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YOU'D BETTER BETON THE ETS

bruegelpolicybriefISSUE2013/02APRIL 2013

by Georg ZachmannResearch Fellow at Bruegel

georg.zachmann@bruegel.org

POLICY CHALLENGEThe ETS must be stabilised by reinforcing the credibility of the system so thatthe use of existing low-carbon alternatives (for example burning gas instead ofcoal) is incentivised and investment in low-carbon assets is ensured. Further-more, failure to reinvigorate the ETS might compromise the cost-effective syn-chronisation of European decarbonisation efforts across sectors andcountries. To restore credibility and to ensure long-term commitment to theETS, the European Investment Bank should auction guarantees on the future

emission allowance price.

This will reduce the riskfor low-carbon invest-ments and enable stabili-sation of the ETS until acompromise is found onstructural measures to re-inforce it in order toachieve the EU's long-termdecarbonisation targets.

Evolution of the EU carbon price since 2008

THE ISSUE The European Union's emissions trading system (ETS), introducedin 2005, is the centerpiece of EU decarbonisation efforts and the biggestemissions trading scheme in the world. After a peak in May 2008, the price ofETS carbon allowances started to collapse, and industry, civil society andpolicymakers began to think about how to repair the ETS. However, the ETS isan effective and efficient tool to mitigate greenhouse gas emissions, andalthough prices have not been stable, it has evolved to cover more sectors andgreenhouse gases, and to become more robust and less distorting. Prices aredepressed because of an interplay of fundamental factors and a lack ofconfidence in the system.

Source: Datastream. Price per EU emission allowance.

01/01/08 01/01/09 01/01/10 01/01/11 01/01/12 01/01/13

35

30

25

20

15

10

5

0

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YOU'D BETTER BET ON THE ETS

THE EUROPEAN UNION'S EMIS-SIONS TRADING SYSTEM (ETS) has

had a bumpy start. In particular,after a peak in May 2008, theprice of tradeable emission al-lowances has collapsed for vari-ous reasons (see section 3). Thiscollapse has resulted in calls fromindustry, civil society and policy-makers to fix the ETS. But is itreally broken? Despite its prob-lems, the ETS has significantlyevolved to cover more sectors,more countries and more green-

house gases. The allocation of al-lowances has become lessdistorting. The treatment of emis-sion rights from outside the EUhas become stricter. Fraud hasbeen made more difficult. The ETSentered its third phase, at the be-ginning of 2013, as a moremature system.

1 THE ETS WORKS

The ETS is a classical cap-and-trade system specifying a cap forannual greenhouse gas emis-sions and allocating a correspon-ding amount of allowances tocompanies covered by thescheme. By definition, as this caphas decreased, emissions havealso been reduced. Excluding thecountries that have entered thescheme since 2005 (Bulgaria and

Romania joined in 2007 andNorway has participated since2008) greenhouse gas emissionsfrom ETS participating installa-tions declined by about 14 per-cent between 2005 and 2012(Figure 1).

Significant emission reductionswere achieved by the tighteningup of the system between the first

and second trading periods(2005-07 and 2008-12) (Abrell et

al, 2011). A year-on-year emis-sion reduction of 3.6 percent ap-

pears to be due to the tighteningof the system. It is not explainedby reductions in firm outputcaused by changing economicconditions and reduced produc-tion in Europe (Table 1).

In addition, there is evidence thatsignificant emission reductionsalready took place before thestart of the ETS in order to complywith the system from the begin-

ning (Ellerman and Buchner,2006; Brewer et al, 2009; Eller-man et al, 2010). Consequently,the ETS has been able to achieveits purpose stimulating addi-tional emission reductions.

The instrument of carbon tradingwas chosen in order to allowdifferentiation of carbonabatement efforts in different

sectors. And indeed, differentsectors exhibited different

emission-reduction strategies(Figure 2). This is good news. It is

in line with the hypothesis thatdifferent sectors have differentmarginal abatement costs, andthe ETS is able to induce thecheapest carbon reductions.

Table 2 shows that non-metallicminerals and basic metals wereresponsible for the main part ofthe emission reductions ob-served during the shift from thefirst to the second trading periods,

while there has been no signifi-cant additional effect for theenergy and paper sectors (Abrellet al, 2011).

We conclude that the ETS is achiev-ing its aim of keeping emissions inthe sectors that it covers under thecap. As the number of allocated al-lowances is irresistibly decliningby 37 million EU allowances

(EUAs) each year, emissions willhave to continue to decline.

Spain Poland Italy United Kingdom Germany Others

2005 2006 2007 2008 2009 2010 2011 2012

2500

2000

1500

1000

500

0

Source: Bruegel based on CITL.

Figure 1: Country-level verified ETS emissions, million tonnes CO2

Table 1: Relative change in the growth rate of emissions between(2005-05) and (2007-08)

Reductions caused by the shift to the second period -3.6%**

Control variablesChanges in turnover 19.1%***

Changes in employment 0.07%

Source: Abrell et al (2011). Note: significance: ** at 5% and *** at 1%.

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1. Seewww.eea.europa.eu/data-and-maps/data/data-

viewers/emissions-trading-viewer.

2. Seewww.entsoe.eu/data/da

ta-portal/production/.

3. Trotignon (2011).

4. The national new en-trants reserves were

set up to distribute freeallowances to new

carbon-emitting instal-lations in order to notput them at a disadvan-tage compared to exist-

ing installations thatobtained allowances for

free in the secondphase of the ETS. Not all

of the reserved al-lowances were used.

5. Article 10(a) 8 of therevised Emissions Trad-

ing Directive2009/29/EC contains

the provision to setaside 300 million al-

lowances for subsidis-ing innovative cleanenergy installations.

6. European Commis-sion (2012).

7. The relative impor-tance of the four factors

for the surplus is diffi-cult to disentangle. An

upper bound for thecontributions of the in-

dividual factors be-tween 2008 and 2012

is in the range of 500million tonnes from the

recession, 1420m

tonnes from interna-tional credits, 200m

2 THE SURPLUS

Since 2008, more EUAs havebeen issued each year than wereused1, leading to a substantialstock of allowances in circulation.Several fundamental factors are

responsible for this surplus. First,industrial production in Europewas strongly affected by theGreat Recession. While produc-tion grew between 2003 and2007 by almost three percent peryear, it decreased by almost twopercent per year between 2008and 2012. In turn, demand for al-lowances substantially de-creased. Assuming an annualdecline of the allowance demandof five percent compared to thebaseline, the annual demand re-duction from 2008 to 2012 wouldbe more than 100 million tonnes.

Second, the ETS is only one ofseveral instruments of Europeanclimate policy. Energy efficiencypolicies and renewable energypromotion also lead to carbon re-ductions. Meeting the EU 20 per-

cent energy efficiency target andthe 20 percent renewables targetreduces the need for fossil-fueledelectricity generation thelargest contributor to emissionscovered by the ETS. The produc-tion of electricity from solar andwind in the EU doubled from 105TWh (terawatt hours) in 2008 to214 TWh in 20122.

Third, emission reductions fromoutside the EU are allowed into

the ETS in the form of additionalcredits. In the ETS second phase,EU legislation allowed 1,420 mil-lion tonnes (ie 284 million tonnesper year) of carbon reductionsfrom outside the ETS to be usedinstead of European emission al-lowances3. This option has beenwidely used, also because noother country or region has al-lowed such a generous monetisa-tion of foreign emissionreductions.

Fourth, according to the EuropeanCommission (2012), some addi-tional 500 million allowancesfrom three exceptional sourceshave been brought to the marketin 2012/2013: 1). Unused al-lowances from the second phasenational new entrants reserves4

were auctioned at the end of thesecond phase. 2). The EuropeanInvestment Bank is selling a fixedamount of third-phase al-lowances in order to fund a

number of carbon capture andstorage and innovative renew-ables projects (NER300 pro-gramme)5. 3). Some third-phaseallowances have been auctionedearly in order to avoid the scarcitythat was feared at the time the cli-mate package was negotiated in2008/2009.

As emission allowances not usedin the second trading period(2008-12) can also be held overand used in the third trading

period, a surplus ofwell over 1.5billion allowances, and even as

large as 2 billion allowances

might have accumulated at thestart of the third phase6, 7.

3 THE EMISSION PRICE SLUMP

A temporary surplus ofallowances is not necessarily aproblem for the ETS. As thesystem is to run indefinitely witha constantly decreasing annual

Table 2: Relative change in the growth rate of emissions between (2005-06) and (2007-08) by sector

Pulp & paper Non-metallic minerals Basic metals Electricity & heat

Reductions caused by shift to the 2nd period -2.9% -8.7%*** -9.5%* -0.1%Controlvariables

Changes in turnover 15.4%** 29.9%*** 8.9% 13.6%**

Changes in employment -6.2% -4.6% 9.9% 1.2%

Source: Abrell et al (2011). Note: significance: * at 10%, ** at 5 % and *** at 1%.

Other

Oilrefineries(-28%)

Metalore(-4%)

Iron&steel(-52%)

Cementclinker(-38%)

Glass(+34%)

Ceramicproducts(+141%)

Pulp&paper(+23%)

Combustioninstallations(-10%)

Cokeovens(-26%)

Aircraftoperators

2005 2006 2007 2008 2009 2010 2011 2012

2500

2000

1500

1000

500

0

Source: Bruegel based on CITL. Note: million tonnes of CO2.

Figure 2: Sector-level verified emissions (reductions 2005-12 in brackets)

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YOU'D BETTER BET ON THE ETS

supply of new allowances it is infact neither likely nor desirable

that the system is tight at everypoint in time. Using cheapemission-reduction opportunitiesearly to save some allowances forthe future is a sensible strategyboth from a company and from asocial perspective. Such efficientintertemporal arbitrage wasexplicitly permitted in thelegislation by allowing thebanking of allowances betweentrading periods.

However, the decline in allowanceprices (see front cover figure)indicates that the possibility ofstoring the surplus allowances tosell them at a later stage has notstabilised prices today. There aretwo possible reasons for this:either there are too manyallowances in the system even inthe long term, or the system as

such is not credible.

On the first possibility, accordingto the European Commissionsown analysis the number of avail-able allowances (see orange tri-angle in Figure 3) will exceed thenumber of required allowances

(see the blue line in Figure 3) untilabout 2023. After 2025, the

banked allowances will start to beused up as emissions exceedannual allocations. Prices willhave to reach 40 by 2030 tokeep emissions below 1400 mil-lion tonnes per year in the Euro-pean Commissions referencescenario8. The current allowanceprice of 5 could thus indicatethat market participants expect in contrast to the reference sce-nario that the present oversup-

ply will continue (for example dueto persistently lower growth9, re-inforced complementary energypolicies and/or technologicalbreakthroughs that make carbon-abatement significantly cheaper).But to date, a laxer ETS demand-supply balance in 2030 appearsno more likely than a tighter thanexpected balance. Significantlyhigher prices would for example

be possible if some decarbonisa-tion technologies do not proveeconomically viable (for examplecarbon capture and storage, oroffshore wind) or if Europe de-cides to step up the ETS in order tomeet stringent 2050 decarboni-sation targets10.

A second rationale for low emis-sion prices today is that the entire

system is not credible. The ETS isa politically created market thatfundamentally depends on thelong-term commitment of policy-makers to maintain the system asthe cornerstone of EU decarboni-sation efforts. But all long-termpolicies are confronted with thedifficulty that policymakers haveto commit to stable regimesbeyond their electoral mandates,and sometimes even their gener-

ation. Such commitments areonly credible when future compli-ance remains cheaper than non-compliance. With the ETS,policymakers commit to makefuture consumers pay high pricesfor carbon, in order to make in-vestment today in low-carbontechnologies attractive. This com-mitment is hardly credible giventhat (1) EU policymakers might

find it difficult to accept the con-tinuation of stringent decarboni-sation policies if other countriesdo not follow suit in due course11

and (2) maintaining a high carbonprice that largely serves to renderpast low-carbon investmentsprofitable might become politi-cally difficult12. Even though thedecreasing allocation within theETS is enshrined into legislation,policymakers can at all points in

time shift the demand-supply bal-ance within the system by includ-ing new sectors, changing thetreatment of international creditsor providing additional incentivesfor carbon reductions within cer-tain countries and/or sectors cov-ered by the ETS. This can have asignificant impact on futurecarbon prices. The non-negligiblerisk that future policymakers will

take measures that obliterate theETS to avoid carbon price hikes or

tonnes from renew-ables, 150 m tonnes

from energy efficiency,500 million tonnes from

exceptional allowanceallocations.

8. This scenario isbased on current poli-

cies but does not in-clude the effects of the

recession, internationalcredits and aviation

but even if those are in-cluded the demand and

supply balance is likelyto cause carbon pricessubstantially in excess

of50 as soon ascarbon capture and

storage is required toprevent industrial emis-sions to exceed the cap.

9. McKinsey (2009) es-timates that a reduction

of average 2005-30GDP growth from 2.1

percent to 1.8 percentwill cause Europes

emissions to drop byonly 6 percent com-

pared to the baseline in2030. Loosely speak-ing, the carbon price

level predicted in theCommissions reference

scenario will bereached 3-4 years later.

10. According to the EUEnergy Roadmap 2050

the ETS price mightthen increase to more

than 200 in 2050.

11. A decision on aninternational

agreement to restrictgreenhouse gas

emissions in the mostimportant economies

2013

2015

2017

2019

2023

2025

2027

2029

2031

2033

2035

2037

2039

2041

2043

2045

2047

2049

2051

2053

2055

2059

2061

2063

2065

2067

Numberofallocatedallowances2013-2067:56.6billion

Numberofallocatedallowancesuntil2050:51.2billionNumberofallowancesneededinthereferencescenarioupto2050:52.6billion

2021

2057

Allocatedallowances

Emissionsroadmapreferencescenario

(blueline)

Allowancepricereferencescenario(rightscale)2500

2000

1500

1000

500

0

60

50

40

30

20

10

0

Source: European Energy Exchange. Notes: reference scenario emissions refer to thesectors currently covered by the ETS: power generation/district heating, energy and

industry; emission allowance prices are linearly interpolated between the values dis-closed in the Roadmap and, as no initial value is provided, 15 is assumed for 2013.

Figure 3: Future development of the ETS (million tonnes CO2, left scale)

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has been deferred, andultimate failure is far

from impossible.

12. See Brunner et al

(2011) for an in-depthdiscussion of the

carbon commitmentproblem.

13. This is in line withNeuhoffet al (2012).

The authors argue thatcompanies that intend

to emit carbon in thenear-to-medium-term

future already acquiredsufficient allowances in

order to hedge againstrising allowance prices.

Consequently onlyspeculators that require

substantially higherrisk premia will do in-

tertemporal arbitrage.

14. Even if all excessallowances are taken

out of the system tomake it immediately

binding and henceprices pick up in the

short term, backloadingwill certainly not

incentivise investmentsinto low-carbon

technologies with longeconomic lifetimes, asthe prices will drop as

soon as the allowancesare reintroduced.

YOU'D BETTER BET ON THE ETS

Commission has proposed ameasure to reduce the immediate

surplus and several policies tostrengthen the system in thelonger term.

To reduce the immediate surplus,the Commission proposed in No-vember 2012 to temporarily takeallowances worth six month of EUemissions (900 million tonnes)out of the trading system, and sellthem in 2019 and 2020 ratherthan 2013-2015. This backload-

ing is supposed to boost carbonprices that dropped below 5 pertonne. The European Parliament isexpected to vote on the plan inmid-April 2013.

In its current form, backloadingcan be seen as a political placebo.In pure economic terms, it is not acure because shifting the alloca-tion of some excess allowances

by some years does not changethe underlying value of the al-lowances14. In political terms, theargument is that politically agree-ing on an economically ineffec-tive treatment such asbackloading is at least an ac-knowledgment by policymakersthat there is a problem with thesystem that they are willing to

rectify, and could pave the wayfor structural measures. Further-

more, there is an implicit threat bythe Commission that eventualstructural measures will essen-tially consist of cancelling the set-aside allowances henceshaping market participants ex-pectations that the backloadingmight not be a temporary but apermanent measure. Even thougheconomically ineffective, wecannot determine to what degreebackloading is a valuable political

signal and/or will be effective interms of market psychology.

But there is a cost to usingplacebos: the credibility of futuretreatments. Backloading seeks tocreate credibility in a system bypolitically infringing on it. The ETSis enshrined in legislation that isvery difficult to change, andforesees a linear decline in

carbon emissions even beyond2050. Demonstrating that thesystem can be politicallycontrolled might backfire in thelong term. Why should marketparticipants that have to takeinvestment decisions that willhave an impact for forty or moreyears care about a price signalthat can so easily be manipulatedby a political decision in 2013?Creating long-term credibility in a

market in which supply anddemand can be largelydetermined by policymakers isvery difficult. But long-termcredibility is essential to driveprivate investment into low-carbon technologies that will onlypay back after decades.Furthermore, backloading is notwithstanding the long-termrisk to reputation an almost

costless exercise and hence onlyof limited value as a signal.

to tackle continued carbon leak-age is undermining the carbon

price today.

Consequently, we consider thatthe currently observed priceslump is more due to a lack oflong-term credibility of the ETS,than to a structural reduction ofthe cost of compliance with thecurrent system. The current lowprice of emission allowances,which given an expected carbonprice of40 in 2030 would imply

a 13 percent annual return, indi-cates that the ETS is less crediblethan the sovereign bonds of, say,Pakistan (Caa1 negative Moodysrating), which are due in 2036and currently yield 12 percent13.

4 DEALING WITH THE PRICESLUMP

The current low carbon price could

put long-term decarbonisation inEurope at peril by incentivisinglong-lived high-carbon invest-ments that lock-in future emis-sion patterns, such as lignite-firedpower plants. It could also desta-bilise the ETS by encouraging na-tional measures (see Box 1).

To stabilise the ETS, the European

BOX 1: THE RISK OF A SELF-FULFILLING PROPHECY

The current surplus is regarded by some observers as a sign of political neg-lect of the ETS. The political acceptance of a prolonged phase of depressedallowance prices might motivate some member states to pursue comple-mentary decarbonisation policies. The United Kingdom, for example, is in-troducing a national carbon floor price that is supposed to exceed the EUAprice. The higher cost of carbon emissions in the UK will incentivise addi-tional emission reductions. Lower emissions in the UK translate into a lowerdemand for EU emission permits. Any permit made redundant in the UK willultimately be sold in the rest of Europe leading to lower ETS prices. Thiscould incentivise other countries to follow the example of the UK and hencethere is a danger that national policies essentially substitute the ETS. TheETS could become ineffective because of national policies that assume that

it is ineffective a classic self-fulfilling prophecy.

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Consequently, the long-term costof backloading might be greater

than its short-term benefits.

The proponents of backloadingsee it as a means to politicallypave the way for structural meas-ures and bridge the current lack ofscarcity until such structuralmeasures are implemented. In2012 the Commission proposedsix different structural measures(Table 3).

The measures A to E would tightenthe demand-supply balance foremission allowances. This is sen-sible if there is a desire to step upthe decarbonisation effort fromthat currently foreseen in the ETSDirective to that foreseen in theCommissions Roadmap 205015.The ETS Directive prescribes alinear reduction of 1.74 percent ofthe average allocation of al-

lowances in 2008-12 about 37million EUAs. This would lead to anallocation of about 654 millionEUAs in 2050, which is about 68percent below the 2013 emis-sions covered by the ETS. In con-trast, the European CommissionsRoadmap 2050 foresees an econ-omy-wide emissions reduction of80 to 95 percent of 1990 levelsby 205016. The Roadmap 2050has been welcomed by the EU

Council but the 80 to 95 percent

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15. See European Com-mission (2011).

16. Considering the dis-proportionate decar-

bonisation burdenallocated to the ETS

sectors (-93 to -99 per-cent for power, -83 to

-87 percent for industry

versus -54 to -67 per-cent for transport), andthe decarbonisation al-

ready done by thesesectors between 1990

and 2012, theRoadmap 2050 would

require an 80 to 95 per-cent reduction in the

ETS sectors comparedto 2013 levels (see Eu-

ropean Commission,2011).

17. Poland also vetoedCouncil conclusions on

the Roadmap in 2012because they con-

tained emissions re-duction targets after2020. There is some

legal question aroundwhether unanimity isrequired for this. See

http://www.europeanvoice.com/article/2012/no

vember/meps-back-qualified-majority-deci-sion-at-climate-talks/7

5789.aspx.

18. In technical terms

this is a put option onthe carbon price.

YOU'D BETTER BET ON THE ETS

decarbonisation target was notformally adopted17. Some

member states especiallyPoland have strong reserva-tions about tightening the ETS.The same holds true for measureF. Such discretionary price-man-agement mechanisms wouldimply a paradigm shift from a purequantity-based to a price-basedmechanism. Consequently, thepolitical discussion on the struc-tural proposals of the Commissionwill take several years and the

outcome is uncertain.

Thus, neither backloading norstarting a discussion on structuralmeasures are sufficient to makemarket participants believe thatthe ETS will remain as the corner-stone of EU decarbonisation poli-cies. Furthermore, the long-termcommitment problem is not dealtwith by any of the proposals.

5 REESTABLISHING CONFIDENCE

To establish the necessary confi-dence in the ETS, policymakersneed to credibly commit to thesystem. Such a commitment istypically achieved by increasingthe cost of future non-compli-ance. Building up a valuable repu-tation for credibility through ahistory of compliance in political

transactions is currently not an

option (but backloading might de-stroy some reputation). External

commitment devices such asinternational carbon reductionarrangements in which an ex-ternal actor punishes domesticnon-compliance, are currentlyalso not conceivable. An internalcommitment mechanism thatrests on borrowing reputationfrom established institutions ap-pears to be the only viable option.

One such promising mechanism

(initially proposed by Ismer andNeuhoff, 2009; Pizer, 2011; andothers) consists of selling guaran-tees of the future carbon price.This could be organised in theform of a private contract betweenthose making low-carbon invest-ments and the public sector. Apublic bank would offer contractsthat agree to pay in the future anypositive difference between the

actual carbon price and a targetlevel18. Investors would bid to ac-quire such contracts to hedgetheir investments. This would pro-duce three benefits: first, thepublic bank would be able to col-lect initial payments (a sort of in-surance premium) and make aprofit if a sufficiently tight climatepolicy is maintained. Second, theprivate investor significantly re-duces its exposure to the politi-

cal carbon market and henceaccepts longer pay-back times forits investments. This wouldunlock long-term low-carbon in-vestments that are currently toorisky. Third and most importantly,public budgets would be signifi-cantly exposed to the functioningof the ETS. If future climate policy-makers take decisions that leadto increases in the number of

available EUAs, they might becalled back by the treasuries, be-

Table 3: Structural measures proposed by the European Commission

Option ContentA) Increasing EU reduction target to 30 percent in 2020

(achievable via b or c);B) Retiring a number of allowances in phase III (2013-20);C) Early revision of the annual linear reduction factor from 1.74

percent per year to a faster rate of decline;D) Extension of the scope of the ETS to other sectors;E) Restrict access to international credits;F) Discretionary price management mechanisms.

Source: European Commission (2012).

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cause this would activate theguarantees pledged to investors.

Consequently, all parties alsoinvestors not covered by thescheme would know that thereis money on the table. This wouldserve as a much stronger andhence more credible commitmentdevice for preserving the integrityof the ETS. The lower risk associ-ated with the future carbon pricewould immediately imply a highercarbon price.

The scheme would introduce asoft form of a floor price bymaking it expensive but not illegalfor policymakers to accept verylow carbon prices in the future. Atthe same time, the possibility offuture carbon policy shifts which undermine the credibilityof discretionary price manage-ment approaches such as auctionreserve prices, which might be

changed from one day to another do not affect the guaranteesgiven to investors under the guar-antee scheme.

There would be significant free-dom of scope in structuring suchguarantee contracts. Importantdesign elements are the amountof guarantees issued, the level ofthe target price, the exercise date(or date range), the reference

price and the mode of allocatingcontracts (eg by tender or by auc-tion). Policymakers might alsodecide to sell products differenti-ated by exercise date and/ortarget price.

The implementation of a schemesuch as we have proposed couldbe but does not necessarily haveto be done by the EIB. As a Euro-

pean public bank backed bymember-state taxpayers money,

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19. The reason for this isthat the portfolio of an

allowance and aguarantee would yield

more than 28.57 if theallowance price rises

above 40 (the presentvalue of a carbon price of

50 is 35.70). If thecarbon price is with 14

percent probability 50and otherwise 0, the

value of the portfoliowould be 29.57. Minus

the cost of the allowancethis is 24.57.

YOU'D BETTER BET ON THE ETS

the EIB would be a credible coun-terpart for writing such guarantee

contracts. Legally, it is plausiblethat only the governing council ofthe EIB, consisting of the financeministers of the member states,would have to agree to such anoperation by simple majority.

The auctioning of a limitednumber of long-term carbon price

guarantees could be used to sta-bilise the current, functioningsystem around the already-agreed linear reduction factor. Itwould provide flexibility for poli-cymakers to change future cli-mate policy and at the same time

BOX 2: THE PROPOSAL IN PRACTICE

To give one example, the European Investment Bank (EIB) might beasked to auction off guarantees for buying back one billion al-

lowances for the year 2030 at a target price of40.

(1) Fair price of the guarantee:The guarantee to be allowed to sell an emission allowance in 2030 at40 is worth slightly more than the discounted guaranteed price (at atwo percent interest rate this is 28.57) minus the current cost of anallowance (currently 5), ie 23.5719. Consequently, with no changeto the carbon price, the EIB would produce significant upfront rev-enues from selling guarantees.

(2) Confidence in the system increases:As a consequence of the political commitment to buy back one billion

allowances in 2030 at a price of40, market participants will under-stand that it is cheaper for future policymakers to stabilise the ETS,than to allow it to fail and thus to have to pay the insured companies.Hence, regulatory uncertainty will diminish and risk premia will de-cline. This will encourage long-term investment in low-carbon tech-nologies that crucially depend on the future carbon price and that arecurrently too risky. Furthermore, the ability to bundle allowances andguarantees into a safe asset would allow companies to more easilyrefinance their low-carbon projects through financial markets (asset-backed securities). Earlier long-term investments in low-carbon tech-nologies should allow Europe to pursue a smoother and hence

cheaper decarbonisation pathway.

(3) The current EUA price will rise:With the reduced risk premia, intertemporal arbitrage will force thecurrent carbon price to rise. One focal point for the current price is theexpected 2030 price of40 discounted at a risk-free interest rate oftwo percent. This would be 28.57.

With increasing current allowance prices, the incomes for nationaltreasuries will increase as they auction off their annual allocations ofallowances. At the same time, the income of the EIB from sellingguarantees will shrink. It might make sense to compensate for this

implicit transfer.

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would socialise the cost that suchshifts have for locked-in low

carbon investors. This will unlocklow-carbon investment. In addi-tion, the guarantees would re-store credibility in the ETS. Thiswill increase current carbonprices and hence result in moreimmediate abatement.

Notwithstanding this operation,the current ETS linear emission re-

European commitment to increasethe reduction factor appears politi-

cally difficult. It is thus crucial toquickly stabilise the ETS in order toallow it to continue to play its im-portant role of cost-effectivelysynchronising Europes existingdecarbonisation commitments.

Research assistance by Amma

Serwaah is gratefully

acknowledged.

duction factor is not sufficient tomeet the 2050 decarbonisation

target set out in the CommissionsRoadmaps. Hence, a further tight-ening of the system requiring achange to the directives wouldbe necessary to achieve the 80-95percent decarbonisation target by2050. In the light of the currenteconomic situation and the uncer-tain state of international climatenegotiations, an early and credible

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