The Council's MSR proposals could cancel 2-3 billion ETS allowances in Phase IV (2021-30)

The Council has proposed doubling the withdrawal rate of the MSR for 5 years, and cancelling MSR allowances from 2024 when the number exceeds the amount auctioned the previous year.

Parliament by comparison has proposed doubling the MSR rate for ~4 years, and cancelling 800 million allowances ahead of Phase IV.

Our provisional modelling suggests that the Council position would cancel far more allowances, perhaps 2-3 billion, with the vast majority being cancelled in 2024.

We estimate, for instance, that 2.7 billion allowances would be cancelled during Phase IV, with 2.1 billion being cancelled in 2024, making the following assumptions:

• Emissions run 5% below the Phase IV cap
• The auction share is 55% each year (i.e. the Council's proposed 2% flexibility is used)
• Surplus allowances enter the MSR at an annual rate of 24% until 2024 and 12% afterwards, unless the market surplus is below 833 million
• Allowances are cancelled from 2024 when the number exceeds the amount auctioned the previous year

If emissions run further below the cap, we would expect greater cancellation. Bearing in mind this sensitivity, we estimate that cancellation would fall in the range of 2-3 billion, with around 2 billion cancelled in 2024.

Contact:

damien.green@perspectiveclimate.com

On 28th February the EU Council adopted a General Approach on ETS reform that will form the basis of its negotiating position in trilogue.
 
It’s structured on the Commission's 2015 proposal, but with significant strengthening of the Market Stability Reserve (MSR), more accurate benchmark reductions, and 2% flexibility in the auction share.
 
Surprisingly, the position is more ambitious than Parliament’s adopted on 15th February, and provides industry with less protection from a correction factor (i.e. it carries a higher risk of a haircut in free allocation).
 
We now have a good sense of each institution’s position, and it is evident that there is a great deal of convergence. We can predict with some confidence, then, that the final ETS reform package will look roughly as follows:

• 2.2% Linear Reduction Factor (2021-30)
• 57% auction share with 2-5% flexibility to protect against a CSCF (2021-30)
• 24% MSR withdrawal rate for 4-5 years from 2019
• Significant cancellation of MSR allowances (from 800 million to perhaps 3 billion, either before or during Phase IV)
• Benchmark reductions in 2021 and 2026 based on the measured improvement of the top 10% (within a corridor of around 0.25% -1.5% per annum from 2008, defined with respect to 2023 and 2028 respectively)
• Adjustments to free allocation based on production changes administered in 10-15% increments (2021-30)

 
How the institutions compromise on MSR cancellation and auction share flexibility will be the most critical areas to watch during trilogue, in terms of the impact on carbon prices and the risk of a Phase IV correction factor.
 
Other areas to watch (where there is less agreement) include, how funds are stocked (which has an impact on the correction factor), and whether there is central compensation for indirect carbon costs (as proposed by Parliament but not Council). 
 
Contact:

damien.green@perspectiveclimate.com
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Notes:
 
The main aspects of the Council’s position are as follows:

• The Phase IV cap would be reduced by a Linear Reduction Factor of 2.2% (i.e. 48,380,081 fewer allowances would be issued each year between 2021-30 if the reference cap for the LRF were unchanged).

• 57% of allowances issued each year would belong to the auction share, and 43% to the free share
• A number of allowances equivalent to 2% of the total issued during the Phase could be transferred from the auction share to the free share when there would otherwise be too few to honour free allocation commitments to installations
• The withdrawal rate of the Market Stability Reserve (MSR) would be doubled for five years (2019-24), withdrawing 24% of surplus allowances each year (when the surplus exceeds a certain threshold—originally intended to be 833 million)
• MSR allowances would be cancelled annually from 2024 when the number exceeds the amount of allowances auctioned the previous year 
• Benchmarks would be reduced in 2021 and 2026 based on the measured improvement of the top 10% (within a corridor of 0.2% - 1.5% per annum from 2008, defined with respect to 2023 and 2028 respectively)
• Free allocation would be adjusted when activity increases/decreases in 15% increments compared to levels recorded under Article 11
• Member States could provide indirect cost compensation (within State Aid rules), but they would be encouraged not to use more than 25% of auction revenues for this purpose 
• Funds would be stocked as in the Commission’s 2015 proposal:
  • The Modernisation Fund would be supplied from the auction share (with a number equivalent to 2% of total allowances)
  • The Innovation Fund would comprise 400 million allowances from the free share and 50 million from the MSR
  • The New Entrants' Reserve would be stocked with 250 million allowances from the MSR and 145 million allowances that weren't allocated to non-carbon-leakage sectors during Phase III, as well as allowances freed up during Phase IV due to significant reductions in production compared to levels assumed in entitlements