EU Emissions Trading Scheme - Another Fine Mess

Whilst US bond markets are reacting to the possibility of a growth surprise or an inflationary shock, or both, and Asia is scrambling to maximise their benefit from the US recovery, the Eurozone looks to be stumbling towards, at best, stagflation. This is partly the result of continued negative interest rates giving birth and succour to a new generation of corporate zombies, and in the immediate future the punishment generated by the EU's bizarrely and brazenly incompetent handling of coronavirus vaccinations.

In these circumstances, the very last thing the EU needs is a sharper rise in energy prices than the rest of the world. A rise in energy prices, after all, retards consumption growth whilst raising output costs. It is, in other words, stagflation's handmaiden.

However, that is what the EU's CO2 emissions trading scheme (ETS) is delivering. This ETS was intended to be an effective pan-EU initiative to address CO2 emissions over the short, medium and long term. Instead, it is generating a level of upward price volatility which is potentially economically destabilizing. Right now it has pushed up the price of CO2 for EU companies by approximately 150% yoy.

To understand what's happening now, we need to know the history of the project, but the fundamental story is much the same as you find almost every time you get governments target a crucial economic input and end up trying to fix prices by using a 'stabilization fund'. You can be pretty certain that whatever it achieves, 'stabilization' will be elusive in the long run.

The EU's ETS was set up in 2005, as a cap and trade scheme. The EU set limits on CO2 emissions, and stipulated that a clutch of large companies needed to own permits up to the amount of CO2 they emitted. At the start this was more signalling the shape of things to come, rather than imposing a hard limit. After all, some sectors managed to get partial immunity (internal EU aviation for example), other sectors were simply handed out their allowances free of charge. So few ended up having to buy their allocations, and when they did, the price was low, because, frankly, the total CO2 ceiling specified was reassuringly high.

Initially too much allocation was issued - as early as 2009 it was clear there was a large surplus and by 2013 that surplus had risen to around 2.13bn allowances. The initial allocations had been generous, but then the GFC had resulted in slower growth, and therefore fewer emissions than expected.

The initial reaction was to slow down how quickly the quotas were issued, with 900mn allowances being postponed until 2019-2020. The EU was essentially gambling on its ability to forecast demand. The idea was that during the 2013-2020 period the proportion of allowances handed out for free would fall gradually from 80% in 2013 to 30% in 2020.

It wasn't enough to mop up the surplus, so in January 2019 the EU established a 'market stability reserve (MSR)' which soaked up the unallocated excess allowances. The rules for how this market stability reserve acts - even though the action is notional - had to be pre-defined, since the scope for political and economic debate between sectors and countries on this is very obvious. This is, after all, effectively a pan-EU tax on CO2. And the new rules put in place meant that the amount of allowances soaked up was raised to 24% of total allowances in circulation, up from a previous 12% - these rules kick in if the reserves holdings of allowances exceeds a threshhold of 833mn. Also, from 2023, the MSR will start retiring allowances entirely if they exceed the previous year's auction volume.

But the tightening doesn't end there. In order to tighten up further, the EU has decided to accelerate the annual rate of decline in allowances issued to 2.2% a year from 2021, compared to 1.74% previously. And whilst some sectors at the highest risk will continue to get their allocations free, for the rest, free allocation is to fall from a maximum of 30% in 2020 to zero by 2030. Who gets them free will be updated by the EU every five years.

Bare bones, this what happened: the carbon trading scheme started out as a figleaf, essentially issuing more carbon credits than the EU needed. Almost virtue signalling, but probably worse, since the allocations had some value, so the kicker was that it was like giving away money to carbon-intensive industries. But this could only last so long, and for the last 10 years or so, the problem has been how to row back and, gently, make this into a real market. But, as they say, stuff happens - first the GFC and now coronavirus which makes a mockery of attempts to anticipate demand. To compensate, the efforts to tightening up have become ever-more frantic. But by committing to a visible long-term tightening of supply at without actually knowing how, if at all, CO2 emissions really can be cut to near-zero in the medium term, it has created the sort of market dynamic which will be familiar to those who've looked at Bitcoin's supply-side fundamentals. Far from stabilizing the market, they have created a classic 'bankers ramp'.

Anyway, the market has cottoned on, and the price is absolutely soaring, from an average of Eu7.60 per ton during 2012 to 2018, to Eu 42.3 a ton earlier this week.

To put things in perspective, a barrel of crude oil is estimated in use to produce 317kg of CO2. With the ETS price at Eu42.3 a ton, that adds about Eu13.5 to the EU effective price of a barrel of oil for the EU economy. At current exchange rates, that comes to an extra $16 a barrel. Currently Brent crude is selling at US$69.4 a barrel, which is bad enough, but add on the ETS price and the price is up to $85.4 in the EU. In yoy terms, these calculations tell us the effective price is up 137% yoy.

Germany is already citing the rising price of CO2 as a reason why their CPI rose 1.3% yoy in February, but we should expect the stagflationary effect to be shared around all those in the EU ETS, and unlikely to be a one-off.

What is more, there seems no good reason to believe that the EU CO2 price will top out anywhere near Eu42.3 a ton, or top out any time soon. In short, its a broad-based tax rise on EU industry which will be past on to the consumer at just the time when its not needed. Worse, there's no knowing how high this tax will rise, nor who, if anyone can stop it. Another fine mess.