Reform, not a patch, will curb carbon price volatility

As energy prices hit record levels, the European Union’s carbon emissions permits – which hit €100 on futures markets in February – have been accused of making electricity too expensive, and although natural gas has a much larger responsibility, the carbon price also plays a role. Up in arms against the suspected evil hand of speculation, some member states, led by Poland, and some members of the European Parliament, have urged the bloc to pass legislation to curb volatility.

Little is said to explain why the carbon price is so high. A new report from the European Securities and Markets Authority (ESMA) found no evidence of speculative manipulation. In 2021, emissions rebounded from a low in 2020, but were still 14% below the Emissions Trading System (ETS) cap. The surplus of emissions permits in the market at the end of 2021 was about 1.2bn after all compliance needs. This was no fewer than in 2019 and enough to cover about a year’s worth of emissions. So, the current situation can hardly be called a shortage. As recently as 2015, large surplus was recognised as a major problem, prompting the 28 member states to create an instrument to mop up some of the excess permits: the Market Stability Reserve (MSR). Some argue that a surplus is useful for power utilities to hedge their forward sales of electricity, but even this ‘useful’ surplus was estimated at no more than 833mn back then, when the EU’s power sector was much more CO2-intensive and the United Kingdom was still part of it.

Here lies the real problem: volatility is not a matter of a lack of supply but of a bad distribution of supply. On the one hand, industry plants making steel or clinker receive free permits in proportional amounts to their output. Consequently, these plants and their clients are indifferent to carbon prices and allow prices to spiral without easing the demand by reducing output. This system has let a war chest of spare free permits accumulate on industry’s registry accounts.

On the other hand, power utilities must buy all their emissions permits. When surplus is considered too high as per the MSR’s design, fewer allowances are auctioned each year to force utilities to buy them from the existing stock, namely from the industry. While this is happening, the main driver for carbon prices is neither gas prices nor overall market balance, but simply industry’s willingness to sell. In healthy economic times and with market reform under way, it is understandable that the industry sticks to its wait-and-see approach, hesitant to sell. But if some kind of financial squeeze were to happen, with credit drying up, the carbon war chest could turn into a giant ATM, rushing millions of unused allowances out of those registry accounts and causing the price to crash. In summary, the free allocation regime causes carbon prices to amplify economic cycles.

Some might argue that prices won’t crash as operators speculate on the longer-term perspective of permit shortfall. However, long-lasting shortfall is not definite, and according to Sandbag’s estimates, it is not in sight before 2030. What will happen after that is highly uncertain anyway: the ETS might be set less stringent goals or decarbonisation might happen faster than expected. Speculation might then reverse and bet on an oversupplied market, thus accelerating the crash.

As carbon price volatility is a major sticking point on the ETS revision, both at the European Parliament and between member states, nothing has been proposed to substantially curb the real cause of the symptom: free allocation.

Instead, discussions have focused on amending so-called Article 29a, a mechanism introduced in 2009 under Poland’s insistence and never used since. Absurdly, all nine amendments, carried by 33 MEPs, including rapporteur Peter Liese of the lead Committee on the Environment, Public Health and Food Safety (ENVI), propose to use Article 29a to release permits into the market from the MSR, the very reserve aimed at removing excessive surplus. Their calls do not even suggest a prior check for excessive surplus before such a release.

Although the search for better alignment of the price with fundamentals is legitimate, it should be kept in mind that any release from the MSR would be equivalent to increasing the market’s cap. For example, a 100mn release in 2030 would allow emissions to exceed the cap by 13% that year. This would effectively renounce the EU’s commitment to its 55% greenhouse gas emissions reduction target.

Proposals to release permits in excess of the cap are all the more absurd as, at the same time, not all permits within the cap are released. This is another illogicality of free allocation: it creates situations where the yearly supply is lower than the cap. An estimated 106mn such allowances failed to be released in 2021 alone. A much better system would exactly match the cap with the supply. Bar one, spare allowances within the cap could be used for Article 29a.

As price volatility comes from a supply distribution issue, we should address just that. Public authorities, namely member states and the Commission, could auction allowances in a way that smooths out temporary supply squeezes, not only using spot sales but also futures sales. This would surely work better than the kind of anti-MSR patch currently proposed.