2018StateoftheEUETSReport

AndreiMarcu,EmilieAlberola,Jean-YvesCaneill,MatteoMazzoni,

StefanSchleicher,WijnandStoefs,CharlotteVaillesandDomienVangenechten

ERCST,WegenerCenter,NomismaEnergia,I4CEandEcoact

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Disclaimer

TheviewsexpressedinthisPaperareattributableonlytotheauthorsinapersonalcapacity,andnottoanyinstitution,whichtheyareassociatedwith,ortothefundersorsupportersofthePaper.

This Paper has been the subject of stakeholder consultations, including aworkshop convened by theauthors with stakeholders including NGOs, think tanks, academia, policymakers,market participantsandrepresentativesofindustry.

A grantwasprovidedby theGermanFederalMinistry for theEnvironment,NatureConservationandNuclearSafety (BMU) todisseminate thispaper throughanumberofworkshops inEUMemberStatecapitals.

The EuropeanRoundtable on Climate Change and Sustainable Transition (ERCST) is a Brussels based initiativeundertheumbrellaoftheInternationalCentreforTradeandSustainableDevelopment(ICTSD),andisintendedtoprovideaneutral spacewherepolicy-makersand regulators canmeet stakeholders, anddiscuss climate changepolicyandasustainabletransitiontoalow-GHGeconomy.WhilefocusedonEuropeanclimatepolicy,thisinitiativeintends to fully recognize, and incorporate in its activities and thinking, the global dimensionof climate changepolicy. Established in 1996, ICTSD is a non-partisan, non-profit, Geneva-based international organization,registeredasanassociationinaccordancewitharticle60oftheSwissCivilCode.

TheWegenerCenterforClimateandGlobalChangeisaninterdisciplinary,internationallyorientedinstituteoftheUniversityofGraz,which servesasa core research center forpooling the competencesof theUniversity in theareasclimatechangeandtherelated issues inclimatephysics,meteorology,andeconomics.Anevidencebasedapproach to the transformation of energy systems, innovative analyticalmodeling concepts, and the design ofenergyandclimatepoliciesarefocalpointsofcurrentresearchactivities.

Nomisma Energiais an independent research company that deals with energy and environmental issues,committedtounderstandenergymarketsandtheirshortandlong-termtrends.NomismaEnergiacoversallissuesconcerning energy markets and environmental policies, which extend from fossil fuels markets to renewableenergies,fromindustrialandmarketregulationtodevelopmentofnewtechnologies,frominternationalpoliticstolocalenergyplanning.Thankstoitsindependency,NomismaEnergiaisabletoprovideobjectiveandreliableknow-howforanin-depthcomprehensionoftheenergysector.

I4CEis an initiative ofCaisse des DépôtsandAgence Française de Développement. The Think Tankprovidesindependentexpertiseandanalysiswhenassessingeconomicissuesrelatingtoclimate&energypoliciesinFranceandthroughouttheworld.I4CEaimsathelpingpublicandprivatedecision-makerstoimprovethewayinwhichtheyunderstand,anticipate,andencouragetheuseofeconomicandfinancialresourcesaimedatpromotingthetransitiontoalow-carboneconomy.I4CEbenefitsfromalargenetworkofpartners.

TheEcoActGroupaninternationaladvisoryconsultancyandprojectdeveloperthatworkswithclientstomeetthedemandsof theParisAgreement.Weoffer solutions to large and complexmultinational organizations for theirsustainability challengesWe believe that climate change, energymanagement and sustainability are drivers ofcorporateperformanceandseektoaddressbusinessororganizationalproblemsandopportunitiesinanintelligentway.TheEcoActGroupincludesAlliantis,CarbonClearandClimatePal.

ERCST,WegenerCenter,NomismaEnergia,I4CEandEcoact

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TableofContentsExecutiveSummary................................................................................................................1

1 Background.....................................................................................................................2

2 AEUETS“fit forpurpose”...............................................................................................33 Relevantpolicyandgovernanceissues............................................................................4

3.1 Phase4review......................................................................................................................4Openissues..........................................................................................................................................6ExpectationsafterP4review................................................................................................................7

3.2 RelevantissuesfromtheEnergyUnion..................................................................................83.3 RelevantissuesfromthenewEUlong-termclimatestrategy..............................................10

Technologyneutrality.........................................................................................................................10Long-termtargets...............................................................................................................................10

4 Environmentaldelivery..................................................................................................104.1 Deliveryagainstthetradingperiodtarget...........................................................................114.2 DeliveryagainstEUlong-termdomesticenvironmentalcommitments................................114.3 Deliveryagainstinternationalenvironmentalcommitments...............................................124.4 Lessonslearnedandissuestounderstandbetter.................................................................13

5 Economicdelivery..........................................................................................................135.1 Emissionanddecarbonizationtrends..................................................................................135.2 IstheEUETSadriverforchange?........................................................................................16

InteractionsoftheEUETSwithotherpolicies...................................................................................16Focusondecarbonizationinthepowersector..................................................................................17Deploymentofnewtechnologies......................................................................................................19Useofauctionrevenues.....................................................................................................................20

5.3 Monetaryimpactsandcarbonleakage................................................................................21Carbonleakage:directcosts..............................................................................................................22Carbonleakage:indirectcosts...........................................................................................................23

6 Marketfunctioning.........................................................................................................24

7 MakingtheEUETS‘fitforpurpose’................................................................................287.1 Restoringtheshort-termscarcitythroughtheMSR............................................................287.2 Dealingwithpolicyinteractionsanduncertainty.................................................................297.3 MakingtheEUETSgovernanceoperational.........................................................................307.4 Managingcarbonleakagerisks............................................................................................317.5 AligningtheEUETSwiththeEUlong-termambitionconsistentwiththeParisagreement..317.6 Providefinancialsupportforlow-carboncompetitivenessofEUindustryandthetransitiontowardsalow-carboneconomy......................................................................................................31

8 Bibliography...................................................................................................................33

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2018StateoftheEUETSReportAndreiMarcu,EmilieAlberola,Jean-YvesCaneill,MatteoMazzoni,

StefanSchleicher,WijnandStoefs,CharlotteVailles,andDomienVangenechten1

ExecutiveSummary

1 AndreiMarcuistheDirectoroftheERCST,EmilieAlberolaisHeadofClimatepolicyandmarketmechanismsatEcoAct,Jean-YvesCaneill isaSeniorAdvisortoERCST,MatteoMazzoni isaMarketAnalystatNomismaEnergia,StefanSchleicherisProfessorofEconomicsattheWegenerCenteronClimateandGlobalChange,WijnandStoefsis a Researcher at ERCST, Charlotte Vailles is a ProjectManager at I4CE, andDomien Vangenechten is a JuniorResearcheratERCST.

The EUEmissionsTradingSystem(EUETS) is important through its roleas the“cornerstone”ofEUclimatechangepolicyaswellasa“rolemode”,and“pioneer”forcarbonmarkets.Itisimportantthat,inadditiontotheregulatoryrequirements,itbesubjectedtoathoroughandindependentreview,todiscoverifitdeliversonexplicit,andwhathavebecome“expected”objectives,aswellasdiscoveranyissuesthatneedtobebetterunderstood.Availabilityofpublicdatahasbeenidentifiedasabarriertosomepartsofthisanalysis.

TheEUETScanbeseenasbeingexpectedtodeliver inanumberofdifferentareas:environmentaltargetsindifferenttimeframes,decarbonizationinaneconomicallyefficientway,includingprotectionagainsttheriskofcarbonleakage,andgoodmarketfunctioningandpricediscovery.

The recently concluded review for Phase 4 (P4) has attempted to tackle a number of outstandingissues,anditsnewparametersandarchitecturewill strongly influencetheEUETS’functioningfromhereon.CurrentpricescenariosindicaterisingpricesduringP4,butalotof issuesstillremainopen,upforimplementation,orupforreview,whichcouldsignificantlyinfluencetheseprojections.

OtherEUclimatelegislation inthepipeline,suchasthegovernanceoftheEnergyUnionRegulationandthenewEUlong-termclimatestrategy,willincludeelementsthatwillleavetheirmarkontheEUETS, its functioningand itsability todeliver,aswellpossibly require future reviewsand revisions. A“sentimentsurvey”conductedaspartofthisreportseemstoindicatethatstakeholdersareunsureoftheeffectivenessofthesechanges,butrecentpricetrendsindicateawillingnesstogiveitthebenefitofthedoubt.

Despitethefactthatemissionsincreasedin2017forthefirsttimein7years,thereisstilllittledoubtthattheEUETSisdeliveringonitsshort-termenvironmentaltargets.However,thepost-2020LinearReductionFactor(LRF)willnotbesufficienttoputtheEUETSonthepathwayoutlinedinthe‘2050Roadmap’,andreachingthegoalsetoutintheParisAgreementwillsurelyrequireadditionalefforts.

While the sectors under the EU ETS are decarbonizing, especially the power sector, it was onlymarginalindrivingthisprocess.Anumberofreasons,includingtheinclusionofinternationalcredits,theeconomiccrisis,aswellaspolicyoverlaps,haveledthemarkettobeoversupplied,keepingEUApricesdown.

Therecent increaseinCO2pricesmight indicatethat thiswillchangeinthefuture,andouranalysis

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1 BackgroundTheEUETS recently completed its P4 review,which canbe seen as an importantmoment.With thisreview,theEuropeaninstitutionsfeelthattheyhavepreparedtheEUETSforlifeuntil2030,inaworldwherethereareNationalDeterminedContributions(NDCs)undertheParisAgreement,andotherETSsoperatingthattheEUETScanbecomparedto.

Asanyotherundertaking,theEUETSrequires,periodically,anassessmentregardingitswell-functioningandthedeliveryofitsobjectives.Inthisrespect,theEUETSisnotdifferent,andshouldnotbetreateddifferently, from any other activity. Article 10(5) of the EU ETS Directive provides for such a yearlyassessment,tobecarriedoutbytheEuropeanCommission.

The revisedEUETSdirectiveadds theobligation toalso reporton ‘other relevant climateandenergypolicies’,andtheproposedGovernanceoftheEnergyUnionlegislationrequiresthis‘functioningofthecarbon market report’ to feed into the yearly ‘State of the Energy Union Report’. This is veryencouraging.

The “State of the EU ETS” Report is not intended to duplicate or replace existing authoritativework,especially thatundertakenby theEuropean institutions. Itaims tobean independentcontribution to

The recent increase in CO2 pricesmight indicate that thiswill change in the future, andour analysisshows thatpricesof €10-30/toncouldbesufficient tomake low-emissionalternatives competewithcoalandgasduring2020-2030.

Monetary impacts have so far mostly been limited to combustion of fuels installations, while freeallocations have covered costs for the industrial sector.However, itmust benoted that, contrary toPhase2(P2),freeallocationismuchmoreinbalancewithactualemissionsduringPhase3(P3),haltingthegrowthorevendecreasingthecumulatedsurplusofallowancesinmostindustrialsectors.

Carbon leakage risks from direct costs have so far seemed to bemitigated, but indirect costs are acontinuousconcernintermsoftheprovisionsthatapplytoit.Sincethereisnoharmonizedapproach,not all Member States have compensation schemes in place, meaning a potential distortion existsacrossEurope.

Our eight KPIs to evaluate the functioningof themarket show themarket functioned slightly bettercompared to lastyear:threeoutoftheeighttrackedKPIsexhibitedanimprovement,whileonlytwoKPIsshowedaworseningperformance.Despitethatsomecriticalpointsremain,wecanstatethatthemarketisfunctioningwell,andevenshowingsignsofimprovement.

To ensure that the EU ETS is ‘fit for purpose’ and ready to face future challenges, we identified anumberofissuesthatwillneedtobemonitoredinthecomingyears,including:

• Restoreshort-termscarcitythroughtheMarketStabilityReserve;• MaketheEUETSresilienttopolicyinteractionsandtopolicyuncertainty;• MaketheEUETSgovernanceoperational;• Managecarbonleakagerisk;• Align the EU ETS with the long-term EU climate ambition, compatible with Paris Agreement

goals;• Provide financial support for low-carbon competitiveness of EU industry and the transition

towardsalow-carboneconomy.

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thepolicydebatetoensurethattheEUETSis“fitforpurpose”andtodiscussthecurrentstateofplayintheEUETS.

Whilethetemptationwillalwaysbethere,asarule, itwilltrytoabstainfromprovidingsolutionsandmakingrecommendations.Itfocusesonidentifyingissuesandmakingassessments.Itisintendedasa“snapshot”.

WhiletheEUETSisacomplexinstrument,andforsomeaworldinitself,itdoesnotexistinavacuum.Forallitsfaults,theEUETSshouldnotbecomparedtoanidealworld,buttorealoptionsthatwouldbeavailabletoaddressclimatechange.

Itmust alsobe remembered that theEUETSoperates in ahighly interconnectedenvironmentand isaffectedbyclimatechangeandotherpolicesatdifferentlevels:global,EUandEUMemberState.Ithastolivewiththatreality,andrespondtoit.

The prolonged economic slump that it was subjected to, together with other factors, has created asystemicsurplus,whichisareality. Inaddition,theEUETSwasalsocreatedlackingthemechanismtomimic reducedsupplyasa resultof reduceddemand.Both these issuesarebeingaddressed,but thesolutions,whileidentifiedandlegislated,willonlybecomeoperationalinthenearfuture.

Meanwhile,theEUETShastocontinuetointernalizenewdevelopmentsthatarerelevant.ThisincludesBrexit and international efforts to address climate change. COP 21 in Paris has brought the ParisAgreementandtheframeworkforanever-increasinglevelofambition,especiallycarbonneutralitybythe second half the century, aswell as an upcoming IPCC special report on 1.5°C. This has “changedeverything”,andwithittheEUETS.

Finally, asmentioned, the EU is not the only jurisdiction pricing carbon anymore. It is now part of agrowingmovementtowardscarbonpricing,withsomejurisdictionsthatmayevenhavehigherlevelsofcarbonpricesthantheEUETS.

2 AEUETS“fitforpurpose”InordertoassesswhethertheEUETSis“fitforpurpose”,wefirstneedtoidentifytheparameterswhichmeasureitssuccess.Simplyput,“whatdoweexpecttheEUETStodeliver?”

In many cases, there are no clear quantitative indicators for what the EU ETS may be expected todeliver. Someof theassessmentswill havea level of subjectivity andpolitical judgement attached tothem. Inothercases,objective,quantitative indicatorsmayemergegradually,asexperience isgainedwith thesemechanisms,both in theEU,butalsoaround theworld. Finally, in somecasesexperiencewithothermarketsmayprovidebenchmarks.

In this context,weneed to remindourselves thatArticle 1of the EUETSDirectiveoutlines its broadobjectives:

“ThisDirectiveestablishesaschemeforgreenhousegasemissionallowancetradingwithintheCommunityinordertopromotereductionsofgreenhousegasemissionsinacost-effectiveandeconomicallyefficientmanner.ThisDirectivealsoprovidesforthereductionsofgreenhousegasemissions to be increased so as to contribute to the levels of reductions that are consideredscientificallynecessarytoavoiddangerousclimatechange.”

Someobjectivesareclearlyenunciatedandidentified,whilesomestakeholdermayseeotherobjectivesas implicit. Asalsomentioned in the2017Stateof theEUETS report (Marcuet al, 2017), thedirectdeliverablesinclude:

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1. Environmentaldelivery.DoesitdeliveragainstabsoluteenvironmentaltargetsasexpressedintheEUETSDirectiveandtheEU’slong-termclimatechangeobjectives?

2. Economic delivery. The reference in Article 1 of the EU ETS Directive could be interpreted asreferring to macro-economic efficiency and cost-effectiveness for compliance. Alternatively,economic efficiency can be seen as being dynamic,while cost effectiveness as amore snap shotview.Aspartof itseconomicdelivery, theEUETSshouldalsoprovideeffective,andproportional,protectionagainsttheriskofcarbonleakage.

3. Market functioning. It is worth having amarket only if it functionswell and leads to good pricedelivery.

Rightorwrong,other“deliverables”havecometobe“expected”.Forexample,thegoodfunctioningoftheEUETShas come tobeequated,wrongfully inor view,with thedeliveryof a “rightprice”whichwouldincentivizecertaintechnologiesoractions.

Another important deliverablewhich the EUETS increasingly is expected todeliver, is that of a long-term(competitive)advantageforEurope.Indeed,stakeholdersareoftheopinionthatEUETSprovisionsshouldhelpacceleratethetransitiontoalow-carboneconomyby:

• Channelingsufficientinvestments;• Creatingthepremisesforalow-carbonproductmarket;• Helpingtoaddresssocialimpactsassociatedwiththetransitiontoalow-GHGeconomy;• Ensuringtherightlevelofprotectionforindustry,bothfordirectandindirectcosts;• Incentivizingbehavioralandsystemicchange.

One additional delivery is the role that the EU ETS has in being a pioneer and promoting carbonmarkets as a tool for addressing climate change, and proving the incentive to work towards aninternationallylinkedcarbonmarket.Therehavebeenmanystudies,includingtheAnnualICAPReport(ICAP,2018),whichshowshowcarbonpricinghasspreadovertheglobe,withcarbonmarketsplayingaprominentrole.

WiththelaunchoftheChinesenationwidecarbonmarketattheendof2017,thecoverageofemissiontradinghastripledinlittlemorethan10years(ICAP,2018).WhilethisisnotadomesticEUdelivery,itisneverthelesscritical,giventheimportanceofhavingotheroperationalcarbonmarkets,andtheabilitytodeliveronEUETSobjectives,withoutjeopardizingthecompetitivenessofEUindustry.

Inexaminingtheseareasofdelivery,theReportwillfocuson:a) QuantitativeandqualitativeindicatorsforthefunctioningoftheEUETS,putinthebroader

contextoftheEUandinternationalpolicieswithwhichitinteracts.b) Lessonslearned,andemergingissues.c) Areasthatrequirefurtherexamination.

3 Relevantpolicyandgovernanceissues

3.1 Phase4review

In July 2015, theCommissionpresented a legislative proposal to revise the EUETS for thepost-2020period. After six Triloguemeetings,making the process longer thanmany experts had anticipated, aprovisional agreement was reached on November 9, 2017. The Directive was adopted onMarch 14,2018andcameintoeffectonApril8.

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Withthisreview,theEuropeaninstitutionshavetriedtotackleanumberofissues,includingaddressingthehistorical surplusof EUAs,making theEUETS supplymore responsive to changes indemandandable to dealwith future oversupply, increasing the funds available for innovation andmodernization,andmakingfreeallocationmorereflectiveofactualproductionandemissionlevels.

Anumberofparametershaveremainedunchanged,suchastheshareofauctioningandfreeallocation(57%-43%2), the inclusion rules and auctioning level (15%) for domestic aviation, and the fact thatshippingemissionsarenotyetincluded,awaitingactiontobetakenbytheIMO.OtherparameterswillchangeinP4comparedtoP3,forwhichaselectedoverviewcanbefoundinTable1.

Table 1. Selected list of changes between Phase 3 and Phase 4 Parameter Phase3 Phase4

End-yearcap 1834mtin2020 1372mtin2030

LRF 1.74% 2.2%

FlexibilityofAuctionShare(InlightofCSCFavoidance)

/ Reductionofupto3%oftheshareofallowancestobeauctioned

Backloading Auctionof900mallowancespostponed(400min2014,300min2015and200min2016)

900millionallowancesbackloadedin2014-2016willbetransferredtotheMSRratherthanauctionedin2019-2020,andconsequentlyupforinvalidationin2023

MSR 12%intakerate 24%intakerateforthefirst5years

InvalidationofallowancesintheMSR

/ From2023,yearlyinvalidationofallowancesabovethenumberofallowancesauctionedtheyearbefore

VoluntarycancellationofallowancedbyMemberStates

/ OptionforMemberStatestocancelallowancesfromtheirauctionsharetocounteracttheimpactofclosingdownelectricitygenerationcapacity,uptotheaverageverifiedemissionsoverthelastfiveyearsprecedingtheclosure

Carbonleakagelistcriteria(Qualitativeassessmentlimit)

Carboncosts≥5%ANDTradeintensity≥10%//

Carboncosts≥30%ORTradeintensity≥30%

Tradeintensity*emissionsintensity>0.2

(>0.15)

Benchmarkrates Ex-antedecided,ascalculatedbytheCommission(fixed)

Willreflectactualintensitychangesinthesector(annualreductionratescappedat0.2%minimum,and1.6%maximum)ascalculatedbytheCommission.BenchmarkvalueswillbeupdatedtwiceforP4

Adjustmentoffreeallocationbasedonchangeinproductionlevels

Onlyreducedwhenproductionlevelsdecreasebyasignificantamount(50%,75%and90%)

Reflectactualchangesinproductionlevelonthebasisofarollingaverageof2years.Changesabovea15%thresholdwithrespecttothebaselineperiodshouldbereflectedintheamountoffreeallowancesallocated

Freeallocationtosectorsnotdeemedatrisk(includingfordistrictheating)

80%,linearlydecreasingto30%by2020,withaviewtoreach0%in2027(30%fordistrictheating)

30% until 2026, linearly decreasing to 0% by 2030(30%fordistrictheating)

Indirectcostscompensation

TobedecidedbyMemberStatesinaccordancewithStateAidguidelines

TobedecidedbyMemberStatesinaccordancewithStateAidguidelines,butanon-bindinglimitof25%ofauctionrevenues,includingobligationtoreportreasonstogooverthislimit+enhancedtransparencyrulesforuseofauctionrevenues

CarbonMarketReport Functioningofthecarbonmarket(includingauctions,liquidityandthevolumestraded)

ExplicitlystatesthattheCommissionshallreporton‘otherrelevantclimateandenergypolicies’

2 The percentage of free allocation can increase up to 3% during Phase 4, at the expense of the auctioning share, to avoid the application of the cross-sectoral correction factor

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NewEntrantsReserve 5%oftotalallowances(around780mallowances,ofwhich300mwenttoNER300)

Non-allocatedallowancesfromP3+200mallowancesplacedintheMSR

Modernizationfund / 2%oftotalallowances.Canbeincreasedbyupto0.5%ifthefullflexibilityforavoidingtheCSCFisnotused

Innovationfund NER300:300mallowances(originatingfromtheNewEntrantsReserve)

400m+50munallocatedallowancesfromtheMSR+unspentallowancesfromNER300+Canbeincreasedbyupto50mifthefullflexibilityforavoidingtheCSCFisnotused

One-offflexibilityfromtheEUETS,includedintheEffortSharingRegulation

/ AnumberofMemberStates3areallowed toachievetheirESRtargetsbyusingalimitedshare4oftheirETSallowancesthatwouldotherwisebeauctioned.Thereisalimitof100mtCO2atEUlevelovertheP4period

Article10cderogationonoptionfortransitionalfreeallocationforthemodernizationoftheenergysector

CertainMemberStateswithGDPpercapitabelow50%oftheEUaveragecouldgivelimitedtransitionalfreeallowancestopowersectorinstallationsinoperationbefore2009.Settogotozeroby2020.

Theschemehasbeenextendedto2030,forMemberStates with GDP per capita below 60% of the EUaverage.More limitations have been added, such asthat the transitional free allowances cannot be usedforhighlyemission-intensiveelectricitygeneration

Openissues

Whilethemainparameters forP4havebeendecided,anumberof issuesstill remainopen,orup forreview.TheseissuesmightimpactthefunctioningoftheEUETSanditspricethroughoutP4,inwayswecannotfullypredict.

Thepossible review,whichmaybe triggeredasa resultof the implementationprovisions in theParisAgreement, is arguably themost important open issue. At the same time, Article 30 of theDirectivestates that the Commission should ‘report’ on each global stocktake (2023 and 2028 in P4),with theview to propose amendments (e.g. changes to the LRF) or additional policies ormeasures needed toreachthe ‘necessarygreenhousegasreductions’.Also in lightofArticle30,climatepolicymeasures inother major economies should be kept under review, which might have implications for the carbonleakagemeasures.

Besidesarticle30,whichcapturesageneralobligation to review,other reviews in thepipeline forP4include:theadoptionofthenewcarbonleakagelistin2019;thereviewsoftheMSRin2021and2026;andupdatesofthebenchmarksfor2021-2025andfor2026-2030.

Thereareotheropenandunclearissuesbeyondthese‘known’reviews:

• Brexitwillhappenin2019,butitisstillunclearhowitwillunfold,andhowGreatBritainwillrelatetotheEUETS;

• CORSIA’s pilot phase will start in 2021, but it is unclear whether the scheme will be deemedsufficientlyambitioustokeepinternationalaviationoutoftheETS;

• AparagraphwasaddedinthepreamblesoftheP4Directive,statingthateithertheIMOortheEU‘shouldstartaction’by2023.Whatthismeans,orwhatthescopeofapossibleinclusionofmaritimeemissionswouldentail,stillremainsunclear.

3Luxemburg,Sweden,Denmark,Finland,TheNetherlands,Austria,Belgium,IrelandandMalta 4Rangingfrom2%to4%ofthecountry’s2005emissions

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ExpectationsafterP4review

Priceforecastscenarios

Whilethisreport isnotamarketanalysisreport, it is intendedtoprovideaviewontheforecaststhatsomeof theanalystshaveput forwardat this special time,when therearehighhopes that,with thecurrent P4 reforms, the EU ETS will regain its luster. The one variable that was factored in was theassumptionBrexit/noBrexit.Wehope for this forecast to becomeabenchmark againstwhich futureyearscanbejudged,aswellasprovideahistory,forfuturereference,offorecastseveryyear.

Figure1indicatesthattheBrexitscenariosseemtoshowalowerpriceintheearlyperiod,withthepricethensurpassingtheno-Brexitscenariopost2020.Thecrossoverpointvaries,buttheseforecastsareingeneraldirectional inthestorytheytell.Thepricedifferentialalso increasestowardstheendofP4, iftheEUistomaintainthesamelevelofeffortandachieveitstargetswithouttheUK.

Figure 1. EUA price scenarios for Brexit/no Brexit, with EU targets of 30% RES and 30% EE by 2030.

Source:NomismaEnergia,ICISandPointCarbon,2018

Note:PointCarbonpricescenarioisfor27%RESand30%EE

MarketSentimentSurvey

Stakeholdersclaimthatmarketsentimenthasplayedanimportantrole,moresothanfundamentals,inthebehavior of the EUETS.As a secondpart ofwhatwehopewill bea yearly updatewhich canbebenchmarked,wehavedoneaMarketSentimentSurvey.Forthispurpose,wesentoutashortsurveyof6 statements5 to 118 persons6whichwe believe are “players& stakeholders” in EU ETS. The sample

5 ThefollowingstatementscouldbeansweredwithStronglyAgree–Agree–NeitherAgreenorDisagree–Disagree–StronglyDisagree:

1. TheEUETSgovernancewillprovideastableandpredictableframeworkforaninvestmentsignal.2. TheEUETSPhase4parameterswillleadtopricepatternsin2020-2030whicharecommensuratewiththeinvestment

trajectorynecessaryfor80-95%reductionby20503. TheEUETSwillprovideanadvantagefortheEUbusinesscommunity.4. TheEUETSwillrequiresignificantchangestotheMSRafterthe2021review5. ThemechanismsinplaceintheEUETSareabletoaddresstheimpactsofpoliciesthatwilloverlapwiththeEUETS.6. Thenewmid-centuryEUdecarbonizationstrategywillstronglyimpacttheEUETS.

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

2016 2018 2020 2022 2024 2026 2028 2030

Price(Euro)

Nomisma- Brexit ICIS- Brexit PointCarbon- Brexit

Nomisma- noBrexit ICIS- noBrexit PointCarbon- noBrexit

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includespolicymakersfromEUMemberStates,industrialoperators,traders,andcivilsociety.Theywereselected based on our judgement, and are not intended as a statistically representative. In total,wereceived75anonymousresponses,representingaresponserateof63,5%.

In examining the outcomes, the following observations captured our attention, which gives aninteresting indicationof thegeneralsentimentofstakeholderswithrespect totheEUETS. AllgraphscanbereviewedinthePowerpointannexedtotheReport.

Figure 2. Results for survey questions 2, 5 and 6.

A firstobservation is that stakeholders arenot convinced that the current EUETSparameterswill besufficienttoreachtheEU’slong-termenvironmentaltargets:stakeholdersseemdividedintheirviewonwhether or not the EU ETS governance will provide a stable and predictable framework for aninvestmentsignal,andonly14%ofrespondentsagreewiththestatementthatpricepatternsinP4willbecommensuratewithan investment trajectorynecessary to reach the2050 targets.Moreover,65%thinksthatthenewmid-centurydecarbonizationstrategy,whichwillpossiblyleadtohighertargetsfortheETSsectors,willhaveastrongimpactontheEUETS.

Secondly,stakeholdersexpectthattheoverlapofclimatepolicieswillremainapressingissueduringP4,since only 20%of respondents think that the current EU ETS instrumentswill be able to address theimpactsofoverlappingpolicies.

Finally, stakeholdersaredividedonthequestionwhether theEUETS isbeneficial forEU industryandbusinesses:while36%of respondents think theEUETSwillprovideanadvantage for theEUbusinesscommunity,36%disagreewiththatstatement.Atthistime, it isnotaringingendorsement,but theseareearlydaysforstakeholderstoreacttotheP4EUETSreform.

3.2 RelevantissuesfromtheEnergyUnion

TheEUETSisoneofthefivecorepolicyareasoftheEnergyUnion,andthereformforitsfourthphasecan be seen as part of a broader climate and energy reform package. In November 2016, theCommissionreleasedthe“CleanEnergyforallEuropeans”package,includingareviewoftheRenewable6 32 representatives of EU Member States, 30 (public) research institutes (Think Tanks, Universities and NGOs), 20representatives of industrial sectors, 19 representatives of the energy sector, 6MEPs and 17 ‘others’ (which include banks,exchangesandprivateanalysts).

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Energy(RES)DirectiveandEnergyEfficiency(EE)Directive.ThispackagealsoproposedaRegulationonthe Governance of the Energy Union, which aims to ensure that policies and measures at EU andnational level are "coherent, complementary and sufficiently ambitious," ultimately allowing thedeliveryoftheEnergyUnionanditsgoals.

EnsuringthecoherenceandcomplementarityofpoliciesshouldincludeensuringthatdifferentEUandnational climate policies do not impact each other’s effectiveness.However, there has policy overlapbetweentheEUETSandotherpolicies in recentyears: theunmanagedeffectsofoverlappingclimatepolicies,bothattheEU(e.g.RESandEEDirectives)andnationallevel(e.g.coalphase-out),havebeenoneofthefactorsthathavehinderedtheeffectivenessoftheEUETSasadriverofdecarbonization.

ToensuretheefficientfunctioningoftheEUETS,theseoverlapsneedtoberecognized,quantified,andmanaged.Thisshouldbedoneattherightpolicylevel–thatis,atthelevelthathasauthorityoverALLthepoliciesthatoverlap.InthecaseoftheEUETS,RESandEE,thiswouldbeattheleveloftheEnergyUnion.

TheamendmentsforP4includeanumberofprovisionsthataimto,explicitlyorimplicitly,addresstheeffectsoftheseoverlaps:

• VoluntarycancellationofallowancesbyMemberStates: intheeventofclosureofelectricity-generationcapacityduetonationalpolicies,MemberStatesmaycancelallowancesfromtheirauctionsharetocounteracttheimpact,

• Market Stability Reserve: the MSR was introduced to address the historical surplus ofallowancesinthemarket,aswellascorrectforimpactifanyoverlapthatmayoccur,

• Functioning of the carbonmarket report: states explicitly that the Commission shall include‘otherrelevantclimateandenergypolicies’inthereport.

While the inclusion of such provisions can only be welcomed, one could argue that some of theinterventionsarenotattheappropriatelevel.Indeed,theEUETSisnottheplacetoanalyzeinteractionsbetween itself andother ‘relevant climateandenergypolicies’, nor is it theplacewhere thedecisionshouldbemadeof‘whattoadjust’.TheassumptionseemstobethatitistheEUETSthatwillbeinsomeway“adjusted“,withnoconsiderationbeinggiventoadjustinganyotherpolicy.

Asmentionedearlier,the‘raisond’être’ oftheGovernanceoftheEnergyUnionRegulationistoensurethatpoliciesandmeasuresatvariouslevelsarecoherent,complementaryandsufficientlyambitious.Assuch,establishingaframeworkforaddressingoverlapbetweendifferentelementsoftheEnergyUnionshould ideallybedoneintheGovernanceRegulation.Atthis level,clearprovisionsshouldbeadoptedthatstipulatewhoshouldanalyzeandquantifytheoverlap,andhowthedecisionshouldbemade,inatransparentandpredictablemanner,onwhichpolicyinstrumentshouldundergotheadjustment.

However, theCommissionproposal for theGovernanceRegulationdoesnot includeanyprovisions toaddress this overlap. It does stipulate that Member States should describe and assess overlap andinteractionsbetweennationalpolicies,butthereisnoframeworkintroducedtoaddressinteractionwithpolicies at the EU level. The general approach adopted by the Council also does not include anyamendmentstoaddressoverlap.

TheEuropeanParliamentdoesseemtohaverecognizedtheissue,andhasadoptedsomeamendmentstoaddressit:

• Article 8 (Analytical basis of the integrated national energy and climate plans): “Theassessmentshallincludeaquantitativeorqualitativeevaluationofanydocumentedinteractionsbetweennationalpoliciesandmeasures,andUnionclimateandenergypolicymeasures.”

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• Article25(Assessmentofprogress):TheCommissionshallassess:o “the overall impact of the policies and measures of integrated national plans on the

operationoftheEUETS.”o “the accuracy of Member State estimates of the effect of national level overlapping

policies andmeasures on the supply-demandbalanceof the EUETS, or, in absenceofsuchestimates,conductitsownassessmentofthesameimpact.”

AstheGovernanceRegulation iscurrentlyunderTriloguenegotiations, it remains tobeseenwhethertheseamendmentswillbeincludedinthefinaltext.

3.3 RelevantissuesfromthenewEUlong-termclimatestrategy

Published in 2011, the “Roadmap for moving to a competitive low carbon economy in 2050” (2050Roadmap)providedtheEUwitha long-termclimatestrategy.Duetochangingcircumstances,suchastheParisAgreementin2015andthefallingcostofrenewables,theEuropeanCommissioniscurrentlyinthe process of preparing a new document, a “Strategy for long-term EU greenhouse gas emissionsreduction”,whichtheEUCouncilhasrequestedbythefirstquarterof2019(EuropeanCouncil,2018).How this new strategy will settle different aspects of the new EU long-term climate strategy willinevitably have implications for the future of the EU ETS – most critically on the assumption oftechnologyneutrality,and(new)long-termtargets.

Technologyneutrality

Thecurrent2050Roadmap isbuiltuponanassumptionof technologyneutrality.As such, itdoesnotpushforanyparticulartechnology,butrecognizesamarketapproachtodecarbonization:itreliesontheEUETStodeliverdecarbonizationinacost-effectivewayforthesectorsandinstallationsitcovers.

However,giventhemagnitudeofthedecarbonizationchallenge,thenewdocumentcould,inprinciple,deviatefromtechnologyneutrality(e.g.throughpublicsupportforaparticulartypeofinfrastructure),inwhichcaseonecanaskthequestionwhethertheEUETSwillstillbeconsideredtobethemaindriverofdecarbonizationintheEU.

Long-termtargets

One of the most important reasons that a new long-term climate strategy is needed, is the ParisAgreement,andtheincreasedlevelofambitionitpromotes.Todeliveronthe1.5°Cand2°Cgoal,theEUwillhavetogobeyondthe80-95%by2050decarbonizationscenariositenvisagedin2011.TheEUwillhavetoachievecarbonneutralitybymid-century,andnegativeemissionsshortlyafter.Moreambitiouslong-termemission targets could require fasterdecarbonizationofEUETS sectors,perhaps throughahigherLRF,whichwouldputupwardpressureonEUAprices.

TheconcreteimplicationsofcarbonneutralitywilldependonhowthenewclimatestrategyenvisagesthedistributionofeffortbetweenETSandnon-ETSsectors.ETSsectorscouldstillemitifnon-ETSsectorscan compensate adequately, or through the introduction of carbon capture and storage (CCS).Alternatively,ETSsectorscouldultimatelyhavetobecomenetsinks.Ofcourse,thehighertheexpectedcontributionfromETSsectors,themoreupwardspressureonEUApricesinthecomingdecades.

4 EnvironmentaldeliveryIftheEUETSistobeconsideredsuccessful,environmentaldeliveryiskey.However,thisdeliverymustbeseenasbeingmulti-faceted,inthatitneedstobeexaminedfordirectachievement,aswellasthatit

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achievesthelong-termclimatechangeobjectivestowhichtheEUhassubscribed.ThislaterconditionisnotexplicitlyexpressedintheEUETSDirective,andcanbeseenasbeingapoliticaldecisionintermsofthetiming(milestones)oftheefforttoreachthelong-termEUdecarbonizationgoals.

4.1 Deliveryagainstthetradingperiodtarget

Inthiscasetheissueisstraightforward:doestheEUETSdeliveragainstitscurrenttradingperiodtargetfor2020 (-21% forETS sectorswhencompared to2005)?A longer-termview,butalsoa clear target,bringsasecondquestion:isitexpectedtodeliveragainsttheagreedtargetforthenexttradingperiod,areductionof43%by2030(vs.2005)?

TheEUETStarget for2020 isbeingreached,aheadof time.TheEuropeanEnvironmentAgency (EEA)figures show that by the end of 2016, emissions from EU ETS covered installations had alreadydecreased by 26% compared to 2005 (EEA, 2018). For 2017, EEA official data is not yet available.Preliminary2017datafromDGClimateActionshowsthatEUETSemissionsfromstationaryinstallationswere0.6%higherthanin2016,whichconstitutesthefirstincreaseinsevenyears(EUTL,2018).

Verified emissions have been under the target pathsince the start of P2. In Figure 3 we consider theobserved historical relationships between changes inGDP and changes in emissions and have created acorridorofpotentialfutureemissionlevelsdependingon GDP growth rates between 0 and 2 percent peryear (currentGDP growth trends fluctuates around 2percent, in contrast to a stagnation in P2). Thisindicates clearly that only under high GDP growthrates actual emissions might exceed the target pathtowards the end of P4. This proposition is howeversensitive to any policy changes, including renewablesdeploymentand/orcoalphase-outs.

Howmuch of this result is due to a decrease in CO2intensity,andhowmuchitisduetoadecreaseinthelevel of economic activity, is also an important issue.According to the “2050 Roadmap”, the EU wants allsectorstodecarbonizeandcontribute,atopicexaminedinChapter5.

4.2 DeliveryagainstEUlong-termdomesticenvironmentalcommitments

To what extent does the trading period target lead the EU to deliver on its longer terms goals andcommitments? This is also relevant to the economic efficiency of the delivery of the EU’s long-termclimatechangeobjective.

AsdiscussedinMarcuetal(2016),EUdomesticclimatechangetargetsareexpressedthroughanumberofdocuments.The“2050Roadmap”mentionsanumberofintermediateGHGreductiontargetsfortheEUasawhole(40%by2030,60%by2040,and80%-95%by2050comparedto1990),andproposedareductionof90%comparedto2005forsectorscoveredbytheEUETS(EuropeanCommission,2011).

AsshowninFigure4,aLRFof2.2%from2021correspondsto85%reductionofGHGemissionsin2050comparedto2005.Tobeconsistentwitha90%reductioninETSemissionsin2050comparedto2005

Figure 3. Verified emissions, target path and projected emissions

Source:WegenercenterelaborationsonEEA,2018and

EUTL,2018Note:datafor2017arebasedontheEUTLofApril3

missinggapsareestimatedbyWegenerCenter

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emissionswouldrequireanincreaseintheLRFto2.4%in2024.Thiswouldcumulativelyreducethecapbyaround1,660MtCO2eby2050.

Figure 4. EU ETS long-term trajectory

Source:I4CE,Enerdata,IFPEN,2017

4.3 Deliveryagainstinternationalenvironmentalcommitments

Thepossible impactof theParisAgreementonEUETSbehaviorwasdiscussed last year in the “2017State of the EU ETS Report” (Marcu et al, 2017), and raised the question of the extent towhich theinternational process could affect the objectives, and market dynamics, of the EU ETS. The ParisAgreement, and the March 2016 EU Council, did not affect EUA prices. The market had alreadyinternalized a “success”, as the2030EUETS target had alreadybeendecidedby the EUCouncilwellaheadofCOP21.

In2018, the situation isdifferent.On theonehand theEUETSP4 reformwasadopted,whileon theother hand the international process ismoving to an important phase,with the expectation that the‘Rulebook’fortheParisAgreementwillbeadoptedatCOP24inKatowice.

Inaddition,theoutcomesofthepoliticalphaseoftheTalanoaDialogue,whichalsotakesplaceduring2018, isunclear,andmay leadtoapush to reinforce the levelofambition throughadoptionofmoreambitiousNDCs.

Fromascientificpointofview,atCOP21,theCOPrequestedtheIPCCtoproduceaspecialreportontheimpacts of global warming at 1.5°C above pre-industrial levels. This report will address appropriatemitigationpathwaystoreach1.5°Cbutalsotheirimpactsonthenaturalandhumansystems.Itwillalsodescribewaystostrengthenandimplementtheglobalresponsetothethreatofclimatechange,whileaddressing,amongothers,sustainabledevelopmentandpovertyeradication.There is littledoubtthatthisreportwillreinforcetheconclusionsofthe5thIPCCARreportontheneedfor‘negativeemissions’.

It is unlikely that the report will have a direct impact on EU ETS prices when it will be published inOctober2018.However,theconclusionsofthisspecialreportcouldhaveasignificantimpactonCOP24and on the Talanoa Dialogue, by pressuring the negotiation process, and reinforcing the sense ofurgencytoact.

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4.4 Lessonslearnedandissuestounderstandbetter

The EU ETS is delivering against its trading period target. Emissions have beenunder the target pathsince 2009, and also under the available supply between 2009 and 2013, in particular due to theeconomicrecession.Thedistancebetweenverifiedemissionsandthepathwaydecreasedbetween2014and2017(234millionto178milliontons).

Translating theParisAgreement intodomesticpolicies is theway to impact the carbonmarket.AfterParis,therewasnoadjustmentinEUETStargets,andassuch,noconcretemarketsignaltorespondto.Thus,itappearsnormalthattheP4reviewhasbeenadoptedwithoutanystrengtheningofthetargets.

However,whenEUdomesticpoliciesdobecomealignedwith internationaldevelopmentsthroughtheadjustmentof EU targets, then, togetherwithanewEU long-termclimate strategy, theymayhaveasignificantimpactontheEUETS.

Inthiscontext,itisalsoimportanttonotethattheEUETSisnolongertheonlycarbonpricingsystem.How its environmental delivery compareswith that inother jurisdictions is important, especially as itwillimpactthelevelofeffort,andcompetitivenessandcarbonleakageissues.Article30oftheEUETSDirective stipulates that the carbon leakage rules ‘shall be kept under review in the light of climatepolicymeasuresinothermajoreconomies’.

The latest ICAP status report (ICAP, 2018) shows that, at present, 15% of global GHG emissions arecovered by emission trading systems, while more are scheduled for implementation. Moreover, thelatestWorldBank’s“StateandTrendsofCarbonPricing”(WB,2017)reportalsoshowsthat,asoftheend of 2017, 55%of globalGHGemissions are covered byNDCs that feature references to domesticand/orinternationalcarbonpricing.

5 Economicdelivery

5.1 Emissionanddecarbonizationtrends

The currently agreed target path for P4 has astrong bearing for both environmental delivery,andthestringencyofthecap.Untillastyear,totalemissions declined by about 2.3 percent per yearduring P3, with fluctuations caused by activitylevels and weather. This overall trend can bedecomposed into an annual average decline ofindustry emissions of around 0.3 percent and ofcombustionemissionsofaround3percent.

However,emissionsin2017mightsignalthatthesetrendsarechanging.For thefirst timesince2010,total emission increased again, by 0.6 percent.Emissions from combustion remained stable, butindustrialemissionsexpandedby1.9percent.Thisreflectsaboveallasurgeineconomicactivity.

Thestringencyofallowancesisnotonlydeterminedbythetargetpathandactualemissions,butalsobyevents (e.g. the economic crisis) and supply-side regulatory interventions (e.g. the backloadingprocedure).Figure5comparesthedemandofallowances(actualemissions)withtheactualsupply.

Figure 5. Total supply of allowances and projected verified emissions

Source:WegenercenterelaborationsonEEA,2018andEUTL,

2018Note:datafor2017arebasedontheEUTLofApril3

missinggapsareestimatedbyWegenerCenter

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Thecurrentsupplysurpluswastriggeredbyanumberofcauses,including:thedropindemandduetothedecreaseineconomicactivity;theinflowofCERsandERUsinP2;andtheimpactsofpolicyoverlap.Ashortagewascreatedthoughbackloading,andcanbeseenbetween2014and2016.

In2017, supplyanddemandwas relativelybalanced.That isexpected tochangesignificantly in2019,whenapronouncedshortagecanbeexpectedduetothefunctioningoftheMSR.

Figure 6 shows the dominant role of thecombustion installations (mainly in thepower sector) in the EU ETS - theycontribute around two thirds of totalemissions. Emissions from the industrialsectorsoriginate from fourmain sectors:refining, steel, cement and bulkchemicals, which together account forthreequartersofindustrialemissions.

Figure7,whichpresentstheindexoftotalemissions in theEUETS,and the indexesfor industrial production (volumes) andelectricity generation, shows thatemissions for the EUETS as awhole (‘allinstallations’) exhibit a significantdownwardtrend,whichstoppedin2017.Thiscanmainlybeattributedtothecombustioninstallations,sinceindustrydoesnotshowadecreaseinemissionsduringthelast5years.

Figure 7. Index of emission and index of volumes of production

Source:WegenerCenterelaborationsonEEA,2018,EUTL,2018andEurostat,2018

Note:Industryproductionshowsthevolumeindexforproduction,combustionproductionshowstheindexoftotalgrosselectricityproduction(gwh)

Fromadifferentperspective,Table2looksatemissionsinindividualindustrialsectors.Inabsoluteterms,thedownwardtrendforemissionsduringtherecessionisunambiguous.Thebigindustrialsectorsshowa decrease in emissions compared to pre-crisis levels. Out of the bigger sectors, production of bulkchemicals seems to be the exception, with 2017 emission levels well above pre-crisis levels. The

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remaining sectors, together roughly 20% of industrial emissions, also show higher emissions in 2017comparedto2008.

Table 2. Verified emissions of stationary installations

Source:EEA,2018andEUTL,2018

Note:datafor2017arebasedontheEUTLofApril3missinggapsareestimatedbyWegenerCenter

Data from thedifferent industrial sectors (e.g. cement, pulp andpaper, andelectricity– as shown inFigure 8) indicates a decrease in carbon intensity. These conclusions need to be tempered by theavailabilityofdatafor independentresearch.Mostof thedataregardingcarbon intensitycomesfrombusinessassociations,andisoftenconfidentialanddifficulttoverify.Intensitydata,evendirectionally,isbasedonvalueadded,whichmayshowdifferenttrendsandmaybeattributedtomarketfluctuations.

Figure 8. Carbon intensity data for production of Paper and Pulp, Grey clinker and Electricity

Source:CEPI,CSI,EEA,2017

Note:PaperandPulp&GreyclinkerinCO2/ton(leftaxis)ElectricityingCO2/kWh(rightaxis)

Dataforothersectors,whichwasprovidedonanun-attributablebasis,onconfidentialcarbonintensitydataofindustrialproduction,alsoshowsanoveralldecrease.However,itmustbenotedthattheissueofdataavailabilityissignificantandwasalreadyraisedinthe2017StateoftheEUETSReport(Marcuetal, 2017). It was also raised during the preparation of the report in meetings with policymakers,stakeholdersandthedifferentsectorrepresentatives.

Verifiedemissions[mtCO2] 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Allstationaryinstallations 2,120 1,880 1,939 1,904 1,867 1,908 1,814 1,803 1,750 1,761Index 100 89 91 90 88 90 86 85 83 83Allcombustionoffuels 1,512 1,385 1,419 1,389 1,378 1,333 1,238 1,226 1,179 1,179Index 100 92 94 92 91 88 82 81 78 78Allindustrialsectors 608 495 520 515 489 575 576 577 571 582Index 100 81 86 85 81 95 95 95 94 96Allrefiningofmineraloil 142 132 130 130 124 128 125 128 127 126Index 100 93 92 91 88 91 88 90 90 89Steeltotal 159 110 131 130 123 141 143 142 136 140Index 100 69 83 82 78 89 90 89 86 88Allproductionofcementclinker 157 126 124 122 114 111 116 114 115 119Index 100 80 79 77 73 70 74 73 73 75Productionofbulkchemicals 32 29 30 29 27 39 39 39 39 39Index 100 91 94 90 85 123 122 123 122 123Paperorcardboard 27 24 25 24 23 23 22 22 22 22Index 100 88 95 91 86 85 81 82 81 83Ceramics 18 13 13 13 12 15 15 16 16 17Index 100 72 72 73 65 87 86 88 90 94Otheractivities 74 62 67 68 66 117 117 116 116 120Index 100 84 91 93 89 160 159 158 158 163

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Thisismadeespeciallycomplexforaddingcombustionemissionstotheindustrialsectortheybelongto,andseparatingfreeallocationforCombinedHeatandPowerplantsbetweentheirclients.

OneofthemajorbenefitsthattheEUETSisseenasbringingisthatoftransparency.This lackofdatamaynegatesomeofthatbenefit,makingitdifficultnotonlyforresearchers,butalsoformarketactorstohaveconfidenceinusingtheEUETSasahedginginstrumentforcarboncomplianceobligations.

5.2 IstheEUETSadriverforchange?

GHGemissionsfromtheinstallationscoveredbytheEUETShavesignificantlydecreasedoverthelast11years.However,itisnotcleartowhichextenttheseemissionreductionsweredrivenbytheEUETS.

InteractionsoftheEUETSwithotherpolicies

InteractionwithEU-levelclimateandenergypolicies

Thereareotherpolicies in theEU,whichalso lead to reductions inemissionsandhavean impactonemissionsfromEUETSsectors,evenwhenaimingatachievingotherEUobjectives–suchasdeployingrenewable energy sources and increasing energy efficiency. Figure 9 illustrates the EU policies thatimpactGHGemissions,andthereforeimpactthefunctioningoftheEUETS.

Figure 9. Landscape of EU legislations in the 2030 climate and energy policy framework

Source:I4CEandEnerdata,2018

Interactionwithnationalpolicies

MemberStatespoliciesmayalsohaveanimpactonGHGemissionsinsectorscoveredbytheEUETS,forexample,coalphase-outschemes.Coalpowerinstallationsaccountedfor39%ofallEUETSemissionsin2016(seeFigure10),whichhighlightsthepossible impactofcoalphase-outpoliciesontheEUETS. Insomecountries–Slovenia,Bulgaria,CzechRepublic,Poland,GermanyandGreece–emissionsfromcoalpowerrepresentmorethan50%ofEUETSemissions.

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Figure 10. Split of EU ETS emissions between coal power, other power and industry

Source:Sandbag,2017

SeveralMemberStatesannouncedcoalphase-outsinrecentyears–Irelandannounceditsphase-outinMarch 2018, while Denmark, the Netherlands, Italy and Portugal did so last year, joining Sweden,Finland,France,AustriaandtheUK,whocommittedinpreviousyears(EuropeBeyondCoal,2018).ThedebateinGermany,Europe’slargestcoalandligniteconsumer,isongoing.

OtherexamplesofnationalpoliciesimpactingtheEUETSincludenationalcarbonpricefloors.AftertheUKinitiativein2011,France,Finland,theNetherlandsandGermanyhaveindicatedsupportforthistypeofinitiativeduringrecentmonths.InMarch2018,FrancecalledonotherEUMemberStatestoadoptaregional carbonprice floor forpowergenerators topromotea shift away fromcoal tomoreclimate-friendlyfuels,withapricefloorbetween25to30eurosperton.

Focusondecarbonizationinthepowersector

TobetterunderstandtheroleoftheEUETSindrivingdownemissions,anin-depthanalysisofthepowersectorwillprovideagoodillustration.Between2005and2015,emissionsdecreasedby300MtCO2e(or23%)intheEUpowersector.Duringthesameperiod,theaveragecarboncontentofpowergenerationdecreased by 20% (see Figure 11). The carbon content decreased by well above 20% in at least tenMemberStates(forsomeeven40%to60%)between2005and2014.

Figure 11: GHG emissions from the power sector and carbon content of power generation (2005-2015)

Source:I4CEelaborationsonEurostat,2017

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AnalysisofhistoricaldriversofGHGemissionsinthepowersector

Aquantitativeanalysisofthecontributionofdifferentdrivers(I4CEandEnerdata,2018),estimatesthatemission reductions in the power sector over 2005-2015 were mainly driven by the deployment ofrenewableenergy–decreasingpoweremissionsbyaround360MtCO2e(seeFigure12).

Figure 12. Drivers of GHG emissions variations in the power sector in the EU (2005-2015)

Source:I4CEandEnerdata,2018

Otherfactors,whichcontributedtothedecreaseinemissions,weretheslightdecreaseintotalpowergeneration,andan improvementof theaverageefficiencyofpowerplants.Onthesideof the ledger,the falling shareofnuclearpower, changes in the fossil fuelsmix in favorof coal,andchanges in thecarboncontentofdifferentfossilfuels(especiallyforgas)contributedtoincreasesinemissions.

The “2017 State of the EU ETS Report” showed that while the EUA price does play a role in thedeploymentofrenewables,itisdefinitelynotsufficientonitsown(Marcuetal,2017).ThepriceofEUAsisoftenseenasapotentialtooltotriggertheswitchfrommorecarbon-intensivefuelsusedtogenerateelectricity-ligniteandhardcoal-tolesscarbon-intensiveones,likenaturalgas(CCGT).Figure13showstherangeofpossiblecoal-to-gasswitchingprices,andthepriceofEUAsbetween2005and2017.

Figure 13.CO2 switching price for different coal and gas generation efficiency in the EU28 in comparison with the EU ETS price

Source:I4CEelaborationsondatafromNomismaEnergiaforcoalandgasprices(respectivelyAPI2andTTF)andfromICE

FuturesEuropeforEUAsprice(forwarddec2007forphaseI;spotpriceforphasesII&III

ItalsoshowsthatthepriceofEUAswasabove,orcloseto,theswitchingpoint,onlyprior2011,butnotbetween2011and2016.Thereductioninemissionscomingfromacoal-to-gasswitchinthepre-2011period is estimated to have been more than outweighed by additional emissions coming from asubsequentgas-to-coalswitch,ascanalsobeseeninFigure12.

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In2017,duetotheincreaseinthepriceofcoalandCO2,coupledwithastablenaturalgasprice,thecostofgeneratingelectricity fromnaturalgaswascomparabletothatofcoal. In thissituation, theEUETScouldtriggerafuelswitch.

However,theseparticularconditionsshouldnotbeconsideredasnormal.Overthepreviousyears,coalhasbeenconsistentlycheaperthangas,lettingcoalplantsgainmarketshareattheexpenseofCCGTs,whichexplainsthenetcontributionofthefossilfuelmixtoemissionsinthepowersector.

Inconclusion, since2005,emissions in thepowersectorhavesignificantlydeclinedand,while theEUETS contributed, it did not play amajor role in the decarbonization of the power sector, whichwasmainlydrivenbythedeploymentofrenewableenergysources.

Itisimportanttonotethattherateofdecarbonizationinthepowersectorhasbeenroughlyinlinewithratesprojecteduntil2020indifferentscenarios,inparticularthe2050Roadmap.However,theserateswill have to greatly increase in the future in order to stay alignedwith the goals stated in the 2050Roadmap. It is estimated that carbon prices well above 40€/tCO2e would be necessary to drive thenecessarytransformationofthepowersector(Eurelectric,2009,2011).

Deploymentofnewtechnologies

Asecondgoal,notdirectlystatedintheEUETSDirective,istocreatemonetaryincentivesforindustrytoinvestinnewtechnologies,andnewprocesses,aimedatreducingemissions.Thisgoalistranslatedinthe ability of operators to anticipate the need for allowances, and thus future costs, and invest inresearchanddevelopmentoflow-carbontechnologies.

Theconstantdropinrenewableenergygenerationcosts,inparticularsolarandwindmayopenupnewopportunitiesforaswitchfromcarbon-intensivegenerationplantstolow-emissionalternatives.Figure14 shows the levelized costsof electricity (LCOE) for different generation technologies,which includerecent auctions held in Europe (for onshore and offshore wind). This can be then compared to therelativecostofdifferenttechnologies,intheperiodupto2030,forpricesof10€/tonand30€/tonCO2.

Figure 14. Dynamic levelized cost of electricity for different plants with CO2 price of 10 €/ton and 30 €/ton

Source:NENomismaEnergiaonIRENA,BEISauctions,Bundesnetzagentur,McKinsey,EIA

Assumptions:WACC=7%;API2(coal)andTTF(naturalgas)priceconstantovertheperiodandequaltotheaverageofthelastfiveyears(2013-2017);USD/EUR=1,20constant.

AsshowninFigure14,adynamicanalysisofthecostsofthedifferenttechnologiesupto2030highlightsthatfuelswitchmaynotoccurifthepriceofEUAsremainsat10€/ton.Onthecontrary,onshorewind

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andphotovoltaics(PV)willevenbecomelesscostlythancoal:onshorewindissettocompetewithcoalalreadyintheperiod2020-2025,whilePVwilllikelybecomecheaperby2030.

WhenweconsideraCO2priceof30€/ton,thelikelihoodofaswitchfromcoaltogasremainsuncertain,andsubjecttothefluctuationsofthepricesofbothcommodities.However,theswitchtoonshorewindand PVmay happen relatively soon.Moreover, in this scenario, hydropower and offshore wind alsobecomecheaperthancoalrespectivelyin2020and2030.

There isofcourseanothersidetothisstory:the incentivesforrenewableenergyhaveotherbenefits,includingsecurityofsupply,greenjobsandairqualityimprovementswhichneedtobefactoredinifarealcost-benefitanalysisistobedone.

Useofauctionrevenues

AuctioningrevenuesfromtheEUETScouldalsoplayanimportantroleinspeedingupthetransitiontoalow carbon-economy, if (parts of) these revenues are re-invested in climate action and low-carbontechnologies–ultimatelycontributingtotheEUETSbeingadriverforchange.

AccordingtotheEUCommission(2017a),thetotalamountofrevenuesfromtheauctioningofEUETSallowancesamountedtoapproximately€3.7billionin2013and€3.2billionin2014,risingto€4.9billionin 2015. The reported data indicates that approximately 82% of the auctioning revenues have beenused,orwasplannedtobeused,byMemberStatesfor“climateandenergypurposes”overtheperiod2013-2015.

Itmust be noted thatwhile projects that fit this category are self-reported byMember States, theyshouldbeinthescopeofArticle10(3)and3dofDirective2003/87/EC,stipulatingalistofacceptedusesof the auction revenues (such as contributions to the UNFCCC Adaptation Fund, reforestation indevelopingcountriesanddevelopingrenewableenergy).

WhiletheCommissiondidperformcheckstovalidatethereported information, the report highlighted importantissues, such as Member States that do not earmarkrevenues, a low level of detail on specific uses of therevenues, and inconsistencies between the reportedbreakdownandtotalofrevenuesused.Moreover,thereis a lack of independently verified figures with aconsistentmethodologyacrossmemberstates.

The inconsistencies in the use of revenues reported ishighlightedbyadifferenceof€825millionbetweenthetotal sum of revenues reportedasused for climateandenergypurposes,and thesumof revenues reported forspecificprojects.Solelybasedonthesumofrevenuesforspecificprojects,75%(€8.8billion)wasusedforclimateandenergypurposes.

This€8.8billioncanbefurtherdividedbetweendomesticuse (90%)and internationaluse (10%). Figure15 showsthatthemostimportantdomesticusesareforrenewableenergy (€2.89 billion) and energy efficiency (€1.95billion),followedbysustainabletransport(€774million).

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Figure 15. Use of auctioning revenues for climate and energy purposes

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For international use of EU ETS revenues, Member States reported channeling €210 million tomultilateral financial institutions and programmes, ofwhich €131millionwent to theUNFCCCGreenClimatefund.

Itisimportanttoputthesenumbersinperspective,againstthetotalamountsoffinanceforclimateandenergy purposes. The European Commission estimates that auctioning revenues used for domesticpurposes amounted to about 6.6% of total investments in climate action. Itmust be noted that thisrelativeweightvariesgreatlybetweenMemberStates,andbetweenobjectives(e.g.RenewableEnergy,EnergyEfficiencyorSustainableTransport).

Therelativeimportanceforinternationalpurposes,althoughdifficulttocompare,amountedtoroughly2.9%in2013and0,5%in2014oftotalinternationalclimatefinancefromEUpublicbudgetsandotherdevelopmentfinanceinstitutions.

5.3 Monetaryimpactsandcarbonleakage

Thereare two important issueswith respect to themonetary impacts causedby theEUETS.Ononehand,itshowsthetotalcostsforsectorsandinstallation,whichisequivalenttotheeconomicincentivetodecarbonize.Onetheotherhand,itisanindicatorfortheriskofcarbonleakage,asthesemonetaryimpactscancausealossincompetitivenessforcoveredsectorsandinstallations,comparedtooperatorsinjurisdictionswithlessstringentcarbonconstraints.

Thestringencyofallowances,andEUAprices,are themaindeterminantsof the levelof impacts.Thedifferencebetween freeallocation,andverifiedemissions is relevant forevaluatingdirect impactsonsectorsandinstallations.

Figure 16 shows the estimate of the yearly net monetary position7, for the combustion of fuelsinstallations, largely represented by electricity generation, and industry sectors (defined by EU TLactivitycodes).

Figure 16. Net costs of allowances

Source:EEA,2018andEUTL,2018

Note:datafor2017arebasedontheEUTLofApril3missinggapsareestimatedbyWegenerCenter

Theseestimates indicatethatthepowersectorhasbeenshortsince2006,whileindustrysectorshavebeenlong,thusbenefittingfromoverallocation.

7 calculatedastheproductoftherelativepositions(theyearlyshortfall/surplusofallowances)ofsectorsmultipliedwiththeannualaveragesofEUAprices.

-8,000

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However,thatmaybeasituationofthepast,aspreliminarydataindicatesthat2017wasthefirstyearwheretheindustryasawholeexperiencedanegativerelativeposition.

The lack of detailed emission data along the lines of industrial sectors, especially the separation ofcombustion and production emissions at energy intensive installations, impedes efforts towardsindependentandaccurateestimates.

Carbonleakage:directcosts

Theexposureofindustrytocarbonleakageiscloselytiedtothedirectcostsofallowancesthatmustbebought via auctioning or other market operations. To evaluate these direct costs for industrialinstallationsintheEUETS,thenetpositionoffreeallowancesisakeyindicator.

OverP2andP3, industry as awholehas cumulateda surplusof allowancedamounting toabout680milliontonsofCO2in2017,comingdownfromapeakof785millionin2013.

Inthefollowinggraphs,wecalculatedthenetsupplyoffreeallowances(asapercentageoftherelatedemissions) and the resulting cumulatedsurplus(inmilliontonsofCO2)since2008forsteel,refineriesandcement,thethreebiggestemittingactivities,whichtogetheraccount for two thirds of industryemissions.

Figure 17 presents the situation for steelactivities8.Theconsiderablenetsurplusoffree allowances in P2 is still sufficient tocompensate for the net deficits in theallocationoffreeallowancesinP3.In2017,we still witness a cumulated surplus ofabout200milliontonsofallowances.Steelcollectedanet surplusclose to75percentof its emissions in the crisis year 2009,whichhighlightstheimpactoftheinflexibleallocation of free allowances with respecttochangingactivitylevels.

Forrefineries(Figure18),thenetsurplusescumulatedinP2werequicklyusedupbynetdeficitsinP3,leadingtoanegativecumulatedsurplusofallowancesinrecentyears.

Figure 19 depicts all activities related to cement from clinker production and shows that the cementindustrystillholdsabout270milliontonsofCO2.

8Tocalculatefreeallowancesforactivitiesrelatedtosteelproduction,weaddedupallemissionsrelatedactivitiestosteelsuchasproductionof coke,metalore roastingor sintering,productionofpig ironor steel, andproductionorprocessingofnon-ferrousmetals.Next,weaddedemissionstiedtofluegaseswhichare,however,bookedundercombustion,andthusdonotreceivefreeallocation.Thishandlingofwastegasesisnotuniformamongcountriesandcreatessomeuncertaintiesinthesplitofemissionsandallowancesbetweenindustryandcombustion.

Figure 18. Steel, sintering, coke, flue gas (activities 22 to 25)

Figure 17. Refining of mineral oil (activity 21)

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Among the remaining industryactivities, significant cumulatedsurplusesoffreeallowancesareheldbybulk chemicals and paper andcardboard. The ceramics activityobtained net surpluses close to 100percent of its emissions in P2 butdespiteanetdeficitinP3,stillexhibitsasurplus. Similar evidence is visible formostremainingactivities.

Insummary,itissuggestedthatdirectcostsweresofarrathernegligibleorevennegativeforindustrialactivities.Thisdoesnothold,however,forthoseinstallationsthatcouldexpandtheiractivitiesbecauseoftheex-antefixedallocationoffreeallowances.

Carbonleakage:indirectcosts

Indirectcosts–thecostsofcomplianceforenergygeneratorsthatispassedthroughtotheircustomersintheirenergybills–isanothertypeofcostsassociatedwiththeEUETS,whichisespeciallyrelevantforenergyintensiveindustries.Whileithasgenerallyreceivedlessattentionthatdirectcosts,itdoesaffectallelectricityusers,andcanbedecisiveforelectro-intensiveindustries.

Aswasmentionedinthe2017StateoftheEUETSReport,estimatingindirectcostsisdifficult,astheydepend on, among others, estimates of pass-through of costs. However, it is clear that some energyintensive industries could experience high indirectcosts,especiallywithEUApricesontherise.

Contrary to direct costs, there is no harmonizedapproach for compensation of indirect costs: onlypartial and regressive compensation is available at thediscretionofMemberStates,andonlyaboutathirdofMember States have compensation schemes in place(seeFigure20).WhiletheP4reviewdidnotchangethisapproach, itdid recognizemoreexplicitly theneed forfinancial measures adopted by Member States tocompensate indirect costs. It however also included asoft cap for this compensation at 25% of auctioningrevenues.

The State Aid guidelines include a maximum aidintensity (as percentage of calculated indirect costs),withamaximumof85%upto2015,droppingto75%in2019. Most Member States provide this maximumamount of compensation, except for Finland, whichonlycompensatesfor50%ofthemaximumpossibleaidintensity.

Figure 20. Map of Member States who have indirect costs compensation schemes in place

Source:EuropeanCommission,2018

Figure 19. Cement clinker (activity 29)

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Compensation data has to be obtained directly fromMember States. Data provided by theMemberStatesthatwerewillingtoshare itprovidesomeinsights9:wherecompensationschemesare inplace,the calculated indirect costs are compensated according to the aid intensity levels, and the foreseenbudgetswerenotexceeded.However,Table3showsthat,exceptforGreece,allMemberStatesusedmorethan25%oftheirauctionrevenuestocompensateforindirectcostsin2016.Giventhesoftlimitof25%includedintheP4review,thismightprovetobeproblematicinthefuture.

Table 3. Indirect costs compensation and total auction revenues in 2016 MemberState Totalcompensation

indirectcostsAuctionRevenues Percentageofauction

revenuesusedFrance 140,339,677.00 234,683,755 59.80%

Germany 288,723,308.06 850,000,000 33.97%

TheNetherlands 45,000,000.00 142,610,000 31.55%

Finland 36,300,000.00 71,220,000 50.97%

Greece 3,845,242.00 148,050,000 2.60%

Flanders 39,383,616.43 56,917,488 69.19%

Source:DataobtainedfromMemberStates,Tiebenandin‘tVeld,2017,&Maximiser,2018

Inconclusion,noharmonizedEuropeanapproachforindirectcostscompensationexists,andsinceonlya third ofMember States provide compensation, there exists a distortion across Europe, as differentinstallationsfacedifferentcostsbasedontheMemberStatetheyoperatein.

Even inMember Stateswhere compensation schemes exist, indirect costs are not fully compensatedduetoregressiveaidintensitylevels,creatingcarbonleakagerisks,anditremainsunclearwhethertheregressiveaspectofaidintensitywillcontinueinP4.

Lastly, the lackofavailabilityofdataoncompensationschemes isproblematic,butshould improve inthe future as the reviewed EU ETS Directive includes a new obligation for Member States with acompensationschemeinplacetopubliclypublishthisdata,from2018onwards.

6 MarketfunctioningAwell-functioningmarket is essential to secure theobjectives set by the regulators. Being a cap andtradesystem,theEUETSreliesonthetradeofemissionallowances in order to provide the right incentives tomarketoperatorsto invest in low-carbontechnologies.Thus, providing good price discovery is an essentialfeatureofawell-functioningmarket.

Basic economic theory describes a well-functioningmarket as open, liquid, legitimate and competitive. Inopenmarkets,itneedstobepossibleforaninvestortobuild up an optimal position, whether physical orfinancial, which reflects his strategy and the expectedfuturestateof themarket.Toguaranteethat, liquidity

9 Germany, France, Finland, Greece, Flanders, data for the Netherlands was obtained from a Report commissioned by the Ministry of Economic Affairs

Figure 21 – Market Functioning Tracker

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isanessentialrequirement:eachpositionneedstobeopenedwithminimallossofvalue,atanytime,and with the costs of opening and closing themmarginal or close to zero. Thus, access and exit ofparticipantsshouldberelativelyeasy.Toensurethis,well-definedpropertyrightsthatdeterminewhatmaybesoldorboughtthehavetobeenshrinedinalegalframework.

Moreover,inacompetitivemarket,noneofthemarketparticipantscanhavethepowerorcapacitytosignificantly influencethepriceofahomogenousproduct,acommodity.Lastly, informationaboutthepriceandqualityofproductsshouldbeavailabletoallatreasonablecosts.

Inordertoevaluatethefunctioningofthemarket,weidentifiedinthe2017StateoftheEUETSalistofeight Key Performance Indicators (KPI) which we have started to track regularly. These indicatorstogetherformanaccurateproxyofthebasicrequirementsdescribedabove.

Volumes

One of the most critical issue the market facedthis year was to preserve volumes, which is acrucial indicator of the liquidity in themarket, inthe faceof lowprices.Overthe last fewyears, inthe face of the decline in the price of EUAs, theexitofmanyfinancialplayersfromthemarketandtheabundantallocationsmanyoperatorsenjoyed,we have witnessed a decrease in volumes. In2017, following theupswing in2016, theupwardtrend continued,bringing volumesupagain,withQ4showingthelargestgrowth.Apositivesignforthemarket.

OpenInterest

Open Interest is the other side of the coin when looking at liquidity. An open interest indicates thenumberofoutstandingpositionsalongthedifferentcontracts:generally,thehighertheopeninterest,themore a particular contract is traded and hence the higher is the level of liquidity. Looking at thepreviousyear,open interestremainedstable in2017,haltingthedownwardtrendregisteredovertheprevious 3 years. It is a relatively positive sign if we take into consideration the expected increasingshareofrenewablegeneration,thatdoesnotneedtobehedgedforward.However,thistrendmayhideanexpectedreboundofemissions in thepowersector,asa resultof increasedgeneration fromfossilfuels.

Auctionparticipation

Auctionparticipation,whichindicatestheaveragenumberofparticipantsinthedailyauctions,showsasurprising improvement. The end of the backloading, and the renewed abundance of EUAs in dailyauctions,appearedtonothavenegatively impactedtheaverageparticipationrate,whichsawaslightuptickin2017:itrosefrom18.15in2015to18.95in2016,andto21.1in2017.

Auctioncoverage

Auctioncoveragerepresentstheratiobetweentotalbidsofanauctiontothenumberofacceptedbids.Alongwithparticipation, it is usedas an index toevaluate thedemandof allowanceson themarket.

Figure 22 – EUA volumes, quarterly and annual

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Comparedtotheincreaseinparticipation,2017didnotshowacomparablegrowthinauctioncoverage:theincreaseinparticipantsdidnotresultinaproportionalincreaseinbids.

AuctionvsSpotspread

Thedifferencebetweentheauctionandspotprices,anotherKPIforgoodmarketfunctioning,remainedinarangethatwouldnotcauseconcernsthisyear,withonlyafewepisodesshowingaspike,whichisanindication that speculation occurred, but was not widespread. This is a sign that the market is stillcompetitiveandnooperator,orgroupofoperators,holdsmarketpower.

Bid-askspread

The bid-ask spread shows the difference between the highest price offered and asked in themarketplace,thusgivingasignalofliquidityinthemarket.Thoughthespreadisstillnarrow,thenumberof times when auctions saw a significant divergence between the bid-ask offer rose in 2017. Thisreinforcesourfindingthatspeculationindeedoccurred,ashighlightedbytheauction-spotspread,butwasnotoutcreatingaspeculativebubble.

Figure 23. Ask-Bid Spread (best ask minus best bid (€)

Source:EEX,2018

Prices

Prices,whicharethemain indicatorofthescarcityofthemarket,showthatEUAswerestill tradedatwhatmanyconsidertobelowlevels.However,theagreementreachedinOctoberonthereformforP4alreadyhadan initialeffectattheendoftheyear,andsawanunexpectedrally inthefirstquarterof2018,reachinglevelsabovewhatanalystswereforecasting.

TheriseinEUApricewecanobserveattheendof2017andbeginningof2018seemstoindicatethatthe oversupply has been reduced. This is also confirmed by the European Commission in its yearlyassessment(EuropeanCommission,2017b).

It must be emphasized that for the authors of this report an increase in prices in itself does notrepresent a standard KPI for market functioning. The current rise in prices can be seen as animprovement from theexistingdisconnectbetween the future scarcity and the currentperceptionofoperators and market participants, with the politics of the EU ETS considering this to be a positivedevelopment.Inamarket,theonlythingthatmattersisagoodpricediscovery,notthepricelevel

0.0

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Figure 24. EUA prices

Source:ICEclosingprices,Decdeliveryofthesameyear,2018

Costofcarry

Thecostofcarryshowstheexpectationsofthefuture.Itisthepremiumoperatorsarewillingtopaytobuyallowancesnowforfutureneeds.Asfortheprice,itcanbeseenasaproxyforthescarcityofthemarket.However,unlikethepriceofEUAs,forwardcontractsdonotseemtopriceinthescarcitymanyexpect.ThereisstilladisconnectionbetweenthepresentandthefuturewhichcanbebothrelatedtotheuncertaintyofthemarketandthelowinterestratesstillenjoyedinEurope.

Volatility

Volatility refers totheamountofuncertaintyorrisk ina financialproduct; it indicateshowmuchandhowquicklythevalueofamarketchanges.VolatilityisadisputedissueintheEUETS:industriesdonotlike it while traders and investment banks are more used to it and more able to exploit pricefluctuations.However,asof2018,financialmarketRegulationssuchasMiFID2andMARapplyinfulltotheEUETS.2017sawadecreaseinvolatilityforEUAsthoughtheyremainariskierproductcomparetootherenergycommoditieslikecrude-oil,naturalgasorelectricity.

Figure 25. Volatility

Source:NomismaEnergiaelaborationsonICE,PLattsandEEXdata

Inconclusion,wecansaythatthemarketfunctionedslightlybettercomparedtolastyear:threeoutoftheeighttrackedKPIsexhibitedanimprovement,whileonlytwoKPIsshowedaworseningperformance,theauction-spotspreadandtheauctions’bid-askspread.Thecurrentriseinpricescaninthiscasealsobeseenasapositivedevelopment.Despitethatsomecriticalpointsremain,wecanstillaffirmthatthemarketisfunctioningwellandevenshowingsignsofimprovement.

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Thingstobebetterunderstood

Lookingahead,thereare3majorpointsthatwillrequireincreasinglymoreattention:

• The likely increase in volatility connectedwith the kick-off of theMSR,which, looking at themarketinthefirstquarterof2018,seemsalreadystartingtoshowadifferentpatternthatmaybecomeevenmorepronouncedinfuture;

• TheimpacttheMSRwillhaveonauctions,intermsofparticipationandcoverage;• Thechangesinthehedgingstrategiesofutilitiesandindustries,whichwillinevitablyaffectthe

liquidityofthemarket.

7 MakingtheEUETS‘fitforpurpose’Thissectionwillhighlight,anddiscuss,anumberofissuesthatneedtobemonitoredtoensurethattheEUETSis“fitforpurpose”,andisreadytofacefuturechallenges,including:

• Restoreshort-termscarcitythroughtheMarketStabilityReserve;• MaketheEUETSresilienttopolicyinteractionsandtopolicyuncertainty;• MaketheEUETSgovernanceoperational;• Managecarbonleakagerisks;• AligntheEUETSwiththelong-termEUclimateambition,compatiblewiththeParisAgreement

goal;• Provide financial support for low-carbon competitiveness of EU industry and the transition

towardsalow-carboneconomy.

7.1 Restoringtheshort-termscarcitythroughtheMSR

TheMSRwasputinplacetoaddressthecurrentEUAsurplus,aswellas“normal”levelsofsurplusthatmayemergeinfutureyears.Itoughtto,barringotherdevelopments,drasticallyreducethenumberofallowancesonthemarketby2024.

Thelowerboundaryisnotexpectedtobereachedbefore2030,thusthefirstreleaseofallowancesfromtheMSRbackintothemarketisnotexpectedtohappenduringP4.AsshowninFigure26,from2019to2028, in addition to allowances initially transferred to the MSR (backloading and P3 unallocatedallowances), theMSR is expected to absorb close to1.8billionallowances. In total, by theendof P4almost2.6billionallowanceswillbeinvalidated.

TheperformanceoftheMSRiscriticaltothewell-functioningoftheEUETS.However,theparametershavenotbeentested,andmanywereputinplaceawhileago,especiallythethresholds.MonitoringtheMSRparameters, and their fitwith the current environment, is an important elementwhen theMSRstarstooperate.

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Figure 26. Volume of the MSR (left) and evolution of the surplus (right) in the 2017 Baseline scenario by 2030

Source:I4CEandEnerdata,2018

7.2 Dealingwithpolicyinteractionsanduncertainty

Policies that support the deployment of renewable energy sources and the improvement of energyefficiencywillcontinuetodriveemissionreductionsintheEU,effectively‘overlapping’withtheEUETS,andultimatelylimitingitsroleasadriverfordecarbonization.

According to I4CEandEnerdata (2018),overP4of theEUETS, achieving theEE (30%)andRES (27%)targets could on their own be sufficient to respect the EU ETS’s emission constraints. Those CO2emissionreductionscouldrepresent2201milliontonnes,almosttheequivalentof1,5yearsofEUETSallowancesinP4.

AnincreaseintheEEandREStargets,whichisthepositionoftheEuropeanParliament,wouldleadtoadditionalCO2reductionsinEUETSsectorsandwillfurtherimpactitssupply-demandbalance,ascanbeseeninFigure27.

Figure 27. Impact of rising EE and RES targets on EU ETS

Source:ERCST

In addition, the EU ETS faces policy uncertainty coming from some Member States, including theannouncements of coal-phase outs and the possibility of adopting carbon floors. However, voluntary

30

cancellation could potentially mitigate the effects of these policies on the supply-demand balance –whilethatdoesnotmeanthattheuncertaintywon’timpactthemarketex-ante.

Some EU policy developments, such as Brexit, and international climate policy developments, mostimportantlywithintheUNFCCCframework,canalsocreateuncertaintyaroundtheEUETS.

Inspiteofthedoublingofitswithdrawalrateuntil2023,theMSRmaynot,undercertainconditions,beable tomitigate the impactofallotherpotentialpolicieson theEUETSduringP4. TheMSR reviewsscheduledin2021and2026willbekeytoassesstheaccuracyofitsparameterstomitigateex-posttheeffectsofoverlappingpoliciesontheEUETS.

All these potential developmentswould increase uncertainty amongmarket players. Thismeans thatmonitoringallthesedevelopmentsclosely,especiallypolicydevelopmentsattheMemberStatelevel,isanimportanttask.

7.3 MakingtheEUETSgovernanceoperational

Inpractice,theEUETSDirective,theMSRDecisionandtheGovernanceoftheEnergyUnionRegulationcan be seen as complementary elements in making the EU ETS ‘fit for purpose‘, by monitoring,reviewing, assessing and adjusting the parameters of the EU ETS. This governance framework,whichneeds tobewell synchronized, isessential inmakinganyneeded forEUETSchanges inapredictableway.

Reviewsof theMSRparametersare scheduled in2021and2026.TheLRF isapossiblevariable tobeadjusted incaseofa reviewof theEUETS,asmentioned inArticle30of theDirective.By requestingassessmentsof the impactsofpolicy interactions, includingontheEUETS,proposedbytheEuropeanParliamentinitsamendments,theGovernanceoftheEnergyUnionRegulationcouldhelptocoordinatetheEUETSfunctioningwithMemberStatespolicies.

One useful action would be for the European Commission to carry out an impact assessment foradjustingtheMSRparameters,and/orincreasingtheLRFinlinewiththeParisAgreementgoal.

Figure 28. The governance framework of the EU ETS in building for its Phase 4

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7.4 Managingcarbonleakagerisks

Managing carbon leakage risks during P4 remains an essential aspect of a successful EU ETS. The P4reviewincludesanumberofprovisionsaimedatprotectingindustryagainsttheriskofcarbonleakage.

It is importanttonotethatthedevelopmentofcarbonpricinginEUcompetitorcountries isnotbeingtaken intoaccount for thecalculationof carbon leakage.TheyearlyEUETS functioningof thecarbonmarket report could include an analysis of global carbon prices and the evolution of other climatepolicies.

While the direct costs are expected to be compensated for in P4, there is still no harmonizedcompensation scheme for indirect costs. This is an issue thatwill requiremonitoring, especially as itrelatestothereviewoftheStateAidguidelines.

A number of questions and challenges for the future remain: while being important to avoid aiddependencyandensureincentivestoswitchtolower-emissiontechnologies,thedigressiveaidintensityrates,ifcontinuedduringP4,willincreasetheshareofindirectcostsnotcompensated.Thiswillincreasetheriskofcarbonleakage,especiallywithEUApricesontherise,andwillneedtobemonitored.

7.5 Aligning the EU ETS with the EU long-term ambition consistent with the Parisagreement

TheCommissionproposalfortheEUETSreviewinJuly2015didnotconsidertheambitionoftheParisAgreement.TheParisAgreement,signedaftertheproposalwaslaunched,aimsatachievinganet-zeroemissionworldby themiddleof thesecondpartof this century.Aswasmentioned inChapter4, thecurrentLRFisonlyalignedwiththelowendoftheEU’s2050climateambitionasmentionedinthe2050Roadmap.

IftheEUETSistobealignedtothelong-termEUclimateambition,itsparameters,forexampletheLRF,willrequireenhancements.ThereviewedDirectiveincludesseveralprovisionswhichcanpotentiallybeusedforthisalignment,includingarticle30.

The review ofMSR parameters scheduled in 2021 and 2026, and voluntary cancellation byMemberStates,areotherpotentialpathways toalign theEUETSwith theEU long-termclimateambition.Theway any voluntary cancellation may be carried out needs to be monitored to ensure it does notnegativelyimpactmarketfunctioning.

The new EU long-term climate strategywill also be an important factor, as itwill likely stipulate therelativeefforttheEUETSwillhavetodelivertohelpreachtheoverallgoalsoftheEU.Thepotentialgoalof negative emissions for EU ETS covered sectors will also have considerable implications and raisequestionsastohowthisshouldbeachieved(e.g.allowuseofcarbonoffsettingtoachievethetargets).

7.6 Provide financial support for low-carbon competitiveness of EU industry and thetransitiontowardsalow-carboneconomy

Whatiscalledinacademictermsthe“doubledividend”oftheEUETS,meaningtheroletheEUETScanplay in supporting the transition to a low-carbon economy in broad terms, is an important issue andneedsmonitoringfromdifferentangles.

Besides creating incentives for covered installations to invest in lower-carbon alternatives, auctioningrevenuescanalsobere-investedinclimateandenergypolicies,inordertospeedupthetransition.

32

AccordingtotheCommissionReport,MemberStatesspent75%oftheauctioningrevenuesonclimateandenergypolicies,amountingto€8.8billionintheperiod2013-2015.AstheEUApricesareexpectedtoincreaseintheinthecomingyears,auctioningrevenueswouldconsequentlyincreaseaswell,whichmay provide stronger incentives forMember States to invest in their low-carbon transition.How therevenuesareusedneedstobecloselymonitored.

TheP4reviewalsointroducedtheModernizationandInnovationfunds.TheestablishmentoftherulesfortheInnovationfundisongoing,withpublicconsultationsclosinginApril2018.

Furthermore,inadditiontoclimateandenergyrelatedinvestments,theEUETScouldalsoaddresstheshort-term socio-economic aspects associated with the transition to a low-carbon economy, byprovidingfundingforcompensationschemesforaffectedstakeholdersandcommunities.Whetherthisisdone,andhowit’sdone,willbeimportanttopicsinthefuture.

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