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Look before you leap: analysis on the design of the Market Stability Reserve

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This report presents a quantitative analysis of the reform of the EU ETS known as the Market Stability Reserve, with recommendations for European governments and for members of the EU Parliament. The latest version of Thomson Reuters' proprietary CO2 price forecasting model is used to produce forecasts and sensitivity analyses for different design options for the Market Stability Reserve. How the Reserve is designed is found to greatly infuence how soon the oversupply in the market is diminished, what trajectory the carbon price follows, what kind of investment signal is sent to the private sector, and how much abatement is triggered by the EU ETS.
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1
CARBON MARKET ANALYST
Look before you leap: analysis on the design of the
Market Stability Reserve
14 October 2014
TO THE POINT CONTENTS
2 Introduction
2 EU ETS outlook under EC
proposal
4 Early implementation
5 The fate of the backloaded
allowances
5 German MSR proposal
7 French MSR proposal
8 The MSR time lag
8 The impact of the MSR
thresholds
9 Power sector hedging and
the MSR
10 Size of the annual
adjustments
11 Resiliency against demand
shocks
12 Timeline for the MSR file
13 Summary of results
14 Annex: Methodology
15 Contacts
The implementation of the Market Stability Reserve (MSR) as proposed by
the Commission is likely to lead to an average 2021-2030 carbon price of
€23/t in real terms, €9/t higher compared to a scenario without the MSR. We
estimate this price increase to result in an additional abatement of 784 Mt in the
EU ETS up to 2030.
The future development of the carbon price is mainly dependent on the
start date of the MSR as well as on the handling of backloaded allowances.
Enacting the mechanism in 2018 will affect EUA prices already during phase
3, leading to a 24 percent increase in the average 2014-2020 carbon price
compared to a start date in 2021. Transferring the backloaded allowances to the
MSR could increase the average price by 15 percent in the same period.
The German MSR proposal will likely lead to a gradual rise in the carbon
price, which could help meet the mechanism’s objective to mitigate the risk
of high-carbon lock in. The average 2014-2020 price is estimated to rise by
approximately 39 percent as a result, compared to a scenario featuring the
Commission’s MSR proposal. The carbon price signal generated by this proposal
is estimated to reduce an additional 469 Mt up to 2030 compared to the
Commission’s proposal.
The French MSR proposal is estimated to result in the same average carbon
prices as the Commission’s proposal over the 2014-2020 (€9/t) and 2021-
2030 periods (€23/t). France’s proposal will however result in a different
carbon price trajectory, which will send a different signal to the market and
could result in 44 Mt fewer emission reductions than the Commission’s proposal
in the 2021-2030 period.
In the event of a financial recession, the implementation of the MSR will
partially offset the impact of the economic shock on carbon prices. The MSR
will over time reduce the number of excess allowances; in contrast, the current
design of the EU ETS would lead to a mounting oversupply in such a scenario.
The expected timetable for the MSR proposal would allow for enacting the
measure earlier than 2021 as proposed by the Commission. The discussions
in the Council are already quite advanced and, depending on progress in the
Parliament, the measure could be adopted by mid-2015.
Carbon Market Analyst 14 October 2014
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2
Introduction
The Commission has proposed to
reform the EU ETS through the
implementation of a Market Stability
Reserve (MSR) - a mechanism that
will automatically adjust market
supply depending on fluctuations
in demand. The impetus for this
proposal has been the large
oversupply in the EU ETS, which
will reach 2.2 billion allowances by
the end of this year, according to
our forecast. The MSR is supposed
to meet two main objectives
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 enhance the inter-temporal
efficiency of the EU ETS. Inter-
temporal efficiency refers to the
ability of the EU ETS to incentivize
low-carbon investments consistent
with the least-cost emissions
pathway necessary to reach the EU’s
long-term climate goals.
The fate of the MSR proposal will
be determined through the ordinary
legislative procedure between
the EU’s two lawmakers – the
Parliament and member states
in Council, a procedure which
normally takes one to two years.
This process has the potential to
change the current form of the
proposal and therefore alter the
way it affects the carbon market.
Council discussions are already
quite advanced with large countries
voicing general support for the
reform proposal. Many member
states have come forward with
their formal positions over the last
months. The process in Parliament
was held up by the European
elections in May, but MEPs are now
starting work on the file as well. The
final form of the MSR will be settled
though negotiations between the
Parliament and the Council, and the
procedure will be finalized through
votes in both institutions.
In this report, we examine the
design parameters of the MSR and
their impact on the market through
sensitivity analysis. We use our
carbon price model to construct
scenarios which change one or two
parameters of the proposal at a time
and compare these to a reference
scenario featuring the MSR as
proposed by the Commission. All
scenarios presented assume a 40
percent GHG target, a 27 percent
renewables target, and a 30 percent
energy efficiency target for 2030 in
line with the Commission’s Energy
and Climate package proposal. More
information about the methodology
of our price forecasting model can
be found in the Annex at the end of
this report. For an introduction into
the MSR proposal, see the textbox
below.
Reference scenario – EU
ETS’ future with the
Commission’s MSR proposal
We present our base case forecast
of the market supply and demand
balance, which reflects the
Commission’s MSR proposal, in
Figure 1a (solid line). We forecast
the market surplus will reach 2.2
Gt in 2014. This will be followed by
a brief reduction in the oversupply
in line with the backloading
measure. However, towards the end
of phase 3, the reintroduction of
most of the backloaded allowances
will expand the oversupply once
again. In 2020, the number of
excess allowances will reach its
highest level in history at 2.3 Gt.
This expansion of the oversupply
occurs despite the attempt of the
Commission to smoothen the return
of the backloaded allowances in
the current MSR proposal through
Article 2, which distributes some of
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.
The Commission’s Market Stability Reserve proposal explained
Carbon Market Analyst 14 October 2014
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3
the allowances from 2020 to the
following two years (see textbox for
details).
After the surplus reaches its peak
in 2020, it will begin declining
again due to the impact of the
MSR and the decreasing cap. We
estimate that it will take the MSR
six years to reduce the oversupply
below the Commission’s upper
boundary of 833 million tons. The
market surplus will then gradually
stabilize by 2030 as the amount of
emission reductions triggered in the
EU ETS is estimated to offset the
shrinking market cap. We forecast
that by 2027 the reserve will have
accumulated close to 1.5 billion
allowances. The reserve will likely
begin to release these allowances
back to the market in 2030.
The development of the market
surplus in our base case is also
reflected in the carbon price pathway
predicted by our price forecasting
model (Figure 1b, solid line). The
carbon price is likely to experience
some instability around 2020 as the
reintroduction of the backloaded
allowances causes a downward
push to the price in 2019 and
2020. The implementation of the
MSR, together with the gradually
decreasing cap are then likely to
induce a gradual rise in the carbon
price which is likely to reach an
average price of €23/t in the 2021-
2030 period in real 2010 euro terms.
Given this carbon price outlook, we
estimate that the EU ETS will trigger
1,680 Mt of abatement from 2014 to
2030.
We note that this report presents
carbon price pathways predicted by
our quantitative model, which may
not always represent our official
price predictions as they do not
include qualitative adjustments.
The prices predicted by our model
therefore should be viewed as
a representation of the relative
impact of different policies on the
carbon market and as indicative
approximations.
What happens without the
stability reserve in place?
In the absence of the MSR,
the market will experience a
substantially greater and longer-
lasting oversupply as illustrated by
Figure 1a (dashed line). The market
surplus will decline relatively slowly
in line with the decreasing market
cap. As a result, the market will
likely still hold an oversupply of 900
million allowances in 2030.
Figure 1b contains the respective
carbon price pathway predicted
by our model. A scenario without
the MSR will see the carbon price
reach rather low levels around
2020 due to the full reinjection of
the backloaded allowances in two
batches equal to 300 Mt in 2019
and 600 Mt in 2020. The price will
likely rise as the cap decreases in
line with a 40 percent GHG target
for 2030. Our model estimates the
price to reach an average 2021-
2030 price level of €14/t. The MSR
therefore accounts for an €9/t rise
in the carbon price post 2020 and
Figure 1a: Market balance with and without the MSR
Reference case reflects TRPC base case assumptions on 2030 targets.
0
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Market balance (Mt)
Reserve (EC proposal) Balance (No MSR Scenario)
Balance (EC proposal)
Figure 1b: EUA price path with and without the MSR
Reference case reflects TRPC base case assumptions on 2030 targets. All prices in
real 2010 euros.
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EUA price (euro per tCO2)
No MSR Scenario EC proposal
Carbon Market Analyst 14 October 2014
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4
accounts for 48 percent of the value
of EUAs in the next decade.
As a result of a lower carbon price,
the EU ETS without the MSR will
incentivize emission reductions
of 895 Mt from 2014 to 2030. We
therefore estimate that the MSR
will cause 784 Mt of additional
abatement if it were implemented.
Early implementation
Given the current progress of the
MSR file, we believe that the earliest
possible adoption of the proposal
could be before the 2015 summer
recess (see policy timeline below).
This would allow for the mechanism
to be brought into operation already
in phase 3 and allowances could
be withdrawn from the market
as soon as 2017. Implementation
in 2017, however, has not so far
received explicit or public support
from member states. Instead, one
of the strongest supporters of an
early implementation – Germany –
has proposed for the MSR to begin
withdrawing allowances in 2018.
Figure 2a displays the impact of
implementing the MSR in 2018 on
the market supply and demand
balance. The market surplus is
likely to begin falling as soon as
the MSR is enacted in 2018. The
reintroduction of the backloaded
allowances will however hamper
the ability of the MSR to reduce
the oversupply. The return of the
backloaded allowances will once
again increase the oversupply of
the market in 2019, as the MSR will
likely be unable to entirely absorb
the backloading’s supply shock.
The backloaded allowances will
return over the course of four years
between 2019 and 2022 in line
with Article 2 of the Commission’s
proposal.
These dynamics are also reflected
in the carbon price trajectory
predicted by our model (Figure
2b). The introduction of the MSR
in 2018 will likely increase the
EUA price to around €12/t already
in 2018. The reinjection of the
backloaded allowances is then
likely to counteract the effects of the
MSR and keep the price from rising
further until after 2020. With the
start of phase 4, the carbon price
is likely to rise and join the same
pathway as the price under the
Commission’s proposal. As a result
of the early start of the MSR, the EU
ETS will trigger 211 Mt additional
emission reductions compared to
the Commission’s proposal, or 1,891
Mt of abatement between 2014 and
2030.
Figure 2a: Market balance in early implementation scenario
MSR implemented in 2018. Allowances begin to be withdrawn in 2018.
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2,500
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Market balance (Mt)
Reserve (2018 start) Reserve (EC proposal)
Balance (2018 start) Balance (EC proposal)
Figure 2b: EUA price path in early implementation scenario
MSR implemented in 2018. Prices in real 2010 Euros.
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EUA price (euro per tCO2)
2018 start of MSR
EC proposal
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5
The fate of the
backloaded
allowances
The backloading measure stipulates
that the 900 million allowances
withheld from the market will be
returned in two batches of 300 Mt
in 2019 and 600 Mt in 2020. Under
the Commission’s MSR proposal the
reintroduction of the backloaded
allowances is stretched over 2019
to 2022. Ths injection of supply
is likely to cause instability in the
carbon price around 2020 as stated
above. Such concerns have led some
member states to discuss possible
ways to coordinate the backloading
and the MSR mechanism by
handling the reintroduction of the
backloaded allowances within
the MSR proposal. Germany has
proposed to transfer the 900
million allowances into the MSR,
while other voices have called
for a permanent cancellation of
allowances.
The market impact of transferring
the backloaded allowances to the
reserve is depicted in Figure 3a. In
this scenario, the market surplus
will likely be stable at just below
2 billion tons for the rest of this
decade. The surplus will begin
declining only after the MSR begins
operating in 2021. As shown in
Figure 3b, the carbon price is likely
to remain stable around €10/t for
the remainder of phase 3 as the
backloaded allowances are not
released to the market. The effect of
the MSR will likely begin to be fully
reflected in the carbon price starting
in 2021.
Abatement is also likely to develop
differently if the backloaded
allowances were transferred in the
reserve. We estimate that as a result
of the higher carbon price pathway,
the EU ETS will reduce 1,937 Mt from
2014 to 2030, 258 Mt more than
under the Commission’s proposal.
German MSR proposal
Germany has voiced support for
an earlier start of the MSR and
for the transfer of the backloaded
allowances to the reserve. In a non-
paper dated 4 July 2014, Germany
advocated for the Commission to
begin publishing an official estimate
of the market’s balance in 2017 and
for the MSR to begin withdrawing
allowances from the market in 2018.
The German government has thus
called for a de-facto start of the MSR
in 2018.
We present the development of
the market balance resulting from
the German proposal in Figure 4a.
The market surplus will likely begin
to decline as the MSR becomes
operational in 2018. The decline
of the market surplus is gradual
as the transfer of the backloaded
allowances to the reserve avoids
a temporary increase of the
oversupply towards 2020. Therefore,
the two components of the German
proposal – a pre-2021 start date
and the transfer of the backloaded
allowances to the reserve – have
complementary functions in
achieving a gradual reduction in the
Figure 3b: 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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40
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EUA price (euro per tCO2)
BL transfer to MSR
EC proposal
Figure 3a: Market balance if backloaded allowances go into MSR
Instead of returning to the market, 900 Mt are transferred directly into the reserve
in 2019 and 2020.
0
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2,000
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Market balance (Mt)
Reserve (BL transfer to MSR) Reserve (EC proposal)
Bal. (BL transfer to MSR) Balance (EC proposal)
Carbon Market Analyst 14 October 2014
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6
market oversupply already in phase
3. The market balance is likely to fall
below the Commission’s prescribed
upper boundary of 833 Mt in 2022,
four years earlier than under the
Commission’s proposal. The reserve
will likely accumulate close to 2
billion allowances, which will begin
to be released to the market in
2030.
We have not modeled the EU
ETS beyond 2030, but it appears
likely that the carbon market will
develop differently post-2030
depending on whether the German
or the Commission MSR proposal is
implemented. As shown in Figure
4a, the reserve under the German
proposal will hold 500 million more
allowances in 2030 than under
the Commission proposal. These
allowances are likely to be released
in the market and mitigate potential
price increases beyond 2030.
The impact of the German proposal
on the carbon price according to our
price model is depicted in Figure 4b.
The combination of a 2018 start and
the withholding of the backloaded
allowances is likely to push the
price higher already in phase 3 and
could result in a price around €18/t
in 2020. Under this scenario the
carbon price is higher than under
the Commission’s proposal until
2027, when prices are likely to reach
the same level of around €30/t.
The overall price trajectory
under the German proposal
shows a relatively stable carbon
price increase compared to the
Commission’s proposal. The gradual
increase in the carbon price is
likely to give market participants a
longer timeframe to prepare for the
emission reductions necessary to
meet the proposed 2030 target of
reducing emissions by 40 percent
compared to 1990 levels. This is
in line with the MSR’s objective
to enhance the inter-temporal
efficiency of the EU ETS, but will
Figure 4b: EUA price path - German MSR proposal
MSR begins to withdraw allowances in 2018. 900 Mt backloaded allowances are
transferred to the reserve in 2019 and 2020. All prices in real 2010 euros.
0
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EUA price (euro per tCO2)
German proposal
EC proposal
Figure 4a: Market balance - German MSR proposal
MSR begins to withdraw allowances in 2018. 900 Mt backloaded allowances are
transferred to the reserve in 2019 and 2020.
0
500
1,000
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Market balance (Mt)
Reserve (German proposal) Reserve (EC proposal)
Balance (German proposal) Balance (EC proposal)
Figure 4c: CO2 abatement - German MSR proposal
MSR begins to withdraw allowances in 2018. 900 Mt backloaded allowances are
transferred to the reserve in 2019 and 2020.
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Annual abatement (Mt)
EC proposal German proposal
German proposal
EC proposal
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7
likely increase the short-term cost
of compliance for participating
companies, which could intensify
companies’ carbon leakage
concerns.
The German proposal will likely
have a significant impact on the
abatement in the EU ETS (Figure
4c). Under the Commission’s
proposal (grey bars) we estimate
the EU ETS to incentivize annual
abatement of 30 Mt on average until
2020, mainly through fuel switching
in the power sector, and rising levels
of abatement in both the power
and industry sectors after the MSR
becomes operational in 2021.
Under the German proposal (orange
bars), we estimate higher carbon
prices to cause higher levels of
abatement at an earlier point in
time, resulting in 469 Mt additional
abatement up to 2030 compared to
the Commission’s proposal. Overall,
the EU ETS under the German
proposal incentivizes 2,148 Mt of
abatement in the 2014-2030 period.
Closer to 2030, the annual
abatement under the German
proposal is estimated to be less
than the abatement triggered by
the Commission’s proposal. This
is due to the fact that the early
abatement mainly triggered by the
early implementation of the MSR
reduces the need for abatement in
the long-run.
The main effect of the German
proposal on abatement is the
distribution of abatement costs
across time. The proposal is likely to
encourage EU ETS participants to
reduce emissions gradually towards
2030. This stands in contrast to the
Commission’s proposal which is
likely to cause market participants
to face a steeper rise in abatement
costs after 2021.
French MSR proposal
France has proposed amendments
to the Commission’s proposal which
alter the formula used to determine
the operation of the MSR. Under
this proposal, the MSR is triggered
when the oversupply is above an
upper threshold of 1,300 Mt. The
MSR would then withdraw a volume
equal to 33 percent of the difference
between the surplus and the lower
threshold, which is set at 800 Mt.
When the surplus is below the lower
threshold, the MSR would release
to the market a volume equal to 33
percent of the difference between
the surplus and the upper threshold.
We model the impact of the
French proposal in Figures 5a
and 5b. This proposal is likely to
result in a quicker reduction in the
market surplus compared to the
Commission’s proposal (Figure 5a),
as the MSR withdraws around 400
Mt on average between 2021 and
2024. This is a significantly higher
volume than the volume taken out of
the market under the Commission’s
proposal (equal to 200 Mt on
average between 2021 and 2027).
From 2026, the MSR will likely begin
Figure 5b: EUA price path - French MSR proposal
Scenario reflects French proposal for the MSR formula. All prices in real 2010
euros.
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EUA price (euro per tCO2)
French proposal EC proposal
Figure 5a: Market balance - French MSR proposal
Scenario reflects French proposal for the MSR formula.
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Market balance (Mt)
Reserve (French proposal) Reserve (EC proposal)
Balance (French proposal) Balance (EC proposal)
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
8
releasing allowances back into the
market under the French proposal.
This will result in an expansion
in the surplus as around 200 Mt
allowance are being returned per
year. These rapid changes of the the
market surplus are reflected in the
carbon price trajectory predicted
by our model which, sees prices
increasing at a relatively fast pace
to reach €27/t in 2025, and then
falling slightly towards €25/t by
2028 (Figure 5b).
Given this carbon price pathway,
we estimate the French proposal
to result in more abatement than
the Commission’s proposal up to
2026, and lower levels of abatement
thereafter. In total, the EU ETS
reduces 44 Mt fewer emissions
under this proposal in the 2021-
2030 period.
A reason for the price fluctuations
shown in Figure 5b is the time lag
which it takes the MSR to adjust
the auctioning volumes. Under the
Commission’s proposal, the MSR
takes two years to adjust market
supply. France has voiced support
for a shorter time lag. A shorter MSR
time lag time will smooth out the
carbon price trajectory displayed in
Figure 5b.
The MSR time lag
Under the current proposal, the
Commission will publish on 15 May
every year an official estimate of
the market’s supply-demand for the
previous year. Any adjustments to
the auctioning volume on the basis
of this number then take place in
the following year, thus leaving a
two-year lag in the operation of the
MSR. France and a number of other
member states have supported a
shortening of this time lag.
It may be possible to shorten the
MSR time lag from two years to one
and a half years. This implies that
the Commission’s publication of the
oversupply volume on 15 May would
be followed by an adjustment of
the auctioning volume perhaps as
early as July of the same year. The
MSR can then adjust the auctioning
volumes scheduled from July to June
the following year.
Figure 6 displays the market impact
from a one-and-a-half-year MSR
time lag. The main difference to the
current proposal concerns the period
after 2026. Due to the shorter time
lag, the MSR is able to react quicker
to the fact that the oversupply
has fallen under the upper limit
of 833 Mt, and cease withdrawing
allowances from the market. This
development in the market surplus
will likely result in a slightly lower
carbon price post-2026 compared
to the Commission’s proposal.
According to our price forecasting
model, the annual carbon price will
be 3 percent lower on average from
2026 to 2030.
These results imply that the carbon
price outlook is not sensitive to the
time lag of the MSR. Instead the
carbon price forecast up to 2030
depends mainly on how soon the
current oversupply is depleted. The
time lag may be of greater relevance
for the EU ETS once the oversupply
has fallen within the preferred
surplus band between the MSR
thresholds. At this point in time, the
time lag will play an important role
in determining how quickly the MSR
reacts to demand shocks, which
drive the oversupply out of this
band. A shorter time lag, such as a
one-and-a-half-year lag will likely
increase the stability of the carbon
price in such cases.
The impact of the
MSR threshold levels
The Commission’s proposal has
set an upper threshold at 833 Mt
(if the surplus is above this level,
allowances are taken out of the
market) and a lower threshold 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 entirely clear. The Commission
argues that the thresholds should
allow the market a certain level
of oversupply. The Commission
assumes that an oversupply in
the market is necessary to help
power companies cover their EUA
obligations for future years in line
with power hedging patterns. We
discuss the power sector hedging
needs in more detail below. Here we
present results from our modeling
Figure 6: Market balance with shorter MSR time lag
Scenario reflects a one-and-a-half-year time lag. Reference reflects a two-year lag
as proposed by the Commission.
0
500
1,000
1,500
2,000
2,500
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
Market balance (Mt)
Reserve (1.5-year time lag) Reserve (EC proposal)
Balance (1.5-year time lag) Balance (EC proposal)
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
9
of the impact of alternative MSR
thresholds on the carbon market.
We first present a simulation where
the MSR upper threshold is set at
1000 Mt and the lower threshold
is set at 600 Mt. The impact of
higher trigger levels results in a
higher market surplus (Figure 7a).
This is likely to lower the carbon
price somewhat compared to the
Commission proposal (Figure 7b).
The chosen thresholds of 1000 Mt
and 600 Mt result in a 2030 carbon
Power sector hedging
and the MSR
A debate has unfolded over the
importance of power hedging
needs for the design of the MSR
and for the proposed thresholds of
400 and 833 million allowances.
Power companies sell electricity
several years in advance, and
simultaneously buy the carbon
allowances necessary for this
future electricity generation. The
Commission has argued that the
MSR proposal should accommodate
this behavior. It has argued that
the threshold levels should allow
the market a certain level of
oversupply, and implied that this
oversupply should be roughly equal
to the amount of allowances power
companies need to buy for future
power generation.
The amount of power hedging
demand from companies is however
not consistently reported and
relatively opaque. Based on public
information, we assume that power
producers sell electricity up to three
years ahead. In 2014 we assume
power producers require 867
million tons of carbon allowances
to cover power sales. This number
is expected to grow towards
939 million tons in 2020 due to
decreasing free allocation to eastern
European utilities. The power
hedging demand is then estimated
to drop to 729 million tons in
2030, due to the growing share of
renewable energy sources. These
numbers suggest that the proposed
thresholds are representative of the
hedging needs of power companies.
However, the future of the power
hedging pattern remains largely
uncertain. Therefore a question
arises as to what the effect on
the market will be if the MSR
thresholds are set below (or above)
the actual power hedging needs.
Some voices say that the annual
price of €31/t, compared to €33/t
under the current Commission
proposal, according to our model.
A lower set of trigger levels will have
the opposite effect on the market. As
an example we show a simulation
with an upper threshold of 600
Mt and a lower threshold of 200
Mt. This scenario is likely to result
in a slightly lower market surplus
towards 2030 (Figure 7a) and a
slightly higher carbon price in 2030
(Figure 7b).
Figure 7b: EUA price paths with alternative MSR thresholds
Scenarios reflecting alternative MSR thresholds. Reference reflects the 833 Mt and
400 Mt thresholds proposed by the Commission. All prices in real 2010 euros.
0
5
10
15
20
25
30
35
40
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
EUA price (euro per tCO2)
600-200 thresholds
1000-600 thresholds
EC proposal (833-400 thresholds)
Figure 7a: Market balance with alternative MSR thresholds
Scenarios reflecting alternative MSR thresholds. Reference reflects the 833 Mt and
400 Mt thresholds proposed by the Commission.
0
500
1,000
1,500
2,000
2,500
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
Market balance (Mt)
Reserve (EC proposal) Reserve (600-200 thresholds)
Reserve (1000-600 thresholds) Balance (600-200 thresholds)
Balance (1000-600 thresholds) Balance (EC proposal)
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
10
hedging demand is far greater than
the proposed thresholds and that
the MSR will create a significant
shortage that could cause EUA
prices to spike. We find the choice
of MSR thresholds is unlikely to
disrupt the orderly functioning of the
market or the stability of the carbon
price, but it is likely to impact the
costs that power companies bear
when engaging in hedging. Our
finding rests on the premise that
an oversupply of allowances is not
necessary to cover power sector
hedging needs.
In the case where no oversupply
is present, power companies can
hedge their power sales by buying
allowances on the forward market.
To attract willing sellers, the price
for forward carbon contract will have
to reflect a large enough premium
on top of the price for a spot carbon
contract. If this were the case,
there would be market participants
willing to offer forward contracts
to power companies, in order to
benefit from an inter-year price
difference. Therefore, if the EU ETS
oversupply were insufficient to meet
power forward hedging, the forward
market will accommodate hedging
demand by increasing the price of
forward carbon contracts compared
to spot contracts.
The oversupply becomes important
only in the way it can affect the
price difference between spot and
forward contracts. The lower the
oversupply in the market is, the
larger the premium for forward
contracts will theoretically be and
vice versa. Another factor which
will determine the price difference
between spot and forward contracts
is the amount of risk that sellers take
on when offering forward carbon
contracts. This in turn will be related
to the perceived credibility and the
predictability of the EU ETS. We find
that setting the MSR thresholds is
therefore a discussion about the
costs of hedging rather than the
orderly functioning of the market.
Size of the annual
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
shall 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.
To model the market impact, we
simulate an arbitrary scenario,
in which the MSR withdraws 20
percent of the market’s surplus. As
shown in Figure 8a, this scenario
will result in a quicker depletion
of the market surplus after 2021.
We estimate that 365 million
allowances will be withdrawn on
average between 2021 and 2025,
a volume greater than the average
200 million allowances withdrawn
under the Commission’s proposal.
As a result, the market surplus will
fall below the upper threshold of
833 Mt in 2024, two years earlier
than under the Commission’s
proposal.
As a result of this scenario, the
carbon price will begin to increase
faster after 2021 than under the
Commission’s proposal (Figure
8b). The price is likely to stabilize
after 2025 as the EU ETS triggers
enough annual abatement to offset
the impact of the declining market
cap. In 2030, this scenario results in
a carbon price roughly equal to the
one generated by the Commission’s
proposal, according to our model.
As the carbon price rises earlier
under this scenario, it triggers more
emission reductions, resulting in an
additional 214 Mt of abetment in the
2021-2030 period compared to the
current proposal.
Figure 8a: Market balance with alternative annual adjustments
Annual take out volume changed to 20% from 12% as proposed by the EC.
0
500
1,000
1,500
2,000
2,500
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
Market balance (Mt)
Reserve (20% take out) Reserve (EC proposal)
Balance (20% take out) Balance (EC proposal)
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
11
Resiliency against
demand shocks
According to the Commission, one
of the two main goals of the MSR
proposal is to make the ETS more
resilient to demand side shocks.
To explore how the market will
react to future demand shocks, we
have devised a scenario in which a
financial recession unfolds in 2021
and follows the same pattern as
the double dip recession the EU has
seen over the past six years. EU GDP
growth in 2021 is set at 0.5 percent,
in line with 2008 growth and 2022
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 2025,
as it did in 2012. Growth eventually
returns to the 1.9 percent for the rest
of the next decade as assumed in
our base case forecast.
In the absence of the MSR, a
financial recession will likely lead
to an expansion of the market
oversupply to over 2.5 billion tons
for most of the next decade (Figure
9a). This long lasting surplus is likely
to discourage market participants
from holding allowances into the
future and could result in extremely
low prices up to 2030 (Figure 9b).
Figure 9a: Market balance in a financial recession
Scenarios reflect a financial recession beginning in 2021. Reference reflects Point
Carbon base case GDP assumptions; See Table 1 for GDP assumptions.
0
1,000
2,000
3,000
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
Market balance (Mt)
Reserve (reference GDP) Reserve (Recession with MSR)
Balance (Recession w/o MSR) Balance (Recession with MSR)
Balance (reference GDP & MSR)
Figure 9b: EUA price paths in a financial recession
Financial recession begins in 2021 and follows same annual GDP growth rate as
the 2008 financial recession. All prices in real 2010 euros.
0
5
10
15
20
25
30
35
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
EUA price (euro per tCO2)
Recession w/o MSR Recession with MSR
Reference GDP with MSR
Figure 8b: EUA price path with alternative annual adjustments
Annual take out volume changed to 20% from 12%. All prices in real 2010 euros.
0
5
10
15
20
25
30
35
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
EUA price (euro per tCO2)
20% take out volume EC proposal
TRPC
GDP
Recession
GDP
2021 1.91 0.50
2022
1.90 -4.40
2023
1.90 1.80
2024
1.90 1.70
2025
1.89 -0.30
2026
1.89 1.20
Table 1: GDP comparison
In ’Recession GDP’ scenario, EU GDP
growth from 2021-2026 is equal to the
historical GDP growth in 2008-2012.
Source: IMF
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
12
On the other hand, if the MSR
is adopted, it will react to the
reduction in demand resulting from
the financial crisis by withholding
more allowances from the market.
The MSR is likely to partially offset
the impact of an economic crisis on
the carbon price (Figure 9b). The
reserve will likely prevent the carbon
price from dropping towards €0/t
and result in an increasing price
trajectory as it reduces the market
surplus over time.
The carbon price trajectory is
forecast to decrease as a result of
a financial crisis as the MSR will
likely not offset the full impact of
an economic downturn. This is due
to the parameter of the MSR which
governs how many allowances can
be withdrawn from the market,
which the Commission has set at 12
percent of the oversupply.
To illustrate this, we examine the
development of EU ETS emissions
as a result of an economic shock. For
2022, our simulation has modeled
a GDP contraction of 4.4 percent.
This lower economic activity reduces
emissions by around 200 Mt in
2022. The MSR will react to this in
2024 by withdrawing 12 percent
of the oversupply in 2022. As a
result of the economic contraction
the oversupply in 2022 is now 200
Mt greater than what it would
have been without the recession.
Therefore, the MSR reacts to the
economic shock by effectively
withdrawing 12 percent of the
additional 200 Mt from the market.
Thus, the supply reduction driven
by the MSR will not match the
demand reduction of an economic
recession. The MSR will nonetheless
reduce the market surplus under
an economic crisis, but it will take
longer to do so than in the absence
of such a shock.
From this example, it follows that
the MSR would be able to offset
the impact of external shocks to
a greater extent if the percentage
of oversupply withdrawn from the
market is allowed to increase the
further away the market surplus is
from the MSR’s upper trigger level.
We also note that the MSR will
never be able to fully offset external
shocks due to the fact that it allows
the market balance to fluctuate
freely between the threshold values
(from the 400 Mt lower threshold to
the 833 Mt upper threshold).
Timeline for the MSR
– waiting for the
Parliament
The ordinary legislative procedure
needed to implement the MSR
normally takes between one and
two years. The overall progress on
this particular proposal will largely
depend on how the debate in the
Parliament develops. We see the
Council debate as quite advanced,
with a number of working group
meetings having taken place
since the MSR proposal was put
forward in January. As discussed
above, many countries have come
forward with official positions on
the proposal, tabling amendments
or measures to strengthen the
measure, with countries increasingly
leaning towards supporting the
reform proposal. Member states
could come to an agreement at
the Environment Council on 17
December, in a qualified majority
vote (i.e. 260 out of in total 352
votes). A Council position at this
point in time would in our view
influence the decision-making
process in the Parliament.
Due to the European elections, the
Parliament is at a different stage
in processing the file, and several
steps will have to be undertaken
before it reaches a position on the
MSR. The Parliament’s environment
committee (ENVI) in charge of the
MSR file has scheduled a vote on
the proposal for its meeting on 23-
24 February 2015. Before this vote
can take place, the committee has
to agree on its opinion based on a
report scheduled to be put forward
early December by the rapporteur of
the file Ivo Belet of the conservative
European People’s Party. Following
the vote in ENVI, a plenary vote will
take place to settle the Parliament
position, possibly in March 2015.
Subsequently, representatives from
the Parliament, the Council and the
Commission would come together
in so-called trilogue negotiations
to find a compromise that can be
accepted by member states and
the Parliament – with the outcome
to be confirmed through formal
votes in both institutions. As such
informal negotiations are normally
quite productive, the aim of the
forthcoming Latvian Presidency of
the Council to pass the proposal into
law within the end of its term in June
2015 could be within reach.
A best-case scenario, in which the
final votes take place sometime
ahead of the 2015 summer recess,
would allow for the adoption of
the MSR before the end of 2015.
Considering only the time needed for
finalizing the legal procedures, this
would allow for an implementation
of the measure as early as 2016
with a view to withhold the first
allowances from the market starting
in 2017. However, political positions
at this point in time indicate that
despite the theoretical possibility
of a start in 2017 the MSR will likely
start at a later point in time.
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
13
Summary
We find that alternative designs of
the MSR can greatly influence how
soon the oversupply in the market
is diminished, what trajectory the
carbon price follows, and how much
abatement is triggered by the EU
ETS. Table 2 summarizes the results
from our modeling of alternative
MSR designs and their impacts.
The start date of the MSR and the
question of how the backloaded
allowances are handled stand out as
the most important considerations
for the development of the EU ETS
up to 2030. The implementation
of the MSR in phase 3 would
result in a quicker reduction of
the market surplus than under
the Commission’s proposal. Of
importance to the carbon price
is also how the implementation
of the MSR will be coordinated
with the scheduled reintroduction
of the backloaded allowances.
The proposal to transfer these
allowances into the reserve will
prevent a drop in the carbon price
towards 2020 and likely cause the
2014-2020 and 2021-2030 periods
are estimated by our model to
be the same as those under the
Commission’s proposal. However,
the trajectory of the carbon price
after 2020 is likely to differ with the
French proposal, which we estimate
will result in slightly less abatement.
In terms of the importance of the
MSR thresholds in relation to the
needs of the power sector to hedge
carbon allowances, we find that the
choice of MSR thresholds is unlikely
to affect the orderly functioning of
the market or the stability of the
carbon price, but it is likely to impact
the costs that power companies
bear when engaging in hedging.
Going forward, the political process
will undoubtedly cover wide ranging
discussions due to the highly
technical nature of the proposal and
its multiple objectives to both reduce
the current oversupply and increase
the future flexibility of the EU ETS
against potential changes in market
demand. To explore additional
carbon price simulations, access our
MSR Simulation Tool, available on
Thomson Reuters Eikon.
oversupply to fall within the MSR
surplus band two years earlier than
the Commission’s proposal.
The German proposal, which
combines these two options, would
result in a gradual decline of the
surplus likely to be coupled with a
steady rise of the EUA price starting
in phase 3. This proposal enhances
the inter-temporal efficiency of
the EU ETS, and improves the
ability of the MSR to meet one
of its objectives of reducing the
current oversupply. Transferring
the backloaded allowances in the
reserve could however add political
complexity as it interferes with
the recently adopted backloading
decision.
France’s proposal to alter the
MSR formula could change the
carbon price outlook post 2020,
while leaving the phase 3 policy
framework unchanged. Due to a
higher rate with which allowances
are removed from the market,
this proposal leads to a reduction
in the surplus in 2024, two years
before the Commission’s proposal.
The average carbon prices for the
MSR Scenarios
Year when surplus
falls within chosen
surplus band
Average
2014-2020
price (€/t)*
Average
2021-2030
price (€/t)*
Abatement
triggered
by EU ETS
(2014-
2020) (Mt)
Abatement
triggered
by EU ETS
(2021-
2030) (Mt)
Allowances
in reserve in
2030 (Mt)
Commission proposal 2026 ~9
~23 116 1,564 1,357
Early Start (2018)
one year earlier +2 +2 +41 +170 +222
Transfer of 900 Mt backloaded
allowances to the MSR
two years earlier +1 +4 +22 +235 +330
German proposal
four years earlier +3 +5 +70 +399 +523
French proposal
two years earlier No
change
No
change
No
change
-44 -359
Alternative thresholds (1,000 Mt
- 600 Mt)
one year earlier No
change
-1 No
change
-61 -204
Alternative thresholds (600 Mt -
200 Mt)
one year later
No
change
No
change
No
change
+36 +177
Alternative size of MSR
adjustments (20% take out)
two years earlier No
change
+3 No
change
+214 +170
Table 2: Summary of Point Carbon model results
*Presents carbon prices estimated by our quantitative EUA price model. Scenario numbers refer to changes vs. EC proposal.
Carbon Market Analyst 14 October 2014
All rights reserved © 2014 Thomson Reuters Point Carbon
14
Annex: The Point Carbon price forecasting model
Our price forecasting model consists of three modules. The first module is an econometric price forecasting model.
This model relates historical EUA prices with the historical “perceived” EU ETS supply and demand balance to
simulate how the observed strategic behavior of market participants influences the carbon price. The perceived
market balance is calculated as ‘Actual Demand’ minus ‘Perceived Supply.
We calculate ‘Actual Demand’ on the basis of historical verified emissions as well as our forecast for future
emissions. Emissions in the power sector have been adjusted for forward hedging needs to reflect the actual
demand of power sector participants in any given year. Forward hedging is done up to three years ahead and is
calculated on the basis of public financial reporting by major European utilities. In the industrial sectors, demand
is based on the sector’s current balance between emissions and free allocation and the sector’s balance for the
next three years. Industrial participants are therefore assumed to optimize their trading three years ahead.
‘Perceived Supply’ is based on the future EU ETS cap as well as market participants’ expectations about any
potential changes to the cap. We expect market participants to evaluate different scenarios regarding the
potential future cap changes and weigh them based on probabilities, representing their expectations regarding
the chance of each scenario. We construct the future ‘Perceived Supply’ based on current legislation as well as
in-house policy analysis regarding any potential legislative changes. The future ‘Perceived Supply’ is based on a
40 percent greenhouse gas target, a 27 percent renewable energy target and a 30 percent energy efficiency target
for 2030. Our base case forecast also factors in the adoption of the Commission’s proposal for an MSR and its
implementation in 2021.
The second module of our price forecasting model simulates the interaction between the future EUA price
expected by the market and the amount of abatement in the EU ETS. A feedback loop is used to estimate the
impact of abatement on the carbon price and to forecast the future carbon prices and abatement levels. Our
model uses marginal abatement cost curves for the power and industry sectors. Fuel switching abatement in the
power sector is calculated by a power dispatch model, while abatement in the industry sector is based on currently
available abatement options and takes into account inter-temporal effects of investment decisions.
The third module simulates a constraint, which specifies that market participants cannot be short of EUAs for
their annual compliance needs. The module simulates the market’s reaction to a potential future shortage by
calculating an abatement schedule based on least-cost optimization. We assume that market participants would
begin to cover shortages by beginning to abate emissions five years in advance. The higher abatement needs
caused by the impending shortage have a bullish effect on the price on the basis of our marginal abatement cost
curves.
1
Price
Regression
model
Abatement
Emissions
model
Perceived
Supply
calculation
Market
shortage
constraint
Marginal
Abatement
Cost curves
Short next 5 years?
Yes No
Price
increase
Long-term
price forecast
Module 1 Module 2 Module 3
Additional
abatement
MSR
MSR
Hedging and industry
optimization
EUA price model illustration
All rights reserved © 2014 Thomson Reuters Point Carbon
15
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retrieval system, copied to a database, retransmitted, forwarded or otherwise redistributed without prior written authorisation
from Thomson Reuters. Breach of these terms is illegal and punishable by fines up to € 50 000 per violation. See Point Carbon’s
”Terms & Conditions” at www.pointcarbon.com
The data provided in this report were prepared by Thomson Reuters Point Carbon’s Trading Analytics and Research
division. Publications of Thomson Reuters Point Carbon’s Trading Analytics and Research division are provided for
information purposes only. Prices are indicative and Point Carbon does not offer to buy or sell or solicit offers to buy or sell
any financial instrument or offer recommendations to purchase, hold or sell any commodity or make any other investment
decision. Other than disclosures relating to Point Carbon, the information contained in this publication has been obtained
from sources that Point Carbon believes to be reliable, but no representation or warranty, express or implied, is made as to
the accuracy or completeness of this information. The opinions and views expressed in this publication are those of Point
Carbon and are subject to change without notice, and Point Carbon has no obligation to update either the opinions or the
information contained in this publication.
Thomson Reuters Point Carbon’s Trading Analytics and Research division receives compensation for its reports. Point
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request of any client of Thomson Reuters Point Carbon.
Contacts
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emil.dimantchev@thomsonreuters.com
Tel +47 23 31 65 08
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For further information about the products please use
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BL transfer to MSR) Balance (EC proposal)
  • Bal
Bal. (BL transfer to MSR) Balance (EC proposal) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
1000-600 thresholds) Balance (EC proposal)
Balance (1000-600 thresholds) Balance (EC proposal) 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
5-year time lag) Balance (EC proposal)
Balance (1.5-year time lag) Balance (EC proposal) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028