Germany urged to cancel permits to protect EU ETS

Germany should voluntarily cancel EU emissions trading system (ETS) allowances when implementing its coal phase-out, to avoid causing oversupply in the carbon market and depressing allowance prices, non-governmental organisations (NGO) and market observers have said.

The German government's commission on growth, structural change and employment WSB has recommended the closure of all German lignite and hard coal-fired power generation capacity by 2038, including the closure of 12.7GW of such capacity by 2022.

The WSB recommendations — which the German government is reviewing, and has not yet said if it will accept — also advise the government to voluntarily cancel an amount of EU ETS allowances to offset the reduction in allowance demand caused by plant closures.

The impact of Germany's coal phase-out on the EU carbon market will depend on whether the country follows this particular recommendation. The country is not legally obliged to cancel EU ETS allowances alongside coal-fired plant closures — and the timings and volume of allowances that would be cancelled are still unknown.

Cancellation option

Under EU law, countries have the option to cancel allowances from their EU ETS auction volumes, in the event of domestic power generation capacity closures.

This option aims to protect the carbon market from oversupply. The closure of power plants can cut a country's demand for EU ETS allowances, so by cancelling permits, the country can neutralise the effect of plant closures on long-term EU ETS fundamentals. But member states are not legally obliged to exercise this option.

NGOs and market observers have urged Germany to cancel allowances, to protect the EU ETS.

"From the point of view of the integrity of the carbon market, yes they should," bank BNP Paribas head of climate change investment research Mark Lewis said.

Failure to cancel EU ETS permits alongside coal-fired plant closures would be bearish for the allowance market, and lead to the so-called "waterbed effect" in the carbon market, he said. This occurs when a reduction in emissions in one region frees up allowances and allows an increase in emissions in other regions, because the total number of allowances in the EU ETS is fixed.

Coal-fired plant closures without allowance cancellations would result in "policy contamination", EU environmental think-tank Carbon Tracker's senior analyst Matt Gray said. This occurs when countries enact measures to cut emissions — such as phasing out coal-fired power generation — which cut their demand for EU ETS allowances and cause a build-up of supply in the carbon market.

German coal-fired plant closures before 2022 must be accompanied by the cancellation of an equivalent amount of EU ETS allowances "to avoid a temporary drop of the carbon price", NGO Climate Action Network's EU climate policy co-ordinator, Klaus Rohrig, said.

Choice to cancel

Germany will be likely to face political pressure from the EU to cancel allowances, to avoid causing oversupply in the EU ETS, and a drop in allowance prices. The EU approved a package of reforms last year, designed to support EU ETS prices and reduce oversupply in the market.

A large influx of allowance supply from Germany — the largest-emitting country in the carbon market — could undo the impact of these reforms, which caused EU ETS allowance prices to soar by more than 200pc last year.

Germany is "under pressure to do the right thing", Lewis said.

By cancelling allowances in order to support EU ETS prices, Germany would help to "keep pressure on other EU countries to phase out coal", NGO Sandbag's European power analyst Dave Jones said.

The country's federal cabinet has previously said that the option in EU law to voluntarily cancel EU ETS allowances is "intended for use in Germany".

But the German government may also consider other factors when deciding if it will cancel permits. One of the arguments for not cancelling allowances is that Germany could lose revenues from such sales. But cancelling allowances may not necessarily result in lower funds from German auctions.

If Germany does not cancel allowances, EU ETS prices could fall — in this scenario, the country would sell more allowances, but at a lower price. Conversely, by cancelling allowances, which would help support allowance prices, Germany could sell fewer permits, but at a higher price.

A higher carbon price would "generate significantly more public revenue", NGO Carbon Market Watch said.

The German government received €2.6bn ($3bn) in revenue from EU ETS allowance auctions last year. By comparison, Germany earned only €1.1bn in auction revenues in 2017, despite auctioning roughly 15pc more permits that year — this was because allowance prices were significantly higher in 2018 than in 2017.

Volume

It is not yet clear how many allowances Germany would cancel, if the government chooses to exercise this option.

The EU ETS directive states that, in the event of power plant closures, countries may cancel allowances "up to an amount corresponding to the average verified emissions of the installation concerned over a period of five years preceding the closure".

"The way I would read that is that the maximum [volume of allowances] Germany can cancel is one year's equivalent of the five-year average," Lewis said. The law suggests that Germany could decide to cancel a volume of permits "anywhere below" this level, he said.

Under this interpretation, the country would cancel a volume of allowances that is significantly lower than the total reduction in CO2 emissions resulting from coal-fired plant closures.

But when German coal and lignite-fired plants close, the net emissions savings will probably be lower than the absolute emissions that the plant had previously emitted. This is because some of the plants are likely to be replaced by increased gas-fired power generation, which still emits CO2, although considerably less than coal and lignite.

Increased gas burn in response to nuclear closures will add to German emissions in the 2020s.

Timings

The timings of any German allowance cancellations will define how the move affects the EU ETS.

Germany would start cancelling EU ETS permits in 2023 at the earliest, following the completion of the first wave of recommended coal-fired plant closures, market observers said.

This could be bearish for EU ETS fundamentals in the short term, if German demand for allowances falls in the coming years, but supply is not reduced until 2023.

Germany's coal phase-out could prompt some plant owners to unwind EU ETS hedges.

Carbon prices posted their largest day-on-day loss for three weeks in the first trading session after the WSB unveiled its recommendations. Traders attributed this bearish price move to fears over a potential sell-off of allowances among German emitters.

But with analyst forecasts suggesting that prices for front-year EUAs in the early 2020s will be considerably higher than current prices in the market's forward curve, German utilities with excess permits may be unwilling to sell carbon credits in the near future, market participants said.