The European Union launched its emission trading scheme (EU ETS) in 2005 to combat climate change and has successfully reduced 43% of carbon emissions by 2020, compared with the level in 2005. However, to achieve carbon neutrality by 2050, continued efforts are imperative. In particular, the EU must solve the continual excess amount of allowance during the first 2 phases. It was estimated that the total surplus amounted to 2.1 billion in 2013. Hence, the European Commission decided to bank 900 million of auctioned allowances from 2015 to 2019. Nevertheless, they need to devise another approach to consume the redundant allowances.
• The Causes and Effects of Excessive Allowances
During the initial period of EU ETS, all allowances (EUAs) were allocated for free from the government, and businesses received the allowances that they had claimed. However, the total amount of allowances allocated greatly exceeds what they needed, and these allowances could be banked across different periods to avoid the price shock.
With the surplus in EUA, firms were less likely to bid allowances via auctioning and hence decreased the market price. It would gradually lower the willingness to reduce carbon emissions. Thus, the government must first boost the EUA price and stabilize it.
• Market Stability Reserve (MSR)
MSR was initially launched in 2015, which is a public reserve system for redundant allowances. If the EUA price remains at a low level, MSR would temporarily store a proportion of EUA to increase the price, and release some EUAs into the market if the supply does not exceed the demand too much. To make it clear, let’s look at its regulation revised in 2018.
The Commission would examine the total annual difference between the supply (Free permits, auction volume) and the demand (Actual emissions) as well as the unavailable allowances (Banked in the reserve), note that the “Back-loading EUAs” were stored into MSR in 2019. This standard, named Total Number of Allowances in Circulation (TNAC), has become a key criterion for MSR absorption/release.
• If TNAC> 833 million, then 24% of the following year’s auction volume would be placed into MSR.
• If TNAC< 400 million, then 100 million allowances would be released from MSR to the market (for the future auction).
• If TNAC lies between 400 million and 833 million, then the total amount in MSR remains the same.
• If the total amount of allowances in MSR exceeds the total auction volume in the previous year, then the exceeding amount would become invalid from 2023 onward.
MSR provides a clear EUA total amount and price signal in the market so that all companies can evaluate how many allowances they need to avoid confiscation of unused allowances and unexpected price shocks.
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