A summary of the mechanisms that can help drive scarcity value within the EU Emissions Trading System and how these can benefit impact investing.
In any market, scarcity is a driver of value. The less available supply of a given commodity, the greater the value of that available supply, regardless of however much unavailable supply there might be.
This principle applies equally, in theory, to the EU Emissions Trading System. A limited supply of EU Emissions Allowances (EUAs) is injected into the market each year. Polluters that are covered by the regulation, such as Utilities, Energy majors, Steel and Cement producers, must draw down allowances from the remaining supply, in order to remain compliant.
However, as the European economy decarbonises, demand for EUAs is expected to decline faster than the cap on emissions, creating the risk of a growing oversupply.
The European Commission has set in place a mechanism to ensure that supply remains in line with demand, known as the Market Stability Reserve (MSR). The MSR is a market resilience mechanism designed to prevent price crashes in response to external price shocks.
The MSR withholds allowances from the market by reducing the number of EUAs that can be sold at auction, thereby forcing compliance entities to buy from the secondary market and, in turn, reduce oversupply. These withheld allowances are transferred to the MSR and subsequently cancelled.
The number of EUAs the MSR withholds is calculated every May, when the European Commission issues a report detailing the Total Number of Allowances in Circulation (TNAC). At present, the MSR withholds the equivalent of 24% of the TNAC each year.1
How can this benefit impact investing?
As the pace of decarbonisation increases in Europe, the MSR is likely to encounter challenges in keeping up with a growing pool of surplus EUAs. The effect of the annual withdrawal of EUAs by the reserve is countered (to an increasing extent) by a reduction in demand, as coal plants are switched off and industrial installations use energy more efficiently.
Short of reforming elements of the EU ETS – which indeed will happen over the next few years – the answer is to “lock up” some of the oversupply so that the MSR withdraws a larger number of EUAs each year, speeding up the process of tightening supply and boosting abatement.
SparkChange aims to support investors in achieving their impact investing goals. Investors who develop a significant portfolio of physical EUAs and hold these for a number of years could i) help ensure that EUA supply remains tighter and ii) force the MSR to withhold a greater volume of allowances each year.
While the investors’ holdings are kept away from the traded market, they still count towards the Commission’s calculation of the total supply (TNAC), thereby increasing the scale of the MSR’s withholding each year.
Covered polluters are therefore left chasing a pool of available supply that diminishes faster, driving up prices and bringing more abatement options within economic reach. This abatement would be permanently captured by the EU ETS, freeing up investment capital to seek out further reductions, accelerating climate ambition for everyone’s benefit.