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The other damaging glut

Emissions-trading systems have suffered from an oversupply of permits. Regulators are trying to fix that and show the mechanisms can still work

As countries from Kazakhstan to Mexico weigh up the pros and cons of establishing carbon trading as part of their contributions to the Paris Agreement, the oldest markets are still striving to tackle their chronic problem: oversupply.

The three main systems in operation, the EU's Emissions Trading System (EU ETS), the Regional Greenhouse Gas Initiative (RGGI) in the northeast US and California's state-wide system, all suffer from gluts of unused permits. This has depressed prices and allowed industrial emitters to buy their way to compliance instead of making changes to their energy-intensive processes.

Critics say this proves carbon markets are ineffective and carbon taxes should replace inflexible market mechanisms.

The total supply of allowances in a market represents the limit, or "cap" on CO2 emissions, while demand comes from regulated installations such as power stations or steel mills. Supply has outweighed demand in every emissions market yet established.

Why do regulators struggle to set meaningful limits on emissions? Politics is the main reason, according to Rachel Jiang, an analyst at Bloomberg New Energy Finance. "There has been political pressure to make these markets oversupplied," Jiang says. "Industry has lobbied hard for regulators to keep costs down" by issuing permits free of charge to industrial plants.

Furthermore, inflexible supply means that the market balance can be upset by economic cycles. The European market, for example, suffered from a huge buildup in supply during and after the economic crisis of 2009, and has yet to fully recover.

How are they dealing with the glut? In Europe, politicians and regulators have been debating a set of reforms that would establish a special mechanism to withdraw the surplus. This Market Stability Reserve (MSR) is expected to absorb around 1.7bn excess permits starting in 2019.

The reforms are now in their final stage of negotiation between the European Parliament, the member states and the European Commission, and a deal is expected to be agreed after the summer.

Market participants are optimistic that a successful MSR would push prices to as high as €30 ($35.45) a tonne by 2030. A survey earlier this year forecast an average price between 2021 and 2030 of around €16/t, compared with €5/t now.

In California, lawmakers last month agreed a bill that authorises the market to continue to 2030 and requires its regulator, the Air Resources Board (ARB), to come up with ways to tackle the existing surplus and support prices.

"A lot of what is certain in [the bill] still requires interpretation by ARB," Jiang says. "There's no direct impact on oversupply in the bill; it depends on how the bill is implemented."

In the first three years of the Californian market, supply has exceeded demand by an average 21.6m tonnes, compared with the annual limit of around 0.5bn tonnes.

The ARB will take around a year to develop a full set of proposed rule changes, and these are likely to include a price collar as well as a system to remove surplus permits from circulation.

Chandan Kumar, the lead economist at analysts, says a successful revamp of the market rules could boost prices by more than 50% (as much as $8.68/t) from today's level of $15/t.

On the east coast, the nine member states of RGGI, ranging from Maine to Maryland, are in the final stages of agreeing changes to that market for the period from 2021.

As with the other markets, "oversupply is the main issue," says Jordan Stutt, an analyst at the Acadia Center environmental group. "The market needs to start from a more reasonable baseline."

RGGI member states slashed the market's limit by 45% from the starting level in 2014 but, even then, power plants covered by the system reported a total of 86m short tons (about 78m tonnes) of CO2, more than 5% below the adjusted cap.

A new RGGI reserve is expected to absorb excess permits from the market when prices drop below certain levels. Regulators are also considering whether to hike the annual reduction in the cap from 3% a year to as much as 5%.

According to modelling carried out by consultants ICF, this steeper reduction path could push prices to more than $17/short ton by 2031, compared to the current price of $3.90.

With all these reforms set to take effect around the same time as the Paris Agreement comes into force in 2020, the pressure is on regulators to show progress in making carbon markets more effective. The collective effort on tackling oversupply may be the first big step towards that goal.

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