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Javier Ramírez

The perfect storm at the carbon emission trading system

The reform of EU Emission Trading System is the cornerstone of the European Commission Fit to 55 in 2030 regulatory package announced to meet the new climate targets. Carbon allowances, which are traded in the systems, trade at all-times highs, adding bullish pressure to energy markets, already tighten by other factors as the soaring natural gas prices. While high costs of CO2 could accelerate the power transition, it also causes pain to consumers in terms of bigger fuel and power bills. Implications vary from country to country and from industry to industry. At the EU, these gaps always mean a long and hard negotiation.

Consumers’ pockets around the world are bearing an increasing burden as energy inflation gets momentum from the US to Europe to Asia. Natural gas and power prices are beating their all-time highs week after week in Europe, while filling the fuel tank is a 40% more expensive than last march.

A mix of factors explains the surge in prices. Energy demand is rebounding as world economies recover from the worst moments of the COVID-19 pandemic. Gas prices are soaring because inventories are still recovering from a long and harsh winter, the growing demand due to the increasing activity, and Russia’s decision to flow less gas to Europe through Ukraine.

On the other hand, power prices are corelated to the cost of carbon emission allowances, that it’s also at is all time highs. Carbon emissions futures traded at an average price of €56,68 in June 2021, more than twice the price of one year before.

The European Union Emission System (EU ETS) “is 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 biggest one”, in the European Commission’s own words.

The EU ETS works on the 'cap and trade' principle. A cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system (10,000 in the power sector and manufacturing industry, as well as airlines operating between the EU countries plus Iceland, Liechtenstein, and Norway). The cap is reduced over time so that total emissions fall. Within the cap, installations buy or receive emissions allowances, which they can trade with one another as needed. The limit on the total number of allowances available ensures that they have a value.

The system was set in 2005, but it became really relevant after its reform in 2018, which introduced the market stability reserve (MSR). Before that, carbon prices traded at around €5 per tonne. 2018 reform put an end to the endemic oversupply of carbon emission allowances in the market, as the MRS is used to withdraw around 300 million allowances annually from 2021 to 2023. With the restrictions, the auction supply does not meet the demand in the market, dominated mainly by power companies.

The Fit for 55 in 2030 package, the regulatory super package European Commission (EC) presented last July 14th in order to meet the increased decarbonization target of at least 55% by 2030 attributes EU ETS a central role. The EC proposes that emissions from the current EU ETS sectors be reduced by 61% by 2030, compared to 2005 levels, 18 percentage points more than the current target. The Commission also intends to remove the free emissions allowances for the aviation sector, and to move to full auctioning of allowances by 2027. European Executive has also proposed a reform of the MSR to absorb what it calls “the historical surplus of allowances”. The EC is also proposing to apply emissions trading in new sectors, as maritime transport, road transport fuel and building.

The tighter new European energy regulation will bring more tension into the system and there’s a consensus among analysts that carbon prices will keep its upward path in the next years. The EC reckons the price of CO2 in 2030 could be around €85 a ton, while other studies forecast €120 per ton.

On top of this regulatory driver, other factor contributes to the current high carbon prices. High natural gas prices are also responsible for the carbon price surge. Front month contract at the Dutch TTF Hub, a key benchmark for Europe, trades around €41 per KWh at the end of July 2021, more than three times its levels of one year before (around €12 per KWh).

In 2019 and 2020, the quite low gas prices drove to fuel switching, replacing coal power production with gas. As the gas prices climbed due to the reasons mentioned above, power generation switched back to coal, leading electricity producers to purchase carbon EU allowances to cover the higher emissions of coal generation, bringing the price of carbon emissions up.

The economic consequences of these high carbon prices vary from industry to industry.

At the power generation sector, high CO2 will accelerate the energy transition. For example, according to ICIS, and independent incommodity intelligence firm quoted by Euroactiv.com, power prices in Germany is reaching €90 MWh, while the levelized cost of photovoltaic power is at around €40-€45. Even though power prices are forecasted to retreat, the profitability is big enough for triggering a wave of investment in renewables.

The updated EU renewable directive, included also in the Fit for 55 package will also help to boost investors interest.

For the energy intensive sectors, the situation is harder, because the lack of flexibility to transform these heavy industries facilities in the short term.

But at the end of the day, the pressure of carbon prices on energy prices is transferred to the power and fuel bills final consumers must pay.

Situation varies from country to country. France has a low carbon energy mix because of its bet on nuclear energy, while Poland still depends highly on coal generation, and Germany on gas.

Negotiation of the EU ETS reform proposed by the EC will not be easy, as the EU will need to close the gap between the Member States.

Governments have already highlighted their concerns. Spain has cut power taxes in an attempt to bring down power prices, today in its all-time highs. Spanish government has also sent a letter to Ursula von der Leyen, president of the EC, asking for a profound revision of the marginalist system of fixing power prices in Europe. Poland has already asked for more revenues from the EU ETS to help the transition of its energy system.

Other stakeholders are also warning about the implications of the new ETS on energy poverty and fair transition. The European Trade Union Confederation (ETUC), which comprises 90 national trade union confederations in 38 countries and 10 European trade union federations, stated after the announcement of Fit for 55 that “the European Commission’s proposal to make working people foot the cost of the green transition by raising the price of petrol and household energy risks creating a Gilets Jaunes-style backlash against urgently-needed climate action”.

In ETUC’s opinion “, the burden of the climate transition is being placed on low-income households through the Commission’s proposal to create a separate Emission Trading System for road transport and buildings”.

Green transition won’t be cheap. The EU institutions, Member States and other stakeholders have a long way ahead to develop the Fit for 55 package to reach the growing climate ambitions of the EC.