Will the CSCF return in EU ETS Phase IV?

 If the 'Duncan mechanism' doesn't survive trilogue it could mean another CSCF in ETS Phase IV

This week the European Parliament adopted a position on EU ETS Phase IV (2021-30) that will form the basis of its negotiations with the Council and Commission in trilogue. One distinctive aspect of the position is the so-called 'Duncan mechanism', named after the file's rapporteur--Ian Duncan MEP. This would allow up to 5% of the total number of allowances to be transferred from the auction share to the free share during Phase IV if the number owed to installations would otherwise exceed the number available.

Due to the Duncan mechanism (and factoring in differences in how funds would be stocked), Parliament's proposal would make ~10% more free allowances available compared to the Commission's proposal, providing additional protection from a CSCF of ~9%. The mechanism is especially important now that other proposals that would have reduced the risk of a cross-sectoral correction factor (CSCF) have fallen by the wayside, such as tiering the carbon leakage list, and introducing carbon border adjustments for the cement sector.

Based on the emerging position in the EU Council, however, it looks like the mechanism may not survive the legislative process—at least not without significant dilution. While Member States regularly pay lip service to wanting to avoid a CSCF, the Duncan mechanism is a hard sell in the Council because governments value auction revenues, and certain Member States use a share of their auction volumes for free allocation to the power sector under Article 10c.
 
At December’s Environment Council, only a small minority of Member States expressed support for the Duncan mechanism (or expanding the size of the free share): most notably, Germany, Belgium, Italy, and Greece. Meanwhile, there was a broad group (comprising Member States that would often occupy opposing poles in the debate), expressing a preference for the Commission’s proposed auction share.
 
While all attention was focused on Parliament last week, Coreper was meeting behind closed doors, and on Friday a draft text was published with the aim of agreeing a general Council position when ministers meet on 28th February. Looking through the draft text, it’s evident that the Council’s emerging position is based closely on the Commission’s 2015 proposal, but with some important changes: namely, 1) doubling the withdrawal rate of the MSR (as proposed by Parliament), 2) reducing benchmarks more accurately (in a very similar manner to that advocated by Parliament), and 3) introducing 1% flexibility in the auction share.
 
Doubling the MSR withdrawal rate is contentious with Eastern European Member States, and the proposed 1% flexibility is a thorny issue with many, with the number still bracketed in the text. Nevertheless, we might expect the Council’s eventual adopted position (whether it's reached in February or June)—and indeed the final package to emerge from trilogue—to look quite a lot like this.
 
In terms of what this would mean for a CSCF in Phase IV, we can refer to analysts' existing models of the Commission's proposal (given the identical provisions relating to the number and distribution of allowances), and just adjust for the new aspects of this hypothetical final package. 

In terms of these adjustments, the MSR doubling proposal would not affect the CSCF estimates, because it reduces the historic market surplus via the auction share. (Although it would increase the value of any shortfall in allocation.) Having 1% flexibility in the auction share, on the other hand, would reduce the risk of a CSCF compared to the Commission's proposal, but would only provide protection from a ~2.5% haircut--significantly less than Parliament's proposal. Meanwhile, more accurate benchmark reductions (within a corridor of 0.3% - 1.5% p.a. from 2008) might be expected to result in a lower average benchmark reduction than the Commission's flat-rate proposal, which would increase the risk of a CSCF.

Making these adjustments, and assuming some modest growth, we might expect the package to trigger a CSCF if the weighted average benchmark reduction comes out below ~0.9% per annum, reaching significant levels as the reduction approaches 0.5%.

For further information, please contact [email protected]