EU must reform the ETS to make it an effective instrument

The Oeko-Institut suggests a number of technical measures that could be used to strengthen the EU ETS in the coming years.

The successful reform of the EU ETS is crucial for the implementation of the objectives of the European Green Deal. As reported in AN2/2022, the Oeko-Institut has done modelling work on how to improve the European Union Emissions Trading System (EU ETS), which is a central element of EU climate policy. Reforms are required in the following four aspects of the EU ETS.

The first aspect is that the cap on the EU ETS is a key element of the climate policy architecture and has a strong impact on the design of other commitment mechanisms (e.g. the Effort Sharing Regulation) if the emission reduction targets that are binding under EU and international law are to be achieved.

Second, in order to achieve the targets set with the EU ETS cap under real-world conditions, the EU ETS must be designed as an incentive instrument in such a way that the cap-based targets for 2030 can also be effectively achieved.

Third, the definition of the EU ETS cap via the Linear Reduction Factor1 (LRF) also raises awareness and sends a clear signal to the market about the time frame in which climate neutrality is to be achieved.
Fourth, the EU ETS is an important instrument for generating financial resources for the transition to a decarbonised society and economy, as well as the necessary accompanying measures.

However, in view of the large surpluses of emission allowances in the market and the huge uncertainties about the baseline emissions trends and the market behaviour of specific market participants (hedging providers, long-term banking by industry), limiting the reform to the cap adjustment will lead neither to a robust framework for the EU ETS, nor to the achievement of the emission targets for 2030.

Thus, there is a high priority to combine the cap adjustments with a further reform of the Market Stability Reserve2 (MSR) of the EU ETS since the withholding and cancellation mechanisms of MSR have an impact on the overall level of allowances that are available for compliance purposes. An important measure for strengthening the MSR mechanism and thus the EU ETS in general would be to adjust the MSR thresholds over time (e.g. in parallel with the contraction of the cap or, even more ambitiously, by adjusting them to zero in 2030). The modelling exercises by the Oeko-Institut show that an isolated analysis of a few reform options for the cap and for the MSR can easily lead to less robust results in view of the various uncertainties.

The integrated analysis of the largest possible number of options and their combinations (e.g. with a view to baselines, caps, MSR design, demand for hedging and/or long-term banking) as well as the relevant uncertainties is an important prerequisite for a sufficiently robust assessment of the upcoming reforms.

Felix-Christian Matthes
Oeko-Institut

Link to the modelling study – The Revision of the European Union Emissions Trading System Directive: Assessing Cap and Market Stability Reserve Reform Options: https://www.oeko.de/fileadmin/oekodoc/Revision-of-the_EU-ETS-Directive.pdf
1The Linear Reduction Factor determines the rate of emission reductions under the EU Emissions Trading System, by reducing the total number of emission allowances each year.
2The Market Stability Reserve (MSR) is a rule-based mechanism that enables the delivery of allowances to respond to changes in demand, thus maintaining the balance of the EU ETS.

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