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Carbon permits: The burning issue

Carbon floor price or free market? Europe's debate shows no signs of calming

For more than a decade Europe's carbon market has been at the centre of a debate on whether a trading emissions system is more effective than taxation. Even as ambitious efforts to reform the EU Emissions Trading System (EU ETS) near completion, critics say setting a floor price for carbon would lead to greater reductions.

Since 2007, the EU ETS built up an oversupply of EU allowances (EUAs) that at its peak was around 2bn tonnes, or the equivalent of a year's worth of emissions from the entire market. Prices plunged from nearly €30 ($/35.39) per tonne in 2008 to €2.46/tonne in April 2013, leading many critics to claim that low prices had removed all incentives to cut climate pollution.

The European Commission steadfastly refused to intervene to fix prices. Instead, it tried to reduce the glut by temporarily withholding 900m permits from supply, but this didn't have the desired impact on prices.

"The European Commission has always said that there should not be intervention in the ETS to set a minimum price for carbon," Bernadett Papp, an analyst at Vertis Environmental Finance, said. "It prefers to adjust supply rather than set a target price."

The United Kingdom eventually lost patience with the lack of EU-wide progress and in 2013 implemented its own carbon price support (CPS) system. The CPS acts as a floor price for the cost of EUAs, and is levied on emissions from UK power generation. The CPS gradually raised the cost of emitting carbon dioxide from power plants to more than €25/tonne by 2015, while the cost of EU carbon permits was less than €7/tonne.

The result has been a dramatic drop in UK power-generation emissions as their rising cost forced coal-fired power stations to shut, according to European Environment Agency data. UK emissions from combustion of fuels fell by more than 46% between 2005 and 2016. In comparison, EU-wide emissions from combustion fell just 19% from 2005 to 2016.

The CPS "contributed a lot to the rapid decarbonisation of the UK economy," Vertis' Papp said. "The UK has been one of the best performers in the EU ETS, due to the carbon floor price and not because of the price of EU allowances." The UK's apparent success has led other EU countries to consider floor prices. French President Emmanuel Macron last month revived a proposal to set a floor price in France, and in Germany a number of stakeholders have also suggested setting a minimum price.

In the US, the Western Climate Initiative market, which groups California, Quebec and Ontario, uses a price floor that increases every year. "This provides industrial emitters with a degree of visibility over the minimum costs, while preserving the flexibility of seeing prices above the floor," Thomas Kansy, an analyst at Vivid Economics, said.

Nevertheless, the Commission in 2014 proposed a permanent change to the EU ETS, in the form of a Market Stability Reserve (MSR). This reserve would, from 2019, withhold permits from the market until supply fell within a pre-set range. "The MSR, in principle, tightens EUA supply, increasing prices, but it is difficult to gauge its price impact," Kansy added. "There is a risk that economic shocks or quicker decarbonisation may decrease emissions faster than the regulators expect."

Phil MacDonald, an analyst at environmental group Sandbag, says the rapid coal phase-out in the UK and other countries will mean the supply of carbon permits will outstrip the withdrawal of allowances by the MSR. "Our modelling shows the MSR will leave a surplus on the market of 1bn by 2025," MacDonald said in an interview. "If we see a rapid coal phase-out, that could boost the glut to 2bn or more. If that's the case, will the price be that much different?"

Political negotiations on the MSR are nearing completion, and a recent poll of market analysts showed the gradual draining of the surplus would boost carbon permits back above €15/tonne by 2020. However, it's doubtful if these changes will silence the voices calling for a floor price.

"An electricity [industry]-only carbon price floor, say between the UK, Germany, France and the Nordic countries, would have a much better chance of being set at a meaningful level for coal-to-gas switching," Sandbag's MacDonald said. "The MSR is unlikely to work fast enough to bring down the surplus in the medium term, and so boost the carbon price."

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