council) have found their respective positions. The positions are on the way to coming together, but there are still differences about separate features of the Post-22 reform. With our White Paper, we intend to put analysis on the table that summarises the effects of single elements adopted in the various positions. The features we are outlining in this paper are by far non-exhaustive, so we picked elements we consider the most important for the development of a potential cross-sectoral-reduction-factor (CSCF) as well as for prices of carbon allowances. The CSCF is an unpopular tool already used during the third trading period. Ultimately, the CSCF ensures that the total allocation does not exceed the maximum volume of available allowances. In other words, it is the top-down haircut capping the bottom-up allocation approach. It has to be noted that in all our modelling used for this report, we assume, when leaving the EU, the United Kingdom will also leave the EU ETS. Although the further participation of the UK in the EU ETS is currently unclear, we consider that the aforementioned scenario is more likely. This is because we do not see the UK accept involvement in a system it has no say over its design. We assume that the UK would leave the EU ETS at the start of the fourth trading period in 221; therefore, the allowances cap would be recalculated without the UK s share. Single important elements The cap and its distribution Both EU co-legislatures, the Parliament and the Council, agree that the annual rate of reduction of the emission allowances cap (linear reduction factor(lrf)) is to be kept at the Commission proposal (2.2%). However, their opinions differ as to the distribution of the cap. Not all changes are straightforward, but the devil is sometimes in the details. Even though both the Council and the Parliament remained at the commission proposal to keep the auction share at 57%, important differences exist regarding the flexible part of the auction share, the sourcing of funds and the New Entrants Reserve (NER). Generally, the cap is shared between different allowance pots: Parliament has adopted a position that would change the cap in two diverging ways: Sourcing the NER from Phase 4 (reducing free allocation) Sourcing the innovation fund from the auction share (increasing free allocation) Allowances to be auctioned (the regular ones and the ones distributed according to solidarity mechanisms) Allowances to be allocated for free to industrial installations (also known as industry cap ) Allowances earmarked for funds (various funds in different proposals) NER In Annex A, the distribution of the cap for the various proposals is shown in diagrams. For the different stakeholders, different elements matter most. For example, industrial compliance companies are keen to keep the industry cap as high as possible to reduce the likelihood of a CSCF, while the power sector wants as many allowances as possible to be auctioned and freely available on the market. The CSCF was a key element during the entire discussion of the Post-22 reform: all stakeholders are keen to reduce the likelihood of the application of a CSCF. In order to do so, both the Council and Parliament propose a flexible auction share. This would mean that if a CSCF were to apply (industry cap not sufficient to serve all allocation requests), the auction share would be decreased to mitigate or completely prevent the resulting allocation cut. The Parliament set it at 5% and the Council at 2% of the overall cap. The Commission on Table 1: Flexible auction share Available flexible auction share Commission. European Parliament Council of the EU

3 the other hand did not mention such a measure in its proposal. In Table 1, the available flexible auction volumes are shown. Overall, the proposals from both co-legislatures increase the maximum volumes available for free allocation, the industry cap. Figures 1 and 2 show the respective effects. Figure 1: Industry cap in Parliament proposal Figure 2: Industry cap in Council proposal industry cao [m EUAs] 6,8 6,4 6, 5,6 5, ,33 industry cap [m EUAs] 6,8 6,4 6, 5,6 5, ,759 5,2 5,2 Allocation system One of the most controversially discussed topics in every EU ETS reform is the impact on free allocation to industrial installations. With the Post-22 reform, this question is all the more important, as the rules, the baselines and the entire system for industrial free allocation is determined. Generally, the allocation that an installation can receive depends on the activity level (historic production of an installation) multiplied by the benchmark of the product manufactured in the installation. Later on, the carbon leakage exposure factor (CLEF) as well as a CSCF (if applicable) are levied to this allocation volume. Activity Levels Regarding activity levels, for the first allocation period (AP1; ) in the fourth trading period the Commission proposed to use the average production in as a baseline. For the second allocation period (AP2; ), the respective baseline would be the average production in Neither the Parliament nor the Council contested this proposal. Benchmarks During , the average emission intensity of the 1% most efficient installations in the period has been used to calculate the benchmark values. The Commission proposal for Phase 4 aims to reduce these benchmarks in order to consider technological progress. Benchmarks would be reduced by introducing a sector-dependent, per-annum, flat-rate reduction rate of either.5%, 1.% or 1.5% for benchmarks. In order to decide which rate to apply for which sector, the Commission would have to make an assessment based on real data. These flat rates would finally be used to calculate a benchmark for AP1 for (223 value) and AP2 for (228 value). Thus, the benchmarks would be flat during each of the two allocation periods. The positions of the Council and the Parliament regarding benchmarks differ only about baselines and definition processes for the flat rates. The most important change of both co- 2

4 legislatures positions compared to the commission proposal is that the flat rates would be merely used as a corridor. This means that the flat rate reduction rates could float within these corridors. The Parliament sets the lower bound at.25% and the upper bound at 1.75% reduction per year, and the Council.2% and 1.5% respectively. The Parliament also proposed changes to one element affecting a specific benchmark, namely waste gas (it emerges when steel is produced in a blast furnace). In the past, not the full carbon content of waste gas was used to calculate the Hot Metal benchmark but instead the carbon content of natural gas. The Parliament explicitly adopted in its amendment a position, which would make it necessary to use the full content. Such a change would increase the benchmark significantly and consequently the free allocation for metal production. According to Eurofer calculations (link), this would increase the Hot Metal benchmark by 11%. Figure 3: Different benchmark proposals of the various institutions Parliament: range Council: range Commission 1.% (real BM) Commission:.5% Commission: 1.% Commission: 1.5% Commission: 1.% In the third trading period, the free allocation volumes available to industry were not sufficient, and therefore, the CSCF was applied, reducing the distributed free allocation volumes by substantial amounts. In parallel, a leftover of allocation volumes was building up during Phase 3, partly due to reduced industrial output, but also partly due to procedural reasons of the allocation process. For the fourth trading period from 221 to 23, the commission proposed to change this process to be able to maximise the allocation volume and minimise the risk of a CSCF. None of the co-legislatures contested this proposal; thus, we expect this new approach to be adopted smoothly. Carbon Leakage All three institutions agree on a binary carbon leakage (CL) list, where any sector being exposed to CL receives 1% of the benchmark level as free allocation. They also agree that only one CL list would apply for the entire Phase 4. This is very important for the overall optimisation of the allocation process. While the three institutions agree on the CLEF for the CL exposed sectors (1%), there is some divergence regarding the CLEF for the other sectors. The Commission intends to hand out 3% of free allocation as calculated by the benchmark and historic activity levels to non-cl exposed sectors. While the Council supports this, the Parliament proposes to use a % CLEF for these sectors instead. However, the Parliament adopted an exemption for district heating where a CLEF of 3% would apply. The Parliament and the Council also change the Commission provisions concerning the thresholds for the application of qualitative criteria to determine whether a sector is CL exposed. Currently, a sector is seen as exposed to CL risk if it is above the.2 threshold of trade intensity multiplied with emission intensity. All three institutions leave room for manoeuvre in reducing the threshold to make more sectors eligible for the CL list (given they pass the qualitative test). The Commission enables sectors to apply for a qualitative test if they are The commission and the Council intend to hand out 3% for non-carbon leakage exposed sectors while the Parliament instead % (with the exemption of district heating) 3

5 between.18 and.2. The Council lowers the qualitative threshold to.16 and the Parliament even further to.12. Even though it may look like a small adjustment, some quite substantial sectors in terms of possible allocation volumes would fall into these categories (just two examples below): Manufacturing of industrial gases (.17) Manufacturing of bricks, tiles and construction products, in baked clay (.17). Overall effect of proposals on free allocation volume The above outlined various elements implemented in the different proposals all affect the free allocation installations can request. Figures 5 and 6 show the various effects in the event of a 1% benchmark reduction on all sectors; Annex B show the respective effect for lower/higher benchmark adjustments. Figure 5: Allocation volume (1.% BM adjustment) in Parliament proposal Figure 6: Allocation volume (1.% BM adjustment) in Council proposal allocation volume [m EUAs] 5,7 5,6 5,5 5,4 5,3 5,2 5, ,57 allocaiton volume [m EUAs] 5,7 5,6 5,5 5,4 5,3 5,2 5, ,498 Cross-Sectoral-Reduction-Factor (CSCF) The CSCF has probably been the most discussed topic in the Post-22 negotiations. As the CSCF, or more correctly the likelihood of an application of the CSCF, is influenced by all parameters affecting the industry cap and the allocation volume, it is based on quite fragile parameters. The Parliament position makes the CSCF applicable only to sectors with an intensity of trade with third countries below 15% or a carbon intensity below 7kg CO2/euro GVA. The first criterion means that many sectors would be excluded while the second criterion is specifically designed to exclude a few emission intensive industries. According to our analysis, none of three proposals would see a CSCF being triggered in the 1% flat rate benchmark adjustment scenario see Figure 6 below. The respective graphs for the minimum and maximum benchmark adjustments are in Annex C. Considering all three extreme benchmark adjustment scenarios minimum, 1.% or maximum for all sectors and keeping in mind that something between the three scenarios would come into effect, proposals from both co-legislatures increase the likelihood of a CSCF being triggered. Although the Parliament increases the industry cap (Figure 1) significantly, the allocation volume on the other hand is also increased drastically. This is mainly driven by the changes to the Hot Metal benchmark as well as the CLlist. Nevertheless, the Parliament also added some features, which would reduce the allocation volumes: If all BM were to be reduced with 1% annually, the CSCF would not be triggered in any of the three positions. % free allocation for non-cl exposed sectors Higher maximum flat rate adjustment for benchmarks 4

6 Based on the Parliament proposal, the determining factor for the CSCF being triggered is ultimately the benchmark adjustment. Without having a better picture on the actual energy efficiency gains in the various sectors, it is however impossible to draw a conclusion. The Council text contains measures that increase the allocation and industry cap. In the end, the same applies as for the Parliament proposal the benchmark question decides whether a CSCF would be triggered or not. Figure 4: Stationary allocation and CSCF calculation for Commission (top), Parliament (middle) and Council (bottom) proposals for 1% benchmark adjustment for all sectors allocation [m EUAs] 1,2 1, 8 Commission 12% 1% 8% 6 6% 4 4% 2 2% % allocaiton [m EUAs] 1,2 1, 8 Parliament 12% 1% 8% 6 6% 4 4% 2 2% % 5

7 allocation [m EUAs] 1,2 1, 8 Council 12% 1% 8% 6 6% 4 4% 2 2% % allocation use of regular left-over use of flexible auction share final allocation cut regular left-over industry cap CSCF (without flexible) CSCF (with flexible) In the Annex, further CSCF graphs using different benchmark levels can be found. Market Stability Reserve (MSR) Intake Rate As part of the Market Stability Reserve (MSR) legislation (passed in Q4 215), the EU agreed to launch the MSR in 219. The MSR is designed to take out 12% of the market surplus until the latter drops below 833m allowances. If the surplus drops further below 4m, 1m are pushed into the market annually to stabilise the price. Even though the MSR comes into action only as of 219 and the Commission proposal is silent on any changes in its Post-22 proposal, both the Council and Parliament decided to adopt a temporary doubling of the intake rate to 24%. This is the most ambitious element in terms of impact on prices in the Post-22 reform. Parliament intends to double the intake rate for a period of four years (through 222), while the Council would like to stretch it over one more year through 223. To analyse the MSR and its impact on prices, it is key to look at companies buying behaviour. We currently assume that hedging/stock building will keep the market short and consequently push prices up. This in turn will trigger abatement (emission reductions) so that the MSR will take out volumes nearly throughout the fourth trading period. This, consequently, would lead to very high MSR stocks in 23. The respective MSR intake is shown in Figure 7. If the surplus required for hedging and building stocks is larger than the surplus available in the market, the market is short and prices will rise. Figure 7: MSR volume intake for the three different scenarios MSR intake [m EUAs] Commission Parliament Council 6

8 Cancellation/Invalidation from the MSR Next to changes to the intake rate, both positions of the co-legislatures also include some kind of cancellation/invalidation of allowances in the MSR. While the Parliament favours a one-off cancellation of 8m allowances in 221, the Council adopted a mechanism, which would ultimately scrutinise the MSR stock annually as of 224 by comparing the stock with the previous year s auction volume. If the MSR stock were higher than the previous year s auction volume, the surplus would be made invalid. After deducting the MSR effect, we expect the auction volume in 223 to be at around 484m allowances and the MSR stock at around 2,982m. As a result, around 2,5m allowances would be made invalid in 224 alone. Over the entire fourth trading period, the total invalidation would amount to roughly 3,m EUAs. Figure 8 summarises the MSR stock including the cancellation/invalidation in the various proposals. Figure 8: MSR stock of various proposals Council MSR position: around 2,5m allowances would be made invalid in 224 alone. MSR stock [m EUAs] 3, 2,5 2, 1,5 1, 5 Commission Parliament Council More elements to consider There are many more elements in the different proposals which affect the EU ETS post-22. However, for the sake of this White Paper, we do not cover the other measures in detail. Especially interesting for the trilogue negotiations will be: The size and governance of various funds Treatment of aviation and shipping Indirect cost compensation 7

9 The impact on prices It is clear that the proposals aim to increase ambition and consequently prices. However, this ambition is reached with volume-based mechanisms and not price management. In that way, the market can still optimise under various exogenous conditions. According to our analysis, all three proposals will increase EUA prices compared to the rules currently in place. The main drivers of price increases are, in all three proposals, the upcoming MSR as well as the tighter reduction target of -43% by 23. Commission proposal Based on our expectations of the MSR taking auction volume out until late in the phase, we predict prices to constantly increase until 228/229. As can be seen in Figure 9, in the last two years of Phase 4, prices are expected to start decreasing again. This development would be triggered by reduced emission levels due to price pressure in previous years, while auction volumes increase again once the MSR is no longer triggered Front-runners to the MSR doubled intake rate are likely to push prices up by 2 already at the end of 218. Parliament amendments The Parliament s amendments, if adopted, would cause a much more severe price increase from 221 to 223, compared to the Commission proposal. This is mainly due to the increased effect of the MSR. The doubling of the intake rate reduces the surplus much quicker than a 12% intake rate, which causes abatement to start earlier. Most interestingly, our modelling suggests that prices would increase until roughly 35. in 223/224 before changing direction. As emissions are significantly reduced because of the MSR in the early part of Phase 4 (higher prices trigger fuel switching and permanent abatement measures), hedging requirements are pushed quicker below the upper threshold of the MSR. The significant reductions paired with the 12% MSR intake rate and the upper threshold create a fundamental yearly surplus in these years so that prices ease downwards. Council amendments Our price forecast based on the Council text is very similar to the Parliament proposal, except for price pressure impact from the MSR intake for one more year. Many other differences from the Parliament proposal are price irrelevant, e.g. the shift of the support mechanisms to the modernisation fund. Thus, the majority of dynamics are similar to the Parliament position. Figure 9: Price developments of different proposals (1% BM adjustment) EUA prices [ /tonne] Commission Parliament Council historic prices 8

10 Conclusion Overall, the effects of the various measures included in the three proposals have a number of important effects on volumes, prices and, ultimately, emission reductions. We conclude that the likelihood of a CSCF being triggered is higher in both the Council and the Parliament positions, compared to the Commission proposal. This is because various elements are adopted in both positions, which potentially increase the allocation volumes. If many sectors end up at the lower end of benchmark adjustments, the measures taken by the co-legislatures to increase the industry cap vice-versa might not be sufficient to mitigate the CSCF likelihood. It can be concluded that all three proposals would increase prices significantly compared to current rules. However, it also needs to be noted, that significant uncertainties are linked to this forecast. The MSR somewhat reduces the importance of future fundamental developments, such as GDP, fuel prices or changes in the power stack, as any reduction in emissions will be balanced by a further reduction of supply through the MSR. That being said, this comes down to a delay effect, so that a change in GDP, fuels or energy policy across Europe will eventually have an impact on EUA prices. Nevertheless, our analysis suggests strongly that prices will increase swiftly under the Parliament and Council texts due to the strengthening of the MSR. The 24% intake rate will affect the auction volume drastically and reduce supply to the market. An interesting result of our analysis is that EUA prices start to decline, if the Parliament and Council proposal were adopted at the beginning of the second half of Phase 4. This is because we expect that the strengthened MSR would trigger permanent emission reductions. Once the MSR gets weaker, the increased auction volumes will create additional surplus. On top of that, due to the permanent emission reductions, the upper threshold of the MSR would prove too high as, along with reduced emissions, hedging requirements would be reduced. This means that the MSR would not be triggered in two years in the Parliament and Council text during the mid-years of Phase 4. The same, however, applies to the Commission proposal, only at a later stage. Consequently, it will be important to review the thresholds of the MSR regularly to adjust it to the current hedging requirements. This will be the key part of keeping the ambition high throughout Phase 4 and beyond. 9

11 Annex A: Cap distribution Cap distributions in the ommission proposal Cap distributions in the European Parliament proposal Cap distributions in the Council of the EU proposal 1

12 Annex B: Effect on allocation volume Allocation volume (lowest BM adjustment) in Parliament proposal Allocation volume (lowest BM adjustment) in Council proposal allocation volumes [m EUAs] 6,6 6,4 6,2 6, 5,8 6, ,436 allocation volumes [m EUAs] 6,6 6,4 6,2 6, 5,8 6, ,434 Allocation volume (highest BM adjustment) in Parliament proposal Allocation volume (highest BM adjustment) in Council proposal allocation volumes [m EUAs] 5, 4,8 4,6 4,4 4, ,74 allocation volumes [m EUAs] 5, 4,8 4,6 4,4 4, ,913 11

13 Annex C: CSCF for minimum/maximum benchmark adjustments Stationary allocation and CSCF calculation for commission (top), Parliament (middle) and Council (bottom) proposals for minimum benchmark adjustment allocation [m EUAs] 1,2 1, 8 Commission 12% 1% 8% 6 6% 4 4% 2 2% % allocation [m EUAs] 1,2 1, 8 6 Parliament 12% 1% 8% 6% 4 4% 2 2% % allocation [m EUAs] 1,2 1, 8 Council 12% 1% 8% 6 6% 4 4% 2 2% % allocation use of regular left-over use of flexible auction share final allocation cut regular left-over industry cap CSCF (without flexible) CSCF (with flexible) 12

14 Stationary allocation and CSCF calculation for Commission (top), Parliament (middle) and Council (bottom) proposals for maximum benchmark adjustment allocation [m EUAs] 1,2 1, 8 Commission 12% 1% 8% 6 6% 4 4% 2 2% % allocaiton [m EUAs] 1,2 1, 8 Parliament 12% 1% 8% 6 6% 4 4% 2 2% % allocaiton [m EUAs] 1,2 1, 8 Council 12% 1% 8% 6 6% 4 4% 2 2% % allocation use of regular left-over use of flexible auction share final allocation cut regular left-over industry cap CSCF (without flexible) CSCF (with flexible) 13

15 The impact of the Post 22 EU ETS reform Market analysis, price forecasts and data to help you make better trading decisions: The EU ETS Portal provides our complete suite of tools designed to help traders, analysts and risk managers interpret the impact of policy and regulatory developments whilst also identifying risks and opportunities in the market. These tools include behaviour-driven analysis, price forecasts and the inputs and outputs from the Timing Impact Model (TIM), which are the perfect starting point for your own analysis. The EU ETS Insight provides the highlights of the ICIS EU behaviour-driven analysis. Therefore, it s ideal for stakeholders who need to keep in touch with key developments in the EU ETS and want to understand the market impact of those developments but require neither detailed datasets nor deeper insight. Request a free trial Request a free trial C CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V C CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V C CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V CHEM CHCEN EURO-whitepaper_post-22_eu_ets_reform_xpro&sfid=71w19N5V Team Archive Judith Schröter Business Director Carbon Market Analytics judith.schroeter@icis.com European Union Carbon Market Philipp Ruf Yann Andreassen Director EU Power & Carbon Analytics Senior Analyst EU Carbon Markets philipp.ruf@icis.com yann.andreassen@icis.com Vincent Ehrmann Stefan Feuchtinger Senior Analyst EU Carbon Markets Analyst EU Carbon Markets vincent.ehrmann@icis.com stefan.feuchtinger@icis.com Simone Lischker Lars Petersen Analyst EU Carbon Markets Analyst EU Carbon Markets simone.lischker@icis.com lars.petersen@icis.com North American Carbon Markets Jackie Cooley Senior Analyst North American Carbon Markets jackie.cooley@icis.com Alina Mihai Analyst North American Carbon Markets alina.mihai@icis.com Chinese Carbon Markets Simon Chen Lead Analyst Chinese Carbon Markets simon.chen@icis.com Iris Chen Analyst Chinese Carbon Markets irischen@icis china.com Dan McGraw Senior Market Strategist North American Carbon Markets dan.mcgraw@icis.com Steven McGinn Reporter North American Carbon Markets steven.mcginn@icis.com Sisi Tang Analyst Chinese Carbon Markets sisi.tang@icis.com Yingli Niu Analyst Chinese Carbon Markets niuyingli@icis china.com 31 March 217 The impact of the Post 22 reform Parliament, Council and Commission position 23 September 216 Aviation and Emissions Trading: Headwind vs Tailwind at 36, Feet 13 June 216 Brexit: a walk in the park for the EU ETS? What would be the market impact of a UK exit from the EU ETS? 16 April 216 German lignite: the known knowns, known unknowns and unknown unknowns How the backbone of German power generation is rendered irrelevant 1 February 216 Power behind the carbongeddon? The role of the power sector in the recent EUA price collapse ICIS accepts no liability for commercial decisions based on the content of this report. Unauthorised reproduction, onward transmission or copying of the EU ETS White Paper in either its electronic or hard copy format is illegal. Should you EU ETS White Paper The impact of the Post 22 EU ETS reform 1 May 217 analytics.icis.com 14