Abstract
To improve the EU Emission Trading System’s resilience to demand shocks, enhance synergies with other climate and energy policies, and address the surplus of allowances in the system, the European Commission introduced the Market Stability Reserve (MSR) in 2015 (European Parliament & Council, 2015). Based on the number of allowances in circulation, i.e., those stored by ETS participants, some of the allowances to be auctioned in a given year are withheld and placed in the MSR instead to reduce the allowance oversupply. The MSR absorbs allowances whenever more than 833 million allowances are banked from one calendar year to the next (European Commission, 2023). The intake period of the MSR is, therefore, determined by market outcomes. When the total amount of allowances in circulation (TNAC) lies between 833 million and 1096 million, the difference between the TNAC and 833 million allowances will be placed in the MSR. If the 1096 million threshold is surpassed, 24% of the TNAC will be placed in the MSR (12% from 2024 onwards) (European Parliament & Council, 2023; Perino et al., 2022). When allowance banks are depleted to below 400 million allowances, 100 million allowances are released from the reserve annually until the reserve is empty or the TNAC rises to above 400 million again. Since the 2018 reform, the capacity of the MSR has been limited. Any allowances placed in the reserve beyond the limit are invalidated. With the latest reform in 2023, the capacity is set to 400 million allowances. This makes the total emission cap endogenous, as the number of available allowances now also depends on the banking decisions of the regulated parties (Perino, 2018).
Limiting the capacity of the MSR and invalidating surplus allowances is an important step towards a better integration of supplementary policies with the EU ETS. In general, cap-and-trade systems are notoriously difficult to combine with additional measures reducing the allowance demand in the regulated sectors. Under the assumption of a binding emission cap, any allowances freed up in one sector due to emissions abated through supplementary policies are absorbed by other sectors leaving the overall cap unchanged. This “waterbed effect” (named after water moving around in a waterbed if weight is applied but never leaving it) is temporarily negated by the MSR invalidating allowances. Any additional abatement effort will result in reduced allowance prices, increasing the incentive to buy and bank additional allowances. Larger banks will, in turn, increase the number of invalidated allowances. However, the “puncturing” of the waterbed only lasts while the MSR is taking in allowances. Once the TNAC falls below 833 million, it is unlikely to exceed this threshold again rendering the MSR and its positive effect on the compatibility of the EU ETS with other policies inactive.
In the worst case, the deactivation of the MSR could even lead to supplementary measures causing the emission cap to grow as Rosendahl (2019) points out. If a new policy is announced while the MSR is still active but is only implemented after the MSR has ceased to function, rational and farsighted market participants will adapt their banking decisions today to react to the future changes in allowance demand. A commonly used example to illustrate this phenomenon is a coal phase-out, as the timespan between the announcement and implementation is usually large. Lower demand in the future leads to a reduced incentive to bank allowances today. This, in turn, causes the MSR to absorb and invalidate fewer allowances. Hence, the overall cap grows. The MSR also fails to improve price stability in this case but instead amplifies the price shock caused by the policy announcement, as fewer invalidated allowances lead to higher supply and, consequently, even lower prices.
Gerlagh et al. (2021) and Perino et al. (2022) use multi-period models to formally prove this interaction between the MSR and policies announced and implemented at different points during its lifetime. They confirm the existence of a perverse effect of supplementary policies that increases with the delay between announcement and implementation. Gerlagh et al. (2021) use simulations (based on the 2018 version of the MSR) to show that an emission reduction of 1 MtCO2 announced in 2020 will increase the cumulative emissions by up to 0.86 MtCO2 if carried out in 2048 or later (Gerlagh et al., 2021). Perino et al. (2022) also predict a substantial increase in the overall emission cap for such a scenario. For an effect of this magnitude to materialise, ETS actors must correctly anticipate demand shocks and adapt their banking strategy accordingly. Quemin and Trotignon (2021) find that price responses to the 2018 reform of the EU ETS are best explained by twelve-year rolling time horizons of market participants, lending support to the assumption of forward-looking traders. However, an event study by Grunau (2023) investigating EUA price reactions to the announcement of national coal phase-outs in 13 countries suggests that the banking strategies of ETS participants are myopic. Grunau (2023) only finds a detectable reaction for the German coal phase-out and only in some model specifications. This result is surprising, as coal power plants in the countries that have announced a phase-out are responsible for nearly 30% of the emissions regulated by the EU ETS (Grunau, 2023). A forward-looking trader should, therefore, expect correspondingly large changes in future EUA demand. Thus, further investigation into the level of foresightedness exhibited by the allowance market participants is necessary to quantify the danger of unwanted increases in the emission cap in regulated industries. In this regard, experimental market games can be a valuable complement to the modelling approaches presented above. To our knowledge, the “Rosendahl effect” has not been investigated experimentally. The set-up outlined below will, therefore, provide a useful addition to the understanding of the efficacy of quantity-based flexibility mechanisms such as the MSR. In particular, we will test two hypotheses:
I. Participants adapt their banking behaviour even in later rounds based on information received at the beginning of the game.
II. The change in the banking behaviour is sufficiently significant to indicate a problem for the EU ETS.
While experimental findings should not readily be translated into predictions about the actual allowance market, a strong Rosendahl effect in an experimental setting can serve as an indicator for the relevance of design shortcoming of the current MSR design.
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