Sandbag’s EU ETS simulator
(Fit For 55 Model)

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. We updated our simulator to reflect the main changes proposed by the Commission. You can read Sandbag’s reaction to the FF55 ETS here and Sandbag’s latest supply and demand analysis here.

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 “Emissions scenarios” options, three “Reduction target” options, two “Cap rebasing” options, and two “MSR design” options.

What does the simulator show?

The graph shows the annual emissions by the industry and other sectors (power, aviation and maritime), the cap and the number of auctions and free allocations issued every year. The graph also shows unused allowances from previous years (Excess EUAs in circulation) as well as two pools of free allowances that can be used on the top of the cap (the NER and the “rolling reserve”).

Excess EUAs in circulation
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.

This figure is similar to the Total Number of Allowances in Circulation (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 in the MSR’s current design, which we do not replicate in this surplus figure. Under the Fit For 55 proposal, and from 2024 onward in the simulator, the TNAC includes the net aviation demand.

NER and Rolling reserve
Allowances from the New Entrants’ Reserve are used for new entrants but also to adjust the level of free allocations given to installations whose operations have increased or decreased over the last two years by more than 15%.

As for the “rolling reserve”, it consists of any remaining allowances from the free allocation share (43% of the cap) that have not been distributed to installations, but that “shall be used to prevent or limit reduction of free allocations […] in later years”.

Key figures
At the bottom right, key figures are displayed:

  • EUAs available to exceed the cap: this equals to the MRS’s upper threshold (inherited surplus) plus the amount of EUAs in the NER, the MSR, the rolling reserve and the reserve of 25m EUAs made available to Greece.
  • EUAs used above the cap: this is the amount of EUAs effectively used above the cap.
  • EUAs available after 2030: this equals to the amount of excess EUAs left (always 0 if the “maximum pathway” option is selected), plus the EUAs from the MSR and any remaining EUAs left in the NER (minus 200m, diverted to the MSR) and the rolling reserve.
What are the two emissions scenarios?

The maximum emissions pathway shows an emissions scenario 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 2023 onwards, using up the EUA surplus by 2030.

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.

The baseline emissions scenario combines several “business as usual” scenarios for key sectors (aviation, power, steel, cement, hydrogen). It considers a number of targets and regulations from the Fit For 55 package, but industry emissions are assumed not to be driven by the EU ETS itself.

What are the assumptions behind each scenario?

Both scenarios rely on the following assumptions:

  • Domestic aviation is assumed to follow Eurocontrol’s Scenario 2, combined with 1% annual growth in carbon efficiency until 2025.
  • Emissions from the maritime sector follow the `MEXTRA50/MAR 1´ scenario from the EC’s impact assessment.
  • 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”.
  • The demand for hydrogen in three sectors (refining, methanol and ammonia) are assumed to decrease in line with emission targets for cars and new farming policies, as per our Hydrogen report. Emissions from hydrogen also take into account the target of 50% of renewable hydrogen for industry laid down in the REDII directive of the FF55 package.

Assumptions for the maximum emissions pathway

  • From 2026, domestic aviation follows the same trend as industry.
  • All industry emissions (except hydrogen emissions, see above) increase in line with GDP growth in 2021 and 2022. Afterwards, a fixed growth rate applies to industry emissions from 2023 onwards, using up the EUA surplus by 2030.

Assumptions for the baseline scenario

  • From 2026 onwards, domestic aviation follows the business-as-usual scenario from the Destination 2050 report by the Netherlands Aerospace Centre and SEO Amsterdam Economics. The scenario is adjusted with 1.5% annual growth in carbon efficiency in order to reflect the targets laid down in the ReFuelEU directive: minimum share of 2% of Sustainable Aviation Fuel from 2025 and 5% from 2030.
  • In 2021 and 2022, emissions from the Steel sector follow GDP growth. From 2023 onwards, emissions follow the baseline scenario by Material Economics (i.e. without demand reduction from a more circular economy or reduced materials intensity). The corresponding emissions are estimated based on Eurofer production data and emissions factors from our CBAM They are adjusted by a carbon efficiency improvement that is derived from Eurostat’s steel production index, combined with historical EU ETS steel emissions growth over 2013-19.
  • In 2021 and 2022, emissions from the Cement sector follow GDP growth. From 2023 onwards, cement emissions follow the baseline scenario from New Climate Institute.
  • All other industry emissions (except hydrogen – see above) increase in line with GDP growth (forecasts by Eurostat and OECD), adjusted by a carbon efficiency improvement.
What are the three 2030 reduction targets?

In December 2020, European Union leaders 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).

The Commission’s Fit For 55 proposal sets a 61% reduction below 2005 levels for EU ETS sectors. 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 these three options.

What does “cap rebasing” mean?

The cap of the EU ETS defines the maximum amount of CO2 that can be emitted each year. This cap decreases year after year by a certain number 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 lower LRF. In the simulator, if the “Sandbag rebasing” option is selected, the cap is reduced based on an average of 2021-2023 emissions and the corresponding LRF is applied from 2022, using 2021 as base year.

In 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 (“Fit For 55 rebasing” option). This creates a very small rebasing, meaning that the rebased cap will remain above emissions for another several years.

In the simulator, the cap is rebased in 2024.

What are the Market Stability Reserve design options?

The Market Stability Reserve (MSR) was set up in 2019 to reduce the currently enormous surplus of allowances and inject allowances when that surplus becomes “too” low. 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.

According to the Commission’s ‘Fit For 55’ proposal, the number of allowances withdrawn shall be calculated differently if the TNAC is between 833 and 1096 million allowances. These changes are implemented under the “Fit For 55 Proposal” option in the simulator.

In the simulator, we consider alternative thresholds of 0 and 100 million for lower and upper, respectively (“Sandbag thresholds” option). This option applies a rule similar to the above with a proportionally reduced level of application (132m allowances instead of 1096m).

In all scenarios, as per the new Directive, the withdrawal rate is set to 24% until 2030. The net demand from aviation is included into the TNAC calculation from 2023 for the “Fit for 55 Proposal” and “Sandbag thresholds” options.

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. For that reason, none of these parameters is really optimal, and the ETS revision must consider other options than those currently being discussed. This is why Sandbag proposes that, if emissions start exceeding the cap in any one year, the ETS should block access to its many additional ‘reserves’, so that the excess emissions cannot 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 maritime emissions from 2024 onwards (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 covering 100% of their emissions from 2026, after a transitional regime in 2023-2025.
  • 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. During 2021-25, we assume that the emission intensity decreases yearly by a constant factor. Not having access to the carbon intensity figures held by the European Commission, we derived it from Eurostat’s industrial production index, combined with historical EU ETS industry emissions growth over 2013-19.
  • In 2026-2030, emission intensity reduces more quickly thanks to the reform of the benchmarks, which for example makes green and low-carbon hydrogen eligible to free allocation. This leads to a higher use rate of free allocation. Green hydrogen in particular, the production of which is assumed to follow the target laid down in the EC’s Hydrogen Strategy, leads to an additional supply of free allowances.
  • 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.
Where do the data come from?

For historical values (until 2020), we use data from the European Union Transaction Log. For 2021, we use activity projections provided by external sources (see above), to which we add a carbon intensity component. Estimations outside industrial sectors are based on well established scenarios provided by e.g. the European Commission, Eurocontrol or Material Economics.

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 look at other aspects of the EU ETS?

Yes – the underlying 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?

Following the Commission’s Fit For 55 proposal, we published an updated version of the model on July 16 2021, which we further adjusted on July 29 2021 and August 02 2021. We implemented several changes: new reduction target, LRF and cap; inclusion of maritime transport; increased Modernisation and Innovation Funds; adjustments to 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 for the period 2026-2030. We adjusted the emissions scenarios for the Power sector and Industry sector (by using production scenarios from our Hydrogen report). We also added a component to reflect changes in free allocation from 2026-2030 (see question on our model’s assumptions). Some minor adjustments were further made on August 24.

On September 30 2021, we added the Baseline scenario to the simulator (cf. question what are the two emissions scenarios) and made some adjustments to our forecasts based on latest data.