Stronger MSR will not correct EU ETS surplus: Sandbag

A stronger market stability reserve (MSR) will not eradicate the huge EU emissions trading scheme (ETS) surplus that is crippling the scheme, environmental lobby group Sandbag said.

Doubling the MSR's initial allowance intake rate will tighten the market earlier in phase 4 (2021-30), but in aggregate it will not correct the massive EU ETS demand-supply imbalance over the phase, Sandbag said.

Members of the European Parliament (MEPs) are debating different EU ETS reform options ahead of a vote by the environment committee scheduled for 8 December.

The latest draft proposal seen by Argus suggests that 750mn allowances placed in the MSR should be cancelled from the outset in 2019. It proposes that the MSR's intake rate should be 16pc in its first year of its operation in 2019, followed by an increase to 24pc/yr — double the 12pc agreed under current legislation — for the next two years.

Political parties in parliament have so far failed to reach consensus on rapporteur Ian Duncan's draft proposal. The Socialists and Democrats (S&D) earlier this week rejected his proposal as they want a higher 2.4pc/yr reduction in allowances instead of the 2.2pc/yr tabled.

But neither a steeper linear reduction factor (LRF) nor a higher MSR intake rate will prevent a further build-up of excess allowances, because actual emissions will continue to be well below the proposed phase 4 cap, Sandbag said.

Rebasing the EU ETS cap at the start of phase 4 to reflect the actual level of emissions in 2020 is the only option being considered that can effectively bring the market back into balance, a Sandbag report, Comparing options for EU ETS reform, said.

The report evaluates the likely effectiveness of EU ETS reforms in terms of creating a well-functioning ETS, with an appropriate supply-demand balance and a high-enough EU ETS price to stimulate both short-term fuel-switching and longer-term abatement.

Increasing the LRF to 2.4pc/yr and strengthening MSR's parameters will have a small beneficial effect, so they could be potentially valuable as a complement to rebasing — but not as a substitute for it, Sandbag said. "Without rebasing they give the appearance of meaningful reform without engaging with what is actually needed," it said.

Emissions have on average been around 200mn below the EU ETS cap each year and this situation will persist for the remainder of phase 3 (2013-20), resulting in a total surplus of 3.8bn-4.4bn by 2020, Sandbag forecasts.

Of this total surplus, 1.6bn-2.2bn will be available to the market and 2.2bn-2.3bn will be in the MSR, it said.

Excess allowances will continue to be generated during phase 4, so that by 2030 the MSR will contain 3.5bn-5bn allowances, equivalent to 25-50pc of the cumulative phase 4 quota, with some surplus still available to the market.

So retiring 2bn allowances from the MSR seems "desirable to keep the MSR to a reasonable size", Sandbag said.

Increasing the LRF to 2.4pc/yr cuts the cumulative surplus in 2030 by only 200mn, or 3-5pc of the cumulative surplus, it said.

A much larger increase in the LRF — for example to 4pc/yr — would be needed to have the scale of effect necessary to rebalance the market, and even this would make less difference in the early years, Sandbag said.

Increasing the MSR reduction rate for the first three years of its operation will have an equally scant effect on the surplus — its main benefit is that it can help create longer-term stability, Sandbag said.

But rebasing the EU ETS cap for phase 4 on actual emissions would limit the surplus at source, because excess allowances would no longer be generated and the existing surplus will start to decrease immediately, it said.

A rebasing of the EU ETS cap is the most robust solution, because it automatically aligns with reality, thereby accounting for variations between actual and expected emissions to 2020, the report said.

It increases confidence that annual supply and demand will roughly match at the start of the phase 4, thereby reducing price uncertainty, it said.

Any concern that rebasing creates uncertainty over the total free allowances allocation can be addressed by simply adjusting the free allowance share of by around the same percentage as the cap is rebased, Sandbag said.

"This retains the absolute amount of freely allocated allowances unchanged, in effect taking the reduction of the cap entirely from the auction share," it said.

Sandbag projects that, under current reform proposals, the EU ETS price will remain below €14/t CO2 equivalent (CO2e) during phase 4 under its reference scenario.

But rebasing will push the EU ETS benchmark price above €22/t CO2e by 2030, it forecasts. But Sandbag cautions that these price scenarios are indicative and for the purpose of comparing reform options only.

Another benefit of rebasing is that it will increase the value of the modernisation, innovation and solidarity funds by up to 50pc — to around €6,000, €10,000 and €17,000, respectively — as price rises outweigh any volume reduction, Sandbag said.