What is the Market Stability Reserve of the EU ETS?
Summary
The Market Stability Reserve (MSR) balances carbon allowances in the EU Emissions Trading Scheme (EU ETS) to prevent extreme price fluctuations and promote decarbonization. It absorbs or releases allowances based on predefined thresholds, and its implementation has successfully raised EUA prices by adjusting supply and demand and improving market sentiment. This is an example of green finance and impact investing.
The Market Stability Reserve (MSR) is a regulatory tool designed to balance the supply and demand of carbon allowances in order to ensure the effectiveness of the EU Emissions Trading Scheme (EU ETS).
The purpose of the Market Stability Reserve
The Market Stability Reserve (MSR) is one of the most significant improvements to the EU ETS since its initial design. It helps maintain market stability by balancing the supply and demand of European Union Allowances (EUAs) in order to prevent extreme price fluctuations. By absorbing excess allowances whenever there is an important market surplus, the MSR also enhances the effectiveness of the EU ETS as a decarbonization tool. It brings about an upward price pressure on the market.
The design of the Market Stability Reserve
The MSR operates based on predefined thresholds and triggers that determine how many allowances are absorbed or released. Here’s how it works:
- Surplus Absorption: When the total number of allowances in circulation (TNAC) exceeds a certain level, the MSR absorbs a percentage of the excess allowances. Addressing the surplus in this way aims at preventing a too large drop of EUA prices.
- Release of Allowances: When the TNAC falls below a lower threshold, the MSR releases a set amount of allowances back into the market to ensure there is enough supply to meet demand and prevent prices from soaring.
The triggers and thresholds of the Market Stability Reserve
The MSR adjusts the market supply based on the following thresholds:
- Buffer MSR Level: 1,096 million EUAs. If the surplus exceeds this level, the MSR absorbs 24% of the excess allowances.
- Upper Threshold: 833 million EUAs. If the surplus falls between 1,096 million and 833 million EUAs, the MSR absorbs allowances according to the difference between the TNAC and 833 million.
- Lower Threshold: 400 million EUAs. If the surplus drops below 400 million EUAs, the MSR releases 100 million allowances into the market annually.
What the Market Stability Reserve has achieved so far
The adoption of the MSR
The concept of the MSR was introduced in 2015 as part of a broader reform of the EU ETS and the mechanism became operational in 2019. At that time, the EU ETS was facing an oversupply of EUAs relative to actual demand. This surplus was enhanced by the financial crisis, which sharply reduced industrial and economic activity. Also, the use of international carbon credits for EU ETS compliance was allowed in the first years of the scheme contributing to the accumulation of excess allowances. To address this issue, a reform was necessary to tighten the market and raise prices in order to improve the effectiveness of the EU ETS for decarbonization.
The Market Stability success at brining carbon prices higher
The adoption of the MSR has successfully raised EUA prices by not only adjusting supply and demand but also improving market participants' sentiment. Increased optimism about the EU ETS’s price discovery mechanisms and anticipated future tightening measures have contributed to this positive shift. Since the MSR’s implementation, EUA prices have risen from below €30 in early 2020 to as high as €97.59 in 2022.
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