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What are the rules in the EU ETS?

Carbon Markets: Rules

This article explores EU ETS compliance, detailing carbon allowance trading dynamics. It demonstrates the market's growing maturity and sophistication.

What are the rules in the EU ETS?

The European Union Emissions Trading Scheme (EU ETS) was created as the backbone of the European Union’s climate and energy policy. There is no way for an industrial emitter of greenhouse gas to escape the system - it is legally binding through European directives. The compliance rate, published every year, is just short of 100%. It was 99% in 2022 as stated in this EU commission report. 

However, as it was engineered in the first place, the scheme was falling short in bringing effective decarbonization effort. The market mechanism was inadequate, leading to ridiculously low prices. They had no incentivizing effect. Regulatory interventions were necessary to reform the EU ETS and create the right conditions for prices to increase.

It is only when the price of allowances are greater than the price of decarbonation solutions, on a per-ton basis, that industries will invest in these solutions. Therefore, regulators need to make sure that prices increase regularly, unlocking decarbonation solutions and incentivizing industries to invest in them. In the EU, regulators adjusted market mechanisms over time to align price with climate objectives.

  • The EU ETS compliance
  • The EU ETS regulations and carbon allowance trading
  • What is the EU ETS trajectory? How has it been stabilized?

The EU ETS compliance

No other choice but to surrender EUAs

Industrials have no choice but to purchase EUAs to offset their emissions. They are facing regulatory accountability - there are penalties for non-compliance with carbon market obligations. Failure to surrender allowances on time incurs financial repercussions. It requires the payment of the allowance cost for every missed allowance along with a €100 penalty per allowance. This system incentivizes timely and responsible participation in the EU ETS.

What is the  EU ETS compliance process?

The Union Registry plays a crucial role in ensuring the accounting for all allowances within the EU Emissions Trading System (EU ETS). To engage in the EU ETS, entities must open an account in the Union Registry, by submitting a request to their “national administrator” - the government’s representative in charge of the EU ETS management. Similar to a bank's record-keeping, the registry tracks the ownership of allowances held in electronic accounts.

What is the  EU ETS registry?

The European Commission’s website gives a list of what we can find in the registry:

  • A list of installations covered by the ETS Directive in each EU country. There are currently around 11 000 installations. 
  • Accounts of companies or individuals holding such allowances.
  • Transfers of allowances ("transactions") performed by account holders.
  • Annual verified CO2 emissions from installations and aircraft operators.
  • Annual reconciliation of allowances and verified emissions, where each company must have surrendered enough allowances to cover all its verified emissions.

What is the EU ETS compliance calendar?

We saw above that industries are required to buy EUAs to align with their emissions. They have to submit them to the EU commission following a specified calendar. Prior to 2024, the deadline for surrendering carbon allowances was April 30 of each year. However, a recent modification has established that from 2024 onwards, industries must fulfill this obligation by September 30. This change aimed at facilitating internal accounting processes for industrial entities.

The EU ETS regulations and carbon allowance trading

What is the EU ETS legislation?

The EU ETS was formally defined in 2005 through an ETS Directive. A European Union directive is a legal act that sets specific objectives for all member states. However, it allows them the flexibility to choose the means of achieving those goals. A directive provides a framework for harmonizing laws across the EU. It ensures consistency in the overall objective while accommodating variations in national implementation.

A carbon price: the result of demand and supply crossing

The EU ETS operates as a cap-and-trade system, enabling installations to trade EUAs among themselves. This market is also open to large financial players but also to individual investors (this has been the case after the introduction of the Homaio platform in 2023). So, the price of carbon is dictated by the financial market mechanisms - the difference between demand and supply. The EU directive simply outlines the "rules of the game" rather than specifying fixed price levels.

What is the EU ETS trajectory? How has the scheme been stabilized?

Ineffective EU ETS at the beginning

The low EUA prices until 2020

The objective of the EU ETS is to impose a financial burden on installations, compelling them to prioritize decarbonization efforts. The higher the cost of allowances, the greater the will to avoid purchasing carbon allowances - this is how regulators want to lead to reduced carbon emissions. They want to make industrials increase their investments in decarbonization technologies. Initially lacking market stabilization mechanisms, EU ETS prices remained considerably low, remaining below the €20-30 range from the inception of the mechanism in 2005 until 2020.

The initial lack of stabilization mechanisms

The initial directive did not outline precise mechanisms to have control over the gap between demand and supply. This resulted in a significant market imbalance within the EU ETS. An endemic oversupply emerged, with a EUA supply consistently exceeding the actual market demand. This led rapidly to a drastic market drop. During a big part of 2007 and 2008 (the financial crisis period), EUA prices remained close to zero - this underscored the need to introduce market stabilization tools to avoid such intense decreases.

The need for EU ETS change to bring climate impact

The excessively low EUA prices failed to align with the environmental reality because they didn’t make emissions expensive enough. Regulatory intervention was needed to prevent such dramatic drops. This was done by an improved management of the disparity between demand and supply. This was possible thanks to a strong characteristic of cap-and-trade systems: their adaptability. As they are created by regulators, they can be amended over time. In contrast to other financial assets, EUAs are not solely driven by speculative behavior and financial market mechanisms. They can be stabilized thanks to legislation and directives. They serve a specific purpose, a function, and have continuously improved in meeting that purpose since 2005.

The EU ETS Market Stability Reserve: preventing huge market drops

What is the Market Stability Reserve?

The Market Stability Reserve (MSR) was implemented in 2015 (and operational since 2019) and aims to enhance the system's resilience. It automatically adjusts the total number of allowances available based on the prevailing market conditions (the current difference between demand and supply). It does so by introducing an annual adjustment to the number of allowances in circulation - the MSR contributes to stabilizing prices and mitigating extreme market fluctuations. The MSR has proven to be an effective tool in bringing EU ETS prices higher.

The Market Stability Reserve in numbers 

The “EUA surplus” is the difference between the total number of allowances in the market (the EUAs that have been issued but have not been surrendered), and the number of EUAs surrendered by the installations.

  • If the surplus is above the buffer MSR level of 1096 Mt, the MSR will hold back 24% of the surplus.
  • If the surplus is between 1096 Mt and 833 Mt (the upper threshold level), the buffer MSR kicks in. The number of allowances placed in the MSR will be the difference between the total number of allowances in the market, and 833 million. 
  • If the surplus is between the upper threshold 833 Mt and the lower threshold 400 Mt, the MSR is muted and there is no intake to the reserve.
  • If the surplus falls below the lower threshold of 400 Mt, the MSR releases allowances to the market and 100 Mt is placed to the annual auctions.

What does the market stability reserve do? Has it been successful?

The Market Stability Reserve (MSR) has enabled regulators to adjust the supply of allowances based on the prevailing market demand. It allowed them to transform the predetermined supply into a responsive force to the real market. This adaptability has been crucial, and the MSR's has proven to be a successful tool. The structural surplus has been decreasing - going from nearly 1700 Mt in 2017 to as low as 1100 Mt in 2023. Beyond tightening the balance between supply and demand, the MSR has also accomplished its role in boosting EUA prices. Post-2020, EUA prices have increased, bringing the price ranges from the €20 area to €60-95 ranges, enhancing the overall climate effectiveness of the EU ETS.

Sources:

Carbon Pulse, 2023. The market impact of the new EU ETS compliance cycle

The European Commission, 2023. Report on the functioning of the European carbon market in 2022

The European Commission, 2023. Monitoring, reporting and verification of EU ETS emissions

The European Commission, 2023. Union Registry

EUR - Lex, 2023. Directive for greenhouse gas emission allowance trading

Veyt, 2023. The hot air is gone: EU ETS has entered a new era

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