The EU must tackle design flaws and speculation in its carbon market to ensure the price of emissions remains high and becomes a more effective tool to drive decarbonisation, according to a report by the Greens in the European Parliament.

The price of carbon on the EU Emissions Trading System (ETS) has risen sharply over the past year, reaching heights not expected before the end of the decade.

But while a high price for emitting climate-warming carbon is a good thing, the volatility of the price of CO2 in the carbon market must be addressed or there are risks of undermining the decarbonization effort, according to Marie Toussaint, a green lawmaker on the Energy Committee. and co-president of the Philippe Lamberts group.

“Although the EU ETS is the cornerstone of EU policy to combat climate change, it has contributed far too little to reducing greenhouse gas emissions in the sectors covered since its inception in 2005,” Toussaint and Lamberts write in the preface to a new report. on the European carbon market.

“Unless the European Parliament and the Council agree to tackle the structural flaws of the European carbon market, our common future could therefore be seriously compromised,” they warn.

An independent report commissioned by lawmakers has found that design flaws in the EU’s carbon market mean it’s not fit for purpose, despite the EU lauding it as a key instrument to reduce emissions. emissions. According to the European Commission, “since the introduction of the EU ETS in 2005, emissions have been reduced by 42.8% in the main sectors covered: electricity and heat production and intensive industrial installations energy”.

But flaws in the design of the European carbon market have undermined its effectiveness, according to the report by Frédéric Hache, a former financial markets professional, independent consultant and director of the Green Finance Observatory.

These include a surplus of emissions allowances in the early stages of market launch, free pollution permits given to companies to prevent them from leaving Europe, and a lack of precautions against speculation.

Speculation and fuzzy price signals

According to Hache’s report, the two tools of the ETS that lead to decarbonisation – the price signal and the cap on available allowances – are flawed and create uncertainty.

For example, he warns that the price signal, which aims to incentivize investment in low-carbon technologies, is clouded by price volatility and speculation.

“A high price without the expectation that prices will stay high will do little to induce behavior and technology change,” warns Hache.

“A strong and stable carbon price signal is essential for the EU ETS to be truly effective. Without the expectation of a future shortage of allowances, energy-intensive industrial sectors will not be encouraged to switch to cleaner technologies,” Toussaint and Lamberts write in their preface.

The other incentive to decarbonize — the cap on emissions allowances — is also failing due to excess carbon allowances on the market, according to Hache. He points out that between 2013 and 2019, verified emissions were on average around 220 million allowances below the nominal cap. And the closure of coal-fired power plants and the adoption of renewable energy will likely continue this trend.

“The extremely high carbon price volatility in the EU ETS, coupled with the vast excess of carbon allowances, thus fully explains its failure to contribute significantly to climate change mitigation,” he writes.

However, tackling these issues must be done carefully, Toussaint and Lamberts say. They warn that, if the EU focuses only on tackling speculation, there is a risk that the price will drop and further undermine the purpose of the ETS.

Instead, they argue that policymakers should proceed in stages, first making drastic cuts to surplus allowances and then curbing speculation.

Insufficient review

In July 2021, the European Commission presented a proposal to revise the European carbon market. There are some positives in the review, Hache says, including the gradual reduction of allowances in the market (via the linear reduction factor) and the inclusion of the maritime sector in the carbon price.

But Hache warns that the review “fails to deal with the huge excess of allowances in the system in a timely manner”, leaves free allowances in the system for another 14 years and fails to combat speculation and limit the price volatility.

Moreover, the Commission’s proposal does not bring any changes to the market stability reserve, introduced in 2019 to deal with the surplus on the market, which currently amounts to 1.5 billion allowances. To do this, the reserve retains a certain number of allowances from the market and injects them if necessary.

And Peter Liese, the German lawmaker leading the EU ETS review in the European Parliament, has made no attempt to increase the ambition of the market stability reserve or the linear reduction factor, which would help fight against excessive quotas, says Haché.

This was confirmed by Liese when he presented his ETS report in January. “I think the Commission, in general, has made a good proposal on ambition,” he told reporters during a press briefing on his report.

Liese has also introduced a “bonus-malus system” to encourage decarbonisation, which rewards the best performing companies with additional emission allowances while penalizing the worst performers by requiring them to introduce climate plans before they can receive their quotas.

This has drawn skepticism from fellow lawmakers, who feel his report lacks ambition. “It is definitely too slow to phase out free allowances, too slow for innovation and too slow for CBAM,” Swedish Renew Europe MP Emma Wiesner told EURACTIV.

[Edited by Frédéric Simon]