From 2018 to 2019, permit prices in the European Union Emissions Trading System (EU ETS) increased by EUR 8.90 per tonne CO2, from about EUR 16 to EUR 25 (ICAP, 2020[12]). At the same time, overall emissions in the EU ETS decreased by 8.9% (Marcu et al., 2020[13]), illustrating a significant short-term response of emitters covered by the EU ETS to higher permit prices. This Annex attempts to illustrate some important mechanisms behind the increase of permit prices and the reduction of emissions.
From a static theoretical perspective, the intersection of the marginal abatement cost curve with the emissions cap determines the permit price in a simple ETS without any price stability instruments. Observing a significant increase in permit price and emission reductions could be interpreted as a sign that cheap abatement options have been sufficient to fulfil the cap so far, but that now - with a more limited permit supply – more expensive abatement options need to be carried out. However, real world ETSs are considerably more complex than their simple theoretical counterparts. At least two dimensions are worth considering.
First, the cap is generally set for several years in advance according to a predetermined decreasing emission pathway. It is common to observe that caps are not binding in current trading periods. Observing positive permit prices can be interpreted as a sign that market participants believe that the cap will become binding some day in the future (when the permit supply will be more restricted). Observing an increase in permit prices would then be a sign that market participants expect more stringent climate policy in the future.
Second, many ETSs now include some form of price stability instruments (Flues and van Dender, 2020[23]). In case of the EU ETS, the Market Stability Reserve (MSR) injects permits into its reserve when the number of permits in free circulation (i.e. permits that emitters do not use for compliance with their obligation to surrender a number of permits equal to their emissions) exceeds a certain threshold. The MSR releases permits from its reserve when the number of permits in circulation falls below another (lower) threshold. In addition, when the number of permits in the reserve exceeds the number of permits auctioned in the previous year, the MSR cancels any permit in excess of the previous year´s auction volume. This automatic permit cancellation makes the cap endogenous, i.e. accompanying climate policies, which also reduce emissions, can cause an additional cap reduction (Perino, Ritz and van Benthem, 2019[30]).
What could explain the increase in permit prices and the decrease in emissions in the EU ETS in 2019? One answer is that the introduction of the MSR increased confidence in climate policy and the demand for permits given expectations of reduced permit supply in the future (Vivid Economics, 2020, p. 15[31]). This immediately increased permit prices. In response to higher permit prices, emitters in the EU ETS, and among those primarily utilities, cut emissions. For example, many utilities switched from emission intensive coal to burning natural gas (which is approximately half as emission-intensive as coal) for generating electricity, because higher permit prices made it more profitable to use gas instead of coal (Marcu et al., 2020, pp. 23-24[13]).