Oversupply and structural measures in the EU ETS · 4.2.6 Summary _____ 45. Oversupply and structural measures in the EU ETS Confidential SS ... nature and level of climate and energy

Oversupply and structural measures in the EU ETS

Finnish Energy Industries

Final report

08th October 2013

Confidential

SS-131008-1632

Oversupply and structural

measures in the EU ETS

Confidential

SS-131008-1632

1

Preface

This study was commissioned by Finnish Energy Industries in summer 2013. The report is based on a literature review and analysis of the GreenStream Network Plc. The report has been prepared by Mr. Sampo Seppänen, Mr. Roland Magnusson and Mr. Jurgen Wiesmann from GreenStream Network Plc.



Confidential

SS-131008-1632

| 08.10.2013

2

Content

1. Background _______________________________________________________________________ 3

2. The factors behind the oversupply of allowances in the EU ETS ___________________________ 6

2.1 Economic recession / lack of growth _________________________________________________ 6

2.2 Overlapping policy instruments _____________________________________________________ 6

2.3 International credits ______________________________________________________________ 8

2.4 Distribution of allowances by Member States __________________________________________ 8

2.5 Conclusions ____________________________________________________________________ 9

3. The impact of various factors on the price of EUAs _____________________________________ 10

3.1 Framework for EUA pricing _______________________________________________________ 10

3.2 Economic recession / lack of growth ________________________________________________ 15

3.3 Overlapping policy instruments ____________________________________________________ 15

3.4 International credits _____________________________________________________________ 18

3.5 Conclusions ___________________________________________________________________ 18

3.6 Incentives for Finnish renewable energy power generation_______________________________ 21

4. Structural measures _______________________________________________________________ 25

4.1 Discretionary price management mechanisms and other stability mechanisms ________________________________________________________________________ 26

4.1.1 An auction floor price ______________________________________________________________ 26 4.1.2 A supply management reserve _____________________________________________________ 30 4.1.3 A rolling cap ______________________________________________________________________ 31 4.1.4 An automatic cap adjustment mechanism ____________________________________________ 31 4.1.5 A buy back guarantee, i.e. a sell option ______________________________________________ 33 4.1.6 Summary ________________________________________________________________________ 34

4.2 Other selected measures _________________________________________________________ 35 4.2.1 Revising the linear reduction factor _________________________________________________ 35 4.2.2 Backloading of 900 million allowances_______________________________________________ 37 4.2.3 Retiring a certain number of phase three allowances permanently,

as an additional measure for previous ones ___________________________________________________ 39 4.2.4 Bringing more sectors into the EU ETS (especially heating sector) ______________________ 41 4.2.5 Limiting access to international credits ______________________________________________ 42 4.2.6 Summary ________________________________________________________________________ 45



Confidential

SS-131008-1632

| 08.10.2013

3

1. Background

There is significant oversupply of Emission Allowance Units (EUAs) in the EU Emission Trading Scheme (EU ETS). According to the Commission, by the end of 2012, the cumulative surplus had grown close to 2 billion allowances.

Figure 1. Historic and likely future profile up to 2020 of supply and demand1

This oversupply is already evident in the markets, with EUA prices down to a 4-5 Euros – compared with their peak of €30 in mid-2008, followed by a period of relatively stable prices of around €15 between 2009 and mid-2011 (See the figure 2 below).

1 http://ec.europa.eu/clima/policies/ets/reform/docs/com_2012_652_en.pdf



Confidential

SS-131008-1632

| 08.10.2013

4

Figure 2. EUA and CER price development2

If banking of allowances is allowed between phase 3 (2013-2020) and phase 4 (2021- ) it is apparent that the oversupply in phase 3 will be transferred to phase 4 of the EU ETS. It is evaluated that the oversupply will remain at least until 2024

3 and in the light of current

knowledge of the amount of surplus even longer. The prices are determined by overall medium–term supply and demand (i.e. sum of the 2013-to 2020 balances), as well as expectations on the post-2020 supply and demand balance. The current market prices clearly imply the possibility of banking allowances for use after 2020. If no banking were allowed, EUA prices for phase 3 (2013-2020) would tend towards zero, given the large surplus expected at the end of 2020.

To address the oversupply of EUAs, the Commission has tabled initiatives for structural measures to solve this supply-demand imbalance and further improve functioning of the EU ETS. As a short-term measure, the Commission has suggested postponing the auctioning of 900 million allowances scheduled for 2013-2015 to 2019-2020. As long-term measures, the Commission has proposed six different options for structural measures.

The Commission has also published a Green Paper4 in order to launch the public

consultation on the content of the 2030 framework. The Green Paper discusses what type, nature and level of climate and energy targets should be set for 2030 and how can

2 Source: ICE

3 http://www.pbl.nl/sites/default/files/cms/publicaties/PBL_2013_Evaluation-of-policy-options-to-

reform-the-EU-ETS_934.pdf

4 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2013:0169:FIN:EN:PDF

- €

5,00 €

10,00 €

15,00 €

20,00 €

25,00 €

30,00 €

35,00 €

40,00 €

EUA FUTURE DEC 2013 @ ICE

CER FUTURE DEC 2013 @ ICE

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32011R1210:EN:NOT

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32011R1210:EN:NOT



Confidential

SS-131008-1632

| 08.10.2013

5

coherence between different policy instruments be attained. By 2030, the GHG emissions would need to be reduced by 40% in the EU, for the EU to be on track to reach a GHG reduction of between 80-95% by 2050.



Confidential

SS-131008-1632

| 08.10.2013

6

2. The factors behind the oversupply of

allowances in the EU ETS

The significant oversupply of allowances in the EU ETS has built up mostly on the phase 2 (2008-2012). The analysis in this section evaluates the contribution of four different factors to the oversupply: the economic recession, the overlapping policy instruments, the utilization of international credits from the JI and CDM mechanisms and the influence of individual member states on the initial allocation of EUAs.

2.1 Economic recession / lack of growth

Zachmann (2012) suggest that the demand decline from the economic recession can be estimated based on the shortfall of industrial production.

5 Based on data from Eurostat

6

trend growth of industrial production in the EU can be calculated as approximately 2%.7 By

contrast, during the recession of 2008/2009 industrial production fell by a total of 16% and recovery since then has been slow at an average rate of 2.5% from 2010 to 2012. As a result, industrial production level was in 2012 around 9% below the 2007 level and 15.6% below what it should have been according to the historical trend. So the industrial production from 2008 of 2012 has been an average of approximately 12% below trend levels. At the same time the verified emissions in EU ETS sector dropped from 2007 to 2012 by 14 %

8. Assuming a roughly proportional impact on allowance demand and

allowing for uncertainty about sectoral effects, the resulting cumulative loss in the demand for allowances can be estimated at one billion to 1.5 billion.

2.2 Overlapping policy instruments

National measures do not lower overall emissions in the EU-ETS sector, as the total cap remains unchanged.

9 However, additional instruments will affect the composition and the

timing of the emission reductions in the EU ETS sector. Mitigation activities will take place in the sectors and the countries that are supported by the additional policy instruments and

5 Zachmann (2012), p.3. They suggest an annual decline in demand of 100 million allowances.

6 http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

7 This is the peak-to-peak growth rate from 1995 to 2007.

8 http://www.eea.europa.eu/data-and-maps/data/data-viewers/emissions-trading-viewer

9 Stefano Clo (2013), 479, Kautto 2012, 119, Sorrell S, Smith A, Betz R, Walz R, Boemare C, Quirion

P, et al.



Confidential

SS-131008-1632

| 08.10.2013

7

the related emission reductions will be pulled forward, thus lowering the demand for allowances. As a result, the price of allowances will be decreased leading to the delay of emission reduction activities in non-supported sectors and countries. On a macro-level, when emission reductions are pulled forward via the use of national policy instruments this enables EU-ETS installations to have higher emissions later on.

By far the most important overlapping policy instruments within the scope of the EU-ETS have been applied in the renewable power generation area, in the form of feed-in tariffs, green certificates, etc.

10 Therefore, Zachmann (2012) suggest that the impact of the

overlapping policy instruments can be estimated based on renewable electricity production.

11 Based on Eurostat data for 2008-2011

12 it can be estimated that from 2008 to

2012 approx. 450-500 TWh of additional renewable power were generated from wind, solar, wood waste and biogas compared with 2007 production levels.

13

The EU-wide carbon emission factor for electricity production from fossil fuels is approx. 0.650 t CO2 / MWh

14. Under the assumption that few renewable energy projects would

have been implemented without the support from national renewable energy policies, the national renewable energy policies therefore lowered demand for EUAs by approx. 300 to 350 million allowances from 2008 to 2012.

Taking account also renewable energy power plants built before 2008, the subsidized

renewable power generation has reduced demand for EUAs by approx. 950 million allowances

15 from 2008 to 2012

16. So the effect of the renewable energy power built before

2008 would be around 600-650 EUAs. However in this study, we will take account only the additional production after the EU`s climate and energy package targets were set by EU leaders in 2007.

10 See for example the table on climate and energy policies in seven European countries in Kautto

2012, p.120.

11 They state that renewable electricity production doubled to 214 TWh in 2012 from 105 TWh in

2008. Zachmann 2012, p.3

12 http://appsso.eurostat.ec.europa.eu/nui/submitViewTableAction.do

13 Note that in Germany power generation from wind and solar increased by 8% in 2012 compared

with 2011. FRAUNHOFER INSTITUTE FOR SOLAR ENERGY SYSTEMS ISE (2013): Electricity production from solar and wind in Germany in 2012.

14 http://www.eea.europa.eu/data-and-maps/figures/estimated-co2-emission-factors-for

15 Without hydro power

16 Finnish Energy Industries



Confidential

SS-131008-1632

| 08.10.2013

8

2.3 International credits

Under the EU ETS Directive the EU ETS is linked with the CDM and JI mechanisms in order to increase the cost-effectiveness of achieving reductions of global greenhouse gas emissions. In Article 11a of the EU ETS Directive the use of CERs and ERUs to meet obligations under the EU ETS is regulated. During the second commitment period, all CERs and ERUs may be used in the EU ETS with the exception of credits for nuclear projects, LULUCF projects and large hydro projects. The percentage of offsets allowed is expressed as a share of the allocation, and determined separately by each Member State at the beginning of the phase in the National Allocation Plans. It must be compatible with Member State’s Kyoto Commitments to be accepted by the Commission. On average, installations were allowed to surrender credits from Kyoto’s project mechanisms up to 13.5% of allocations, i.e. a total of 1420 million international credits over the 2008-2012 period.

17 Altogether 1058 million CERs and ERUs have been surrendered for use in the

EU-ETS system from 2008 to 2012,18

i.e. approximately 75% of the allowed quota.19

2.4 Distribution of allowances by Member States

The quantities allocated in the first two phases were decided by the member states themselves and stated in the National Action Plan (NAP) of each member state. Essentially, this implied that each member state could decide for itself the amount of mitigation to take place inside and outside the ETS sector. Consequently, the overall cap in the ETS resulted from these individual national decisions, which however had to be approved by the Commission on the basis whether the NAPs were in line with the principles of the EU ETS Directive. The Commission insisted on cuts of 236 million allowances per year for the 2008-2012 NAPs.

20

It is difficult to predict exactly how restrictive emission caps would have been had they been imposed directly by the Commission rather than by the member states. However the size of the requested cuts proposed by the Commission gives an indication of the order of magnitude that is involved. It is plausible that if allowances had been allocated directly by the Commission the allocated amounts would have been lower than those that resulted from the actual process. However the difference would probably not have exceeded 120 million allowances per year, i.e. an additional 50% of the cuts that the Commission actually made. As a result, the allocations for 2008-2012 might have been up to 600 million allowances lower.

17 Raphael Trotignon: Combining cap-and-trade with offsets: Lessons from CER use in the EU ETS in

2008 and 2009, p.5-6.

18 European Commission (2012b): Emissions trading: 2012 saw continuing decline in emissions but

growing surplus of allowances, p.3. http://ec.europa.eu/clima/news/articles/news_2013071002_en.htm

19 Zachmann 2013, 3: 1420 million t of CER / ERUs from 2008-2012.

20 For the 2005-2007 the Commission had asked for cuts of around 300 million allowances. Claire

Dufour and Alexia Leseur (2006), p.4.



Confidential

SS-131008-1632

| 08.10.2013

9

2.5 Conclusions

During the 2008-2012 period the impact of the economic recession and the impact of the use of international credits are approximately equal in size, while the impact of the overlapping mechanisms and the distribution of allowances by member states is less than one-third the size.

Table 1. Summary of the effect of different factors

Factor Effect (in million allowances)

Lack of growth 1,000 – 1,500

International credits 1,058

Distribution of allowances by member states 300 – 600

Overlapping policy instruments 300 - 350

The factor “Lack of Growth” is of special importance for the declining price that has been associated with the surplus of allowances because the sustained economic recession has been a surprise while the impact of the other three factors was to some extent foreseeable at the beginning of the Kyoto period.

This is also evident from the timeline of EUA price. Prices start to drop once the impact of the economic recession becomes clear in the second half of 2008. They drop again in the summer of 2011 when it becomes clear that there will not be quick recovery in Europe (See the Figure 2.).



Confidential

SS-131008-1632

| 08.10.2013

10

3. The impact of various factors on the price

of EUAs

3.1 Framework for EUA pricing

The pricing of EU allowances can be analyzed with standard Natural Resource Economics models. The allowances can be considered a limited resource, i.e. the overall supply over a given time period (for example from 2008 to 2050) is limited. Standard natural resource economics models then predict that in a dynamic equilibrium situation prices will increase over time at a discount rate that reflects the time preference of market participants. The key for such a regular price increase is that “banking” of allowances is possible, i.e. market participants can choose to utilize emission rights either early or late in the overall period (2008-2050). The possibility for such intertemporal arbitrage then requires that prices stay relatively constant over time, while increasing at a certain discount rate. While the rate of increase is determined by the discount rate, the level of the price curve is determined by the tightness of the intertemporal budget constraint, i.e. by how challenging and costly it is to stay within the emission limits. Prices serve to drive the mitigation behavior that is required to meet the emission targets, and more stringent targets will result in higher price levels throughout the overall period. External shocks that increase the long-term supply or lower the long-term demand, such as prolonged economic recessions, technological breakthroughs in mitigation technologies, the existence of complementary energy policies or expectations that future emission targets will be less stringent will shift the price curve down over the whole overall period, while maintaining the gradual upward movement of the expected price curve over the overall period. If frequent shocks occur the actual prices may be quite volatile, and it may not be easy to recognize the gradual upward-sloping nature of the price curve by looking at graphs of allowance prices over the short-term. Expectations of future emission targets affect allowances prices now

21. An oversupply of allowances in

the second (2008-2012) and third (2013-2020) commitment period does not mean that prices have to fall to zero when banking between commitment periods is allowed. As long as a shortage of allowances is expected in the future, positive prices throughout the overall period will then result in order to drive the required mitigation activities. Market participants will have an incentive to use cheap emission-reduction opportunities early to save some allowances for the future.

22 A decision now to impose a lower cap for 2030 will lead to a

higher carbon price today already and hence also more incentives to mitigate today.23

21 Stefano Clo (2013), 479

22 Zachmann 2012, 4:

23 Sigurd Naess-Schmidt 2012, p.23



Confidential

SS-131008-1632

| 08.10.2013

11

Discount Rate

The discount rate obviously is a key driver of the expected price path. The figure below provides a simulation of how varying the discount rate between 3% and 10% can affect the expected price over the overall period. The higher the discount rate the more market participants have an incentive to postpone investment in mitigation activities and utilize ever more expensive mitigation options towards the end of the period. A high discount rate therefore results in very low allowance prices in the beginning but higher allowances prices at the end of the overall time period. By contrast a low discount rate offers market participants an incentive to pull mitigation activities forward and results in a relatively flat trajectory of allowances prices over time. It is important to note that the discount rate is not a policy variable but rather it is determined by the time preference of market participants. Key determinants are inflation expectations, the real interest rate, and a suitable risk premium. The risk premium has to cover country risks, policy risks, market risks and technological risks. Policy risks represent uncertainty about the support for specific technologies, such as renewable energy, energy efficiency and CCS. Market risks represent uncertainty about fuel prices, especially coal and gas. And technological risks represent uncertainty about the availability and costs of mitigation options.

24

Inflation expectations can be estimated as 2%, based on ECB inflation target of “below, but close to, 2% over the medium term”

25. The expected real interest rate in the core European

countries can be estimated as 2.5 to 3.5%, based on the fact that average real interest rates in Germany were 2.5% between 2001 and 2008.

26 Risk premiums could add another

2.5% to 5%, so that the overall discount rate would likely be 7.5% to 10% in nominal terms. Hermann et al have developed three scenarios with discount rates varying from 7.5% to 12.5%.

27 In order to draw conclusions about the level of prices required to drive certain

mitigation activities it is often preferable to look at the real discount rate, i.e. the discount rate above and beyond the inflation rate, which could be estimated as 5.5% to 8%.

In order to forecast the future price levels for EUAs a typical approach is to work backwards from the emission target in a given year, for example a 30% internal reduction in 2030 within the EU-ETS. In a second step one identifies the mitigation activities that would be necessary to achieve this. The marginal abatement cost curve can then be used to determine the expected price for allowances. The below example (See the Box 1.) that was prepared by Blyth and Bunn for the EU ETS sectors

28 suggests that more than 40%

(See the figure 5. Cumulative reduction potential up to 998 MtCo2) of internal reduction by

24 Blyth & Bunn, p.4586.

25 http://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html

26 Inflation rates are taken from the following website: http://www.global-rates.com/economic-

indicators/inflation/2012.aspx. Interest rates are taken from the following website: http://www.ecb.europa.eu/stats/money/long/html/index.en.html.

27 Hermann et al , p.53-54.

28 Source: Blyth and Bunn (2011)

http://www.global-rates.com/economic-indicators/inflation/2012.aspx

http://www.global-rates.com/economic-indicators/inflation/2012.aspx



Confidential

SS-131008-1632

| 08.10.2013

12

2030 can be achieved at a marginal cost of approx. €40 / t CO2.29

The EUA price for 2030 can then be fixed as €40 and earlier prices can be calculated based on the chosen discount rate. In the simulation given below two options are presented: 5.5% and 8%.

Figure 3. Simulated EU Pricing (2008-2030)30

Box 1. MAC curve for 2030

Below is the Marginal Abetments Costs (MAC) curve for 2030 suggested by Blyth and Bunn (2011). Blyth and Bunn splits off-shore wind power, carbon capture and storage (CCS), and solar photovoltaic (PV) into multiple tranches and assume that early-stage tranches are more expensive than mature stage tranches because of learning. The early-stage tranches are necessary for mature-stage tranches to become available. Since the mature stages of the technologies cannot be undertaken before the early-stage tranches, the mature-stage tranches appear further to the right in the MAC curve shown than the early-stage tranches. Table 2 shows the MAC Curve in more detail.

29 This is below the €55 suggested by the European Commission. Commission Staff Working

Document accompanying the communication from the Commission to the European Parliament , the Council, the European Economic and Social Committee and the Committee of the Regions. Analysis of options to move beyond 20% greenhouse gas emission reductions and assessing the risk of carbon leakage. Background information and analysis. Part II, page 44.

30 Source: Greenstream

Simulated EUA Pricing (2008-2030)

0,0

5,0

10,0

15,0

20,0

25,0

30,0

35,0

40,0

45,0

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Year

EU

A P

rice

5.5% discountrate

8% discount rate



Confidential

SS-131008-1632

| 08.10.2013

13

Figure 4. MAC curve for 2030. Source: Blyth and Bunn (2011)

Table 2. Costs underlying the MAC in Figure 4. Source Blyth and Bunn (2011).

For comparison, Figure 5 shows the case where member states introduce additional policy measures, which bring forward the expensive early-stages stages. An example of such additional policy measures is the EU’s renewable energy target and the policies used to reach it. In constructing the MAC curve in Figure 5, the assumption is that the early-stage options will be implemented independently of the carbon price, although emissions reductions will still contribute to meeting the EU-ETS target. This has the effect of shifting the rest of the curve to the right, and reducing the marginal cost at which the EU-ETS target is met.



Confidential

SS-131008-1632

| 08.10.2013

14

Figure 5. MAC curve for 2030 with renewable energy and CCS demonstration plant brought to the front of the curve. Source: Blyth and Bunn (2011).

Table 3. Costs underlying the MAC in Figure 5. Source Blyth and Bunn (2011).



Confidential

SS-131008-1632

| 08.10.2013

15

3.2 Economic recession / lack of growth

In 2012 European industrial production was still 15.6% below what it should have been according to the historical trend. Under the assumption that during the period from 2013 to 2020 industrial production will grow at a rate of 4%, i.e. twice as fast as the historical trend, then the catch up will be completed at the end of 2020. This would mean that during the 2013-2020 period industrial production would still be 7.5% lower than it would have been according to the historical trend that could have been expected in 2008. Assuming a roughly proportional impact on allowance demand and allowing for uncertainty about sectoral effects, the resulting cumulative loss in the demand for allowances can be estimated at one billion to 1.5 billion EUAs, very similar in size to the shortfall caused during the 2008-2012 period.

3.3 Overlapping policy instruments

The EU’s Climate and Energy Package of 2009 set a target not only to reduce emissions by 20% relative to 1990 levels, but also to have 20% of energy consumption sourced from renewables and to improve energy efficiency by 20%, all by 2020. Contrast to the two former targets, the energy efficiency goal has not been binding

31, until to October 2012,

when EU adopted the Directive on energy efficiency. The Directive establishes a common framework of measures for the promotion of energy efficiency and aims to ensure the achievement of the Union’s 2020 20 % headline target on energy efficiency and to pave the way for further energy efficiency improvements beyond that date.

32

The complementary renewable energy and energy efficiency policies lower the costs for the implementation of certain mitigation technologies in certain countries. While the total EU ETS cap remains unchanged, the complementary policies are pulling forward abatement activities in certain sectors and countries. This leads to lower prices that will in turn delay the introduction of other mitigation activities.

Renewable energy

In its 2008 Impact Assessment the European Commission estimated that the share of renewable energy would be 15.8% in 2020 without complementary renewable energy policies if only the 20% reduction in GHG emissions was pursued.

33 The individual

countries have developed National Action Plans to implement the Renewable Energy Directive. The results are summarized in a report commissioned by European Environment Agency and prepared by the Energy Research Center of the Netherlands.

34 The report

31 Egenhofer, p.7.

32 http://ec.europa.eu/energy/efficiency/eed/eed_en.htm

33 Commission Staff Working Document. Annex to the Impact Assessment. Document accompanying

the Package of Implementation measures for the EU's objectives on climate change and renewable energy for 2020, p.34.

34 L.W.M. Beurskens, M. Hekkenberg, P. Vethman. Energy Research Center of the Netherlands

(2011): The Renewable Energy Projections as Published in the National Renewable Energy Action Plans of the European Member States



Confidential

SS-131008-1632

| 08.10.2013

16

distinguishes between renewable energy for electricity production, heating / cooling and transport. Of the three areas the one that is within the scope of the EU ETS is renewable power generation. Since the EU ETS only covers combustion installations of at least 20 MW capacity, the heating and cooling sector is not included in this study, since it almost exclusively consists of small-scale installations.

35 By far the most important overlapping

policy instruments within the scope of the EU-ETS have been applied in the renewable power generation area, in the form of feed-in tariffs, green certificates, etc.

36 Following the

approach of Zachmann (2012) the impact of the overlapping policy instruments can be estimated based on renewable electricity production, in particular wind power and PV. Between 2005 and 2020 the share of electricity production from renewable sources is expected to increase from 15.3% in 2005 to 31.3% in 2020.

37 Total renewable energy

production is expected to increase from 479 TWh in 2005 to 1217 TWh in 2020.38

It can be calculated that compared with 2007 levels additional renewable electricity production from 2013 to 2020 will be approximately 3500 TWh.

A key question is how much additional renewable power generation there would have been even without the renewable energy policies. The question can be answered based on the marginal abatement cost curves for the EU ETS, which have been analyzed by Blyth and Bunn (2011).

39 The curves suggest that the abatement costs for onshore wind power (€39 /

t CO2), biomass (€74 / t CO2), offshore wind power (€75 / t CO2) and solar are much higher than the allowance price levels expected until 2020. It is therefore plausible that without complementary renewable energy policies most of the additional renewable power production would not occur until at least 2020, with the exception of some on-shore wind power projects in favourable geographical areas. In addition, some of the most favourable projects related to hydro power or fuel switching from fossil to biomass could also be implemented. Under the assumption that 25% of the additional wind power production comes from such favourable locations the additional renewable power generation that is due to renewable energy policies is approximately 3000 TWh. The EU-wide carbon emission factor for electricity production from fossil fuels is approx. 0.650 t CO2 / MWh

40.

Based on the assumption that without overlapping renewable energy policies there would not have been any additional renewable energy development, it can then be calculated that additional renewable power generation displaced the need for approx. 2000 million allowances from 2013 to 2020. This is in addition to the estimated 300-350 million allowances displaced from 2008-2012.

35 Renewable Heating and Cooling (02/07/2013): Input from the Renewable Heating and Cooling Technology Platform to the

consultation on “A 2030 framework for climate and energy policies”. See http://www.rhc-platform.org/fileadmin/Press/News/Input_from_the_Renewable_Heating_and_Cooling_Technology_Platform.pdf

36 See for example the table on climate and energy policies in seven European countries in Kautto 2012, p.120.

37 ECN 2011, p.20.

38 ECN 2012, p.22.

39 Blythe & Bunn (2011), p.4579.

40 http://www.eea.europa.eu/data-and-maps/figures/estimated-co2-emission-factors-for



Confidential

SS-131008-1632

| 08.10.2013

17

Box 2. Energy efficiency41

41

http://ec.europa.eu/energy/efficiency/eed/doc/2011_directive/sec_2011_0779_impact_assessment.pdf

In impact assessment1 of the Energy Efficiency Directive, Commission made some estimation of the

impact of reaching the 20 % energy efficiency goal by 2020 to the EUA price. The clear outcome was

that the binding energy efficient target would give some pressure to the prices. With assumptions, that

unlimited banking of EUAs is allowed from phase 2 of the ETS until 2050 and full compliance with the

renewable energy targets for 2020, the estimated EUA price would fall to 14.2 €/t CO2 compared to the

price around 16.5 €/t in 2020 reference scenario.

Blyth and Bunn, has also made simulations how the 20 % Energy Efficiency target by 2020 will affect to

the EUA prices. They consider three scenarios (See figure 5. below):

1. The “all off” scenario, in which no additional support for renewables, CCS demonstration or

energy efficiency is provided outside the EU-ETS.

2. The “RE CCS on” scenario, in which the support for renewable energy is adequate to meet

the EU 20% renewable energy target sufficient support for CCS demonstration is provided to allow

mature-phase CCS to be commercially available.

3. The “RE CCS EE on” scenario assumes that in addition to scenario 2 that policies are put in

place to meet the EU target of an increase in energy efficiency of 20 % by 2020.

Figure 6. Marginal cost with 20% cap. Source: Blyth and Bunn (2011)

In the 2020 scenario under the weaker 20% abatement target the introduction of additional

policies leads to a significant decrease of the EUA price. In the “RE CCS on” scenario there is a

30% probability that the price is less than EUR 5 per tC02. In the “RE CCS EE on” scenario this

probability is 80%.



Confidential

SS-131008-1632

| 08.10.2013

18

3.4 International credits

The exact quantity of international credits that can be used by installations under the EU-ETS is regulated for each installation in Article 11a, paragraph 8 of the EU ETS Directive. EU ETS participants operating stationary installations will be entitled to use international credits during the 2008-2020 period up to the higher of two limits: (a) The international credit entitlement specified in the national allocation plan for the phase 2; OR (b) 11% of the free allocation of EU allowances granted to them in that period. Slightly different rules are applied to new entrants, operators of installations with a significant capacity extension and aircraft operators. Herrmann et al. have calculated that from 2008 to 2020 a total of 1622 million international credits can be used.

42 1058 of these have already been used

during the Kyoto period (2008-2012).43

As a result, there are still 564 million international credits to be used.

3.5 Conclusions

The oversupply of allowances is expected to last throughout the third commitment period. At the end of 2020 the oversupply is expected to be around 2,200 million allowances.

44

Three factors of similar magnitude are contributing to the surplus; first the lack of growth in the European economy, second overlapping policy instruments and third the utilization of international credits. It is notable that during the 2013-2020 period the overlapping policy instruments have become the most important factor contributing to the surplus of allowances.

45 By contrast the use of international credits plays a diminished role after 2013.

42 Hauke Hermann, Felix Chr. Matthes (2013): Strengthening the European Union Emissions Trading Scheme and

raising climate ambition, p.38.

43 http://ec.europa.eu/clima/news/articles/news_2013071002_en.htm

44 See Figure 1.

45 Without effects of the EE measures and renewable energy power built before 2008.



Confidential

SS-131008-1632

| 08.10.2013

19

Table 4. Summary of different factors

Factor Effect (in million allowances)

Years 2008-2012 2013-2020 2008-2020

Lack of growth 1,000-1,500 1,000-1,500 2,000-3,000

International credits 1,058 564 1,622

Overlapping policy instruments46

300-350 2,000 2,300

Distribution of allowances by member states

300-600 - 300-600

The expected surplus of allowances at the end of 2020 is one of two developments holding down prices within the EU ETS. The second one are the expectations on the supply and demand balance for the time after 2020, in particular the expectation of how ambitious the mitigation efforts within the EU will be. As seen above, a target of 40% internal reduction by 2030, which is consistent with the long-term reduction targets of 80-95% by 2050, would result in marginal abatement costs of approx. €40 in 2030. It is clear that the currently observed prices are not consistent with such a scenario. Even if a high 8% real discount rate is applied, prices should be above €10. Clearly market participants are not convinced that an internal reduction of 40% will be required by 2030. The credibility of the long-term emission reduction path is clearly an issue for current EUA prices.

Egenhofer et al point out that it is difficult for market participants to form long-term views. “Despite the linear annual reduction factor of 1.74% as of 2013, the Directive foresees a revision of the cap in the case of a global climate change agreement. The current cap based on the linear reduction factor is also not in line with EU and international climate change objectives or the most common interpretation of climate science. And many businesses remain suspicious about the stability of political decisions. As a result, there are credibility problems. These could be partly resolved by the adoption of a global climate change agreement. If such an agreement is not reached, an EU strategy ‘going it alone’ in line with its long-term 2050 target is most likely not credible enough to trigger investment on its own as investors would need to consider the risk that a strong unilateral EU position might be revised.”

47In addition to addressing the surplus it is therefore important for the

European Union to make credible commitments about the future emission reduction path in order to allow market participants to form rational expectations about future prices of EUAs.

It is quite challenging to accurately estimate the contributions of different factors to the EUA price drop. At the time when the Climate Package was approved and the ETS cap was fixed for the third trading period (2013–2020), a €30/t carbon price was expected

48. It can

46 Without effects of the EE measures and renewable energy power built before 2008.

47 Egenhofer et al, p.3.

48 European Commission, 2008



Confidential

SS-131008-1632

| 08.10.2013

20

be assumed, that at that time the future use of international credits was already incorporated in the estimation.

So, basically there are three main reasons for the price drop:

Recession

Overlapping policies

Uncertainty about the post 2020 emission reduction path.

As in the table 4 is summarized the contributions to the oversupply of allowances resulting from overlapping policies and the economic recession is of similar magnitude. The table doesn’t include the effects of the Energy Efficiency Directive, which clearly have decreasing effect to the EUA price (see the Box 2.). However the dominant view is that the recession is the primary reason for the current oversupply and the low prices associated with it

49. This is likely due the fact, that the sustained economic recession has been a

surprise while the impact of the overlapping policies, especially RES policies, was largely, even though not completely, foreseeable.

This has been showed by Blyth and Bunn (2011), who has been estimated the effect of the recession and overlapping policies to the price of EUAs. The comparison is made by running the simulation with two different assumptions about the growth of the economy, based on the World Economic Outlook scenarios WEO 2008 and WEO 2010. Figure 7. shows the differences in terms of the probability density function of the marginal cost at which the last ton of CO2 of the EU ETS cap could be avoided. In other words, it provides a good picture of the expected EUA price.

Figure 7. Marginal cost with 20%

Figure 7. shows that, as a result of the recession, marginal cost, and consequently the EUA price, has dropped. Blyth and Bunn (2011) explains this shift with the downward revision in electricity demand expectations.

49 see e.g. Egenhofer et al. (2012)



Confidential

SS-131008-1632

| 08.10.2013

21

The simulations made by Blyth and Bunn (2011) shows that the recession has had a very significant effect on the EUA price in the 20% abatement target scenario. Most noteworthy is the observation that the recession has opened up the possibility that the EUA price drops to zero or close to zero in 2020 in the 20% abatement scenario. In the outcome of their study, the effect of the renewable energy policies on the EUA price is less dramatic but definitely non-negligible. Without the RES policies the simulations suggest that the EUA price would lie in the range of EUR 20-40 in 2020, and with them in the range of EUR 5-30.

3.6 Incentives for Finnish renewable energy power generation

Finland has to increase its renewable energy share of the final consumption to 38% by the

end of 2020. For achieving the target Finland has set a guaranteed minimum price through

a feed-in-tariff for:

New wind power plants

New biogas power plants (gas produced by digestion)

New wood-fuelled power plants, which also produce heat for utilization

(The nominal capacity of the generator must be between 100 kVA and 8 MVA.)

For new biogas and wood fuel plants, the target price is € 83.50/MWh. So the basic subsidy is the difference between € 83.5/MWh and the market price. And for wind power plants the target price is €105.30/MWh until the end of 2015 and after that it is €83.50/MWh. Normally the prices are guaranteed for 12 years of operation. In the case of wood fuel plants, if a plant has produced gains of more than € 750,000 in four consecutive

obligation periods, the subsidy will be ceased. 50

For biogas there is also additional €50/MWh heat premium and for new wood-fuelled power

plants €20/MWh heat premium on top of basic subsidy.51

For the timber chip power plants the subsidy system is bid of different and the subsidy level

is determined by the three-month mean price of EUA`s and the energy tax on peat.52

The

paid subsidy level is between €0-13 /MWh. The law includes the formulas for calculating

the subsidy level. In practice, if the EUA price is €10 or less the subsidy level is around 13

€/MWh.53

54

.

50 http://www.res-legal.eu/search-by-country/finland/single/s/res-e/t/promotion/aid/premium-tariff-

2/lastp/127/

51 http://www.emvi.fi/files/Feed_in_tariff_summary_6_2013.pdf

52 Source: Energy Market Authority

53 http://www.finlex.fi/fi/esitykset/he/2012/20120107#id1922593

54 http://energia.fi/uusiutuvan-sahkon-tuotantotuet

http://www.finlex.fi/fi/esitykset/he/2012/20120107#id1922593



Confidential

SS-131008-1632

| 08.10.2013

22

On August 2013 the Forward Derivative prices of 2014-2020 of electricity in Nasdaq OMX

has been around 35 €/MWh and the Helsinki area CfD price has been around 5€/MWh

above that. So the total price in Finland has been around 40 €/MWh.55

Table 5. Feed-In-Tariffs in Finland.56

Wind power

Type Guaranteed price

Subsidy (EUR/MWh)57

65 (2012-2015) 43,5 (2016-)

Subsidy + electricity price (EUR/MWh)

105 (2012-2015) 83,5 (2016-)

Length 12 years

New biogas power plants (gas produced by digestion)


Subsidy (EUR/MWh) 43,5 (CHP 93,5)


83,5 (CHP 133,5)

Length 12 years

New wood-fuelled power plants, which also produce heat for utilization


Subsidy (EUR/MWh) 43,5 (CHP 63,5)


83,5 (CHP 103,5)

Length 12 years

Biomass (Timber chip power plants)

Type Premium

Subsidy (EUR/MWh) 13 (with current EUA price)


53 (with current EUA price)

55 http://www.nasdaqomx.com/transactions/markets/commodities/markets/marketprices/

56 Table doesn’t include the restrictions of the feed-in tariffs

57 with current (8/2013) Electricity prices



Confidential

SS-131008-1632

| 08.10.2013

23

As we can see from the table 5. the subsidy for renewable power plants (excluding timber chip power plants and extra from CHP) has been around €43,5/MWh in August 2013 (€65/MWh for wind power plants, 2013-2015).

We can assume that these feed-in-tariff subsidy rates for new wind power, biogas power and new wood-fuelled power plants are set on the level that those are bit higher than production cost of the renewable energy power plants (in average) and operators have incentive to invest to the renewable energy. So we will use that level (€ 83.50/MWh) for the reference price.

58

Effect of the carbon price on the electricity prices

In this study we assume a factor of 0.7 to illustrate the impact of the EUA price on electricity price. For example, if the EUA price would be at the level of €10, it would increase the electricity price by 7 €/MWh. So the total effect from the current €4.5 EUA price to the electricity price in Nordic markets is about €3.15 per MWh. The factor varies over time and depends on the EUA price

59.

In previous chapter we evaluated the effect of the overlapping policies to the EUA prices. Based on that, we can make a rough estimate that the current EUA price without overlapping policies would be around €10-15. If we will use the upper end of this rough estimation and with the factor of 0.7 the current electricity price would be around €47 per MWh.

Table 6. the effect of the EUA prices to the electricity prices

EUA price Increase of electricity price

(factor 0,7)

Electricity price

€ 4.50 current price € 3.15 €40

€15 without overlapping policies

€ 10,5 €47

€30 Commission estimation for the period (2013-2020)

€ 21 €57,5

Conclusions

If we compared this to the current feed-in-tariff level in Finland, we can see that even though there wouldn’t be any overlapping policies (e.g. renewable subsidize or energy efficiency targets) in EU level, which would have increasing effect to the EUA price, effect

58 Note that, there is probably a continuum of projects with somewhat different costs.

59 http://www.tem.fi/files/35135/Sahkomarkkinaskenaariot_2035_10122012_Final.pdf

http://www.tem.fi/files/35135/Sahkomarkkinaskenaariot_2035_10122012_Final.pdf



Confidential

SS-131008-1632

| 08.10.2013

24

to the electricity price wouldn’t be enough to have same incentive level for making investments to the renewable energy. However this is the same in the case that the EUA price level would be around €30, what was assumed price between 2013-2020.

So achieving the same incentive to make investments to renewable energy (wind-,biogas,

wood-fuelled power plants), than the incentive with feed-in-tariffs, the carbon price (EUA)

should be above €60.

Also high volatility of the prices of the EU carbon markets compared to the feed-in-tariffs can be barrier for the investment decision. Keeping in mind, that there is always possibility for regulatory actions taken by government and the laws of guaranteed feed-in-tariffs can be changed. However, in the situation where the EU RES target is needed to achieve, major changes will unlikely to be implemented for the current subsidy system.

On the case of timber chip power plants, to achieve the same investment incentive level than the current subsidy around 13 €/MWh, the EUA price should be around €15 higher than the currents price. So the EUA price increase due the removal of overlapping policies would not provide the same incentive to investment to the timber chip power plants than the current subsidy level. However without RE policies and with a higher carbon price the incentives would at least be somewhat similar.



Confidential

SS-131008-1632

| 08.10.2013

25

4. Structural measures

As an immediate measure, to address the current market imbalance, the Commission has proposed back-loading of emission allowances, by postponing the auctioning of 900 million allowances scheduled for 2013-2015. In addition, the Commission has identified six alternatives for structural measures. The Commission’s list for structural measures is as follows.

1. Increasing the EU reduction target to 30% in 2020. 2. Retiring a number of allowances in phase 3. 3. Early revision of the annual linear reduction factor. 4. Extension of the scope of the EU ETS to other sectors. 5. Limit access to international credits 6. Discretionary price management mechanisms

In the analysis that follows, the focus is on the function of different discretionary price management mechanisms and how the different institutional variation will influence the effectiveness and feasibility of the EU ETS scheme and whether the measure would increase the confidence in the scheme. This will be evaluated in the first subsection. The second subsection covers the remaining measures, including backloading but excluding increasing the EU reduction target to 30%. The discussion in the second subsection will focus on the effect of the suggested measures on the oversupply of EUAs.

In general terms, the measures to address the market imbalance can be divided in three categories, as shown in Figure 8, in which the left-hand sides shows the allocation process and the right-hand side shows the market. The dotted line shows the point of market entry of EUAs.



Confidential

SS-131008-1632

| 08.10.2013

26

Figure 8. Categorisation of measures that address the market imbalance.60

Another dimension along which the mechanisms can be categorised is the extent to which they address the root cause of the current imbalance. The root cause of the imbalance is that supply is fixed, whereas demand is not. Demand depends primarily on the level of economic activity, e.g. if the EU is hit by a recession, the whole demand curve is shifted to the left.

4.1 Discretionary price management mechanisms and other stability mechanisms

In this subsection selected proposal for discretionary price management mechanisms and other stability mechanisms are discussed and analysed.

4.1.1 An auction floor price

An auction floor price sets the minimum price for which allowances are sold. If the auction floor price is set above the current market price, some allowances will be unsold. If the

60 Source: GreenStream.

DEFLECT ENTRY

• Introduction of a

auction reserve price

• Backloading

• Introduction of a price

and supply

management reserve

CurrentEUA

surplus

2015201620172018

Currently , the yearly allocation, is set to

decrease by 1.74% per year

EUA surplus

The allocation process of EUAs

Point of market entry

REDUCE ALLOCATION

• Tighten the annual linear reduction factor

• Introduce a automatic cap adjustment

mechanism

The market for EUAs

RE-INJECT AT A LATER STAGE

RETIRE

RETIRE ACCUMULA

TED

SURPLUS

• Retire a part

of the surplus

that has been

accumulated

on the market



Confidential

SS-131008-1632

| 08.10.2013

27

auction price floor is set below the current market price, neither supply, demand or prices are affected.

In the case where the floor price is above the market price and the unsold allowances are retired, the floor price induces further emissions reductions, reductions that extend below the cap set for the EU ETS. As a result, the supply of EUAs is shifted permanently to the left, which has a permanent price increasing effect. Considered over time, the higher price will bring forward some mitigation actions. As a result, emissions fall below the original cap set for the EU ETS.

In the case where the floor price is above the market price and the unsold allowances are not retired, emissions are unaffected. In this case, initially, when the auction price floor is introduced, the market price will increase and equal the floor price. However, the long-term price effect is ambiguous. If the floor price is sufficient to pull forward some real mitigation actions then future demand for allowances will be slightly lower and result in a slightly lower long-term price of EUAs. With no retirement, an auction price floor will accumulate a reserve that must be re-injected to the market at a later stage. This reserve creates an additional source of potential surplus of EUAs, which may reduce the confidence in the EU ETS.

Figure 9, Illustrative figure of constant price floor after phase 3.

If the auction floor price is permanently over the market clearing price, i.e. the price where demand equals supply, the EU ETS will be reduced to a carbon tax equal to the floor price, with a partial or full reimbursement for some operators. In this scenario, there is a surplus of EUAs on either or both sides of the market-entry line in Figure 8. The three alternatives to escape this scenario are as follows.

- €

5,00 €

10,00 €

15,00 €

20,00 €

25,00 €

30,00 €

35,00 €

40,00 €


Price floor

The floor price sets the minimum price for which allowances are sold in auctions

If the clearing price in auctions will be below the price floor. The unsold allowances can be retired or postponed to the future auctions



Confidential

SS-131008-1632

| 08.10.2013

28

1. Remove the auction floor price, which will force the market price down 2. Retire the accumulated surplus on either or both sides of the market-

entry line in Figure 8 3. Cut future allocation of EUAs, either by tightening the annual linear

reduction factor or by some automatic adjustment mechanism

There have been calls for caution in the case where a price floor is proposed not only to address the risk of a very low carbon price, but to compensate for an insufficiently stringent emission trajectory

61. Under current conditions in the EU ETS, an auction reserve price

should not be implemented on its own without a set-aside in the short term and a tightened long-term cap

62, especially in the case where there is no retirement. Due to the

accumulated surplus, few would purchase new allowances at the reserve price, but also few would want to trade what they have and would rather wait until the market catches up with the floor price years into the future. This would reduce auction revenues and would fix the price rather than allow demand to drive it through emissions trading.

Recent experiences from the Regional Greenhouse Gas Initiative (RGGI) shows the likely course of events when a price floor is introduced into a market with a surplus of allowances. In 2011, in the RGGI, emissions were 33% below the cap

63. The allowance

price had not collapsed, because of a floor price applied in the allowance auctions. However, since the introduction of a floor price, allowances have gone unsold and all transactions within the RGGI have been done at roughly the floor price. This has transformed the RGGI effectively into a carbon tax.

Pros of an auction floor price:

1. An auction floor price may reduce short-term volatility 2. An auction reserve price would create a price path, which is bounded

from below, which alleviate some of the uncertainty faced by low-carbon technologies

3. Without retirement, relatively straightforward to introduce. With retirement, much more complicated.

4. With retirement, an auction floor price reduces supply and address the root cause of the current imbalance, which may increase confidence in the EU ETS.

5. With retirement, the auction floor price induces further emissions reductions, reductions that extend below the cap set for the EU ETS. This may improve the alignment of the EU ETS sector with the EU target for 2050.

61 Neuhoff, Karsten (2011), “Carbon pricing for low-carbon investment”, Report by Climate Policy

Initiative (CPI) and Climate Strategies (CS).

62 Grubb, Michael (2012), “Strengthening The EU ETS: Creating a stable platform for EU energy

sector investment”, Climate Strategies.

63 Newell, R. G., Pizer, W. A., & Raimi, D. (2013). Carbon Markets 15 Years after Kyoto: Lessons

Learned, New Challenges. The Journal of Economic Perspectives, 27(1), 123-146.



Confidential

SS-131008-1632

| 08.10.2013

29

Cons of an auction floor price:

1. Without retirement, may only provide a temporary relief to the market imbalance.

2. Choosing the floor price is difficult, and is likely to be a subject of intense lobbying. It has been noted that a price floor is ultimately a political decision, and thus raises credibility issues and that there is the major question of whether EU governments could agree on the level of a floor price

64.

3. With retirement, the auction floor price may induce, if high enough, reductions below the cap set for EU ETS. This reduction comes with additional cost, and is thus in contradiction with the view that the primary objective of the EU ETS is to achieve a certain quantity of abatement at least cost

4. Without retirement, an auction floor price that exceeds the market price will create a reserve of unsold EUAs. This reserve creates an additional source of potential surplus, which may reduce the confidence in the EU ETS.

5. An auction floor price that is permanently over the market clearing price, reduces the EU ETS to a carbon tax.

6. An price floor adds considerable complexity for linking with other cap-and-trade systems

64 Neuhoff, Karsten (2011), “Carbon pricing for low-carbon investment”, Report by Climate Policy

Initiative (CPI) and Climate Strategies (CS).



Confidential

SS-131008-1632

| 08.10.2013

30

4.1.2 A supply management reserve

A supply management reserve has many analogies with an auction price floor with no retirement of unsold allowances. The basic idea of the supply management reserve is to observe the surplus accumulated in year y, and adjust the auction volumes starting form y + 0.5 years or starting from y + 1 year. Withdrawn allowances won’t be cancelled, as this would cut the cap. Instead, any unsold allowances will be deposited in a reserve and will be re-injected if the cumulative surplus goes below the minimum threshold.

The idea is illustrated in Figure 10: actual supply of allowances in the current year compensates the discrepancy between target supply and actual emissions of the previous year.

Pros of a price and supply management reserve:

1. Reduces price volatility

Cons of an auction floor price:

1. Does not address the root cause of the problem 2. If the reserve becomes very large, which is likely if the EU is hit by a

recession and the cap is not adjusted accordingly, the difficulty arises of when to re-inject the reserve.

3. Should there be an upper limit on the size of the supply management reserve, what about a lower limit, can it run a deficit? Answering these questions is not going to be easy.

Figure 10. Supply compensation for maintaining target stringency65

65 Source: http://www.ceps.eu/files/Schleicher2.pdf

Time

Emis

sio

ns

(a) Adjusting to a long market

(b) Adjusting to a long market

-1

-1

0

D-1

C-1

S

D-1

C-1

S

-1 0

D-1

T

T-1

T-1

T

S = actual supply of allowancesT = target supply as to the emissions target pathC = actual emissionsD = discrepancy between target supply and actual emissions

D = T –CS = T -D-1

http://www.ceps.eu/files/Schleicher2.pdf



Confidential

SS-131008-1632

| 08.10.2013

31

4.1.3 A rolling cap

The basic idea of the rolling cap is to offer the possibility of flexibility under defined rules in target setting. For example, the Australian ETS relies on a fixed 5-year emissions cap, which is annually updated 5 years in advance for each subsequent year

66. Through this

process, the Australian ETS attempts to combine a lagged flexibility to respond to unforeseen events by supply-side adjustment with some kind of predictability and credibility about the emissions pathway.

For the EU, the rolling cap approach raises the issues of governance, particularly on how an institutional structure can be designed to allow the EU to reach consensus quickly on a regular basis, especially if annual updates to the cap are contemplated

67. One option is to

delegate powers to a new or existing institution to manage the supply of allowances. This would require the centralization of a large amount of control over the carbon market’s emissions trajectory and prices in the hands of an independent bureaucracy, which rises, in the EU context, questions about political feasibility.

Pros of a rolling cap:

1. Provides some flexibility to respond to unforeseen events

Cons of a rolling cap:

1. A 5-year fixed cap, as in the Australian ETS, can be slightly slow to react to unforeseen events.

4.1.4 An automatic cap adjustment mechanism

The basic idea of the automatic cap adjustment mechanisms is to issue or withhold allowances so as to stabilise the ETS price along a pre-determined trajectory. It has the same effect on emissions as an auction price floor with retirement.

66 Egenhofer (2012) Reviewing the EU ETS Review – Report of the CEPS Task Force On Does the

ETS market Produce the ’Right’ Price Signal?





Confidential

SS-131008-1632

| 08.10.2013

32

Figure 11. Illustrative figure of the automatic cap adjustment

mechanism after phase 3.

Pros of an automatic cap adjustment mechanism:

1. Would stabilise the allowance price, and would thus give a more stable environment for investing in low-carbon technologies.

2. Is less vulnerable to unanticipated demand shocks, caused e.g. by a row of sovereign debt defaults.

3. The extent to which it increases the confidence in the EU ETS depends on how credibly the EU Member States can commit to the price trajectory.

Cons of an automatic cap adjustment mechanism:

1. Very difficult to implement because it would change the EU ETS from a quantity-based instrument to a price-based instrument, i.e. it would constitute a major paradigm shift

2. Is in conflict with the view that the primary objective of the EU ETS is to achieve a certain quantity of abatement at least cost.

3. Would definitely put some of the auction revenues at risk 4. Agreeing on the price trajectory, faces similar challenges as agreeing on

the auction price floor, and is likely to be the subject of intense lobbying.

- €

5,00 €

10,00 €

15,00 €

20,00 €

25,00 €

30,00 €

35,00 €

40,00 €


Price floor

Price ceiling

Target price gap for EUA allowances



Confidential

SS-131008-1632

| 08.10.2013

33

4.1.5 A buy back guarantee, i.e. a sell option

The basic idea of a buy-back guarantee is that the governments guarantee a certain carbon price to investors in low-carbon technologies. If the carbon price is below the guaranteed price, the governments (the option writer) will pay the difference to the investor (the option holder). Hence, in case of a low carbon price, potentially detrimental to the competitiveness of low-carbon investments, the investor gets some compensation, which reduces risk. At the same time, if the governments issue large volume of option contracts, it creates an incentive for policymakers not to water down climate policies in the future. On the other hand, option contracts may create a conflict of interest for governments who are responsible for the policy that affects their financial liability.

68

Pros of a buy back guarantee:

1. Reduces the risk of investing in low-carbon technologies

Cons of a buy back guarantee:

1. Affects neither supply, demand not the price of EUAs. However, indirect effects are possible in the long term. One possible channel for indirect effects is that CO2 intensive technologies are replaced by low-carbon technologies, which reduces demand for CO2, and consequently EUAs.





Confidential

SS-131008-1632

| 08.10.2013

34

4.1.6 Summary

Table 7, summarises the five discretionary price management mechanisms. For the sake of comparison, the auction price floor is chosen as the benchmark mechanism.

Table 7. Effects and feasibility of the discretionary price management mechanisms.

Mechanism Effect on price

Effect on emissions

Political feasibility

Effect on price confidence

Benchmark: an auction price floor

Immediate None, if the unsold EUAs are re-injected at a later stage. Negative, if they are retired.

Depends on whether the unsold allowances are retired or not. If retired, constitutes a change to the EU ETS cap. If not, political feasibility is similar to that of backloading.

Would increase short-term price certainty. However, without retirement, may accumulate a surplus in the allocation process, which may undermine long-term price confidence.

A supply management reserve

Depends on the how the reserve is defined, in any case, slower than the benchmark

None if the rules require that the whole reserve must be injected to the market

Has a larger range of issues that must be settled than the benchmark

Similar effect on confidence as the benchmark

A rolling cap Slower than the benchmark

As per definition, would change the cap

Politically less feasible than the benchmark because it would necessitate an agreement on the mechanism of how to adjust the cap

Would improve long-term confidence

An automatic cap adjustment mechanism

Significantly slower than the benchmark, if not combined with a permanent set-aside

As per definition, would change the cap, if the price will exceed or undercut the price lines.

Would change the EU ETS from a quantity-based instrument to a price-based instrument

Would have a major positive impact on the long-term confidence

A buy back guarantee, i.e. a sell option

No effect on price

No effect on emissions

Raises difficult questions because the sell option would need to be issued by a government and depending on how prices move, the options could have potentially large fiscal effects

Would give some confidence to investors in low-carbon technologies



Confidential

SS-131008-1632

| 08.10.2013

35

4.2 Other selected measures

In this subsection selected proposals are discussed and analysed. Especially the effects to the current oversupply in EU ETS will be evaluated.

4.2.1 Revising the linear reduction factor

At the moment the ETS cap for stationary installation is decreasing 1.74% annually. This Linear Reduction Factor (LRF) means emissions reduction around 37 million emission reduction allowances (EUA =tCO2e) per year. One of the Commission proposals (option 3.) is early revision of this linear reduction factor.

Figure 12. Current Linear Reduction Factor (LFR)69 Adjustment of LRF to 2.25% European parliament (ENVI committee) has proposed an adjustment of the linear reduction factor from 1.74% to 2.25 % annually. This way the cap would decrease 50 million allowances per year. If the 2.25% linear reduction factory would implemented on 2013, this would mean cumulative reduction effect of around 315 million allowances by the year 2020 compared to the current situation. By the year 2030 the cumulative effect would be around 1,720 million allowances (tCO2e) less compared to LRF of 1.74%.

70

69 Source: Öko-Institut

70 http://www.greenpeace.de/fileadmin/gpd/user_upload/themen/klima/20120610-Studie-

Emissionshandel-englisch.pdf



Confidential

SS-131008-1632

| 08.10.2013

36

Adjustment of LRF to 2.52% If LRF would be set at the level of 2.52%, which would reflect the needed reductions based on Commissions Roadmap 2050, the allowance cap would reduce roughly 54 million allowances per year at the stationary sector and the cumulative effect would be around 470 million allowances by the year 2020 and 2 569 million allowances by the year 2030 compared to the current LRF level of 1.74%.

71

Table 8. Cumulative effect of changing the LRF from 2013 onwards (without aviation)

linear reduction factor 2020 (Million) 2030 (Million)

2.25% 315 1 720

2.52% 470 2 569

Adjusting the LRF after the phase 3 If the linear reduction factor would be increased from the level of 1.74% to the level of 2.52% after year 2020, the cumulative effect by the year 2030 would be significantly less than in the case, where deepening the LRF would start on 2013. Assuming that the total cap in the EU ETS in 2020 would be 1 772 million allowances

72, the cumulative decreasing

effect to the supply side by the year 2030 would be around 400 million allowances. With LRF of 2.52% the EU ETS cap would be in 2030 around 1281 million allowances and in 2050 around 388 million allowances.

If the LRF would be changed from 2020 onwards from the level of 1.74% to the level 2.71%, in order to meet the 88 to 92% reduction target by 2050

73, the cumulative effect

would be around 580 million allowances by the year 2030. With LRF of 2.71% the EU ETS cap would be in 2030 around 1244 million allowances and in 2050 around 283 million allowances.

Table 9. Cumulative effect of changing the LRF from 2020 onwards (without aviation)

linear reduction factor 2030 (Million)

2.52% 400

2.71% 580



72 Reference Scenario (linear reduction factor 1.74%) on the study: http://www.pbl.nl/sites/default/files/cms/publicaties/PBL_2013_Evaluation-of-policy-options-to-reform-the-EU-ETS_934.pdf





Confidential

SS-131008-1632

| 08.10.2013

37

Only the steep linear reduction factor from 2013 onwards would affect clearly to the current surplus. For example if the linear reduction factor would be changed on 2013 to level of 2.25 %, the surplus would be maintained by 2023

74and in the light of current estimations of

the oversupply even later.

The main advantages of implementing the steeper linear reduction factor include the following:

Permanent clear signal to the market

Decision which results in to lower cap for 2030, will likely lead to a higher carbon price already on phase 3. and more incentives to mitigate earlier

The main weaknesses of implementing the steeper linear reduction factor include the following:

Can`t be front-loaded to deal with current surplus in short term

If the linear factor will not be very steep, the efficiency in short-term is very weak.(e.g. linear factor of 2.25 % delivers a long-term effect, but the surplus would be maintained by 2023)

4.2.2 Backloading of 900 million allowances

The European Commission tabled in November 2012 a draft amendment which would reduce the number of allowances to be auctioned in the years 2013 to 2015 by 900 million and increase the number auctioned in 2019-2020 by the same amount. Table 10. Backloading proposal

The European Parliament voted in its plenary session on July 2013 in favor of this ETS Directive amendments that allow the backloading of EUAs. The text mentions that the Commission may ”in exceptional circumstances” modify the auction timetables, but only once during the Phase 3 and only related to a maximum amount of 900 million allowances. The idea of the backloading is that there would be annual deficit of the allowances between the years 2013-2015 and surplus in the EUA markets would reduce immediately in short term. However backloading does not reduce the overall number of allowances to be

74 http://www.greenpeace.de/fileadmin/gpd/user_upload/themen/klima/20120610-Studie-

Emissionshandel-englisch.pdf

Year 2013 2014 2015 2019 2020

Amount - 400 - 300 - 200 + 300 + 600



Confidential

SS-131008-1632

| 08.10.2013

38

auctioned during phase three and the total surplus (around 2 000 million) on 2020 would be the same than without backloading. (See the Figure 14).

Figure 13. Total surplus and annual or surplus, when back-loading 900 million allowances

7576

The backloading, without any other structural measure, wouldn’t have a significant impact to the average EUA prices over the period 2013-2020, because the total amount of allowances in phase 3. would remain at the same level. However there can be slightly near-term price effects especially due the expectations that the back-loaded allowances will not return to the markets (backloading would turned to permanent set-aside). On the last years of the phase 3, the EUA price is expected to decrease, when supply increases again.

75 Note that in the 900 allowances in the figure will be returned to the markets between 2018-2020.

76 Source: http://ec.europa.eu/clima/policies/ets/cap/auctioning/docs/swd_2012_xx2_en.pdf



Confidential

SS-131008-1632

| 08.10.2013

39

Table 11. Overview of projections of impacts by market analysts77

The main advantages of implementing the back-loading include the following:

Can be front-loaded to deal with current surplus in short term

It can have a short-term price effect to the EUA market

The adoption of back-loading is also a signal that structural reforms are more likely to be adopted

It will give time to preparation and to establish other structural measures on phase 3.

The main weaknesses of implementing the back-loading include the following:

It is not a permanent solution for the current oversupply and clear signal to the market

Shifting the allocation for some years does not change the underlying value of the allowances

Even thought there can be short-term price effect, it will certainly not incentivise investments into low-carbon technologies, because the prices will drop as soon as the back-loaded allowances are back to the markets

4.2.3 Retiring a certain number of phase three allowances permanently,

as an additional measure for previous ones

Permanent cancellation of 900 million allowances If the Commission will implement the back-loading plan of 900 million allowances, it is relevant question, that will the withdrawn allowances be returned to the markets via

77 Source: COMMISSION STAFF WORKING DOCUMENT PROPORTIONATE IMPACT

ASSESSMENT Accompanying the document Commission Regulation (EU) No .../.. of XXX amending Regulation (EU) No 1031/2010 in particular to determine the volumes of greenhouse gas emission allowances to be auctioned in 2013-2020

Backloading

of900 Mt

Source* Min price €

2013- 2015

Max price €

2013-2015

Point carbon 10,0 (4,0**) 12,0 (5,0)

Bloomberg 8,6 (6,2) 20,0 (6,7)

Tschach Solutions 13,0 (4,5) 23,5 (8,0)

* Tschach Solutions only projects price impacts up to 2014 prices, first two quarters** Market price projections with no backloading



Confidential

SS-131008-1632

| 08.10.2013

40

auctioning on the last year of the phase 3.78

If the withdrawn allowances won`t be returned to the markets, back-loading will turn into permanent cancellation. This would decrease the amount of the oversupply in the markets immediately starting from the year that the first withdrawn from the markets has happened. And the total effect to the oversupply would be 900 million allowances. However on 2020 the total cap of allowances would remain at the same level than without the permanent cancellation and it would remove only around half of the current surplus.

The main advantages of implementing the permanent set aside of 900 million allowances include the following:

Can be front-loaded to deal with current surplus in short term Permanent clear signal to the market and it will create a long-term price

effect to the EUA market

The weakness of implementing the permanent set aside of 900 million allowances include the following:

Doesn’t solve entirely of current oversupply problem

Does not change expectations about post 2020 requirements Set aside of 900 million allowances in addition to changing the linear reduction factory 2020 onwards.

If the permanent cancellation of 900 million allowances would be done immediately, the oversupply would be on 2020 around 1 100 million allowances. However, as in above was pointed out the total cap would be on 2020 the same than it would be in the case where wouldn’t be any other structural measure before 2020 and the oversupply would still remain at the amount of 1 100 million allowances in the markets. If the linear reduction factor would be changed from 2020 onwards from the level of 1.74% to the level of 2.71%, in order to meet the 90% reduction target by 2050, the cumulative effect would be around 580 million allowances by the year 2030. So the total cumulative effect by 2030 of the combination of these two structural measures, permanent cancellation of 900 million allowances and linear reduction factor of 2.71% from 2021 onwards, would be 1 480 million allowances.

78 Such a set-aside was proposed on 20 December 2011 by the European Parliament as an additional amendment tothe proposal for

an Energy Efficiency Directive.



Confidential

SS-131008-1632

| 08.10.2013

41

The main advantages of implementing the permanent set aside of 900 million allowances and changing the linear factor by 2.71% from 2020 onwards include the following:

Can be front-loaded to deal with current surplus in short term Permanent clear signal to the market and it will create a long-term price

effect to the EUA market

The weakness of implementing the permanent set aside of 900 million allowances and changing the linear factor by 2.71% from 2020 onwards include the following:

Doesn’t solve entirely the current oversupply problem

4.2.4 Bringing more sectors into the EU ETS (especially heating sector)

The fourth option proposed by Commissions for structural measures in the EU ETS is to extend the scope of the EU ETS to other sectors, like fuel consumption. The idea behind the extending is that the non-EU ETS sector hasn`t been so strongly influenced by economic cycles than EU ETS sector. For example emissions in non-EU ETS sector decreased 4 % in 2009 and at the same time the emissions in EU ETS sector decreased more than 11 %.

79

The carbon prices outside of the ETS sector are significantly higher than the allowance price in the EU ETS.

80 The EU ETS would provide to the other sectors, which are now in

the non-ETS sector, option to buy additional allowances and the carbon price could rise. This may also improve the overall cost-efficiency of reducing greenhouse gas emissions in the EU. Expanding the EU ETS could introduce additional scarcity on the carbon market only if the amount of allowances is less than the sector’s current emissions. If the created shortage in the sector is relatively small, the impact on emissions and emission price would also be relatively small.

The Netherlands Environmental Assessment Agency PLB made an analysis, how the inclusion of liquid fuels for road transport to the EU ETS would affect e.g. to the EUA prices. In their analyses they included 877 million allowances from fuels used in the road transport to EU Cap on 2013. So the total cap of EU ETS was then 3 239. The ETS would provide road transport with the option to buy additional allowances, which can drive up the price of EU ETS allowances. However in PLB evaluation, the EUA price increased only slightly compared to the scenario, where the transport sector wasn’t included.

The total energy sector emissions has been around 1000 Mt CO2 outside of the EU ETS in 2005

81. This is quite same magnitude than the emissions in the transport sector. Reflecting

the analysis made by The Netherlands Environmental Assessment Agency PLB,


80 Source: http://fores.se/assets/691/Reform-of-the-EU-ETS-system.pdf

81 http://ec.europa.eu/clima/policies/effort/docs/esd_emissions_projections_en.pdf



Confidential

SS-131008-1632

| 08.10.2013

42

expanding the EU ETS with heating sector would not change the current oversupply and low price situation hardly at all.

Pros and Cons of bringing more sectors to the EU ETS

The main advantages of bringing more sectors to the EU ETS include the

following:

May increase the cost efficiency by exploiting the cheapest abatement options to reduce the cost of CO2 emissions

Including sectors that face relatively expensive abatement options, while reducing their amount of allowances relative to the base line, additional scarcity is introduced on the carbon market and the carbon price may rise.

The main weaknesses of such a measure include the following:

Doesn’t solve the current oversupply problem and wider scope of the EU ETS is only an indirect way to reduce emissions in order to create a stronger price signal.

As the created shortage in this sector is relatively small (compared with the options reducing supply of allowances), the impact on emissions and emission price would also be relatively small.

Several policy questions would need to be addressed, such as who would carry the obligation to report emissions and surrender allowances, fuel producers or users, or some kind of a hybrid system.

4.2.5 Limiting access to international credits

Overall, international credits can be used to cover emissions of some 1.6-1.7 billion tonnes of CO2 (or the equivalent amount of nitrous oxide or perfluorocarbons) between 2008 and 2020. This represents half the reduction in emissions that will be made under the EU ETS in that period. It seems likely that the market of international credits (CER/JI) will be oversupplied by 2020 by one billion international credits or more. The expected oversupply is already reflected in the collapsing prices of CERs and ERUs and their de-coupling from the EUA price (See the Figure 2). The low price of the international units has made CER`s and ERU`s attractive for operators under the EU ETS to use international units to meet their emission reduction targets. The use of the international credits has been very popular between 2008-2012 and operators used 1.058 billion international credits in phase 2.

82. It is

very likely that the rest of the allowed, nearly around 600 international credits, will be used

82 http://ec.europa.eu/clima/policies/ets/linking/index_en.htm



Confidential

SS-131008-1632

| 08.10.2013

43

in the EU ETS. Without international credits, the surplus in the EU ETS by 2020 would potentially be only around a quarter (25%) of the presently expected surplus

.83.

If the limiting of the international credit use would be implemented on the phase 3, the impact to the oversupply would be very similar to other measures that reduce medium-term supply, especially the permanent set-aside. However Commission has indicated that the limiting access to international credits could be implemented in phase 4. This would basically mean that the reductions targets to 2030 would be implemented without international credits or much more limited access to international credits than on phase 3. This would ensure that the necessary mitigation efforts would be undertaken and wider extend of low carbon technologies would be used in Europe. However without using any international credits or similar initiatives, which are under discussion (e.g. new market mechanisms), could have an impact on the future climate negotiations and post -2020 climate agreement.

Reduction target without international credits on phase 4.

Assuming that

The international credits would be cheaper than the EUA allowances (like in current situation)

The EU ETS installations could use international credits for compliance purposes up to 50 % of the increasing target (like in 2008-2020) after 2020

The phase 4. would be between 2021-2030 We can do following assumption:

If the linear reduction factor would stay at level of 1.74% from 2020 onwards the EU ETS cap would decrease from 1772 allowances to 1440 allowances. This would mean reduction of around 37 million allowances per year and the total cumulative decreasing would be around 2000 million allowances between 2021- 2030. If operators are allowed to use international credits to cover their emissions 50 % of the increasing target, it would mean total of around 1000 million international credits during the phase 4.

If the linear reduction factor would be changed to the level of 2.71% on 2021, in order to meet the 90% reduction target by 2050, the cumulative effect would be around 2580 allowances by the year 2030. If half of this cumulative effect would be used by international credits, it would mean that the total international credit use would be around 1290 million credits.

So if the 2030 target should be reach without international credits, there should be 1000 million CO2 mitigation efforts implemented in EU ETS, if the linear reduction factor would be 1.74% and 1290 million if the linear reduction factor would be 2.71% from 2020 onwards.




Confidential

SS-131008-1632

| 08.10.2013

44

The main advantages of limiting access to international credits in the EU ETS

on phase 4.:

Clear signal to the market

More low carbon technologies would be used in Europe.

The main weaknesses of such a measure include the following:

It is not a permanent solution for the current oversupply

May have negative impact on the future climate negotiations and post 2020 climate agreement.



Confidential

SS-131008-1632

| 08.10.2013

45

4.2.6 Summary

Table 12, summarises the effects of the different structure measures to the oversupply and EUA prices in EU ETS.

Table 12. Effect to oversupply and EUA prices

Effect to oversupply Effect to EUA prices

Mechanism Efficient in near-term

(2013-2020)

Efficient in medium and long term (2021-2030)

Increasing effect in near-term

(2013-2020)

Increasing effect in medium and long term

(2021-2030)

Revising the annual linear reduction factor during the phase 3. (2.52%)

Partly. (470 million)

Yes, but depends how deep the LRF will be. (2569 million)

Partly,implementing the deeper LFR in the early state on phase 3, will likely lead to a higher carbon price already early state on phase 3.

Yes, but the effect depends how deep the LRF will be.

Revising the annual linear reduction factor after the phase 3. (2.71%)

No Yes

(580 million)

No, if the politically decision won`t be made early enough

Yes, but the effect depends how deep the LRF will be.

Back-loading of 900 million allowances

No, but would induce annual deficit for years 2013-2015.

No No, but some near-term effect can be, especially due the expectations, that the back-loaded allowances will not return to the markets.

No

Permanent Set-aside of 900 million allowances

Partly, would reduce around half of the current surplus (900 million).

Partly, would reduce around half of the current surplus But no additional effect after 2020.

Yes, clear signal to the markets.


Set-aside and revising the annual reduction factor after 2020. (2.71%)

Yes, would reduce around half of the current surplus.(900 million)

Yes, but would not solve the entire oversupply problem.

(580 million)

Yes, clear signal to the markets


Bringing more sectors into EU ETS

No Partly, if the created shortage in the sector would be relatively big.

No Partly, if the created shortage in the sector would be relatively big.

Limiting access to international credits in phase 4.

No Partly, depends of the total target cap on phase 4.

No Partly, depends of the total target cap on phase 4.



Confidential

SS-131008-1632

| 08.10.2013

46

It seems like the current oversupply will not melt away before 2024 without some adjustments to the scheme. Concerned by the low carbon price and the current oversupply situation, Commission has tabled multiple structural measures to relieve the problem. The proposed structural measures would take some time, at least around 2 years, to be implemented and as Commission has pointed out: all the options would require the consent of both the bloc’s Parliament and national governments in a lengthy legal process.

84 However, as soon as expectations start to rise that the proposed

structural measure is going to be implemented the prices will react.

The approval of the European Parliament of the ETS Directive amendments that allow the backloading of EUAs will maintain the possibility that there could be some structural measures implemented on the phase 3. However the backloading discussion continues now between the European Council, Parliament and the Commission who are trying to find a compromise text that is acceptable for all parties. The trilogue negotiations may last until the end of the year and implementation of backloading could happen at the earliest in 2014. If the backloading will be implemented it would give some time to preparation and to establish other structural measures already on phase 3. The most straightforward way would be then a permanent set-aside. This measure would reduce around half of the current oversupply, but would not be solve the entire oversupply problem.

It seems that one of the best solution85

for giving a clear signal to the markets and to reduce the oversupply in long term, would be changing the linear reduction factor in phase 3. However, it is unlikely that it could be implemented in near-term and before 2020. After 2020 the linear reduction factor should be relative steep, to be in the line with the European 2050 target. If set-aside would be implemented during the phase 3. and the linear reduction factor would be adjusted on phase 4, the total effect to the current oversupply would be quite remarkable and would give clear signal for the markets in near- and long term.

Bringing more sectors into the EU ETS would be negligible effect on the current oversupply. In long-term there could be some effect to price volatility due the larger scheme. The question is more about that should some sectors from non-ETS sector added to the EU ETS to increase cost efficiency by exploiting the cheapest abatement options to reduce the cost of CO2 emissions.

The effect of limiting the international credits use on phase 4. depends on what would be the overall emission reduction targets after 2020. This adjustment would be clear signal to the markets and investors, that the mitigation actions have to undertake in EU. But there could be negative consequences for future climate negotiations and post 2020 climate agreement. This could be eased by keeping the option for governments to use international credits to achieve their targets in non-EU ETS sector.

84 Source: EU Commission report COM(2012) 652, The State of the European carbon market in 2012

85 from the measures, which has been evaluated in chapter 3.2

Oversupply and structural measures in the EU ETS · 4.2.6 Summary _____ 45. Oversupply and structural measures in the EU ETS Confidential SS ... nature and level of climate and energy

Documents