Sandbag’s EU ETS simulator

The European Union Emissions Trading System (EU ETS) is a key policy instrument to reduce greenhouse emissions in the power, industry and aviation sectors. This simulator has been designed to help stakeholders understand how the scheme works and what would be the impact of some parameters on its overall functioning.

The EU ETS is currently under review and a public feedback round took place in November 2020. You will find Sandbag’s response here.

On 14 July 2021, a long-expected reform proposal of Europe’s carbon market was published by the European Commission (see Sandbag’s reaction here). We updated our simulator to reflect the main changes proposed by the Commission.

Questions & Answers

How can I use this simulator?
You can select different parameters on the left menu by clicking on the buttons. The selected parameters are highlighted in blue. You can choose between two “Reduction target” options, two “Cap rebasing” options, three “MSR withdrawal rates” options and two “MSR thresholds” options.
What is the “maximum emissions pathway”?

The bold red line shows an emissions pathway that would be permitted by the scheme as amended by your selected parameters. This pathway was calculated by applying a fixed growth rate to industry emissions from 2021 onwards while using up the EUA surplus by 2030. Emissions from electricity generation are assumed to follow the ‘REG’ scenario set out in the EU’s Impact Assessment.

The maximum emissions pathway is not a forecast of emissions but is intended to illustrate how the selected parameters can alter the scheme’s real constraint despite the stated reduction target selected at the top left. This shows that, while the target is important, other structural factors of the EU ETS will have a big impact on how strictly the target must be adhered to.

What does the “Excess EUAs in circulation” represent?

This figure is the amount of greenhouse gas emissions permits (EUAs) left each year in the system after all installations have surrendered the permits that cover their emissions. It is therefore a surplus of EUAs which installations do not need.

Please note that this figure is similar to the ‘TNAC’ published yearly by the European Commission to calculate the number of withdrawals into the Market Stability Reserve, except for an aviation-related adjustment made by the EC which we do not replicate in this surplus figure.

What are the two 2030 reduction targets?

In December 2020, European Union leaders have agreed on a goal to cut greenhouse gas emissions by at least 55% by the year 2030 compared with 1990 level. According to the Impact Assessment accompanying the Communication on stepping up the EU’s 2030 climate ambition, this could translate into a reduction target of 65% for the ETS stationary installations compared to 2005 levels and a reduction target of 41% for other sectors (ESR and domestic aviation).

However, the European parliament called for a 60% emissions cut, whereas NGOs are calling for a 65% cut aligned with the 1.5 degrees goal of the Paris Agreement. Assuming the same ETS/ESR share as under the -55% scenario, this would translate into a reduction target of 73% for the ETS stationary installations compared to 2005 levels and of 54% for other sectors.

The Commission’s “Fit For 55” proposal sets a 61% reduction below 2005 levels. The proposed Linear Reduction Factor (4,2%) would actually lead to a 62% reduction, according to EC’s own Impact Assessment, whereas a true 61% reduction would be achieved by a slightly different LRF. The simulator lets you choose between the two options.

What does “cap rebasing” mean?

The cap of the EU ETS defines the maximum amount of tonnes of CO2 that can be emitted each year. This cap decreases year after year by a certain amount of allowances, defined by the Linear Reduction Factor (LRF). The LRF is calculated so that the reduction target is reached in 2030.

During the last decade, the cap has been far above the actual emission levels. To bring the cap back in touch with reality, since 2016 Sandbag has been proposing to reset its starting point to not more than the latest verified emissions level, which we called ‘rebasing’. It would lead to a less steep LRF. In the simulator model, if the “Sandbag rebasing” option is selected, the cap is reduced based on an average of 2021-2022 emissions and the corresponding LRF is applied using 2021 as base year.

Following the Commission’s proposal released on July 2021, the cap would be reduced as if the new LRF (4,2%) had been applied since 2021. This creates a very small rebasing, meaning that the rebased cap will remain above emissions for another several years.

What are the Market Stability Reserve design options?

The Market Stability Reserve (MSR) was set up in 2019 to reduce the surplus of allowances. Every year, if the total number of allowances in circulation (TNAC) exceeds the upper threshold (833 million), the MSR withdraws a number of allowances that would otherwise be auctioned. Each year that the TNAC falls below the lower threshold, the MSR releases 100 million allowances (until it runs out). This is shown by selected the “current ETS” option in the simulator.

Following the Commission’s Fit For 55 proposal, an extra buffer for the MSR has been introduced (1096 million allowances) as well as new rules for the cancellation of allowances. The proposed Directive also reinstates the demand from airlines into the TNAC calculation. These changes are implemented under the “Fit For 55 Proposal” option in the simulator.

In the simulator, we consider one possible change that Sandbag is advocating for (low thresholds option): the lower and upper thresholds are set at 0 and 100 million respectively, plus the cumulated aviation demand excluded from TNAC calculation. This option also includes the new rules for the cancellation of allowances as well as an extra buffer for the MSR, set to 132 million allowances.

In all scenarios, the withdrawal rate is set to 24% until 2030 and the net demand from aviation is included into the TNAC calculation.

Which combination of parameters is the most desirable?

The above simulation shows how difficult it is to keep emissions below the stated cap using the parameters commonly discussed at EU level. This is why Sandbag proposed that, if emissions start exceeding the cap in any one year, the ETS should block the access to its many additional ‘reserves’, so that the excess emissions can not persist for too long. This is explained in our submission here.

What are the model’s assumptions?

The model’s main assumptions are:

  • The EU ETS’s scope includes power, industry, intra-EU aviation emissions, and following the new Commission’s proposal, maritime emissions (intra-EU voyages and half of the emissions from extra-EU voyages and emissions occurring at berth in an EU port). Shipping companies will need to buy allowances for 100% of their emissions in 2026, after a transitory regime in 2023-2025.
  • Emissions from power generation are assumed to follow the MIX scenario of the latest EC’s Impact Assessment, which focuses “on both carbon price signal extension to road transport and buildings and strong intensification of energy and transport policies”.
  • Domestic aviation is assumed to follow Eurocontrol’s Scenario 2, combined with 1% annual growth in carbon efficiency; then follow the same trend as industry.
  • Industry emissions are assumed to claw back their 2019 levels after the 2020 Covid-19 trough in 2021, plus a constant annual progression rate applied until the end of the scheme.
  • Emissions from maritime transport are assumed to follow the MAR1/MEXTRA50 scenario of the latest EC’s Impact Assessment.
  • The split between free allocation and auctions is based on the ETS’ regime currently in place for Phase 4. Each year, the number of free allowances is based on the previous two years’ production figures multiplied by benchmarks. We assume that emissions intensities decrease yearly (the rate if calculated based on latest data from the EC). We also assume that there are no ‘frictions’ between production and allocation variations, despite the scheme’s allocation being based on thresholds (15% up or down) rather than fully dynamic.
Why is free allocation near zero in some scenarios?

In the ETS’s current design, permits are allocated to a list of sectors and processes based on their output levels. However, in order to achieve the most ambitious reductions, part of the output from those sectors will need to be substituted by other products not currently included in the ETS, which will necessitate a change in the allocation rules. For this reason, we chose to set the auction level to 100% after 2025 rather than make new assumptions on such new rules.

Where do the data come from?

For historical values (until 2019), we use data from the European Union Transaction Log. For 2020, we use activity projections provided by external sources (see below), to which we add a carbon intensity component. Other estimations are based on our own calculations, on historical values or forecasts from different sources (see next question). As we continuously adjust our model based on most up-to-date data, the data displayed on the simulator may change over time.

Does the model take into account the COVID-19 crisis?

Yes, it does! For the industry, power and heat sectors, our estimations for the year 2020 build on Eurostat estimates. For the aviation sector, we use Eurocontrol’s forecasts.

Does the model take into account Brexit?

Yes, it does! The cap has been set to 1 571 583 007 allowances in 2021 following Brexit. For aviation, flights to and from the UK have been removed.

Does the model look at other aspects of the EU ETS?

Yes – our model can also provide analysis of aspects like free allocation, revenues of the Modernisation Fund and Innovation Fund, use of flexibility mechanisms, etc. Over the coming months, we will be adding further graphs and information to our EU ETS simulator. If there’s a particular set of data you’d like to be made available or particular parameters you would like to try out, please let us know by sending an email to contact@sandbag.be.

Why is there a surplus in the EU ETS and is it necessary?

The surplus arises because the cap is so high above actual emissions levels – as the supply of allowances is greater than demand, a number of allowances remain unused. While the MSR was designed to reduce this surplus, it has not yet been able to tackle a large part of it. And indeed, the MSR will release more allowances when the surplus falls below its lower threshold.

So if even the MSR is designed to maintain a certain level of surplus in the ETS market, is a surplus necessary?
Many argue that a surplus is needed to allow power utilities to hedge (reserve their allowances several years in advance). The thresholds of the MSR are indeed based on these hedging needs (albeit outdated ones from 2013). However, hedging only requires that allowances are available at the future delivery date, not the date the contract for those allowances is signed. As the surplus is not actually relevant to hedging needs, it creates an artificial demand that will be rolled over until the final years of the EU ETS/ until electricity is decarbonised. As long as this unnecessary surplus exists, it can potentially undermine the emissions reduction effect of the EU ETS cap and prevent the carbon price from reaching the levels required to incentivise decarbonisation.

What has changed since the previous version?

On 9 Feb 2021 we recalibrated two assumptions based on the European Commission’s REG scenario: the split between ETS and ESR to achieve the EU’s global target, and the power sector’s emissions forecasts. In addition, we chose to set the auction level to 100% after 2025 for some scenarios where the emissions reductions from existing ETS sectors will probably need to be topped up by emissions avoidance from substitute products and processes not covered by the current allocation rules.

Following the Commission’s Fit For 55 proposal, we published an updated version of the model on July 16 2021, which we further adjusted (July 29 2021). We implemented several changes in the model: new reduction target, LRF and cap; inclusion of maritime transport; increased Modernisation and Innovation Fund; adjustments to the MSR (new buffer for the MSR, new rules for the cancellation of allowances, inclusion of emissions from aviation in the calculation of the TNAC); inclusion of ESR/ETS flexibilities; changes in benchmarks’ calculation rules. We also adjusted the emissions scenarios for the Power sector (following EC’s latest impact assessment) and updated a number of figures based on EC’s latest publications (carbon efficiency, benchmark values, TNAC, etc.)