It would be a mistake to believe that a “reformed” EU Emission Trading Scheme (ETS) would be a sufficient instrument for the decarbonisation of the EU economy, writes Oliver Sartor of the Institute for Sustainable Development and International Relations (IDDRI) in Paris. A carbon market is necessary, but it is not enough. A recent study from Climate Strategies, in which Sartor participated, suggests that Member States develop long-term climate and energy strategies and maintain a healthy role for risk-mitigation policies for renewable investments, in addition to the ETS.
Today, Wednesday, the European Parliament is expected to vote to approve an amendment to the EU Emissions Trading Scheme (EU ETS) Directive to establish a market stability reserve (MSR). This reform is expected to (gradually) redress the oversupply of emission allowances in the carbon market which is keeping down the CO2-price.
However, while a lot of attention has been focused on the outcome of the MSR reform, a more fundamental question has been overlooked: what role is the carbon market being expected to play in the decarbonisation of the EU economy?
This question is now more relevant than ever. With the 2030 climate and energy framework, the EU has begun develop the policies that will fundamentally shape its ability to achieve its 2050 climate targets. However, there is an increasing risk that the EU will expect the EU ETS to play a role that it is ill-suited to perform, based on a misguided view of its capacity to be a cost-effective instrument for all aspects of the transition in the sectors it covers. If so, this approach will lead to higher costs for energy consumers and risks putting the achievement of 2050 targets out of reach.
While there is an important role for the carbon market to play in driving high carbon assets out of the power mix, the carbon market is likely to be highly inefficient at driving mature low-carbon technologies into the power mix
The conventional view of the role of the carbon market in the policy mix is roughly the following: There is a role for complementary policies to tackle market failures on the energy efficiency side; there is a role for market push policies to promote immature technologies. However, once technologies are mature, the carbon market should “choose” which technologies and operational changes that are the least cost way of achieving a given emissions target. This view is reflected, for example, in the EU’s State Aid Guidelines for Energy and Environment of 2014, which suggested that investment support policies for mature renewable technologies should be phased out post-2020.
Risky prices and financing costs
But is it that simple? A study published last week by Climate Strategies, an independent research organisation that brings together researchers from different think tanks and academia, and co-authored by researchers from think tanks in France, Germany and Spain, looked at whether this model can really be expected to be the least cost approach to reducing emissions in the European power sector – i.e. the biggest single sector covered by the EU ETS. The conclusion was that, while there is an important role for the carbon market to play in driving high carbon assets out of the power mix, the carbon market is likely to be highly inefficient at driving mature low-carbon technologies into the power mix. There are three reasons for this.
Firstly, the high capital/operational cost ratios of low-carbon generation technologies – whether renewables or nuclear – mean that minimising their costs is, to a large extent, about minimising the costs of financing. Financing costs in turn are sensitive to the price risk for the power generated from these investments. However, the current power market design in Europe does not provide investors with any possibility to hedge these price risks over the time horizons of their investment. Nor does the carbon market help the situation much. The carbon price is, after all, another risky price on top of the existing fluctuating power price. It is not credible to the financial sector as a basis for a rock-solid investment case.
Secondly, the price risk faced by low-carbon investments is also aggravated by the “merit order effect”. Based on the current power market design, the more zero-marginal cost technologies enter the market, the lower the average power price tends to become. Moreover, pass-through of the carbon price into the electricity price will become more volatile.
The carbon price is, after all, another risky price on top of the existing fluctuating power price. It is not credible to the financial sector as a basis for a rock-solid investment case
Thirdly, there are genuine risks of technology lock-in for low-carbon technologies. Integrating large shares of renewables into European power markets poses significant coordination challenges in terms of infrastructure development, changes to market designs, the deployment of storage technologies, etc. The carbon market is of course blind to these coordination issues. A more predictable roll out of mature low-carbon generation assets than the carbon market can provide is necessary.
Therefore, in addition to the carbon market, minimising the costs of deploying low carbon generation technologies will require a greater willingness to provide price risk-mitigation instruments beyond 2020. Specifically, contracts for difference and feed-in-tarrifs, if well designed, would actually help to reduce costs for power consumers during the low-carbon transition more than a carbon market only approach.
Secondly, the need for coordinated deployment highlights the importance of credible and enforceable quantitative targets for deployment, even if not based on a top-down allocation of renewables targets to Member States. To avoid adding to the ETS surplus, the cap in the carbon market must therefore be set taking into account an important role for these complementary policies.
Phasing out high carbon assets
This is not to argue that we don’t need the ETS. The carbon market is necessary and must remain part of the policy mix. As a pan-European instrument with a declining cap on emissions, the carbon market is vital to ensuring that all Member States have similar incentives to implement low-carbon generation policies and to phase out “high carbon” assets. If there is a scarcity of allowances in the market, the carbon market has also shown that it can be an efficient tool to gradually drive coal out of the power mix in favour of lower carbon alternatives, like efficient gas plant.
However, our analysis also shows that, even with the new MSR, the ETS may only start to create incentives for the phase down of coal by the latter half of the next decade. This raises a risk that the EU will begin to phase down carbon intensive assets too slowly. For example, Poland currently has around 90% of its power sourced by coal and lignite, very limited existing fuel-switching potential and around 35 GW of coal and lignite capacity in its power system. If Poland were to have a very similar energy mix in 2030, then this challenge starts to look very difficult. While in principle carbon prices should rise until emissions are reduced in line with the cap, in practice, politics would probably intervene if the carbon price got “too high”.
Our study therefore suggests that, as a complement to the ETS, greater consensus must be built around what is needed for coherence between Member States’ short term policy actions and the EU’s longer term climate goals (including the implications of a declining ETS cap).
We therefore propose that, as a starting point, Member States’ new national energy plans should be complemented by a document or chapter outlining strategies to manage their coherence with the EU’s long term climate goals, including costs for energy consumers as the cap becomes binding. This information should then feed in to dialogues between Member States on solutions.
If the EU is to minimise the costs associated with decarbonising the power sector, then it will need complementary instruments to the EU ETS beyond 2020, both to minimise the cost of investment in low carbon technologies and to avoid lock-in risks in specific Member States. The EU ETS is essential for this, but it is not sufficient.
Oliver Sartor is Research Fellow Climate and Energy Policies at the Institute for Sustainable Development and International Relations (IDDRI) in Paris.