The document discusses reform options for the EU Emissions Trading System (EU ETS). It summarizes that while the EU ETS has kept emissions below caps, it lacks dynamic efficiency to ensure long-term cost-effectiveness due to low and decreasing carbon prices. The proposed Market Stability Reserve is seen as insufficient and uncertain in its impact. Alternatively, Euro-CASE proposes a comprehensive reform package including setting a price collar to stabilize expectations, expanding the ETS to more sectors, additional policy tools to spur innovation, and addressing carbon leakage through international linking of carbon markets. Without reform, fragmented climate policies risk higher costs.

1. The EU ETS: Ex-Post Analysis,
the Market Stability Reserve and
Options for a Comprehensive Reform
Seminar on the EU Emissions Trading System
Dr. Brigitte Knopf
Helsinki, 13 November 2014
Presentation of the Euro-CASE policy brief
Dr. Brigitte Knopf (PIK)

2. Scientific Background: New IPCC Report 2014
• There are multiple mitigation pathways
that are likely to limit warming to below
2°C relative to pre-industrial levels.
• These scenarios […] are characterized by
40% to 70% global anthropogenic GHG
emissions reductions by 2050 compared
to 2010, and emissions levels near zero or
below in 2100.
• In the majority of low‐concentration
stabilization scenarios […] fossil fuel
power generation without CCS is phased
out almost entirely by 2100.
www.mitigation2014.org
IPCC Synthesis Report (2014)
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3. Political Background: The EU 2030 Framework
• Decision on headline targets by the European Council (23 Oct 2014)
• “At least 40% domestic” GHG reduction by 2030
• Binding EU-wide target for renewables of 27%
• Indicative EU-wide target for energy efficiency of 27%
• Reform of the EU ETS:
• January 2014: Legislative proposal for reform of the EU ETS with a
Market Stability Reserve to start in 2021
• Council conclusion refer to a „reformed ETS with an instrument to
stabilise the market in line with the Commission proposal“
• Change of linear reduction factor to 2.2% p.a. compared to the current
1.74% p.a. (accepted by the EU Council)
• Timing: ENVI Committee is set to vote on 24 Feb. 2015
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4. European Council of Academies of Applied Sciences,
Euro-CASE Policy Position Paper
Reform Options for the European
Emissions Trading System (EU ETS)
Chairs of the Euro-CASE Energy Platform:
Ottmar Edenhofer, Bo Nordmark, Bernhard Tardieu
http://www.euro-case.org/images/stories/pdf/position-paper/Euro-CASE-policy-paper-ETS-reform.pdf
Dr. Brigitte Knopf
Technologies and Engineering

5. The EU ETS: ex-post analysis
• Carbon pricing is essential for climate policy
• Strong decline of the CO2 price
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6. Ex-post analysis of environmental effectiveness
• Emissions stayed below the cap
• In fact, annual cap did temporarily not set a constraint and did
not provide incentives for action (“non-binding cap”)
Grosjean et al. 2014
Phase 1 Phase 2
Phase 3
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7. Price formation in a market with non-binding cap:
Empirical evaluation of EUA price drivers
Koch et al (2014)
• Only 10% of price changes can be explained by market fundamentals
(renewable deployment, economic crisis, CDM, …).
• The price formation in a market where scarcity is governed by political
decisions crucially depends on expectations of market participants about
future scarcities and future political decisions
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8. Expectations about future scarcities are crucial:
Dynamic cost-effectiveness of ETS is lacking
• Currently: decreasing CO2 price
Dr. Brigitte Knopf
EUA nearest contract and Futures 2020
8

9. Expectations about future scarcities are crucial:
Dynamic cost-effectiveness of ETS is lacking
• Currently: decreasing CO2 price
• Also in the future, no substantial price increase is expected (only
little spread between nearest contract and future contract for 2020)
Dr. Brigitte Knopf
EUA nearest contract and Futures 2020
9

10. Expectations about future scarcities are crucial:
Dynamic cost-effectiveness of ETS is lacking
• Also in the future, no substantial price increase is expected
• Models show cost-efficient price path with increasing prices of
EUA nearest contract and Futures 2020 Cost-efficient CO2 price from modeling
Dr. Brigitte Knopf
Knopf et al. (2013)
more than 20€/tCO2 by 2020
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11. The problem with the low price
• A low price is – in conventional thinking – a sign of a well-functioning
market. But in this case, it reflects the expectation
of traders that the oversupply will be sustained even beyond
the current commitment period.
• In other words, the EU ETS does not incentivize the search for
low-cost mitigation options but reflects mainly the
expectations of traders about future political decisions.
• The EU ETS has been transformed into a betting shop for the
commitment period after 2020.
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12. Summary of problem analysis
• The EU ETS is a market where scarcity is governed by political
decisions and not by natural scarcity. Expectations of market
participants on future political decisions are crucial
• Environmental effectiveness of ETS is given. But the cap did not set
a constraint as emissions stayed below the cap
• Dynamic cost-effectiveness is not given; prices are not expected to
increase significantly until 2020
• Key question and requirements for ETS Reform to address:
 How to stabilize expectations of market particpants?
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13. Reform proposal by EU Commission:
The Market Stability Reserve (MSR)
• In the course of the debate about the ETS reform, the EU Commission
changes the wording from „too low price“ to „too high surplus“ of EUA
certificates
• January 2014: proposal of MSR as a quantity based instrument
Dr. Brigitte Knopf
Trotignon et al. (2014)
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14. Market Stability Reserve - Impact
• Does the MSR stabilise expectations?
• Contributes to decrease surplus (due to exogenous shocks) of
allowances in phase IV
• But oversupply does not dissipate until 2030
• Effect of MSR on price is unclear
Source: European Commission (2014)
Dr. Brigitte Knopf 14
Millions

15. Market Stability Reserve - Evaluation
• The MSR does not address the problem of missing long-term cost-effectiveness
and price uncertainty
• Choice of quantity instrument is questionable
• It addresses the existence of a large allowance surplus, but
oversupply does not dissipate until 2030
• If hedging is the rationale behind the trigger it should change
over time
• The impact is difficult to assess because the rationale behind the
mechanism is not transparent
• MSR will have an uncertain impact on low-carbon investment
• Timing of the effect might be too slow; review phase in 2026 gives
additional uncertainty
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16. Alternative reform proposal by Euro-CASE:
Instead of a narrow reform of the EU ETS, a fully-fledged reform
addressing several aspects of carbon pricing is required:
1. Setting a price collar within the ETS as a hybrid instrument
2. Sectoral expansion of the EU ETS to enhance the cost
effectiveness of EU climate policy
3. Policy instruments in addition to carbon pricing are required
for stimulating innovation
4. Addressing carbon leakage
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17. 1. Setting a price collar
• Reliable framework for investment decisions; price collar will
stabilize expectations; dynamic cost effectiveness is assured
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18. Advantages of a price collar within the EU ETS
• General: price collar will stabilize expectations and lead to dynamic cost-effectiveness
• Price ceiling is motivated by the fact that prices can also increase
subtantially through shocks. With setting a ceiling this risk is reduced
symmetrically, what would be important for investors
• Price floor (auction reserve price) would allow addressing national
preferences, e.g. more ambitious domestic mitigation goals, without
undermining the environmental effectiveness of the additional national
policies
• Hybrid instrument of ETS and floor price also installed in California and
other US Regions; might support possibility of linking
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19. Can Linking of International Emission Trading Systems deliver
Momentum for UNFCCC Climate Change Negotiations?
Dr. Brigitte Knopf
IPCC WGIII, Fig 13.4
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20. 2. Sectoral Expansion of the EU ETS
• The ETS currently covers about 45% of all GHG emissions, but
all sectors need to significantly reduce GHG emissions.
• There are different options on how to add further sectors, but
upstream inclusion is the most favorable.
• Revenue recycling (auctioning vs free allocation) important
for sectoral expansion:
• Possibility of lowering costs to particular industries by
exemptions and revenue-recycling
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21. Example of sectoral coverage of carbon
markets worldwide
Worldbank 2013
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http://www.worldbank.org/en/news/feature/2013/10/02/carbon-markets-world-view-infographic

22. 3. Instruments in addition to carbon pricing
• In addition to carbon pricing, other policy instruments for
innovation and diffusion of low carbon technologies might be
required
• There are indications that especially the innovation spillovers are
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high
• R&D policies could therefore support innovation and should be part
of the portfolio if market failures can be observed

23. 4. Tackling carbon leakage
• Carbon leakage only affects a few sectors
• It can be addressed by expanding the group of countries that
participate in the ETS or by linking it to other regions
• Within the group, free allocation of some emission permits as well
as tailor-made trade policies should be considered
• Lowering costs to particular industries by exemptions and revenue-recycling
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24. Increasing the number of ETS worldwide is the
best way to address carbon leakage
Dr. Brigitte Knopf
Worldbank 2013
http://www.worldbank.org/en/news/feature/2013/10/02/carbon-markets-world-view-infographic

25. Summary
• Pricing carbon is essential for climate policy. In the EU ETS emissions
stayed below the cap, but the EU ETS lacks dynamic efficiency to ensure
long-term cost-effectiveness.
• The MSR does not address the current problem. It might turn out to be a
toothless tiger.
• Instead, Euro-CASE proposes a reform package with setting a price collar
as the foremost element and includes a sectoral expansion, policy
instruments in addition to carbon pricing and addresses carbon leakage.
• Without a comprehensive reform of the ETS, there is a clear danger of a
revival of fragmented climate and energy policies across Europe which
have the potential to increase the costs of climate policy substantially.
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