Market Stability Reserve Research Articles

Carbon market design and market sentiment

Concerns about systematic price distortions in the EU Emission Trading System (ETS) have risen in recent years. This paper shows how carbon-market design affects the impact of market sentiment, i.e. systematic deviations of price expectations from fundamentals by at least some market participants, on equilibrium prices. The Market Stability Reserve (MSR) of the EU ETS that adjusts supply based on past allowance banking undermines self-stabilization of the carbon market by discouraging rational intertemporal arbitrage. The MSR increases vulnerability of the EU ETS to market sentiments. Initially, the allowance price responds more to distorted expectations while the MSR (partially) prevents the distortion to spread across periods. Making the MSR more responsive to banking decisions increases the likelihood that distorted expectations turn out to be correct ex post. In contrast, a mechanism that adjust the cap based on the current allowance price does not face a trade off between stabilizing prices in the present and the future.

Impact of different CO2 price paths on the development of the European electricity system

In energy system transformation studies, the assumption of linearly rising CO2 prices is common and based on the decreasing issued European allowances (EUA). The actual auction price for allowances is influenced by market dynamics, resulting in non-linear variations in CO2 prices due to the possibility of banking allowances. This study explores the impact of non-linear CO2 price trajectories on the European electricity market. Various scenarios, such as increasing prices with the market interest rate, early price peaks, collapse, or fluctuations, are examined until 2030. The study quantifies the effects on power plant investments, profitability, consumer costs, and government revenues. The findings reveal that early and high price signals lead to an earlier transition with 7 % more wind power plants but at 4 % higher costs. Conversely, lower initial prices delay power plant investments in wind power plants by 6 % and result in 21 % higher emissions. Compensation for climate impact costs can yield a positive cost-benefit analysis in scenarios with early and high price signals when emissions are avoided through mechanisms like the Market Stability Reserve (MSR).

A coordination failure between EU climate policies exemplified by the North Sea energy island

ABSTRACT We highlight a coordination problem between the EU Emissions Trading System (ETS) and the EU's offshore renewable energy strategy. We exemplify this coordination failure by analyzing carbon leakage effects associated with Denmark's planned North Sea energy island. The Danish energy island project will not start production before 2033, implying a long interval between project announcement and production. Using a dynamic model of the EU ETS, we show that the large time gap between announcement and production likely results in a ‘Green Paradox’, where the energy island increases aggregate EU ETS emissions. The mechanism leading to the emission increase is complicated and works through the Market Stability Reserve (MSR). The estimated 2050 leakage rate is 145 percent in our main scenario and not below 100 percent in any alternative scenario. We discuss how to improve the climate benefits of the energy island or similar large-scale renewable energy projects. This includes possible revisions to the EU ETS and the role of Power-to-X technologies.

The Market Stability Reserve in the EU Emissions Trading System: A Critical Review

Having experienced low prices for about a decade, the European Union Emissions Trading System has been supplemented with the market stability reserve (MSR) that adjusts the supply of allowances to market outcomes. We critically review the literature assessing the performance of the MSR against several policy objectives. In doing so, we cover both conceptual aspects and quantitative assessments. We conclude by pointing out important policy implications and open issues for further research.

Exploring the Relationship between the EU Emissions Trading System and Renewable Energy Development in the EU

This research paper examines the impact of the EU Emissions Trading System (EU ETS) on the development of the renewable energy market in the European Union. Using regression analysis, the study investigates the relationship between the volume of emission permits, EU GDP, and the share of renewables in the overall energy balance. The results reveal that the EU ETS has a significant negative impact on the development of the renewable energy market in the EU, with an increase in the volume of emission permits corresponding to a decrease in the share of renewables. The study also finds that economic growth alone may not necessarily lead to an increase in the share of renewables; however, when combined with other policies and measures, economic growth may promote the development of renewable energy in the EU. The findings suggest that the EU ETS needs to be improved to encourage renewable energy development effectively, and policymakers should consider introducing additional policies and measures to promote the deployment of renewable energy. In addition to analysing the impact of the EU ETS on the renewable energy market, this paper provides an overview of the EU ETS and its challenges. As a cap-and-trade system covering over 11,000 installations across the European Economic Area, the EU ETS has faced challenges from the beginning due to an oversupply of emission allowances. This resulted in a low carbon price insufficient for driving climate change mitigation. To address these issues, the EU ETS Market Stability Reserve (MSR) was established to absorb excess allowances from the market and manage past surpluses. However, the MSR cannot handle sudden shocks or future surpluses. The paper also presents data on the distribution of emission allowances by country and sector. Germany has the most significant emissions under the EU ETS, followed by Italy, Poland, and the United Kingdom. The stationary installations sector, encompassing power plants and other large industrial emitters, received the most allowances, followed by the fuel combustion sector. The data indicates that energy and industry are the largest emitters and thus receive the most ETS allowances. This research contributes to the understanding of the EU ETS and its impact on the development of the renewable energy market in the EU. The results emphasise the need to improve the EU ETS to promote the deployment of renewable energy and suggest that policymakers should consider introducing additional policies and measures to facilitate the transition to a low-carbon economy.

If invisible carbon waste can be traded, why not visible construction waste? Establishing the construction waste trading ‘missing market’

Of all the solid waste produced by the world's rapidly urbanising regions, a significant proportion flows from construction activities. While construction waste permit trading could incentivise both reduction and recycling, there are no known examples of such trading. Meanwhile, trading carbon permits has been successfully mainstreamed. Drawing on Coase Theorem, our research specifies a cap-and-trade construction waste trading scheme. We investigate various emissions trading schemes to propose and elaborate a preparation-implementation-evolution-review roadmap. In the first step, we decide a waste cap based on social optimum and a benchmarking method to allocate permits. Second, we establish a market that minimises transaction costs. Third, we set up a reward scheme to subsidise low-waste behaviours so that, in the fourth step, the cap can be decreased through regular reviews. Two major risks are identified, namely price volatility and fly-tipping, in response to which we propose a market stability reserve and deposit-refund system, respectively.

The European Union Emissions Trading System Market Stability Reserve: Does It Stabilize or Destabilize the Market?

The Market Stability Reserve (MSR) was introduced into the European Union Emissions Trading System to address a historical surplus of emission allowances and to improve the system’s resilience to major shocks through automatic adjustments to the supply of allowances. We summarize the main strengths and weaknesses of the MSR and identify when it stabilizes the market as intended, as well as when it is destabilizing. We argue that recently proposed design changes strengthen both its stabilizing and destabilizing effects. We conclude that a price-based supply adjustment mechanism would help to address the main shortcomings rooted in the banking-based approach of the current MSR design.

Shifting concerns for the EU ETS: are carbon prices becoming too high?

Carbon prices in the EU Emissions Trading Scheme (EU ETS) have risen from around 5 euro per ton of CO2 in 2017 to above 90 euro in 2021. One probable explanation is the cancellation mechanism implemented along with the Market Stability Reserve (MSR) of the EU ETS in 2018. We identify realistic conditions under which the MSR results in truly massive cancellation of emissions allowances, pointing to the steepness of the emissions pathway over time as essential. A flattening of the emissions pathway implies huge reduction in cumulative emissions, suggesting much higher ETS prices. The concerns about too low and ‘ineffective’ carbon prices may turn into concerns for too high prices. The results have important ramifications for planned revisions of the EU ETS.

Raising climate ambition in emissions trading systems: The case of the EU ETS and the 2021 review

We provide a quantitative assessment of policy options to inform the 2021 review of the EU Emissions Trading System (ETS) and raise climate ambition. We use a permit trading model in which firms utilize rolling finite planning horizons, which replicates historical price and banking developments well compared to an infinite horizon. When firms have bounded foresight, indirectly raising ambition through the Market Stability Reserve (MSR) is not equivalent to directly raising ambition through the emissions cap trajectory. Leveraging the MSR turns out to be efficiency improving as it compensates for firms’ bounded foresight by frontloading abatement efforts. We analyze the MSR interaction with the cap trajectory to exploit synergies and minimize the cost of raising ambition. We also provide a comparative assessment of a complete suite of changes in the MSR parameters. Whatever its parameters, MSR-induced resilience to demand shocks remains limited by design: the MSR acts more as an unconditional price support provider than as a responsive price stabilizer.

Exploring the short-term and long-term linkages between carbon price and influence factors considering COVID-19 impact.

Because of global lock-downs caused by the unexpected COVID-19, the interactions between emission trading and related markets have changed significantly compared to the pre-COVID-19 period. Considering the pandemic effect, this paper established an integrated system to identify the relationship trajectories between carbon trading market and impact factors. A noise-assisted multivariate empirical mode decomposition (N-A MEMD) method was utilized to simultaneously decompose the original multi-dimensional time series into intrinsic mode functions (IMFs), after which the Lempel-Ziv (LZ) complexity algorithm was applied to reconstruct the IMFs into high-frequency (HF), low-frequency (LF), and trend modules. Vector autoregression (VAR) and vector error correction (VEC) models were then used to systematically simulate the correlations. The time span was split into pre-COVID-19 and post-COVID-19 periods for comparison, and the mobility trends data during the outbreak period released by the Apple company was chosen to reflect the pandemic effects. The empirical analysis results revealed the energy prices, macroeconomic index, and exchange rate are the main external impact factors of carbon price in the short term. Summarizing from the cointegration models over the long term, the market stability reserve (MSR) mechanism was found to have ability on stabilizing the carbon price under the epidemic shock. Furthermore, the COVID-19 was found to complicate the relationships between carbon price and influence factors, which resulted in fluctuating markets.

Beyond Control: Policy Incoherence of the EU Emissions Trading System

In this article, we explain why the current climate policy mix of the European Union (EU), consisting of the EU Emissions Trading System (ETS) and overlapping policies, is incoherent with respect to emission abatement and cost-effectiveness. The concept of policy coherence guides our analysis in identifying the EU ETS’ current dynamic supply adjustment mechanism, the Market Stability Reserve (MSR), to be at the heart of the shortcomings of current market design. Incoherence emerges due to the MSR’s quantity-based indicator for scarcity. It only works well for current and past demand fluctuations, but not for anticipated changes in demand, e.g., caused by a member state’s fossil-fuel phase-out. As a result, instead of fostering synergies as intended, the MSR undermines coherence by creating backfiring interactions and making precise predictions of overlapping policies’ impacts close to impossible. Considering the European Commission’s reform proposal of July 2021, we argue that a change in the MSR’s parametrisation leaves the fundamental cause of incoherence unaddressed. Based on recent findings in the economics literature, we propose introducing a price-based indicator for scarcity as a solution to substantially reduce the current incoherence of the policy mix.

Coping with the liquidity crisis: a new dynamic quota readjustment scheme for carbon markets.

Because of insufficient liquidity, prices in the carbon market are more vulnerable to unexpected events, for which the impact duration lasts longer than that of the general market. The root reason for this phenomenon lies in the irrationality of quota distribution. The existing quota adjustment schemes and policies, e.g., the market stability reserve (MSR) and some recent adjustment measures, have poor timeliness and effectiveness, which has increased the risk of market crashes. Using the Hidden Markov Model (HMM), this paper develops a new dynamic quota adjustment scheme that can rapidly reduce the risk of quota supply by bridging quota price and quantity with price feedback as a response signal. To achieve this, we integrated the HMM algorithm and a two-step quota adjustment model by setting price thresholds and then connected the quota adjustment transition matrix and historical quota price. By comparing the MSR from 2013 to 2018, our scheme will help mitigate risks in quota price because the HMM can show the actual impact of price feedback on quota adjustment with merits of steady quota price and timely supply optimization. Moreover, our scheme, which recalculates the transition matrix, can be applied in other mature carbon markets.

Reviewing the Market Stability Reserve in light of more ambitious EU ETS emission targets

The stringency of the EU's Emission Trading System (ETS) is bound to be ratcheted-up to deliver on more ambitious goals as formulated in the EU's Green Deal. Tightening the cap needs to consider the interactions with the Market Stability Reserve (MSR), which will be reviewed in 2021. We analyse these issues using the model LIMES-EU. First, we examine how revising MSR parameters impacts allowance cancellations. We find that varying key design parameters leads to cancellations in the range of 2.6–7.9 Gt – compared to 5.1 Gt under current regulation. Overall, the bank thresholds, which define when there is intake to/outtake from the MSR, have the highest impact. Intake rates above 12% only have a limited effect, and cause oscillatory intake behaviour. Second, we analyse how more ambitious climate 2030 targets can be achieved by adjusting the linear reduction factor (LRF). We find that the LRF increases MSR cancellations substantially up to 10.0 Gt. This implies that increasing its value from currently 2.2% to only 2.6% could be consistent with an EU-wide target of −55% by 2030. However, MSR cancellations are subject to large uncertainty, which increases the complexity of the market and induces high price uncertainty.

Influences of sentiment from news articles on EU carbon prices

In this paper, we calculate the carbon tone index that reflects sentiment in news articles through a self-built dictionary. We study the effect of carbon tone index on carbon price return in the period from September 19, 2017 to October 9, 2020. In addition, we employ the Latent Dirichlet Allocation (LDA) method to explore the differential influences of different topic carbon tone indexes on carbon prices. The market confidence boosted by the approved Market Stability Reserve (MSR) policy led to a continuous increase in volume in 2018. Using two subsample periods divided by the implementation of MSR, we explore the problem whether the increased high volume changed the speed of information absorption in carbon market. Quantile regression with control variables (coal, oil, natural gas, electricity and stock prices) is used to test the robustness of the estimated results. The empirical results show that carbon tone index is closely associated with changes in carbon prices and the efficiency of carbon market is improved after MSR. Finally, we use all carbon tone indexes at the 10% significance level in eight predictive models and show the economic value of the optimal predictive model. In summary, carbon tone index has a strong predictive power for carbon prices.

An endogenous emissions cap produces a green paradox

Abstract The European Union’s Emissions Trading System (EU ETS) is complemented by a Market Stability Reserve (MSR). After a major revision of the EU ETS in 2018, the MSR effectively makes the supply of allowances responsive to demand. In this paper, we show that a cap-and-trade scheme with an endogenous cap, such as the EU ETS produces a green paradox. Abatement policies announced early but realized in the future are counter-effective because of the MSR, they increase cumulative emissions. We present the mechanisms in a two-period model, and then provide quantitative evidence of our result for an annual model disciplined on the price rise in the EU ETS that followed the introduction of the MSR. Our results point to the need for better coordination between different policies, such as the “European Green Deal.” We conclude with suggestions to improve the workings of an endogenous cap, ahead of the MSR review scheduled for 2021.

Emissions trading with rolling horizons

We develop an emission permits trading model where covered firms can (1) utilize rolling planning horizons to deal with uncertainty and (2) exhibit bounded responsiveness to supply-side control policies. We calibrate the model to reproduce annual market outcomes in the EU ETS over 2008–2018 and show that a rolling finite horizon reconciles the banking dynamics with discount rates implied by futures contracts’ yield curves. It also replicates the price dynamics well compared to a standard infinite horizon, including the new price regime induced by the 2018 market reform. We then use our calibrated model to decompose the impacts of the 2018 reform’s design elements, quantify how they hinge on the firms’ horizon and responsiveness, and highlight important implications for policy design. For instance, when firms utilize rolling horizons, the Market Stability Reserve can improve effectiveness by frontloading abatement efforts and induce lower cumulative emissions compared to an infinite horizon.

Hedging and temporal permit issuances in cap-and-trade programs: The Market Stability Reserve under risk aversion

Cap-and-trade programs such as the European Union's Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging.

Hedging and the Temporal Permit Issuance in Cap-and-Trade Programs: The Market Stability Reserve Under Risk Aversion

Cap-and-trade programs such as the European Union’s Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging.

Market Stability Reserve under exogenous shock: The case of COVID-19 pandemic

The EU implemented the Market Stability Reserve (MSR) in response to the 2008 financial crisis to deal with short-term impacts of future shocks, such as the COVID-19 pandemic. We link a model that intertemporally optimizes the handling of banked allowances every five years with one that simulates the annual working of the EU ETS including the MSR with its potential cancelling. Neglecting the pandemic, 2.16 billion allowances are cancelled. Accounting for the pandemic, 0.28 billion additional allowances are cancelled if the European economy fully recovers by 2021, which even overcompensates the 2020 drop in CO2 emissions. Additional cancelling increases when the pandemics lasts longer, meaning that the MSR even outperforms its initial purpose. Thus, we conclude that no additional policy measures to support abatement are required in response to the COVID-19 pandemic.

MSR Under Exogenous Shock: The Case of COVID-19 Pandemic

The EU implemented the Market Stability Reserve (MSR) in response to the 2008 financial crisis to deal with short-term impacts of future shocks, such as the COVID-19 pandemic. We link a model that intertemporally optimizes the handling of banked allowances every five years with one that simulates the annual working of the EU ETS including the MSR with its potential cancelling. Neglecting the pandemic, 2.16 billion allowances are cancelled. Accounting for the pandemic, 0.28 billion additional allowances are cancelled if the European economy fully recovers by 2021, which even overcompensates the 2020 drop in CO2 emissions. Additional cancelling increases when the pandemics lasts longer, meaning that the MSR even outperforms its initial purpose.