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Update 04/05/16 following full publication of Mr Federley’s proposal

The 150 million ETS allowances proposed to be used to top up the Innovation Fund are not destined to be removed the Market Stability Reserve (MSR), as reported in the media (see below). Apologies for any confusion.

The allowances Mr Federley proposes to use for the enlargement of the Innovation Fund are ‘new’, in that they are intended to be found from the pot of unallocated allowances not known about by Parliament during the MSR reform (resulting from the application of the Cross Sectoral Correction Factor). Sandbag agrees, and indeed advocates, that the use of such allowances for the purpose of enlarging the Innovation Fund should not further damage the carbon price, if the allowances would otherwise need to be auctioned at the end of Phase 3.

However, for the ETS to become a functional instrument driving emissions reductions, it desperately needs the cancellation of surplus allowances, not just their reallocation.

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On Friday MEP Frederick Federley, the Industry, Research and Energy Committee (ITRE) rapporteur on the Emissions Trading Scheme reform, announced the pot of ETS allowances available for innovation post-2020 should be radically enlarged. He proposed the allowances should come from the unused pot of the phase 3 ETS allowances intended to go into Market Stability Reserve (MSR). On the face of it, a great step for boosting innovation, but dig deeper and we find this proposal could crash the value of the fund.

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Federley’s proposal calls for the post-2020 Innovation Fund to be increased by selling 100 million more EUAs than in the Commission’s proposal. These 550 million EUAs would be taken from  the pot of Phase 3 unallocated allowances which Council agreed would be placed in the Market Stability Reserve (MSR), according to Carbon Pulse. This proposed increase in supply, on top of the Commission’s proposal, further cancels out much of the additional scarcity in Phase 3 promised by 2015’s MSR reform, as well as other proposed changes, such as increasing the Linear Reduction Factor. It also sets a dangerous precedent, which could further damage the market’s confidence in the integrity of the Reserve beyond its already weak impact on the carbon price observed so far.

MEP Frederic Federley comments on the proposal:

It aims to strike a balance.  While the ETS should drive all sectors in a low carbon direction, there are some that are almost at the technical limit of that without making further huge investments that aren’t economically viable.

Sandbag agrees that making more resources available under the Innovation Fund is important, but the real value of the Fund will be driven predominantly by the future carbon price. Carbon Pulse estimated that the Commission’s proposal for the Innovation Fund could generate some €685 million if sold over the preceding three years, according to analyst projections, which in the Federley’s proposal would translate to €2,055 million. But the amount is subject to fluctuations in the EU carbon price – a factor that resulted in severely mismatched expectations around the funding available under the NER300 – the predecessor of the Innovation Fund.

The changes proposed by the Swedish MEP question also the environmental ambition of the ETS – something that should not go unnoticed. The relation between the ETS environmental ambition and the EUAs price is a key to understanding the potential consequences of proposal and the value of available funding within the scheme. In our briefing “Sharing the Burden: EU ETS support to Central and Eastern Europe” we explain in detail how increased ambition drives more support to investments on the example of the funds available for energy sector in Central and Eastern Europe. The same is true for the Innovation Fund.

Ola Mirowicz, Sandbag’s lead analyst on the ETS funds, comments on the proposal:

Keeping the integrity of the MSR should be the first priority of any MEP who wants to increase the value of funding for industrial innovation. In fact, any increase in ambition within the EU ETS should yield more attractive results than forever increasing the number of allowances in the pot.

Another route to innovation

Fortunately, there are ways to adjust the Federley’s proposal without endangering the integrity of the MSR. Under current legislation, if industry’s benchmarked free allowances are less than the maximum free allowances available, any spare allowances are divided between Member States for auction. This is captured under Article 10(1) of the ETS Directive which states “From 2013 onwards, Member States shall auction all allowances which are not allocated free of charge in accordance with Article 10a and 10c.” This rule is carried over unchanged in the current ETS revision.

We propose instead that in the event that industry applies for fewer allowances than are available, any spare allowances should be diverted towards the New Entrants Reserve and used to top up the Innovation Fund.

With the Federley’s proposal already supporting the tiered-approach to carbon leakage, the small adjustment Sandbag proposes could bring very pronounced opportunities within the existing cap for the free allocation to industry in Phase 4. In the tiered approach to carbon leakage not only is the Cross Sectoral Correction Factor not triggered, but a very large buffer of allowances reserved for free allocation remain unused. By our calculations, some 654 million allowances will remain unused in Phase 4 (assuming industrial production grows by 1% per year, and benchmarks decline by 0.5% a year on average).

Fig. 1 The potential to unlock allowances within the Phase 4 cap for industrial innovation

A 650 million tonne buffer against the correction factor is a huge insurance policy against the haircut from the cross-sectoral correction factor, and it could be partially used for other purposes such as industrial innovation. This would help maintain scarcity of supply while boosting the fund to protect industrial competitiveness and support increased spending on low-carbon innovation.

Stay tuned. The full Federley’s draft report is due out the 23rd May, and we will publish our full policy recommendations for the EU ETS reform soon!