Changes to the European Union’s Emissions Trading System (ETS) this year have breathed new life into the formerly lackluster scheme. But buoyant carbon pricing, which is credited with hastening the demise of coal plants, is endangered by Brexit.
If the U.K. leaves the European Union without a deal, as seems increasingly likely given Westminster’s repeated failures to agree on separation terms with Brussels, then British carbon permits would flood back into the EU and dampen ETS prices.
The influx of permits would upset Europe’s attempts to shore up its cap-and-trade system through a mechanism called the Market Stability Reserve, which came into effect in January and has helped drive EU Allowances (EUAs) up to values not seen in more than a decade.
The Market Stability Reserve involves storing away excess allowances from the ETS, the world’s largest emissions trading scheme, which had suffered from a glut of permits since Europe was hit by the Great Recession in 2008, driving prices down to unexpectedly low levels.
In May last year, the European Commission announced it would put 265 million allowances into the Market Stability Reserve in the first eight months of 2019, amounting to 16 percent of all EUAs in circulation. A revised EU ETS Directive would double the rate at which allowances were to be placed in the reserve between 2019 and 2023, the Commission added.
As well as holding EUAs removed from circulation, the reserve is home to 900 million new allowances that were due to have been auctioned between 2014 and 2016 but were held back to prevent further burdening the ailing ETS.
So far, the effort to rein in the number of allowances in circulation seems to have worked. One EUA, allowing the emission of one ton of carbon dioxide, currently trades around €25 ($28.30), having hovered in the €3 to €8 range for most of 2012-2017.
The upswing in price began at the beginning of 2018, and prices have strengthened further since the Market Stability Reserve came into effect. In April, Reuters reported analysts were predicting a dip in pricing after months of bull trading.
Eight analysts predicted an average price of €24.31 ($27.30 at today’s rates) per EUA this year. Since April, prices seem to have kept mostly above that level.
But Brexit is adding considerable uncertainty to the picture, said Alex McGregor, an analyst at U.K.-based Cornwall Insight.
“As [the U.K. is] one of the larger emitters in the EU ETS and therefore a big buyer of EUAs, Brexit would have added a surplus of EUAs to the market,” he said. “As such, prices have been volatile as Brexit faces delays and uncertainty.”
Carbon pricing is spreading globally, albeit slowly and often at prices too low to make a big impact on emissions. The Regional Greenhouse Gas Initiative, which covers nine U.S. states, saw allowances sell for $5.62 in its most recent auction. This year Canada introduced a nationwide carbon price starting at C$20 ($15.19) per ton, set to rise if it can survive political opposition.
If the U.K. does eventually manage to agree to a separation deal with the EU, the country will remain part of the ETS until the current phase of the scheme comes to an end in 2020, McGregor said.
Under a no-deal scenario, meanwhile, the U.K. plans to introduce a domestic carbon tax originally set at £16 ($20.23) per metric ton, which would help make up for revenues lost from auctioning EUAs.
A sell-off of U.K.-held EUAs would likely depress the ETS in the short term, though the Market Stability Reserve gives the EU a way of counterbalancing such a shock.
Longer term, the question is what pricing level the ETS should aim for to maximize its decarbonization potential.
McGregor said that if prices were too high there could be a risk of carbon leakage, whereby major emitters would simply move operations outside the EU and thus deprive the Union of jobs while at the same time getting away with emissions.
At the same time, though, low carbon prices had been the main reason the ETS had failed to work in the past.
"Probably, levels below €20 [per metric ton] provide the limited drive for the market to achieve carbon emission reduction targets, so in future policy will likely aim to support the current market,” McGregor observed.
“Estimates for the true carbon cost on society are wide, but for context, the Report of the High-Level Commission on Carbon Prices concludes that the explicit carbon price level consistent with achieving the Paris temperature target is at least $40 [per metric ton of CO2] by 2020.”