The emerging endgame

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Estimated reading time ~ 9 mins

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“No tree grows to heaven.”

- old Wall St adage

In early 2023, the Potsdam Institute for Climate Impact Research (PIK) published a report discussing the implications of the EU ETS emissions cap approaching zero, the “emerging endgame” as they call it. The authors opine on the potential implications on the EU ETS market structure, and crucially, the ability of the scheme to continue to deliver on its policy objectives.¹

The foundational question is what happens when the EU ETS emissions cap - without which the cap-and-trade-scheme could not exist - approaches zero. Recall that the Linear Reduction Factor (LRF), the annual rate at which the cap declines, will accelerate from 4.3% currently to 4.4% from 2028 onwards.

If the cap continues to decline at 4.4% post 2030 then by 2040 the cap will hit zero. It will mean that not a single tonne of carbon dioxide can be emitted by those sectors of the economy covered by the EU ETS. It seems like a nice problem to have, after all the EU ETS has been instrumental in cutting emissions, but there is still a long way to go.

How EU policymakers react will have a huge implications for the future of the EU carbon market. It has undergone profound changes during its almost 20 year history. Over the next few years, beginning in early 2025, we will begin to see the next stage in this market start to take shape.

The PIK report outlines three broad knock-on effects of the emerging endgame, namely financial, informational, and societal.

Banking constraints, market thinness, and trading frictions: In theory, the prospect of ever an scarcer supply of EU emission allowances (EUAs) should prompt some market participants to hold EUAs for the long-term, anticipating the impending shortage and associated high carbon prices. The ability for participants in the EU carbon market to bank EUAs normally helps smooth out imbalances in the market, and in this case could prolong the availability of EUAs, i.e., banked EUAs will eventually return to the market once the buyer wishes to sell.

The PIK report suggests two reasons why holding EUAs for the long-term might be less than optimal. Some market participants such as heavy industry have yet to really become active in the market, and this lack of risk management experience could result in less than optimal long-term banking of EUAs. PIK also highlight financial constraints, including credit risks associated with the energy transition, as potentially impacting industrial sectors ability to hold EUAs long-term.

However, in the long-term, as the cap approaches zero, the size of the market (banked EUAs plus auctioned volumes) will inevitably approach zero. The urge to hoard allowances in anticipation of higher prices could negatively affect the functioning of the market. In this scenario EUAs might lose their ability to function as a ‘Currency of Decarbonisation’.

“As allowances become scarcer, market participants may become reluctant to trade and may instead tend to cling on to their allowance holdings, so that trading costs and illiquidity may increase.”

Information frictions, regulatory uncertainty, and coordination failures: Fuel switching between coal and gas has historically been a pivotal driver of EUA prices. However, this will become less relevant as first coal, and then gas is phased out. Market fundamentals will become increasingly dominated by the marginal costs of industrial decarbonisation.

“This has implications for allowance price formation, because information about industrial abatement is more fine-grained and dispersed (technologies differ considerably by firm and facility) and associated fundamentals are less readily observable (their underlying’s are less transparently traded) than for fuel switch. In other words, information about costs will increasingly become private.”

The authors of the paper then correctly identify the potential for carbon dioxide removal (CDR) to be included in the EU ETS. They recognise that the market will need to guesstimate as to how the cost of DACCS, BECSS and any other CDR methods might evolve, the degree to which they are included in the EU ETS, and how that could change over time. As with industrial decarbonisation, the cost of CDR is bounded by a large price range, whose development involves a high degree of uncertainty, with this information also likely to be private.

“In the longer term, price formation may undergo a more fundamental change dictated by the need to offset or even exceed residual emissions with removals, possibly to a greater extent than in our numerical analysis where a relatively small amount of BECSS is considered. To the extent that allowance prices reflect long-term expectations, they may in part be driven the anticipation of the still uncertain costs of removal technologies.”

Trade-offs between efficiency and equity: PIK’s quantitative analysis indicates that carbon prices could hit very high levels, potentially over €200 per tonne by 2040, and even in excess of €300 per tonne sometime in the late 2040’s. Depending on how the carbon price is passed through to consumers, it is likely to raise concerns about the adverse impact on society and perceptions of fairness. The European Commission will not be able to pull on the same levers in the future if they are concerned by carbon prices hitting politically unpalatable levels.

“These issues have historically been addressed through free allocation and auction revenue use (e.g., to finance other decarbonization or targeted fiscal relief policies). But these levers will become less and less actionable as both allowance supply volumes and auction revenues decrease over time.”

As we approach the emerging endgame, the right to participate in the market may have to change. This could for example mean that participants in the market without an obligation are limited to the extent that they can hold EUAs. It may mean that price caps, or other mechanisms need to be introduced to ensure prices do not increase too far, too fast.

“Yet as allowances become scarcer and more expensive, both the pre– and post-trading distribution of allowances across market actors and sectors may still become increasingly more relevant for the regulator—e.g., because some sectoral or firm-level emissions are harder to abate than others, or because firms’ ability to respond to higher allowance prices also depends on their financial leverage. In other words, various criteria other than market forces may become increasingly relevant in determining who may ‘rightfully’ hold and use increasingly scarcer allowances.”

The net present value of zero

In The zero lower bound: What happens when EU ETS emissions approach zero? I highlight how strange things begin to occur as you approach zero, whether that is in nature (e.g., as water turns to ice), or in economics (e.g., as interest rates approach zero). I argue that the same is true in cap-and-trade schemes such as the EU ETS, and it will inevitably result in profound changes to the way the system currently operates.

What are the options available to Europe’s policymakers if they seek to address the emerging endgame?

* The second part of this two part series will be published next week *