Emissions of a Nuclear Exit
By: Ruben Baetens
Tags: Climate Action, Renewable Energy, Nuclear Energy, Emissions Trading

The EU ETS ‘Waterbed Effect’

The European Emissions Trading Scheme (EU ETS) is often seen as the flagship of European climate policy and is based on a simple principle:

For every tonne of CO₂ emitted in the European electricity sector, the energy-intensive industries, and the aviation sector, the emitting party must submit one emission allowance (or ‘EUA’), and the number of allowances manually put into circulation is regulated by the European Commission.

The EU ETS is a strong mechanism because of three aspects:

First , the total allowances (and hence emissions) within the system are finite by definition: year after year, Europe puts fewer and fewer allowances into circulation and moves towards zero allowances in 2050.

, the total allowances (and hence emissions) within the system are finite by definition: year after year, Europe puts fewer and fewer allowances into circulation and moves towards zero allowances in 2050. Second , the emissions trading system covers a significant part of total European emissions: at its start-up in 2005–2007, more than 12 000 industrial installations are covered by the EU ETS, initially corresponding to 2.3 GtCO₂ annually or 40% of total emissions in Europe.

, the emissions trading system covers a significant part of total European emissions: at its start-up in 2005–2007, more than 12 000 industrial installations are covered by the EU ETS, initially corresponding to 2.3 GtCO₂ annually or 40% of total emissions in Europe. Third, the trade and banking of allowances should result in a cost-efficient energy transition at the European level — realizing the cheapest emission reductions first and the most expensive ones last.

Trading of allowances can take many forms: some companies or sectors receive free allowances, others have to buy their allowances at official auctions or may choose to trade them among themselves.

Emission allowances also do not have an expiry date either. This means allowances can be banked for later use, and that the total number of allowances put into circulation will also equal the final emissions. Temporary surpluses, e.g. due to economic stagnation or an accelerated roll-out of renewables, thus initially only affect when emissions would occur and who would emit — not the number of emissions. Hence, we say the Waterbed Effect applies: each measure that results in 1 tCO₂ of emissions takes 1 allowance out of rotation, which reduces everyone else's possibility of emitting by 1 tCO₂.

Since 2015–2019, however, this picture looks slightly different.

In the first decade of EU ETS, the actual emissions were significantly lower than the allowances put into circulation. Surpluses accumulated, and the price stagnated at around €6 per allowance.

In order to make the EU ETS a strong mechanism again, two things were changed:

The annual linear reduction factor (LRF) in the number of allowances put into circulation was increased. A market stability reserve (MSR) was set up to accommodate historical non-auctioned or allocated allowances and annual surpluses.

The tightening of the annual reduction factor from 1.7% to 2.2% reduces the number of allowances issued in 2031 to 1.2 GtCO₂, or 57% of the number in 2005. The resulting cumulative number of allowances that will be put into circulation after 2018 is thus reduced to 43.8 GtCO₂.

Furthermore, the market stability reserve seeks to stabilize emissions trading in two ways:

If there is an excess of allowances in circulation, each year a proportion of the allowances that are to be auctioned will not be auctioned but placed in the reserve. In this way, the impact of historical surpluses on the market price is gradually eliminated.

When there is a scarcity of allowances in circulation, allowances that were previously withdrawn from circulation are put back into circulation and auctioned.

To this end, Europe makes an annual inventory of the total number of allowances in circulation (TNAC). As long as the number of allowances in circulation exceeds 833 MtCO₂, a total of 24% of this number is removed from circulation in the following two years. After 2024, this will be reduced to 12%. If the total number of allowances in circulation falls below 400 MtCO₂, rights are taken out of the reserve again and put back into circulation.

At the beginning of 2020, there were still 1385 million allowances in circulation and 333 million allowances have been placed in the market stability reserve. One year earlier, the TNAC was 1655 million allowances and 397 million had been transferred. On top of that, allowances that were not auctioned or allocated yet have also been placed in the reserve. As such, a total of 1600 million EUA have already been allocated to the reserve.

The tightened LRF and the MSR will ensure a more stable supply of allowances, a higher carbon price and a 16% reduction in total cumulative allowances. However, both measures do not affect the Waterbed Effect.