European leaders are meeting this week to discuss the future of region’s energy and climate policy. Among other things, countries will debate the European Commission’s proposal to cut EU emissions 40 per cent below 1990 levels by 2030.

Some of the most important discussions may be on an item that isn’t officially on the agenda, however: how to get Europe’s carbon market, the EU emissions trading scheme (EU ETS), working properly.

The EU’s 2030 policy framework could be key to unlocking a new global deal in Paris next year, but leaders are yet to hammer out the details.

A draft of the policy framework’s conclusions seen by Carbon Brief says “a well functioning, reformed EU ETS will be the main European instrument” for cost-effectively achieving the region’s emission reductions. The commision has laid out some reforms it hopes will improve the market’s effectiveness.

But yesterday, the UK government published a positioning paper calling the commission’s proposals “insufficient”. We take a look at the UK government’s plans to reform the struggling carbon market, and why doing so could be a key part of the EU’s climate plans.

Oversupply

The European carbon price hit an historic low last year. In response, the European Commission scrambled to push through short-term reforms designed to boost the carbon price, while working on a longer term plan to make the market function more effectively. Neither plan was particularly well received.

As in any market, prices rise if demand outstrips supply, and prices fall if there is more supply than demand. The recent economic recession meant lots of Europe’s largest polluters emitted less than was originally anticipated, flooding the market with credits and causing the carbon price to dive.

When the carbon price is low, companies have much less incentive to make low carbon investments. That’s bad news in the long run, as it means companies and countries could end up spending much more in a short space of time to hit the EU’s emissions reduction goals.

In other words, an oversupplied ETS doesn’t push the EU down the most cost effective decarbonisation path, as it should in theory do.

Last year, the commission implemented a short-term plan to temporarily remove 900 million credits from the market and boost the carbon price, known as backloading.

In January this year, it laid out plans for a longer term reform called a market stability reserve. It works like this:

• If the surplus of credits exceeds 833 million allowances, 12 per cent of the surplus is put into a ‘reserve’ – basically a central bank for carbon credits.
• If the surplus gets below 400 million, the reserve puts 100 million credits back into the market.

In theory, the stability reserve should create just enough scarcity to boost the carbon price to a level that incentivises long-term action to cut emissions. At the same time, it should stop carbon prices getting too high, spooking carbon intensive industries into moving outside of Europe.

Strengthening reforms

Many analysts don’t believe the combination of backloading and the market stability reserve will be enough to fix the ETS, however.

For starters, backloading only temporarily takes carbon credits out the market. The European Parliament’s opposition to the plan forced the commission to allow the credits to be reintroduced in 2019 and 2020.

The graph below shows what campaign group Sandbag expects the impact of backloading to be on the supply of carbon credits:

Source: Sandbag. The chart assumes the cap trajectory persists at its current level and that emissions decline at one per cent a year after 2013. It also assumes 60 million offsets are surrendered each year from 2014-2020, and looks at stationary sectors only (no aviation).

As you can see, backloading means there won’t be as many permits in the next couple of years, which should boost the carbon price a bit. But reintroducing the glut of permits in 2019 and 2020 means the price is destined to crash again.

That’s why Sandbag and the UK government are calling for the 900 million backloaded permits to be permanently cancelled or at least put straight into the reserve, not reintroduced into the market.

The UK government also recommends a few tweaks to the commission’s proposal for a market stability reserve.

For starters, it says it’s set to come into force too late. The UK proposes bringing the start date forward to 2017 rather than 2021, as the commission proposes. That should allow the reform to “adequately and urgently address the surplus” now, rather than waiting six years, the government says.

It also wants countries to agree to review the stability reserve every five years so there’s a built-in opportunity to fix or tweak it, rather than having to pass new measures to do so – as was the case with backloading.

2030 debates

So what do these techy arguments about long term market reforms have to do with negotiations over the EU’s headline climate and energy goals?

The ETS is very sensitive to political statements, according to the Potsdam Institute for Climate Impact Research. If countries can convince companies they are serious about reforming the ETS in the long term, it could make the market more effective now.

A majority of member states and the European Parliament must agree to the reforms before they can be implemented.

Germany and the UK are likely to support similar reforms, Reuters and the ENDS report suggest. But Poland is likely to object to the plans. It vocally opposed the backloading plan, and is set to oppose many of the goals EU leaders are discussing this week.

Whether the UK can drum up support for the reforms could determine the carbon market’s prospects in both the short and long term.