What is the market stability reserve in the EU ETS?

The Market Stability Reserve (MSR) is one of the most important mechanisms within the European Union Emissions Trading System (EU ETS), designed to regulate the imbalance between the supply and demand of emission allowances. By stabilizing carbon prices and introducing upward pressure when necessary, it enhances climate change mitigation efforts. Operating by adjusting the supply of allowances in response to real-time market conditions, the MSR absorbs surplus allowances when supply exceeds predetermined thresholds. It can also release allowances back into the market if scarcity arises. Since its introduction in 2015, the MSR has undergone amendments to align with European climate goals, including a recent review in 2023. Complementing the rising Linear Reduction Factor (LRF), the MSR has effectively contributed to driving EUA prices upward by mitigating oversupply and promoting market stability.

• What is the Market Stability Reserve (MSR)?
• The Functioning of the Market Stability Reserve
• How has the MSR of EU ETS evolved over time? 
• What is the impact of the MSR on carbon prices?

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What is the Market Stability Reserve (MSR)?

What is the definition and purpose of the market stability reserve?

The Market Stability Reserve (MSR) is a key mechanism within the European Union Emissions Trading System (EU ETS) designed to address imbalances in the supply and demand of emission allowances. It serves as a regulatory tool to stabilize the supply and ensure the effectiveness of the EU's efforts to combat climate change.

How does the MSR operate within the EU Emissions Trading System (ETS)? 

The MSR operates by adjusting the supply of emission allowances in response to changing market conditions. When there is an excess supply of allowances, the MSR absorbs surplus allowances from the market, thereby reducing oversupply and preventing prices from falling by too much. On the other hand, if allowances become scarce, the MSR releases EUAs into the market to ensure sufficient availability. Historically, the MSR has always absorbed EUAs, never the other way around. 

What are the goals of the MSR in ensuring market stability?

The goal of the MSR is to maintain a balanced carbon market by regulating the supply of emission allowances. By mitigating extreme price fluctuations and preventing prices from being way too low, the MSR provides more predictability for market participants while incentivizing emissions reduction efforts.

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The Functioning of the Market Stability Reserve

Mechanisms for Adjusting the Supply of Emission Allowances

The MSR adjusts the supply of emission allowances through a process of an adjustment based on predefined trigger levels. When the total number of allowances in circulation exceeds a certain threshold, allowances are automatically taken out from the market and transferred to the MSR temporarily. Conversely, if allowances in circulation fall below a specified threshold, EUAs are released from the MSR back into the market.

What are the Triggers and Thresholds for Activation of the MSR?

The relationship between market surplus and the operation of the Market Stability Reserve (MSR) is as follows:

• When the surplus exceeds the buffer MSR level of 1096 Mt, the MSR will withhold 24% of the surplus.
• If the surplus falls between 1096 Mt and 833 Mt (the upper threshold level), the buffer MSR will activate. The number of allowances placed in the MSR will equal the difference between the Total Net Annual Change (TNAC) and 833 million. For example, if TNAC is 950 Mt, 117 Mt or 12% will be placed in the MSR.
• When the surplus lies between the upper threshold of 833 Mt and the lower threshold of 400 Mt, the MSR remains inactive, and no allowances are taken into the reserve.
• If the surplus decreases below the lower threshold of 400 Mt, the MSR will release allowances to the market, with 100 Mt being placed in auctions annually.

In 2022, the TNAC was 1 134 794 738 allowances.

The latest data for 2023 told us that the TNAC is currently 1 111 736 535 EUAs.

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How has the MSR of EU ETS evolved over time? 

Historical Context and Development of the MSR

The concept of a market stability reserve was first proposed as part of reforms to the EU ETS in response to concerns about price volatility and oversupply of allowances. The MSR was officially introduced in 2015 as part of the EU's efforts to strengthen and improve the functioning of the carbon market. It became operational in 2019. 

How has the MSR been amended over time?

Since its inception, the MSR has been reviewed to keep up with the European climate ambitions and environmental promises. Initially, the 2015 MSR Decision had set the intake rate at 12 % and the minimum number of allowances at 100 million. However, there was a change in 2018 deciding to double these parameters to 24% and 200 million until the end of 2023. 

What is the latest MSR review from 2023?

The latest amendments were voted in 2023. Regulators deceased to keep the doubled figures of 24% and 200 million allowances as thresholds until the end of Phase 4 in 2030. From 2031 on, the intake rate would revert to 12% and the minimum number of allowances to 100 million. 

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What is the impact of the MSR on carbon prices?

Is there a link between the MSR and the Linear Reduction Factor (LRF)?

The Linear Reduction Factor (LRF) determines the annual reduction in the total number of emission allowances available in the market. Currently, the LRF stands at 4.3% per year and will go up to 4.4% after 2028. By adjusting the supply of allowances in response to changes in emissions levels, the MSR complements the objectives of the LRF in setting up the emissions volume targets.

Is the MSR effective to drive EUA prices up?

The Market Stability Reserve has been effective in raising EUA prices. Following its implementation, tighter market conditions led to a significant increase - from 2020 onward, EUA prices have been rising, going from below €30 ranges to as high as €97.59 in 2022. This trend is attributed to the removal of the structural carbon allowances surplus that was prevailing before the introduction of the MSR.

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Key takeaways 

• The MSR is a mechanism within the EU ETS aimed at stabilizing carbon prices by regulating the balance between supply and demand of emission allowances.
• The Market stability reserve operates by adjusting allowance supply based on market conditions, absorbing surplus allowances when supply exceeds thresholds to prevent price drops and releasing allowances back into the market when scarcity arises.
• The primary goal of the MSR is to maintain market stability by regulating allowance supply, mitigating extreme price fluctuations, and providing predictability for market participants while incentivizing emissions reduction efforts.
• The Market Stability Reserve  has contributed to driving EUA prices upward by mitigating the structural oversupply that occurred in the first stages of the ETS.

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