Large Surplus Remains in EU Emissions Allowances


EU ETS Emissions Allowances (Excess Supply, Reserves and Cap) vs. Emissions, 2013-2021

Sources: European Commission, European Environment Agency

Key points: The EU compliance trading market for emissions allowances announced an 8% decline in allowances in circulation for the coming year. However with this “excess supply” still at 1.45 Billion tons, there is no change in the argument for more aggressive reductions of allowances in order to create financial pressure on EU industry to lower GHG emissions.

EU ETS (over)supply cut to 1.45 Billion emissions allowances. The European Union this week announced a 130 Million, or 8%, reduction in the Total Number of Allowances in Circulation (TNAC) in its Emissions Trading System (ETS) from a year earlier (blue bar in the chart). The TNAC is a measure of oversupply of emissions allowances in the ETS and has a direct bearing on pricing for ETS allowances. The ETS is the EU compliance cap and trade system and each allowance is equivalent to one ton of CO2-equivalent emissions.

The TNAC is managed through the use of a Market Stability Reserve (MSR) (orange bar in the chart) — a formula-based process to remove allowances for the following year when there is oversupply and keep them off the market unless the market swings to a pre-determined under-supply level. For the coming year, 708 Million allowances are to be put into the MSR to bring the total to 2.63 Billion; the addition reflects primarily (1) the annual formula-drive additions (24% of the oversupply) plus (2) previously unallocated allowances being reserved minus (3) deductions for a new entrants reserve.

The MSR has been a key to firming up EU ETS prices. With chronic oversupply in its market through much of the 2010s and allowances priced below €10/ton, prices of emissions allowances began to firm in 2018 (to €20-30/ton) with the advent of the MSR as well as other restrictions on access to allowances. A combination of pressures in 2021, including political, speculative and higher energy prices (driving greater demand for coal and thus more emissions allowances) bid up prices further in 2021 and into 2022, peaking near ~€100/ton.

Although the MSR helps, oversupply seems likely to persist without more stringent cuts to allowances. As can be seen in the chart above, emissions have consistently run under the caps set by the EU, creating more excess supply every year. This faster emissions reduction is credited to the power sector as it has switched to renewable sources, while heavy industry emissions had fallen only 8% by 2020 vs. 2013 (at least in part as these industries continues to receive nearly all of its allowances at no cost).

Oversupply remains the default expectation over the medium term given continued decarbonization of the power sector (e.g. Germany’s coal retirement scheme) even if this has been disrupted by Russia’s invasion of Ukraine. Although the MSR helps to constrain that supply, the emissions allowances remain available for future use. A tightening of caps and lower TNAC has been recommended, with potential steps including increasing the formula-driven rate of excess put into the MSR each year, making it harder to put MSR allowances back into circulation, retiring allowances held by the MSR after a certain number of years and lowering the emissions cap more quickly than the current reduction factor of 2.2% per year.