Kari Kankaanpää
Posted by: Kari Kankaanpää
28.04.2014

Many of us are familiar with the European Stability Mechanism (ESM) in the euro area. Although the mechanism as such is complicated, the underlying principle is simply to stabilise the financial market. A mechanism of the same kind is currently being outlined in the European carbon market.

Why is a Market Stability Reserve needed?

In recent years, the EU carbon market has been characterised by high price volatility and a significant surplus of the commodity – the EU allowances. The market is also highly sensitive to political risk, changing  rules and overlapping policies undermining the price formation based on supply and demand. Due to the inflexibility of supply, the market has been faced with demand shock due to the European economic recession.

To stabilise the carbon market, a Market Stability Reserve (MSR, link to a Fortum presentation), is being considered. Fortum welcomes the EU Commission’s proposal from January 2014 to establish such a mechanism, as the first step to revitalising the emissions trading system (ETS).

How will the Market Stability Reserve work?

The proposed Market Stability Reserve (link to EU Commission> ETS Reform) will depend on the number of allowances in circulation, i.e. the number of allowances in the market that are not needed for compliance. The number of allowances in circulation is a measure of the cumulated surplus in the system.

The mechanism ensures that market participants can easily understand and estimate the changes in auction volumes for the following year. The system will work in two directions based on pre-defined rules. The mechanism would include a pre-set optimal surplus band. Being transparent and predictable, it enables the market participants to plan their hedging and compliance strategies in advance. Such clarity of the rules is welcomed by market participants, both energy producers and energy-intensive industries, who need predictability to operate.

The MSR is designed to work across trading periods as the allowances are bankable. A focused review of the mechanism is set to take place in 2026.

Timing is key

The Commission proposes introducing the MSR in 2021. We at Fortum consider the timing of implementation to be most crucial. The MSR should be started as early as possible, followed by other structural measures in due time. Earlier implementation of the MSR – before the backloaded allowances return to market in 2019-2020 – is necessary in order to ensure a smoother transition to rebalancing supply and demand. Otherwise, larger fluctuations would be created by returning the backloaded allowances to the market and then, shortly after, withdrawing them to the MSR.

To reinforce the impact of the Market Stability Reserve to the supply-demand imbalance in the market, tightening of the annual linear emission reduction factor of the ETS and the permanent cancellation of allowances must be planned in parallel to the implementation of the MSR. However, the MSR must not be conditional to any other reforms of the ETS.

Above all, agreement on the single greenhouse gas reduction target in the EU is needed. Fortum strongly supports the 40% reduction target for 2030 and encourages the EU to implement a cost-efficient burden sharing of the target between the ETS and non-ETS sectors. International credits could be included as an additional 10% target on top of the 40%, and this would help with the linking of the ETS to other international trading schemes. Enlarging the scope of the ETS might also be considered if this is likely to reduce the overall cost of emissions reduction.

Kari Kankaanpää, Senior Manager, Climate Affairs, Fortum

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