The secret life of the LRF
Minimising the risk of a CSCF in ETS Phase IV has preoccupied policymakers, but the choice to apply the LRF to certain allocations has slipped under the radar unquestioned.
The Linear Reduction Factor (LRF) is not just used to calculate the number of ETS allowances issued each year. It's also used to reduce free allocation to certain installations in much the same way as the more notorious Cross-Sectoral Correction Factor (CSCF). This has not received the attention it deserves and could have significant implications in Phase IV for new and expanding installations.
According to Article 10a (paragraphs 4 and 7) of the EU ETS Directive (and the related Benchmarking Decision), the LRF must be applied when calculating allocation to certain installations that generate electricity, as well as new capacity entering the EU ETS. This is done cumulatively, cutting allocation by an additional 1.74% every year during Phase III. Other installations receiving free allocation, meanwhile, have the CSCF applied instead (if there is one).
In Phase III, installations subject to the LRF will lose a smaller proportion of their allocation than those exposed to the CSCF: 12.2% in 2020, for example, rather than 17.5% (based on the original CSCF values). But in Phase IV the situation may well be reversed, as the LRF increases and measures to reduce the risk of a CSCF (such as auction share flexibility) are introduced.
If the LRF haircut were reset to 0% at the beginning of Phase IV and then raised annually by 2.2 percentage points, installations exposed to the LRF would lose 19.8% of their entitlement in 2030 and almost 10% on average during the phase. This exceeds most expectations for a Phase IV CSCF. If, on the other hand, the LRF haircut was not reset but continued from where it left off in Phase III, it would cut relevant entitlements by 14.4% in 2021 and 34.2% in 2030, averaging 24.3% across the phase. This far exceeds forecasts for the CSCF.
If the LRF continues to be applied to new entrants' and expanding incumbents' allocations in Phase IV, then, it could mean that new production receives significantly fewer allowances than incumbent production (until accommodated in the next NIMs round), even if it is indistinguishable in every respect and the New Entrants' Reserve is well stocked.
We might question why the LRF is being applied at all. The CSCF is triggered by a shortfall in allowances that year, but applying the LRF is a choice with no direct connection to constraint in supply. If policymakers are determined to eliminate the CSCF, why are they choosing to apply the LRF?
Perhaps the argument will be made that installations should be improving their emissions intensity in line with the ETS cap so should receive fewer allowances every year. But the new benchmark proposals for Phase IV already factor in annual improvements in a more nuanced way. And this wouldn't justify applying the LRF selectively to new production, creating an uneven playing field between installations. Or perhaps the aim is to level the playing field with incumbent installations subject to the CSCF. But in this case why not apply the CSCF to new production rather than a different haircut?
For many installations, the LRF could be the threat in Phase IV, not the CSCF. This could be changed by policymakers at the stroke of a pen, without the need for complex mechanisms, and deserves greater attention during trilogue. If, the ETS Directive retains provisions in this area, it will be important to define in implementing legislation how the LRF will be baselined and whether it will apply to expanding installations' as well as new entrants' allocations.