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EU Energy: ETS Reform Should Not Be Set Aside

London, 13 April 2012

The EU-ETS and the need for a long-term price signal - being the only commodity market in the world where demand varies in real time but supply is fixed years in advance. To the extent that the ETS is designed not  only to reduce emissions in line with the EU's 2020 target, but also to generate a long-term price signal to incentivize low-carbon investment, this seriously impedes its effectiveness, according to a special report by Mark Lewis and Isabelle Curien of Deutsche Bank's commodity research team.

"This is all the more true now that we think the EU economy is in the midst of a second recession within three years and that the implementation of the Energy-Efficiency Directive (EED) is likely to reduce demand for EUAs further over 2014-20," say the authors.

Deutsche have  increased their forecast for the over-supply of EUAs out to 2020, estimating that implementation of the EED will lead to incremental ETS emissions reductions over Phase 3 of 201Mt, and after updating their base-case scenario for the ETS supply-demand balance out to 2020 to take account of this they now project an accumulated EUA surplus by 2020 of +1,264m (+1,063m previously).

"Of course, the true impact of the EED could be greater or smaller than this, and this is precisely the problem as far as the current configuration of the ETS is concerned: the impact of all of the key demand drivers (economic growth, weather patterns, and the EU's policies on renewable energy and energy efficiency) is unknowable ahead of time, and yet the supply of EUAs is fixed years in advance. That is why the system ends up being hugely over-supplied if demand crashes, and why EUAs have recently fallen to a new all-time low," the report says.

Restoring Confidence

A set-aside is necessary but not sufficient: The European Commission would appear to favour withholding allowances from the pool of EUAs to be auctioned over Phase 3 as a way of addressing the current over-supply. "However, whilst a set-aside would undoubtedly be the most pragmatic way of re-establishing meaningful price tension in the near term, we do not think it would be enough, on its own, to re-establish the long-term credibility of the scheme," accordin to Deutsche. This is because industrial investors in low-carbon technologies need long-term predictability on pricing, and as a one-off measure a set-aside by definition could not provide this.

The time for a serious debate over the future of the ETS is now insist Deutsche. "We think that EU policymakers need to implement a material set-aside as soon as possible -- on our estimates withholding 1,200m EUAs over 2013-20, or 600m over 2013-16 might well lift prices back into the €15-20/t range -- whilst also committing to structural reform of the ETS."

Specifically, they think a mechanism is needed to make the ETS cap more responsive to variations in demand. Without the promise of such a mechanism in the future, the risk is that even if a material set-aside can be agreed in the near term, power companies will still not feel sufficiently confident in the long-term pricing outlook for EUAs to make the enormous capital outlays required for the transition to a low-carbon future.

As such, without the promise of structural reform Deutsche believe the most likely default outcome will be an EU-wide dash for gas over the second half of this decade, with implications for;

(i) the EU's long-term emissions trajectory,

(ii) its security of supply, and

(iii) the efficiency of EU power markets.

"In other words, there will likely be an over-reliance on gas for new generation capacity, and a need for costly complementary measures in any Member State wanting to incentivize low-carbon generation (indeed, we already have an example of this with the UK's Carbon Price Support Rate)," the report says.

Ends --

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