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EU Mulls Tighter Carbon Goal, Permit Withdrawal to Curb Glut

The European Union set out a tighter climate goal and cancellation of carbon permits as potential options to strengthen its emissions trading system in the coming years and reduce a glut of allowances.

The 27-member bloc may also consider introducing mechanisms to support carbon prices and limits on imported credits, the European Commission, the bloc’s regulatory arm, said in a report about the functioning of the EU emissions program today. The document is intended to trigger a debate on the best strategy to overhaul the world’s biggest cap-and-trade system after carbon prices sank to a record amid oversupply.

“The commission wants an even more robust European carbon market that provides a stronger driving force for carbon markets elsewhere,” EU Climate Commissioner Connie Hedegaard said in a statement published today in Brussels.

The long-term options sketched out by the commission would complement a proposal on Monday to delay sales of 900 million allowances originally foreseen for the period from 2013 through 2015 to alleviate the surplus and help prices recover. The strategy to postpone some auctions of carbon permits is known as backloading and needs approval from national governments to be enacted.

“We must not flood a market that is already oversupplied,” Hedegaard said. “Market operators must have clarity before year-end on this. At the same time, the Commission presents options for possible structural measures that can provide a sustainable solution to the surplus in the longer term.”

Delaying Auctions

The EU Climate Change Committee, composed of representatives of national governments, is scheduled to first discuss the proposed backloading volume at its next meeting tomorrow in Brussels. While delaying auctions of 900 million allowances won’t change the emissions cap in the system, it will temporarily lead to a better balance between supply and demand, resulting in a more gradual build-up of the surplus, the commission said.

Two other scenarios the EU considered to propose, postponing auctions of 1.2 billion or 400 million allowances, would either increase the risk of “significant upward pressure” at the beginning of the next trading period starting in 2013 and a corresponding decline later, or would fail to sufficiently rebalance supply and demand at the start of the next phase, the commission said.

60 Percent

EU carbon permits for December declined as much as 4.2 percent to 8.06 euros ($10.27) a metric ton on the ICE Futures Europe exchange after the report was published, and stood at 8.15 euros as of 11:36 a.m. in London.

The contract has lost about 60 percent in the past four years as the financial crisis hurt industrial production and cut demand from industry for pollution rights, boosting a glut of allowances to almost 1 billion metric tons, or almost half of the average annual pollution limit in the system at the beginning of 2012. The excess can be around 2 billion permits by the end of the next trading period, known as Phase 3, if the EU fails to tackle it, the commission said.

While backloading would allow for a more stable functioning of the carbon market in Phase 3, it will not address the structural surplus of allowances, according to the report. To do so the EU will need to enact measures that would affect “more profoundly and permanently the balance between supply and demand,” the commission said. The six long-term scenarios outlined in the report don’t constitute legislative proposals.

Increase Target

One option may be to increase the EU target to reduce emissions to 30 percent in 2020 compared with 1990 levels from the current 20 percent, according to the report. To tighten the goal to that level the EU would need to remove 1.4 billion allowances from the market, the document showed. A revision of the current EU law would require support by national governments and the Parliament.

A second option would be to cancel permits through a new decision by the parliament and member states, without changing the existing law, the commission said. That would affect allowances to be auctioned while leaving free allocations to companies in the ETS intact, according to the report.

“The measure could be effective in addressing the overall supply-demand imbalance over Phase 3,”the commission said. “It would implicitly increase the numerical reduction target for 2020 and thus (partially) restore the ambition level of the 2008 climate-energy package, but it would not directly affect the framework after 2020.”

Linear Reduction

The third potential option included in the report is a revision of the 1.74 percent linear reduction factor by which pollution caps in the ETS fall annually from 2013. While the EU law envisages a review of the factor as of 2020, with a decision to be adopted by 2025, the change could be brought forward, according to the commission. Any potential change, which would address the imbalance in the next trading period and also affect the supply of allowances after 2020, would need approval by governments and the Parliament.

The ETS could also be strengthened by expanding into new sectors or tougher rules on imports of carbon offsets in Phase 4, starting in 2020, to initially allow “for no or much more limited access to international credits,” the report showed.

“Short-term demand shocks could be contained through the remaining surplus in the EU ETS, and do not require per definition a large amount of international credits,” according to the commission. “Additional flexibility regarding the access to international credits could be foreseen in case of strong and sustained price increases.”

Price Floor

The sixth scenario floated by the commission includes two mechanisms to temporarily support the price of allowances, a carbon price floor and a price management reserve. Under the latter an amount of permits could be put in a reserve if a decline in demand would lead to “an excessive price decrease below a certain level deemed to affect the orderly functioning of the market,” the commission said.

These mechanisms would “alter the very nature of the current EU ETS being a quantity-based market instrument,” according to the commission.

“They require governance arrangements, including a process to decide on the level of the price floor or the levels that would activate the reserve,” the commission said. “This carries a downside in that the carbon price may become primarily a product of administrative and political decisions or expectations about them, rather than a result of the interplay of market supply and demand.”

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