The Market Stability Reserve (MSR) aims to provide carbon price stability for the EU emissions trading system (EU ETS). But serious questions are being asked about how much stability – if any – it provides, say Michael Pahle and Simon Quemin. They argue that the MSR rules are too complex, have difficulty accommodating changing EU and national policies, and can cause regulatory uncertainty as well as market speculation. The authors recommend a reform of its core design – focussing on prices, not quantities of carbon allowances – instead of adjustments that make it even more complex and vulnerable to its existing weaknesses.
The future of the EU ETS and its capacity to deliver on the more ambitious climate targets formulated in the EU Green Deal will crucially hinge on what becomes of the Market Stability Reserve (MSR). With the twin objective of reducing the historical ‘surplus’ of emission allowances in the market and improving its resilience to future shocks, the MSR was substantially strengthened as part of the 2018 reform. Notably, an add-on cancellation mechanism (CM) post 2023 was introduced.
While the subsequent run-up in prices is often attributed to these revised features, concern lingers about the stability of the now higher price regime. Additionally, MSR-induced resilience is expected to be limited in the face of the demand-curbing impacts of the COVID-19 crisis, complementary EU decarbonisation policies such as renewable targets, or emerging overlapping unilateral policies at the national level such as the German coal phase-out.
The importance of the 2021 MSR review
It thus comes as no surprise that many observers expect that significant changes will have to be made to the MSR as part of its review starting next year. Yet concerns have been voiced that the MSR review might be an ‘empty shell‘, with significant changes being deferred to a coherent ETS reform as part of the Green Deal.
Drawing on extant research, we critically discuss the functioning of the MSR and caution against such a deferral. In particular, taking the review too light-hearted bears the risks of falling short of understanding the MSR’s complexity and respective impact on price formation, which may destabilise the market rather than stabilise it. If this risk is not accounted for and addressed head on in the review, a future substantial reform of the ETS may ultimately be built on shaky ground.
MSR price impact: An observable increase in transitional stringency…
Even though it was never explicitly stated this way, in essence the 2018 reform aspired to increase prices back to a ‘meaningful’ level. And indeed, as an automatic apparatus of auctions backloading, a key impact from the MSR is an increase in transitional stringency relative to the linear cap trajectory (see Figure 1), reflected in higher short-term prices. Importantly, this also reinforces the cumulative stringency of the system via the CM. Yet, the relevant question is whether the price increase just comforted concerned observers – or if it actually triggered abatement.
Does it actually reduce emissions?
The mere frontloading of long-term shortage, as it were, can force firms to behave more consistently with long-term emissions targets. By preponing stringency it can trigger more investments in clean capacities early on, which has beneficial long-term emission impacts: Once substantial clean capacity has been built up, there is little incentive to rebuild fossil capacity, even when allowances start to ‘trickle’ back into the market.
However, so far there has only been anecdotal evidence of such impacts, for example lower emissions from coal power generation. Accordingly, empirically measuring the MSR impacts on firms’ behaviours and investments would thus be a most valuable indicator of the MSR performance for the 2021 review – beyond merely looking at price and ‘surplus’ impacts, which are respectively hard to comprehend or simply mechanistic.
Figure 1: Supply trajectory over time with the MSR in place relative to the linear cap path (source)