COVID-19, emissions trading and the implications for a future UK ETS

The impact of COVID-19 on the price of carbon illustrates just how important it is to build flexibility into cap-and-trade systems and this is something policymakers should remember for the design of the UK’s post-Brexit emissions trading system, argue Josh Burke and Luca Taschini.

The spread of COVID-19 across the globe has seen commodity prices taking a battering from the turbulence of stock markets, which have experienced unprecedented pandemonium for the last two months. According to the Bloomberg Commodity Index, commodity prices are down by 23 per cent since the start of this year.

The price of carbon is no exception. Despite being one of the best performing commodities over the last 18 months, reaching highs not seen since 2008, it has not escaped this bear market. At the time of writing, prices have fallen by almost 30 per cent over the last two months.

Why are emissions trading schemes vulnerable?

Gauging the full impact of COVID-19 will take time, and the initial focus should rightly be on the humanitarian response. But it is inevitable that climate policy will be impacted and in terms of immediate repercussions for existing policies, the efficacy of the European Union emissions trading system (EU ETS) is particularly vulnerable. The ability of an emissions trading scheme like the EU’s to provide certainty over the quantity of emissions while retaining dynamic pricing is one if its strengths but also one of its greatest and fundamental weaknesses. As a result, the carbon price in an ETS fluctuates depending on the demand for allowances: the carbon price may be higher when the economy is booming and lower during a downturn.

History has shown this be true. This is not the first time carbon markets have suffered a significant exogenous shock. The great recession of 2008 reduced demand for carbon permits and the subsequent oversupply in the market precipitated a steep decline in carbon prices within the EU ETS, taking 10 years to recover, and only after significant market reforms were implemented. It therefore begs the question: will the effects be as long-lasting this time or will recent market reforms be enough to tackle this unexpected supply–demand imbalance?

Lessons from 2008 – permit oversupply caused a weak price signal

Economic shocks, technological progress or the introduction of new policies can influence the efficacy of cap-and-trade programmes, as has been evidenced in the case of the EU ETS. A key lesson from the 2008–2012 economic downturn in Europe is the importance of building flexibility into cap-and-trade systems. If such a response mechanism had been in place prior to the 2008 crash, then oversupply of permits from phase 2 would not have been carried forward to phase 3. The surplus amounted to around 2 billion allowances at the start of phase 3 and increased further to more than 2.1 billion in 2013.

Such oversupply in phase 3 of the EU ETS meant there was a weak price signal that failed to drive innovation in new low-carbon technologies, incentivise additional investment in low-carbon assets or reduce investment in carbon-intensive products and processes. In Europe, the absence of institutional rules permitting adjustments of the cap in the face of demand shocks contributed to the need to invoke different, potentially less efficient, regulations. In sum, this undermined the overarching objective, which motivated the subsequent calls to augment the EU ETS with additional policies.

Policy reforms – the Market Stability Reserve

Climate economists were kept busy for many years with the lessons to be learnt from the great recession. Chief among them was how policy should respond to ensure the stability and credibility of price signals within carbon markets. What emerged from the debate was the proposal – in January 2014 – from the European Commission for a structural reform of the EU ETS called the Market Stability Reserve (MSR). The Grantham Research Institute provided the academic underpinning for the reform of these rules and continues to evaluate the performance of EU ETS reforms.

Finally coming into force in 2019, the MSR addresses the current surplus of allowances and improves the system’s resilience to demand shocks by adjusting the supply of allowances to be auctioned. While generally viewed as a positive move, making it easier to adjust the EU cap might have some drawbacks. Greater flexibility may infer potential for political interference, which could adversely affect the credibility of governments’ commitment to reducing the emissions cap and introduce new uncertainties into the system.

Falling electricity demand as COVID-19 spreads

According to a report published by Ember on 23 March, every country in Europe saw electricity demand fall 2–7 per cent week-on-week from 9 to 22 March, with Italy experiencing a 20 per cent drop in demand over that two-week period alone. Although emissions will decline in conjunction, the situation is no cause for celebration given that the response is unplanned and chaotic and will likely prove inequitable, as more often than not it is poor people and communities that are most vulnerable to impacts of this kind.

Such a steep reduction in electricity demand and industrial output also means significant reductions in demand for carbon permits. Notwithstanding a fall in government revenues from auctioning permits, as demand plummets and oversupply ensues we have seen a corresponding drop in the EU carbon permit prices.

So how is the current price response different from 2008?

The current collapse of EU ETS prices is much steeper than in 2008. Prices have fallen by 30 per cent in the last two months owing to a decline in demand as panicked investors have offloaded holdings in search of safer havens, speculators sold in droves to hedge their options positions, and some polluters dumped permits to raise cash. Compare that to 2008, where during the first two months of the crash the fall was approximately 10 per cent. That said, the price collapse in 2008 was sustained over a long period of time. Between August 2008 and February 2009 it fell 70 per cent from €30 to €10. Permit prices then stabilised for two years (May 2009–May 2011) and then continued to fall – albeit at a slower rate – for roughly six years until Q3 of 2017.

The key question is whether the market reforms that have been introduced are agile enough to prevent a sustained fall in permit prices this time around. It is vital that prices can be stabilised and maintained at a high enough level to maintain fuel switching in the EU, where, for example, Germany (like the UK) has generated significantly less electricity from coal fired power stations in 2019 and 2020 because of higher carbon prices and lower gas prices.

Research by Carbon Tracker suggests ETS prices will need to hover at €30 per tonne to maintain fuel switching in the German power sector. This seems a tall order indeed. If this is the case, lower EU Allowance prices could improve coal-fired generation margins for some utilities, which could prompt them to increase output from coal.

Will the reforms work?

In our recent consultation response to the UK’s future of carbon pricing we stated that the Market Stability Reserve would not be able to make the ETS fully responsive to external shocks and that the supply of allowances in the market could be managed in a more active way to try to adjust for shocks to the system as and when they arise. In light of the current situation we think that it might be necessary to review the intake rate of allowances to the MSR by reviewing the supply-regulating MSR alongside other stimulus measures as governments scramble to tackle the spread of COVID-19.

In its current form, the MSR absorbs 24 per cent of EUA oversupply annually until 2023, when this rate is then scheduled to halve. But the effect on the allowance supply is delayed somewhat, with the absorption figure calculated each May based on the previous calendar, and with corresponding monthly sums to then be withdrawn from member state auctions over the 12 months starting in the following September.

In light of the current crisis, any intervention should not be rushed. After all, the drop in carbon prices could relieve pressure on crisis-hit industries.

Implications for the design of a UK ETS

The impact of COVID-19 illustrates just how important it is to build flexibility into cap-and-trade systems. This is something policymakers should remember for the design of the UK’s post-Brexit ETS; more so, given that its initial standalone nature will increase volatility.

A number of UK ETS design features have been consulted on. In light of the current shock, three are particularly relevant and worth scrutinising.

  1. The Supply Adjustment Mechanism (SAM). In principle, the objective of a SAM is to make the standalone UK ETS responsive to shocks and, in the spirit of the EU ETS MSR, tackle unexpected supply–demand imbalances. Therefore, the factors that should determine the design of a standalone UK ETS SAM are fundamentally linked to the causes of possible market imbalances that may develop in the UK allowance market. With this in mind, we would recommend that the Department for Business, Energy and Industrial Strategy (BEIS) consult with the UK stakeholders to identify the number of years it would take SAM to absorb the potential surplus.
  2. The Auction Reserve Price (ARP). If the ARP is purely transitional until the SAM comes into effect, then the SAM would have to be consistent with the net-zero target. However, in the event that future linking of a UK ETS with its EU counterpart is unsuccessful, the ARP could act as an effective minimum price guarantee or price floor. In this regard, it is no longer about aiding the transition to a new linked ETS, but it could be an effective way of ensuring the total carbon price (ETS plus carbon price support [CPS]) remains at a level consistent with net-zero. Floor prices could provide an effective way of ensuring prices do not collapse when society faces another economic shock.
  3. The role of banking. Banking works on the basis that if tomorrow’s discounted expected cost is higher than today’s, it is worth banking allowances, whether obtained by abating more emissions today or by purchase, and either using them to cover some of tomorrow’s emissions or selling them for profit later on. In the case of a standalone UK ETS, unlimited banking provisions allow firms to respond to UK specific shocks. When these provisions alone are not sufficient because the market is faced with severe allowance demand shocks, such as the one we are currently facing, the Supply Adjustment Mechanism (SAM) can help pick up the slack or alternatively, a longer banking period could be used.

Clearly, how carbon pricing instruments should respond to business and economic cycles is a topical policy question and there are important lessons to be learnt from how to price carbon in good times and bad. It is too soon to say exactly how ETS prices will be affected over the longer term, but unlike in 2008, policymakers at least have tools at their disposal to intervene in, and help stabilise, the market. Time will tell if they are truly sufficient to deal with such an unpredictable shock.

Josh Burke is a Policy Fellow at the Grantham Research Institute and Luca Taschini is an Associate Professorial Research Fellow at the Grantham Research Institute and Reader, Centre for Business, Climate Change and Sustainability, University of Edinburgh Business School. 

The views in this commentary are those of the authors and do not necessarily represent the views of the Grantham Research Institute.