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What overallocation at the system level are we facing and what are the perspectives to reform the EU ETS to avoid overallocation in the future? Anne Schopp and Karsten Neuhoff German Institute for Economic Research (DIW Berlin)

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  1. What overallocation at the system level are we facing and what are the perspectives to reform the EU ETS to avoid overallocation in the future? • Anne Schopp and Karsten Neuhoff • German Institute for Economic Research (DIW Berlin) • Overallocation– a scourge of emission trading systems, Zurich CMA • Zurich, 12 March 2014

  2. Outline Surplus in the EU ETS Actorsbankingsurplusallowances Reformingthe EU ETS

  3. EU ETS surplus • 1 Cumulativesurplus High RenewableEmissions Scenario 3.0 CurrentPolicy Initiative Emissions Scenario 2.0 Reference Emissions Scenario International CDM / JI creditslinkedtoEU CO2 surplus allowances in billion tonnes Time profileofauctions 1.0 Cap minus Emissions 0.0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Neuhoff, Schopp, Boyd, Stelmakh, andVasa (2012)

  4. Carbon price development Source: EEX

  5. Actors banking surplus allowances • Power sector: sells power on forward contracts up to three years in advance and buy in parallel fuel inputs and CO2 to hedge • Industry sector: banks free allowances that are not needed to cover annual emissions • Banks: bank allowances and sell forward contracts at 3-5% to cover cost of capital • Speculative investors: bank allowances if they can realise their required rate of return 10-15% Emitter/ Hedger Arbitrageur/ Speculator Source: Neuhoff, Schopp, Boyd, Stelmakh, andVasa (2012)

  6. 100% Power hedged with non-fossil generation Power hedged with fossil generation 50% 0% 3 years ahead 2 years ahead 1 year ahead Hedging strategies by power generators 84% Percentageofpower hedged 46% 20% Source: Annual reports 2011, Eureelectric 2010

  7. Aggregate hedging corridor 2.0 7.5 € /tCO2 1.6 1.2 CO2 hedgingvolume in billiontonnes 0.8 0.4 0.0 - 5% 0% 5% 10% 15% Expectedgrowth rate ofcarbonprice < market rate of 5% = market rate of 5% > market rate of 5% Source: Schopp andNeuhoff(2013)

  8. EU ETS surplus vs hedging corridor 3 Cumulative surplus in EU ETS Speculative investment 2 CO2 surplusallowances in billiontonnes 1 Hedging volumeby power sector 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Schopp andNeuhoff(2013)

  9. Gap between today's price and price expectations 35 Price in period 2 Speculators 30 entermarketat 15% discount rate 25 Price in period 2 20 Price equilibriums in Euro/tonne 15 Price in period 1 with unlimited banking at 5% 10 5 Price in period 1 withmarketdemandforhedgingandbanking - 1.0 1.2 1.5 1.7 2.1 2.2 Cumulativesurplusallowances in billiontonnes CO2 Source: Schopp andNeuhoff(2013)

  10. EU ETS reform options 3 Cumulativesurplus Billion tonnes CO2 Backloading 0.9 bn 2 30% CO2 reduction Reserve price 1 Set aside 1.4 bn Hedging volumeby power sector 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Neuhoff, Schopp, Boyd, Stelmakh, andVasa (2012)

  11. Market stability reserve 3 Cumulativesurplus Billion tonnes CO2 2 Hedging volumeby power sector 1 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

  12. Conclusion • Surplus in EU ETS accumulated in Phase II and is estimated to grow • CO2 hedging by power sector can absorb surplus some allowances • With increasing surplus the discrepancy between today's price and price expectations widens • Surplus of allowances in the EU ETS needs to be reduced to a level corresponding to hedging demand

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