Coronavirus may aid the climate - if policymakers act wisely

Coronavirus may aid the climate - if policymakers act wisely

Every cloud has a silver lining

Although nobody would have expected it at the start of this year, Germany will probably reach its 2020 target of reducing greenhouse gas emissions by 40% compared to the 1990 level. The reason for this likely success is less comforting, however: the partial lockdown of the economy due to the coronavirus crisis has led to a big fall in energy consumption by the industrial and transport sectors across Europe, including Germany. The decline in demand has dragged wholesale energy prices sharply lower.

Not only have energy prices fallen, so have the prices for greenhouse gas emissions in the EU emissions trading system (EU ETS). In the extreme, CO2 prices fell from around 24€/t CO2 at the beginning of March to around 15€/t CO2 in the second week of March. Despite the drop, however, there has been no resurgence in the output of carbon-intensive coal power plants because, with gas prices lower than they have been in a long time, it remains more profitable to run gas plants. In addition, an increasing share of power demand is being met by renewables, which benefit from low variable production costs and from subsidies. The current crisis might thus further accelerate the phase-out of coal power production in Germany and elsewhere – a silver lining to the dark coronavirus cloud.

But where do we go from here? What role will market interactions and policy interventions play as the world emerges from the coronavirus crisis. Economic and social developments will depend largely on the measures governments take during and after lockdown. Policymakers seem determined to use all means at their disposal to tackle the economic problems arising from the pandemic. We examine a number of scenarios and how they might impact the energy sector, the main contributor to CO2 emissions. We pay particular attention to possible next moves in climate policy and consider what may happen both in the immediate aftermath of the crisis and in the medium term.

What is to be done?

“Take it easy” – One approach could be to ease the burden on industry by reducing the impact of climate policy, e.g. by cutting environmental taxes and softening CO2 targets. Such a policy could lead to a weakening of the ETS system in order to achieve even lower emissions prices or at least the granting of some exemptions to energy-intensive sectors. The open question would then be this: at what point of the economic recovery does climate policy get back on the old path of tightening CO2 emissions year on year?

While this approach is tempting, given the dramatic economic problems that Europe faces, politicians will be aware of alternative, more direct possibilities to bolster industry and the broader economy without abandoning climate targets. Tellingly, statements by leading politicians at the national and European level indicate that they want to find a balance between supporting the economy and maintaining climate goals. For instance, the vice-president of the European Commission wrote in a letter to the EU Council Presidency that plans for restarting the economy have to take account of the transition to a green and digital economy. Similarly, EU environment ministers published a joint statement on April 9 saying “The Green Deal provides us with a roadmap to make the right choices in responding to the economic crisis while transforming Europe into a sustainable and climate neutral economy. We should withstand the temptations of short-term solutions in response to the present crisis that risk locking the EU in a fossil fuel economy for decades to come.”

“Speed it up” – Various governments have announced or are preparing post-crisis stimulus packages. Powerful fiscal measures will be an important prop for the economy, with a particular focus on those sectors with high future potential. Green technologies are one likely beneficiary. The upshot may be an acceleration of infrastructure investment aimed at facilitating a low-carbon transition in the energy, mobility and manufacturing sectors. One objective could be to boost hydrogen technologies, using renewable electricity combined with hydrolysis (“green hydrogen”) or using natural gas and carbon capture and storage (“blue hydrogen”). If such a push further develops the market for clean and efficient energy and spawns competing technologies and firms, energy consumers stand to benefit as well.

We are not completely in the dark about what may happen. The policy response to the financial crisis in 2008-09 provides a pointer: governments resorted to strong stimulus but maintained their climate aims. During that episode and the follow-on Euro crisis, economic activity slumped and society emitted less CO2 than previously anticipated, while the public supply of emission rights continued according to plan. This led to an overhang of certificates in the market (equivalent to one year’s worth of CO2 emissions in the EU). In order to stabilise carbon prices, policymakers tried to strengthen the ETS by `backloading’ emission rights. They withheld CO2 permits from the market while retaining the option to inject them later (if emissions were to pick up considerably) or remove them from the market for good (in case emissions were to stabilise or fall). The ETS was subsequently transformed by the launch of a long-term mechanism for reducing surplus emission rights: the Market Stability Reserve (MSR).

All eyes on the Market Stability Reserve

Thanks to the MSR, policy support for the ETS in the current crisis does not need to take the form of ad-hoc interventions (as was the case previously with backloading). Rather, policymakers have a well-defined mechanism at their disposal. By absorbing overhangs of certificates, the MSR works like a central bank, although controlling the supply of emission rights rather than the supply of money. If the total number of allowances in circulation (TNAC) exceeds the threshold of 833mt CO2, the MSR reduces the supply of permits through auctions by (up to) 24% of the TNAC. If industrial activity and energy consumption increase again (pushing the TNAC below the threshold of 400 mt CO2), the MSR gradually releases some of its certificate reserve (100mt CO2 per year). From 2023 onwards, allowances kept in reserve will be cancelled if they exceed the auction volume of the previous year. As a consequence, the MSR allows for only limited shifts of allowances into the future and achieves a partial cancellation of surplus emission rights.

So what might happen in the current crisis? The MSR is a rules-based system. This allows conjecture as to what could unfold absent other policy interventions. The MSR is already overflowing with surplus certificates as a result of backloading during the last crisis. According to last year’s surplus calculation, an additional 400mt CO2 will be put into the reserve by August 2020. The surplus that is currently building up will not be added to the reserve until 2021/2022. And according to the existing rules, only a fraction (24%) of the certificates freed up in the current crisis will be transferred into the MSR. This could lead to a situation whereby the newly arising certificate overhang cannot be fully extracted from the market through the MSR mechanism. There are broadly two options for what might happen then:

Stick by the rules” – In this instance a significant overhang of certificates remains in the market and CO2 prices stay low. As a consequence, climate policy investment would not be steered through CO2 prices, but more likely through subsidy schemes. This would continue to drive a wedge between climate-friendly projects that result from (then low) CO2 prices and projects that are subsidised. Judging from the design of a number of policy instruments, subsidy schemes may support projects with a CO2 abatement cost of up to 500 €/t CO2 (or even higher) while the CO2 price in the traded market is below 25 €/t CO2.

Change the rules” – In an alternative scenario the rules are amended. The rate of absorption of surplus emission rights into the MSR may be increased from the current limit of 24%. Furthermore, the rule by which the rights stored in the MSR are cancelled may be strengthened. In an extreme scenario, the existing reserve might be set to zero (meaning certificates currently in the reserve would be annulled) and the possibility of storing emissions rights might be revoked completely (also cancelling out a newly arising permit overhang). Even the option of annulling the existing reserve and placing the newly arising certificate overhang in the MSR would be economically equivalent to cancelling out the new overhang.

But why does this matter? Companies are making trading decisions and investments based on their expectations about developments and prices in the CO2 market. The more investors expect a tight CO2 market and high CO2 prices, the more climate-friendly investments are likely. But whether the CO2 market will indeed be tight and prices high will depend to a significant extent on the outcome of discrete – and almost binary – policy choices. Therefore, if policymakers want to maintain the credibility of the CO2 regime, they will need to tread carefully.

Choosing the right tool

If they do not, investors will lose trust in the ETS scheme, just as they lost confidence in the past in some renewable quota schemes that were ultimately abandoned. Policymakers would then need to resort even more to subsidy schemes. In a world of subsidies they would have to be bold about picking winning and losing technologies. Policy design, instead of being EU-wide, would become more of a matter for national governments. Significant efficiency losses would ensue. The energy and climate transition would be more costly than it would be relying increasingly on a credible emissions trading scheme and other technology-neutral market-based measures.

The coronavirus might provide a unique and unforeseen opportunity to limit climate change. But if they are not to miss this golden opportunity policymakers need to make careful, considered choices.



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