COVID-19, Green Deal and recovery plan permanently change emissions and prices in EU ETS Phase IV

The European Union Emissions Trading System (EU ETS) faces challenges from three significant shocks impacting allowance demand or supply: a temporary negative demand shock due to COVID-19 lockdowns reducing energy demand; a potential positive or negative demand shift from the NextGenerationEU recovery stimulus; and a permanent negative supply adjustment from the EU's more ambitious 61% emissions reduction target by 2030 (compared to 2005 levels) under the Fit for 55 Package, implementing the European Green Deal's goals. Traditionally, under a fixed-cap emissions trading system, these shocks would primarily affect carbon prices, not cumulative emissions (the 'waterbed effect'). However, the EU ETS's 2018 market stability reserve (MSR) invalidation rule modifies this. If the total number of allowances in circulation (TNAC) exceeds 833 MtCO₂, the MSR absorbs allowances, and exceeding allowances are invalidated. This invalidation, conditional on TNAC, means shocks and policies impact cumulative emissions, essentially 'puncturing' the waterbed. The impact of a policy or shock on cumulative emissions depends on when the policy influences allowance demand, when it's announced, and when the waterbed seals (TNAC falls below 833 MtCO₂). The timing of a policy directly affects allowance invalidation; early actions have a greater impact on the number of invalidated allowances. The announcement of a policy triggers indirect effects through adjustments to the emission allowance price profile; expectations of future changes alter current market behavior and emissions. The year the waterbed seals is an endogenous market outcome influenced by TNAC changes. This study numerically estimates the impact of these overlapping policies and shocks on cumulative emissions, considering both the 2018 EU ETS and MSR designs and the Fit for 55 Package proposal, highlighting the consequences of proposed design changes.

The paper draws upon existing literature on the EU ETS, market stability reserve, and the impacts of shocks and overlapping policies on emissions trading systems. Key references include works analyzing the effect of the 2009 recession on allowance prices (Koch et al., 2014), the impact of the COVID-19 pandemic on the EU ETS (Azarova & Mier, 2021; Bruninx & Ovaere, 2020; Gerlagh et al., 2020), and the interaction of overlapping climate policies (Bertram et al., 2015; Perino et al., 2020). The concept of the 'waterbed effect' and its modification by invalidation rules is discussed (Perino, 2018; Rosendahl, 2019). Studies on carbon leakage, both intertemporal and spatial, are referenced to contextualize the potential for policy backfiring (Jensen et al., 2015; Eichner et al., 2011; Aichele & Felbermayr, 2015; Kuik & Gerlagh, 2003; Zhang et al., 2020). The authors also cite research on the 'buy, bank, and burn' strategy (Gerlagh & Heijmans, 2019), and the long-term impact of the market stability reserve on the EU ETS (Bruninx et al., 2020). The 'new green paradox' (Rosendahl, 2019), which describes scenarios where policies intended to reduce emissions lead to increased emissions due to price effects and expectations, is also discussed. Finally, the authors' prior work on modeling the EU ETS is incorporated (Bruninx et al., 2020; Perino & Willner, 2017).

The researchers employ a stylized EU-ETS-MSR model, a simplified version of their detailed long-term investment model (Bruninx et al., 2020), similar to Perino and Willner (2018). This partial equilibrium model assumes a rational, price-taking, risk-neutral representative firm optimizing abatement and banking actions over the EU ETS horizon. The firm abates until its marginal abatement cost (MAC) equals the allowance price. The model minimizes the procurement cost of allowances, considering a discount rate. The balance between allowance demand and supply is a key constraint, linking firms' decisions. The net supply of allowances is adjusted for MSR actions. To solve for equilibrium allowance prices, an iterative price-search algorithm based on ADMM (Bruninx et al., 2020) is used. This algorithm proposes new prices based on the imbalance between allowance demand and net supply, with the firm re-optimizing its decisions after each price update. The process continues until equilibrium is reached. Marginal abatement cost curves (MACCs) are parameterized using a functional form where marginal cost is a function of baseline emissions, a slope, and a curvature. A set of time-invariant MACCs is calibrated to reproduce average 2019 allowance prices, considering observed emissions and the EU ETS's initial state in 2019. 75 MACCs with varying curvatures are used in the analysis. Waterbed leakage is estimated by comparing cumulative emissions with and without an overlapping policy, ensuring the policies don't affect the duration of the waterbed puncture. The direct and indirect effects are separated. The direct effect is computed using a hypothetical emission profile where the demand shock is added directly, and the indirect effect is inferred. Analytical approximations for the direct effect under both the 2018 and Fit for 55 designs are presented. Five policy scenarios are simulated, varying the emission reduction target, inclusion of COVID-19 impact, and additional demand shocks, reflecting potential impacts of the recovery stimulus package. The impact of Brexit and the inclusion of maritime transport are also considered. The model includes the minimum intake limits for the MSR, the 24% and 12% intake rates, and the TNAC thresholds under the Fit for 55 package.

The study's key findings revolve around the concept of 'waterbed leakage,' defined as the change in cumulative emissions divided by the change in allowance demand. The authors find that the effect of overlapping policies and shocks on cumulative emissions depends significantly on when the waterbed is sealed (when the TNAC falls below 833 MtCO2). Under the 2018 EU ETS and MSR design, waterbed leakage is always less than 1, indicating a less than proportional effect. However, under the Fit for 55 design, waterbed leakage can exceed 1, indicating a more-than-proportional impact. This is due to an interaction between changed MSR intake rates, TNAC definition, and the timing of supply adjustments. The indirect effect—the impact of announced policies on current prices and behavior—can either reinforce or counteract the direct effect. In the 2018 design, the indirect effect is always negative, leading to policy backfiring. The Fit for 55 design can have positive indirect effects, amplifying the policy's initial impact. Regarding the impact of specific events, the COVID-19 pandemic's negative demand shock is found to largely translate into lower cumulative emissions. Raising the 2030 ambition to -55% (Fit for 55) is projected to increase 2021 allowance prices to 45-94 €/ton CO2 and reduce cumulative emissions significantly compared to a -40% target. Overlapping policies, such as renewable support or electric vehicle adoption, are shown to have a significant, albeit uncertain, impact on cumulative emissions, depending on the timing and the duration of the waterbed puncture. The magnitude of the effect depends heavily on the year the waterbed seals.

The findings highlight the complexity of the EU ETS, particularly under the Fit for 55 design. The endogenous nature of the waterbed sealing makes predicting the precise impact of policies challenging. While the study provides a range of possible outcomes, the uncertainty emphasizes the need for careful policy design and evaluation. The more-than-proportional impact under Fit for 55 warrants further investigation, as it underscores the potential for both amplified positive and negative effects. The backfiring of policies under certain conditions warrants attention and highlights the necessity for complimentary measures. The results showing that the COVID-19 pandemic's negative demand shock translates to reduced emissions is significant, but the potential for prolonged waterbed puncture underscores the complexity of integrating such shocks into climate policy analysis. The study suggests that the EU ETS price's recent increase may reflect the market's internalization of the increased stringency of the new 2030 targets. The observed EUA price increase aligns with the estimated range from the simulations, demonstrating some degree of predictive validity, although the model is simplified. The model's results are highly sensitive to the assumed marginal abatement cost curve. The study calls for improvements to the Fit for 55 MSR design, such as reducing the threshold at 1096 MtCO2 to prevent oscillations in intake, and modifying the timing of supply adjustments to ensure the direct effect of pre-sealing policies does not exceed 1.

This research demonstrates that the EU ETS's invalidation rule, particularly under the Fit for 55 design, creates a complex interplay between policy shocks, market expectations, and cumulative emissions. The waterbed leakage concept provides a valuable framework for evaluating the impact of overlapping policies and shocks, but the endogenous nature of the waterbed sealing introduces substantial uncertainty. The study's quantitative estimates offer valuable insights for policymakers and market actors, highlighting the potential for both significant emission reductions and unintended consequences. Future research should incorporate more realistic assumptions, such as myopic decision-making, risk aversion, and a more detailed modeling of abatement options across sectors.

The study employs a simplified model with several assumptions. Perfect foresight and intertemporally optimizing firms are assumed, which might not fully reflect real-world behavior. Myopic decision-making and risk aversion are not explicitly considered, potentially influencing the duration of waterbed punctures and invalidation volumes. The model's reliance on marginal abatement cost curves simplifies the complexities of real-world abatement options. Furthermore, interactions with sectors not covered by the EU ETS and broader economic factors are not fully incorporated. The analysis is deterministic, neglecting the role of uncertainty in shaping market responses. The specific calibration of the marginal abatement cost curves is a critical element that could influence results.