The Business for CBAM Coalition takes note of recent announcements by the European Commission President at the 19 March European Council on the EU ETS (ETS1) to stop the invalidation mechanism of the Market Stability Reserve (MSR).
The MSR invalidation mechanism has invalidated over 3 billion surplus allowances since 2023, contributing to a more robust and stable ETS1 price signal. The Commission has now proposed to stop this mechanism. Doing so will likely have a very limited short-term impact on the carbon market and even less on electricity costs, given that direct carbon costs only make up 11% of the average electricity bill. Why is this? Because the MSR only releases allowances back into the market if the total number of allowances in circulation (TNAC) goes below 400 million, and this is not expected to happen until well into the 2030s.
However, stopping the invalidation mechanism has potentially negative long-term impacts. Without invalidation, hundreds of millions of extra ETS1 allowances (EUAs) will continue to accumulate in the MSR on top of the original 400 million threshold. In addition, some voices are now proposing to use MSR allowances on the market and sell them to raise new funding.
That would be disastrous for market confidence. This is because artificially increasing supply of EUAs assuming a stable demand will increase overall ETS1 GHG emissions and very likely undermine the ETS1 price. This will therefore not necessarily translate into an increase of ETS1 revenues (which is a product of supply times clearing price). Furthermore, a lower ETS1 price weakens the investment signal for low-carbon solutions. Therefore, under no circumstance should MSR allowances be artificially returned to the market. This was considered during the 2022 REPowerEU plan when the Commission initially proposed tapping MSR allowances as part of raising EUR 20 billion. The announcement alone caused EUA prices to fall sharply. Co-legislators ultimately rejected the MSR route as the primary funding source, financing the package instead from the Innovation Fund and frontloaded national auctions – precisely to protect market integrity. Going down this road again can fundamentally undermine trust in the ETS1 by creating a negative feedback loop where a higher EUA supply and lower market trust push ETS1 prices lower.
What would be an acceptable avenue for MSR allowances to be returned to the market? As explained in our post-2030 ETS1 position paper, the Business for CBAM Coalition proposes to make the MSR more dynamic, because the ETS1 is now moving into a new era characterised by structurally lower surpluses. The MSR should become a counter-cyclical measure that reacts to changes in the Total Number of Allowances in Circulation (TNAC), rather than just levels. It should distinguish between expected TNAC declines and unexpected TNAC movements (i.e. shocks). By doing so, it can help manage price volatility, preserve political predictability and avoid discretionary intervention.
Such a “TNAC-change MSR” works as follows:
- If the TNAC declines in line with the ETS total cap, do nothing.
- If the TNAC declines too fast, release allowances.
- If the TNAC increases unexpectedly, absorb allowances.