Making EU's climate policy fit for current political challenges

After Russia's invasion on Ukraine, the EU is getting serious about breaking its dependence on Russian energy. Reconciling climate, social and security goals will be difficult, but Europe already has some tools in place to face those challenges.

The reforms of the EU's Emissions Trading System might be one of the important steps to make EU more resilient and less dependent on fossil fuels imported from Russia.

The Russian invasion on Ukraine came amid hiking costs of natural gas (which was at least partly caused by Gazprom's market manipulations) and rising price of CO2 allowances in EU.

On the political level, the unprecedented scale of the Western sanctions also revealed serious limitations and vulnerabilities of the West, due to its energy dependence on Russia.

Poland, together with other central and eastern European (CEE) countries has been warning about the threats of such dependence for years and has long ago adapted a long-term strategy, which will allow it to get rid of Russian gas from 2023, thanks to LNG imports and the Baltic Pipe project. Germany, finally, put Nord Stream 2 on hold and decided to invest in LNG infrastructure.

The necessary steps are discussed among member states and within organisations like International Energy Agency. The discussion now revolves not around "whether" but "how" to put an end to imports of natural gas, oil or coal from Russia. The biggest issue is to find the right balance between EU's climate goals and security and social challenges.

Commission's toolbox

This May, the European Commission proposed its REPowerEU strategy — a set of measures to address some of these challenges, which were set out as the set of legislative proposals and guidance.

The ambitious package proposes both short- and long-term tools, including cooperation with foreign LNG suppliers, boosting the share of renewables and increasing energy savings.

One of the measures that is particularly interesting is the European Commission's proposal to sell the emission allowances that are held in Market Stability Reserve (MSR) and are not currently available on the market, to finance reforms and investments.

Such proposal draws the attention to one of the most important EU decarbonisation tools: the Emission Trading System (EU ETS).

The proposal comes amid the legislation works on Fit for 55 and discussion on how to revise the system.

With the current energy security challenges, it could be used to decarbonise EU industry and at the same time protect companies against price shocks. It is even more important due to fact that many stakeholders push for cancelling large part of allowances held in MSR, instead of using them to stabilise the market.

Rethinking EU ETS

The EU cannot do much on the energy supply side in the short-term. The investments in green technologies and cooperation with foreign partners on natural gas or green hydrogen deliveries are the right thing to do, but this will take time.

On the other hand, EU can reform its own EU ETS market, to make European industry more resilient to price shocks.

The main shortcomings of EU ETS design were highlighted by the price crisis. The Market Stability Reserve is designed to absorb the oversupply of the allowances from the market and release the allowances in case of scarcity.

However, the trigger mechanism is not based on the price of allowances but on the total number of allowances in circulation (TNAC).

This design has serious flaws: if the allowances are bought and simply held on the accounts of investors/companies they are still calculated as if they were in circulation, even though they are subject to a long term "buy and hold" strategies.

It means, that MSR does not react to the price shocks like the recent one, especially if it (incorrectly) assumes that the supply of allowances is about right. One of possible solutions is to add also price-triggered mechanism.

The other measure, that was designed specifically to protect EU against high energy prices — Article 29a of the EU ETS directive — should be amended too.

It is activated if for more than six consecutive months the price of allowances is more than 300 percent of the average price in the two preceding years.

It is enough to say that it has never been used so far (even during the recent EU ETS price spikes) and will most likely remain ineffective tool, if it is based on the current multipliers only — introducing a mechanism based on a specific price limit or softening the triggering thresholds would be more effective.

The reform of MSR combined with softening the triggers to use Article 29a mechanism would not only protect the European companies against price volatility and make the prices more predictable.

However, those measures should go hand in hand with increasing market transparency and rethinking the role of financial actors on the European carbon market.

Their strategies evolve from maintain liquidity to cause skyrocketing carbon prices for their sole benefit. The recent years showed how the EU ETS and especially MSR is vulnerable to speculative actions, therefore the co-legislators should address this problem in finding a right balance between the necessary market participation of financial intermediaries and financial benefit they can generate from the EU ETS market.

Otherwise, the skyrocketing energy prices won't disappear with high gas prices.\n \n

Conclusions

While the commission is (rightly) putting forward new initiatives to ensure EU's long-term energy security, it is also important to consider the reforms of existing tools and mechanisms and ETS reforms is just one of such examples. The necessary amendments in EU ETS directive and MSR decision are not a silver bullet, but definitely can be a quick remedy (or at least quicker than some of the proposed measures).

Given natural gas prices volatility, the more predictable EU ETS market will make it easier for utilities to plan their long-term green investments.

It is even more important, due to fact that massive investments in renewables are crucial to deliver EU's climate goals and get rid of Russian fossil fuels.