Review of the Market Stability Reserve set to strengthen the mechanism

The result of the ongoing review of the market stability reserve (MSR) will have significant consequences for Europe’s carbon market (EU ETS). In a scenario-based simulation of different designs we conclude that an additional reduction of the MSR thresholds would support market stability and environmental integrity of the ETS.

Evaluering av markedsstabilitetsreserven i ETS styrker trolig mekanismen

The market stability reserve (MSR) is a volume-based mechanism to manage structural supply-demand imbalances in the European carbon market (EU ETS). It was implemented to counteract the massive surplus of allowances that built up in the aftermath of the financial crisis and became operational in 2019. Now the mechanism is up for review. Following the Commission proposal on 14 July 2021 it is now up to the European Parliament and the member states in Council to move this file ahead.

The reserve operates according to pre-defined rules. Each year by 15 May, the Commission publishes the total number of allowances in circulation (TNAC). The rules define that the MSR intakes allowances into the reserve in times of oversupply and releases allowances from the reserve in times of undersupply. The most important parameters determining the MSR operation are the upper and lower thresholds and the withdrawal rate. In 2019-2023, the upper threshold is 833 million allowances in circulation and the withdrawal rate, if the upper threshold is exceeded, is 24%. The MSR releases 100 million allowances if the TNAC drops below the lower threshold of 400 million allowances in circulation. As of 2024, the MSR withdrawal rate is to be reduced to 12 %.

As the MSR parameters have different significance for the number of allowances removed from auction volumes and implicitly for the development of EUA prices, emissions and the ability of the MSR to react to external shocks, we have studied different MSR settings in terms of their market impact considering the ongoing legislative process.

Our simulation clearly shows that the MSR thresholds are a key factor for determining the MSR market impact. Keeping thresholds at 833/400 million in combination with a 24% withdrawal rate after 2024 will result in the total number of allowances (TNAC) to fall below the upper threshold late during phase 4 (2021 – 2030). This will stop MSR withdrawals, cause EUA price volatility and increase stationary emissions.

Scenarioene vi har analysert, dekker ulike kombinasjoner av overføringsrate, terskelverdier og en buffersone, et nytt element som er foreslått av EU-kommisjonen for å fjerne den binære mekanismen dagens øvre terskelverdi representerer. Vi har også gjort sensitivitetsanalyser av ulike utviklingsbaner for utslipp via endringer i brenselspriser og kapasitetsmiks i kraftmarkedet, og en stresstestanalyse som simulerer en fullstendig utfasing av kullkraft i Tyskland.

The different MSR designs have a significant impact on cumulative phase 4 and 2030 emissions. Scenarios with lower thresholds show a significantly higher reduction in stationary emissions compared to unchanged thresholds. The effect is especially visible for industry sector emissions, as here a stable price trajectory unlocks abatement potential through supporting decisions on capital-intensive changes.

A steady and uninterrupted MSR application results from lowering the thresholds compared to current levels, and this would be best achieved through introducing dynamic thresholds, an element currently not proposed by the Commission. Dynamic thresholds would develop over time in relation to a reference variable instead of remaining static at one pre-defined value as currently the case. For our simulation, we ran one scenario with thresholds reducing in line with the cap. In the absence of dynamic (cap-adjusted) thresholds a simpler option would be to lower the upper threshold of 600 million combined with a buffer level starting at 789 million, as this would trigger the MSR more smoothly throughout phase 4.

The modelled scenarios and sensitivities provide guidance to the policy process with regards to the interaction of design parameters and market behavior but should not be understood as forecasts. The MSR is an important tool that helps the EU ETS to bridge from a period of oversupply during the trading phases 2 and 3 to a tight market balance by 2030 and to prevent such oversupply from building up again. Therefore, it is desired from a market perspective to design the MSR set-up in a least disruptive way.

The analysis is performed on behalf of EDF S.A., Enel, Fortum, Iberdrola, SSE, Statkraft, Uniper, Vattenfall, Ørsted.

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