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All rights reserved © 2014 Thomson Reuters Point Carbon
1
CARBON MARKET ANALYST
Winds of Reform: Examining the design parameters of the
Market Stability Reserve
04 March 2014
TO THE POINT CONTENTS
2 Introduction
3 Effects of an early
implementation of the
reserve in 2017
4 Changes to Article 2: the
fate of the backloaded
allowances
5 Changes in the trigger
levels
6 Changing the size of the
automatic adjustments
7 Response to demand
shocks
8 Conclusions
9 Contacts
With an early implementation of the Market Stability Reserve in 2017, the
average EUA price over 2014-2020 could rise by around 39%, compared to an
implementation in 2021 as proposed by the Commission. Early implementation
will likely cause a decline of the market surplus beginning already in 2017. The
surplus would decline more gradually, giving market participants more time to
prepare for the abatement needed to meet EU’s climate targets for 2030 and
beyond, therefore likely leading to higher inter-temporal efficiency compared to
an implementation of the reserve in 2021.
Transferring the 900 million backloaded allowances to the reserve will likely
have an identical effect on the market balance as a permanent cancellation
in the time frame up to 2030. If the backloaded allowances are transferred
to the reserve in 2019 and 2020, they will likely remain there until 2030. This
scenario helps avoid the disruption of the market balance resulting from the
return of the 900 million backloaded allowances.
The market surplus is relatively insensitive to changes in the trigger levels,
according to results from our model. In comparison, changing the size of the
annual adjustment - i.e. how many allowances are removed from or released
into the market each year – could have a greater impact on the market surplus.
In the event of another financial recession, the implementation of the Market
Stability Reserve will likely support the market balance and the carbon price,
as opposed to a scenario featuring the current design of the EU ETS, in which
supply is inflexible.
The impact on the market from changes to the Market Stability Reserve
proposal could be greater than that of changes to the 2030 GHG or
renewable targets. A failure to implement the proposal could lead to 33%
lower average EUA price over 2021-2030. In comparison a 35% GHG target
likely translates into a 10% lower average EUA price over the same period.
Commencing the Market Stability Reserve in 2017 and transferring the
900 million backloaded allowances to the reserve may help achieve the
Commission’s goal of avoiding high carbon lock-in. The average 2014-2020
price could rise by approximately 57% as a result, compared to our base case.
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
2
Introduction
As part of the 2030 climate and
energy framework proposals
published on 22 January this year,
the European Commission has
proposed structural reform of the EU
ETS in the form of a Market Stability
Reserve (MSR) - an automatic
mechanism which will adjust market
supply depending on fluctuations in
demand. The mechanism will have
two main purposes according to the
impact assessment accompanying
the proposal – 1) reduce the current
oversupply of allowances and 2)
make the EU ETS more resilient to
demand-side shocks in the future.
By achieving these objectives, the
Commission aims to increase the
inter-temporal efficiency of the ETS
and prevent the EU from locking its
energy infrastructure in high-carbon
assets.
Discussions on the MSR proposal
kicked off at an EU Environment
ministers meeting on 3 March.
Due to the Eurpean elections, we
expect the conventional co-decision
procedure between the Union’s
two lawmakers – the Parliament
and member states in Council to
practically start sometime around
late 2014 or early 2015. This will
likely be followed by one or two
years of deliberations until the
proposal can become law.
In this report, we provide a
sensitivity analysis which looks into
how changes to the Commission’s
proposal will impact the market
surplus and the EUA price. We
provide several scenarios which
change one or two parameters
in the current proposal at a time,
while keeping all other assumptions
constant. We compare these
scenarios to the market surplus
and the EUA price path reflecting
the Commission’s proposal as it
currently stands. See the textbox on
this page for an introduction into the
Commission’s proposal.
Reference scenario
As a basis for comparing different
designs of the MSR, we present our
base case forecast of the market
surplus, which reflects the proposal
as proposed by the Commission
(Figure 1). In the reference scenario,
we foresee the surplus increasing
late in phase 3 as the backloaded
allowances return to the market. The
market surplus begins to decline in
2021 and is eventually used up in
2027, when the market turns short.
At this point market participants
are required to abate emissions to
balance the market.
Figure 1: Market surplus with MSR proposal
Reflects TRPC base case assumptions with the proposed MSR and 2030 targets.
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Reserve (reference) Reference - EC proposal
The Market Stability Reserve proposal explained
The Market Stability Reserve functions as an automatic adjustment of the
annual auctioning volumes. The basis for the annual adjustments is the
market surplus (also referred to as “allowances in circulation”) defined
as: the allowances allocated since 2008 + international credits used for
compliance since 2008 – verified emissions since 2008.
On 15 May of each year beginning in 2017, the Commission will publish
an official estimate for the market surplus for the previous year.
The MSR will begin operating in 2021, according to the Commission’s
proposal. In 2021, 12 percent of the surplus recorded for 2019 (two years
back) is withdrawn from the annual auctioning schedule and placed into
the market stability reserve. In 2022, 12 percent of the surplus recorded
for 2020 will be withdrawn and placed into the market stability reserve.
This will be repeated every year until the surplus falls below the upper
trigger of 833 Mt. The proposal also defines a lower trigger equal to 400
Mt. If the market surplus is below this number, allowances are returned
to the market from the reserve in annual installments of 100 Mt.
Article 2 of the proposal foresees an additional adjustment in auctioning
volumes to take place in 2020. This adjustment is equal to two-thirds of
the difference between the auctioning volumes in 2020 and the average
auctioning volumes in 2021 and 2022. This volume, which we estimate
will be 421 Mt, will be withdrawn from the auctioning schedule in 2020
and released back in equal halves in 2021 and 2022.
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
3
In addition to the MSR proposal, our
base case includes our assumptions
on 2030 climate and energy targets
and our expectations for future
emissions growth. We assume
a 40% GHG target and a 27%
Renewable target for 2030, in line
with the Commission’s proposal. Our
emissions forecasts reflect a GDP
growth of 1.7 percent on average in
2014-2020 and 1.9 on average in
2021-2030.
Early implementation
The European Commission proposes
an implementation of the MSR
from the start of phase 4, in 2021.
The German environment minister
Barbara Hendricks has suggested
that the MSR could be introduced
“considerably earlier” than 2021.
During the Environment Council
on March 3, the UK, Denmark and
Sweden also voiced support for an
early start of the mechanism.
Our expected timeline for the
adoption of the MSR sees a possible
entry into law sometime in early
2017 (for more details, read our
report on the 2030 framework).
This would allow for the possibility
that the mechanism be brought into
operation already in phase 3 and
allowances be withdrawn from the
market possibly as soon as 2017.
The impact of this scenario on
the market surplus is depicted in
Figure 2a. Implementing the MSR
in 2017 addresses the accumulated
oversupply sooner and the surplus
begins to decline already in 2017.
The surplus rises again in 2019 and
2020 as the backloaded allowances
return to the market, but less
dramatically than it does in the
base case. The MSR will therefore
alleviate the fluctuations in the
market balance that result from
the injection of the backloaded
allowances at the end of phase 3.
In 2020, an additional 421 Mt are
withdrawn from the auctions and
reintroduced in equal halves in the
next two years. This adjustment
is in line with Article 2 of the
Commission’s proposal, which calls
for a certain auctioning volume of
2020 to be delayed to 2021 and
2022. This adjustment applies in
both the base case scenario and the
early implementation scenario.
In 2021 the surplus begins to
decline gradually. In the early
implementation scenario, the
surplus is lower than in the base case
all the way up to 2030 as the reserve
will likely have accumulated more
allowances by that point. An early
implementation would also result
in a more gradual depletion of the
market surplus, which would give
market participants more time to
prepare for the emission reductions
necessary to meet EU’s climate
target for 2030 and beyond.
The lower market surplus is
expected to lead to higher EUA
prices particularly in phase 3.
Figure 2b shows the potential price
path for EUA prices expressed
in real 2010 Euros. The grey line
Figure 2b: EUA price path in early implementation scenario
MSR implemented in 2017. Prices in real 2010 Euros.
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Scenario - MSR begins in 2017 Commission proposal (reference)
Figure 2a: Market surplus in early implementation scenario
MSR implemented in 2017. Allowances begin to be withdrawn in 2017.
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Scenario - MSR begins in 2017 Reference - EC proposal
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
4
presents the price path resulting
from the Commission’s current
proposal, which we expect to reach
€48/t (€71/t in nominal terms)
in 2030. Our price forecasting
model estimates that the early
implementation scenario causes
the average 2014-2020 price to rise
by around 39% and the average
2021-2030 price by around 13%,
compared to a scenario featuring
the Commission’s current proposal.
The two price paths will eventually
converge as the reserve releases all
allowances back to the market.
Changes to Article
2: the fate of
the backloaded
allowances
Article 2 of the Commission’s
proposal allows for a certain volume
of allowances to be taken out of
2020 and reintroduced in 2021 and
2022 in equal halves. This reflects
the Commission’s intention to
alleviate the large influx of supply
that will result from the reinjection
of the backloaded allowances in
2020. We estimate that under the
proposal 421 Mt will be withdrawn
from 2020 and 210 Mt will be added
to the auctions in 2021 and 2022.
We expect the fate of the
backloaded allowances to be part of
the discussions on the Commission’s
proposal, which can make Article 2
a hot topic of debate going forward.
The Commission has argued that
“specific provisions are necessary to
tackle a potential supply peak /…/
in 2020”. Article 2 of the current
proposal will smoothen the supply
peak resulting from the return of the
backloaded allowances. However,
it may be contested by certain
stakeholders, member states and
Parliamentarians alike during the
co-decision process, as it represents
an interference with the already
agreed backloading plan.
Figure 3 depicts a scenario where
Article 2 is excluded from the
Commission’s proposal and 600
million tons are reintroduced in
2020 in line with the backloading
decision. The exclusion of Article 2
would result in a sharp rise in the
market surplus in 2020 to 2.6 Gt. In
this scenario, the surplus eventually
decreases as EUAs are placed into
the reserve and the market surplus
realigns with the base case in 2022.
The influx of supply will likely lead
to volatility in the EUA price, which
is expected to be lower in 2020 and
2021 compared to the base case.
When it comes to the backloaded
allowances, climate ministers in
the UK and Denmark voice support
for a permanent cancellation of
these allowances. While this option
appears unrealistic at this stage,
a possible compromise may arise,
in which a decision is taken to
transfer the 900 million backloaded
allowances into the reserve directly
instead of returning them to the
market. Currently 300 Mt are due
to be released in 2019 and 600
Mt are due to be released in 2020
as a result of the backloading. We
present a scenario in which these
volumes are placed directly in to
the reserve in 2019 and 2020. In
this scenario, the MSR still begins
to take out allowances in 2021, as
currently envisioned.
Figure 4a depicts the possible
resulting impact on the market
surplus. In this scenario, the
surplus remains largely unchanged
until 2020, after which point, it
begins to narrow as a result of the
implementation of the MSR. By
2030, the reserve will hold 975
million EUAs. This implies that the
900 million backloaded allowances
will still be in the reserve in the
entire time horizon up to 2030,
according to our model. Therefore,
transferring the backloaded
allowances to the MSR will possibly
have the same effect on the market
surplus and the EUA price as a
permanent cancellation of these
900 million allowances, in the
timeframe up to 2030.
The transfer of the backloaded
allowances to the MSR will likely
avoid the spike in market surplus
in 2020 and most likely lead to
higher prices towards the end of
phase 3. Our price forecasting model
estimates that the average 2014-
2020 price will be approximately
16% higher, and the average 2021-
2030 price around 19% higher as a
result (Figure 4b).
Figure 3: Market surplus after excluding Article 2
Excludes Article 2 of EC proposal which calls for transfer of allowances from 2020
to 2021 and 2022.
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Reserve (reference) Reserve (scenario)
Scenario - Excluding Article 2 Reference- EC proposal
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
5
Two of the scenarios mentioned so
far - transferring the backloaded
allowances to the MSR and
implementing the MSR in 2017 –
may have complementary functions
in addressing the market oversupply
already in phase 3.
Figure 5 depicts the market surplus
when both of these scenarios
are implemented and all other
assumptions are kept constant.
This combined scenario results in
a gradual decrease of the market
oversupply starting in 2017 and
avoids any volatility at the end of
phase 3. As a result the gradually
declining surplus, the market will
likely receive a signal for the need of
low-carbon investments sooner than
under the Commission’s current
proposal. Our price forecasting
model suggests that the narrower
market surplus could translate into
an increase to the average 2014-
2020 EUA price of around 57%
compared to the reference and a rise
of the 2021-2030 average EUA price
of approximately 27%.
Changes in the trigger
levels
The Commission’s proposal has set
an upper trigger level at 833 Mt
(if the surplus is above this level,
allowances are taken out of the
market) and a lower trigger at 400
Mt (if the surplus falls below this
level, allowances are returned to
the market). The reasons behind
the choice of these specific levels
are not very clear. The Commission
argues that the upper trigger should
roughly represent the annual needs
of power generators to cover EUA
purchasing needs for future years.
Power hedging patterns however
are relatively opaque as not all
operators make such data available,
and varying assumptions about
the magnitude of hedging can lead
to different views on the “correct”
Figure 5: Market surplus in a high inter-temporal efficiency scenario
MSR begins to withdraw allowances in 2017. 900 mill backloaded allowances are
transferred to the reserve in 2019 and 2020.
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2017 start + transfer BL to MSR Reference - PC base case
Figure 4b: EUA price path if backloaded allowances go into MSR
900 Mt transferred in the reserve in 2019 and 2020. Prices in real 2010 Euros.
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Transferring BL to MSR Commission proposal (reference)
Figure 4a: Market surplus if backloaded allowances go into MSR
Instead of returning to the market, 900 Mt are transferred directly into the reserve
in 2019 and 2020.
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Scenario - Transferring BL to MSR Reference - EC proposal
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
6
upper trigger level.
According to our model, the market
is rather insensitive to changes to
these trigger levels. As an arbitrary
example, we present a scenario
in which both trigger levels are
changed to zero. In this case,
allowances are withdrawn from
the market until there is no surplus
of allowances. Once the market
reaches this point, allowances begin
to be released from the reserve.
In this scenario, the surplus is likely
to be only slightly lower than it
is in the base case after 2025, as
only a small amount of additional
allowances are withdrawn from the
market (Figure 6). Allowances begin
to be returned to the market in 2027
(as opposed to in 2026 in the base
case). Overall, the slightly narrower
market surplus may translate into
an approximate 3% increase in the
average EUA price over 2021-2030.
The results presented here are
partially a consequence of our
assumption that market participants
do not bank the surplus but use it
as rapidly as possible to meet their
compliance needs. If a significant
portion of the surplus was banked
farther into the future, the difference
between an upper trigger level
of 833 Mt and one at zero would
be greater, implying a greater
impact on the market than the one
presented here.
Changing the size of
the adjustments
The annual adjustments determine
how many allowances are removed
from the market or released back.
The Commission’s proposal specifies
that 12 percent of the oversupply
should be removed from the market
each year the surplus is larger than
the upper trigger of 833 Mt. The
proposal also sets the amount of
allowances to be returned into the
market at 100 million tons per year.
In the time horizon up to 2030, the
market will likely be relatively more
sensitive to size of the removals. As
an arbitrary example we show the
results from our model in a scenario
where 20 percent of the oversupply
is removed from the market and
placed into the market stability
reserve. The upper trigger level
is kept at 833 million tons in this
scenario and all other parameters
remain unchanged.
This scenario likely results in a
steeper decline in the market
surplus (Figure 7). More allowances
are placed into the market stability
reserve with around 400 Mt
allowances withdrawn from the
market each year in 2021 and 2022
(in comparison, removing 12 percent
of the oversupply leads to an annual
removal of around 250 Mt in the
first two years of phase 4, according
to our estimates). The market is
relatively shorter towards the end of
phase 4, requiring larger emissions
reductions to balance the market.
This scenario may drive the average
2021-2030 EUA price around 16%
higher than in our base case.
Figure 7: Market surplus with changed annual removals
The size of the annual removals is changed from 12 percent to 20 percent of
oversupply.
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Scenario - Change of adjustment Reference - EC proposal
Figure 6: Market surplus with changed trigger levels
Upper trigger changed from 833 Mt to 0 Mt and lower trigger from 400 Mt to 0 Mt.
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Scenario - Changed trigger levels Reference - EC proposal
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
7
A reduction of the annual
adjustment from 12 percent to 5
percent will likely have a similar
but opposite effect of increasing
the market surplus in comparison
to the base case reference and
likely leading to roughly 17% lower
average EUA price in the period
2021-2030, according to our price
forecasting model.
In comparison, decreasing the size
of the returning volumes has a lower
effect on the price in the period up
to 2030. A reduction of the annual
volume to be released from 100 Mt
to 50 Mt potentially increases the
average 2021-2030 EUA price by
3%. An increase of this volume to
150 Mt would have a corresponding
effect of a 3% decrease to the
average EUA price.
Response to demand
shocks
The financial crisis that began in
2008 now appears to be behind
us, but future periods of economic
volatility cannot be ruled out. One
of the two main goals of the MSR
proposal is to make the ETS more
resilient to such demand side
shocks. To test the current proposal,
we have devised a scenario in which
a financial recession unfolds in 2014
and follows the same pattern as
the double dip recession the EU has
seen over the past six years. EU GDP
growth in 2014 is set at 0.5 percent,
in line with 2008 growth and 2015
growth is set at -4.4, to mirror the
contraction in 2009 (Table 1). A
recovery follows before the economy
falls into a recession again in 2018,
as it did in 2012. Growth eventually
returns to the 1.9 percent for the
next decade as assumed in our base
case forecast.
For this analysis, we have assumed
that the MSR begins in 2014, with
the first allowances withdrawn from
the market already in 2014. This is a
hypothetical scenario, used purely
for the purposes of showing how the
MSR would react to the theoretical
financial crisis described above.
Figure 8 depicts the impact of the
described recession on the market
surplus with the MSR (orange line)
and without the MSR (black line).
In the absence of the MSR, a
financial recession will likely lead
to an expansion of the market
oversupply that could reach almost
4 billion tons in 2020. In this case
the oversupply would decline
somewhat to around 3 billion
tons by 2030. This long lasting
surplus is likely to discourage
market participants from holding
allowances into the future and could
result in extremely low carbon prices
all the way up to 2030.
On the other hand, if an MSR
mechanism is present as of 2014,
it will likely prevent the expansion
of the oversupply. In this case, we
estimate that the MSR will remove
187 Mt per year on average from
2014 to 2020. The reserve will soak
up some of the extra supply and
reach a peak of around 3 billion
tons in 2029. As a result the market
surplus will not deviate far from
the reference in phase 3. Our price
forecasting model suggests that
EUA prices would remain supported
until 2018, but fall to relatively low
levels between 2019 and 2022. After
2023, prices could begin to recover
and possibly reach somewhere
around €27/t in 2030.
The financial recession will still leave
a mark on the market surplus in the
long term, as can be seen from the
way the orange line deviates from
the base case reference in phase
4. This implies that while the MSR
could prevent certain short term
Figure 8: Market surplus in a financial recession
Financial recession begins in 2014 and follows same annual GDP growth rate as
the 2008 financial recession
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Market oversupply (million tons)
Reserve (reference) Reserve (scenario)
Scenario - Recession w/o MSR Scenario - Recession with MSR
Reference - EC proposal
PC GDP Recession
GDP
2014 1.3 0.5
2015
1.6 -4.4
2016
1.8 1.8
2017
1.8 1.7
2018
1.9 -0.3
2019
1.9 1.2
2020 1.9 1.9
Table 1: GDP comparison
In ’Recession GDP’ scenario, EU GDP
growth from 2014-2018 is equal to the
historical GDP from 2008-2012.
Source: IMF
Carbon Market Analyst 04 March 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
8
fluctuations it will not be a cure for
the long term effects of financial
recessions.
This is partially caused by the fact
that annual removals are based
on a percentage of the oversupply,
and therefore become smaller as
the oversupply declines. If this were
changed to a fixed absolute number,
such as 200-250 Mt, the reserve can
have a greater impact in the long
term as well.
Another reason is the level of the
lower trigger level, currently set at
400 Mt. If this trigger level were
reduced or changed to a negative
number this would imply that
allowances would be returned to
the market farther out in time. In the
case of a financial recession such
as the one described here, this may
help support the carbon price for a
longer time horizon.
Conclusions
Implementation of the MSR in
phase 3 avoids disruptions in the
supply/demand balance which
would result from the rapid return
of 900 million allowances to the
market in 2019 and 2020. As we
have argued in previous analyses,
this option enhances the inter-
temporal efficiency of the EU ETS.
Commencing the MSR in 2021
but transferring the backloaded
allowances into the reserve could
achieve a similar goal, but will likely
lead to a longer period of low prices,
as the EUA price may remain around
€10/t up to 2020.
A possibility to combine these two
options also exists, and would
result in a gradual decline of the
surplus starting in 2017. This will
likely be coupled with a steady
rise of the EUA price, avoiding any
volatility around 2019-2020. This
option may help avoid high carbon
lock in to a greater extent than the
Commission’s current proposal. It
will however also likely result in a
significant rise in the carbon price
already in phase 3. The interference
with the recently adopted
backloading decision could also
draw some objections from several
member states, Parliamentarians
and stakeholders.
Changing the size of the
adjustments could also have
significant impact on the market,
depending on the size of the
adjustments. In comparison,
changing the trigger levels will likely
lead to relatively small changes in
the supply/demand balance and the
EUA price.
The impact on the market from
changes to the MSR proposal could
be greater than that of changes to
other aspects of the Commission’s
2030 climate framework. As our
previous report showed, a 35% GHG
target for 2040 could decrease
the average 2021-2030 EUA price
by 10% compared to our base
case forecast. A potential increase
of the RES target to 30% on the
other hand can translate into 13%
lower average EUA price over the
2021-2030 period. By contrast,
failure to adopt the Commission’s
MSR proposal will likely lead to a
33% lower EUA price in this time
period compared to our base case.
Changing the design parameters
of the MSR - such as the size of the
annual adjustments in auctioning
volumes as well as the timing of
implementation - could also result
in larger effects on the carbon price
than changes to the 2030 targets.
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