The EU ETS

The European Union Emissions Trading System (EU ETS), established in 2005, marks a pivotal step in global efforts to combat climate change, serving as the world's first major international carbon market. Its genesis stemmed from the Kyoto Protocol, aiming to reduce greenhouse gas emissions through a cap-and-trade mechanism. The system revolves around EU Allowances (EUAs), each representing a tonne of CO2, which companies must acquire to cover their emissions. The EU ETS has progressed through distinct phases, each characterized by unique challenges and policy responses, significantly influencing the evolution of carbon pricing.

The initial phase (2005-2007) served as a pilot, revealing the complexities of implementing a large-scale carbon market. National Allocation Plans (NAPs), which primarily provided free allowances, led to an oversupply of EUAs. This resulted in a volatile market, with prices initially surging to around €25-€30 per tonne before collapsing to near-zero by 2007.

This phase underscored the critical importance of accurate emissions data and robust cap-setting mechanisms. Phase 2 (2008-2012) aimed to rectify the issues of the pilot phase by tightening caps and expanding the scope of the ETS. However, the onset of the 2008 financial crisis drastically reduced industrial output, leading to a substantial surplus of EUAs and a prolonged period of low prices, typically below €10 per tonne. The availability of cheaper international credits further exacerbated the oversupply, keeping prices depressed.

Phase 3 (2013-2020) witnessed a fundamental restructuring of the EU ETS to address the persistent surplus and enhance market stability. Key reforms included the introduction of a single, EU-wide cap that declined annually, the shift to auctioning as the primary allocation method, and the establishment of the Market Stability Reserve (MSR). Despite an initial surplus of 2 billion allowances, the implementation of "backloading" and the activation of the MSR significantly improved market balance.

The MSR, which automatically adjusts the supply of allowances based on market conditions, proved particularly effective in restoring scarcity and driving up prices. Anticipation of these reforms led to a notable increase in EUA prices, climbing from around €5.8 in 2017 to €15.5 in 2018, and further into the €20-€30 range by 2019-2020.

Currently, Phase 4 (2021-2030) reflects the EU's heightened climate ambitions under the "Fit for 55" package, aiming for a 55% reduction in emissions by 2030. This phase is characterized by a further tightening of the ETS cap, the expansion of the system to include maritime shipping, and the creation of a separate ETS for buildings and transport.

The MSR has been strengthened, and the system now includes the permanent cancellation of excess allowances to prevent future gluts. These measures have resulted in record-high EUA prices, with trading often exceeding €80 per tonne. While external shocks, such as the COVID-19 pandemic and the 2022 energy crisis, caused temporary market fluctuations, the EU ETS has demonstrated resilience, quickly rebounding and maintaining a robust price signal.

Throughout its evolution, the EU ETS has been shaped by a complex interplay of factors. Supply-demand dynamics, driven by cap adjustments and actual emissions, have been the primary drivers of EUA prices. Regulatory changes, such as the introduction of auctioning and the MSR, have fundamentally altered market behavior. Market confidence and speculative trading, while present, have been secondary to fundamental supply-demand shifts.

External economic and geopolitical events have also played a role, with recessions and energy crises impacting emissions and EUA demand. The shift from free allocation to auctioning has increased transparency and made the carbon price a more direct cost for emitters. Looking forward, the EU ETS is expected to maintain its role as a key instrument for incentivizing emissions reductions, with ongoing refinements aimed at ensuring its stability and effectiveness.

Key Takeaways: Evolution of the EU ETS

• Phase 1 (2005-2007):
  • Pilot phase marked by oversupply and price collapse.
  • Highlighting the need for accurate emissions data and robust cap setting.

• Phase 2 (2008-2012):
  • Impact of the 2008 financial crisis led to prolonged surplus and low prices.
  • Use of international credits further depressed prices.

• Phase 3 (2013-2020):
  • Significant reforms: single EU cap, auctioning, Market Stability Reserve (MSR).
  • MSR crucial for restoring market balance and driving price recovery.

• Phase 4 (2021-2030):
  • "Fit for 55" package increases climate ambition.
  • Expansion of ETS to maritime and new ETS for buildings/transport.
  • Strengthening of the MSR, and the start of allowance invalidation.
  • Record-high EUA prices, demonstrating market resilience.

• Price Drivers:
  • Supply-demand dynamics (caps, emissions, MSR).
  • Regulatory changes (auctioning, MSR, reforms).
  • Market confidence and fundamental supply/demand shifts.
  • External economic and geopolitical factors.
  • Shift from free allocation to auctioning.

• Outlook:
  • Continued role as key instrument for emissions reduction.
  • Ongoing refinements to ensure stability and effectiveness.