Firstly, a decrease in production may lead to a lower allocation of emission allowances to companies. Secondly, many companies may opt to sell emission allowances because they think they no longer need them. As a result, the price of emission allowances will fall, as occurred in March (see the current price and price movements of allowances). In the past, a sharp fall in the issue price has led to what is termed ‘backloading’ (explained in more detail in this blog) and may lead to the transfer of allowances to the market stability reserve. Thirdly, in addition to the direct impact on the ETS, there was a risk that the coronavirus crisis was going to delay the introduction of a CO2 tax; relevant for ETS participants. However, the CO2 tax industry Act (Wet CO2-heffing industrie) has now been presented for public consolation. We will discuss this shortly.
Consequences for allocation: fewer allowances due to 'cessation'
When companies reduce or stop production of activities involving CO2 emissions, this can have an impact on the number of allocated emission allowances. In addition, companies participating in the ETS should be aware that the decrease or cessation of their activities may have to be reported. We will explain this below.
With regard to the (full or partial) 'cessation' of production, we limit discussion to the rules applicable to the current (third) trading period, running from 1 January 2013 to 31 December 2020, since the coronavirus crisis is currently affecting business operations and the allocation of emission allowances in the current trading period.
An installation that is 'stopped' in part or in whole causes less (or zero) CO2 emissions. This means that fewer CO2 emission allowances have to be surrendered. However, operators of a greenhouse gas installation should be aware that they may be allocated fewer allowances. This is the case when activities (which cause CO2 emissions) for manufacturing a certain product are reduced by half (or more). This is called a 'partial cessation' (Article 23 Decision 2011/278). Partial cessation occurs not only when a greenhouse gas installation is actually shut down, but also when significantly less is produced by the installation.
Partial cessation leads to a reduction in the number of allowances allocated (Article 23(2) Decision 2011/278). The reduction depends on the decrease in operations, i.e., the downturn in production. In principle, the number of allowances to be allocated is pre-determined by the allocation decision; however, this may be corrected afterwards. If the number of emission allowances is retrospectively reduced, any emission allowances that have been issued in excess can be reclaimed (by writ of execution) or set off against the next trading period (Article 16.35c of the Environmental Management Act (Wet Milieubeheer, hereinafter: Wm)).
As lower production also requires fewer allowances to be surrendered, a lower allocation due to the partial cessation of activities does not necessarily cause problems. Operators should, however, keep this in mind when selling 'surplus' emission allowances in the event of lower production output. A lower ex-post allocation could then lead to a shortage of emission allowances. In that case, operators will have to buy additional emission allowances. In addition, penalties may follow in the event of a partial cessation which is not reported, as discussed below.
Notification of partial cessation and possible sanctions
It is important for operators of a greenhouse gas installation to realise that a partial cessation must be reported in time. Failure to do so is punishable by sanctions. Notice of partial cessation must be provided in writing to the Dutch Emissions Authority (NEa) (Article 16.13a Wm in conjunction with Article 45(1) of the Emissions Trading Scheme). The notification must be made before 20 January of the year following the year in which partial cessation took place; for a partial cessation in the year 2020, this date is 20 January 2021.
Failure to report a partial cessation is a violation (Article 16.13a Wm) for which the NEa may impose an order subject to a penalty payment (pursuant to Article 18.6a Wm) and an administrative fine (pursuant to Article 18.16a(1) Wm).
Significant reduction in capacity?
In this context, it is also relevant to mention that a reduction in production and activities may also involve a significant capacity reduction (Article 3(j) of Decision 2011/278). A significant capacity reduction also results in a significant reduction in activities, leading to a reduction in the allocation of emission allowances. However, in the case of a significant capacity reduction, there must be an identifiable physical change that reduces capacity and activities. This will probably not be the case for companies that shut down their installations in response to the coronavirus crisis, as no physical changes to the installation will take place and the capacity will not be changed.
Impact on emissions trading: price decrease, backloading and the market stability reserve
As a result of the coronavirus crisis, the price of emission allowances fell sharply in March. An allowance (the term given to the right to emit a tonne of CO2) dropped from around EUR 25 to around EUR 15. The fall in prices is probably due to the fact that many companies and factories have shut down or are producing less. Since companies are emitting less CO2, they also need fewer emission allowances. Companies may then choose to sell their surplus emission allowances – not least because companies struggling at the moment will have greater need for liquidity than for emission allowances that cannot be used. Since there is a large supply of emission allowances on the market, against little demand, the price of emission allowances fell sharply. The price has since risen again to around EUR 20.
A fall in the price of allowances is undesirable in view of the objective of the ETS. After all, the objective is to reduce CO2 emissions from companies. This objective can only be achieved if the price of an allowance (also called the ‘CO2 price’) reaches such a balance that it pays to take emission reduction measures. A relatively high CO2 price stimulates investments in clean, low-CO2 technologies and ensures that CO2 emissions are reduced. With a relatively low CO2 price, it will be cheaper for companies to buy emission allowances than to invest in more sustainable variants.
This leads to the question of whether something can and will be done to raise the price again. In the past, mechanisms have been devised and applied by the European Commission to maintain a relatively high price, and thus the functioning of the ETS, as far as possible. As a result of the crisis in 2009, the price of emission allowances fell sharply and there was a surplus of emission allowances. This surplus amounted to approximately 2.1 billion emission allowances by 2013. Such a large surplus of allowances prevents the ETS from reaching its objective; in this scenario, it is relatively cheap to buy emission allowances, and this reduces the incentive to innovate in more sustainable solutions. The European Commission had therefore decided to postpone the auctioning of 900 million allowances until 2019-2020 (see Regulation 176/2014). This was referred to as ‘backloading’. This meant that the annual number of allowances to be auctioned was reduced in the 2014 to 2016 period by temporarily withdrawing these allowances from the market at that time. The idea was to auction these allowances in the 2019-2020 period.
However, this did not happen. In 2015, the European Commission established the market stability reserve (MSR) (see Decision 2015/1814). The MSR is a structural possibility to remove emission allowances from the market in the event of a surplus and place them in a reserve (see Decision 2015/1841). When establishing the MSR, the decision was made to incorporate the 900 million emission allowances that were 'temporarily' withdrawn from the market via backloading into the MSR.
As a result, these emission allowances were not immediately 'expired'. The aim of the MSR is to place a percentage of the number of allowances into the reserve each year upon reaching a certain threshold, or to place a percentage back on the market when the number of allowances in circulation falls below a certain threshold. This is assessed annually on 15 May. When many allowances are in circulation, this threshold may more easily be reached. Where this is the case, a percentage of those allowances will be removed from the market and placed in reserve. For the year 2020, this would mean that 24% of allowances would be placed in the MSR if the number of allowances in circulation exceeds 200 million (Article 5 Decision 2015/1841).
Importantly, from 2023 onwards, a cancellation mechanism will come into effect that will allow a surplus of allowances to be definitively cancelled (Article 5a Decision 2015/1841). The cancellation of the surplus will take place in the event that the number of allowances in the reserve exceeds the number of allowances auctioned the previous year. As a result, a certain number of allowances will definitively disappear from the MSR, and no longer return to the market.
In addition, the number of allowances in circulation is also reduced by an increased reduction of the annual emission ceiling. The emission ceiling determines the total number of allowances allocated to all ETS participants combined (aviation has a separate emission ceiling). In the current trading period of 2013-2020, this total number has been reduced by 1.74% each year. The total number of allowances will decrease by 2.2% annually as of 2021 onwards (Article 9 Directive 2003/86). This means that ETS participants will be allocated (slightly) fewer allowances per year.
The above leads to the conclusion that there are mechanisms in place to reduce the number of emission allowances in circulation, which may increase due to current circumstances. The question is whether, in this case, the standard MSR mechanism alone will lead to a reduction, or the European Commission sees a need for more stringent measures, such as taking allowances out of the market on a one-off basis (backloading).
Consequences for industry: possible postponement of CO2 tax?
The government has previously announced its intention to introduce a CO2 tax. It follows from the Climate Agreement that this tax will also apply to companies participating in the ETS. The content and form of the CO2 tax is not yet known, as there is no concrete bill yet. The Climate Agreement envisaged the introduction of the CO2 tax in 2021.
Recent reports claimed that the introduction of the CO2 tax may be postponed (Het Financieel Dagblad, 10 April 2020). According to government sources, the reason for this is that companies are already being hit hard by the coronavirus crisis, and an extra tax would not be desirable now. However, no official statement has yet been made by the government about a postponement. On Tuesday, 14 April, parliamentary questions were asked about a possible postponement. These questions asked whether the introduction of the CO2 tax will indeed be postponed, and what the state of affairs is regarding the bill. We will continue to monitor these developments.
When companies sell emission allowances on a large scale, the emission price drops and a surplus may arise. It is important to be aware of the measures offered by the ETS rules to avoid a surplus of allowances. These measures result in a decrease in the number of allowances in circulation, as a result of which the CO2 price is expected to remain relatively high.
When the production of CO2-emitting companies ceases or decreases, this can result in fewer emission allowances being allocated. Companies should be aware that they themselves must report any cessation of activities to the NEa. Failure to do so may result in an order subject to a penalty, or a fine. This blog has provided an outline of the partial cessation of activities. Whether there is in fact such partial cessation depends on a number of technical conditions. Operators of greenhouse gas installations would do well to think about their situation now.
More about the coronavirus
You can read more publications on the impact of the coronavirus on our website. Here you will also find a list of contacts within our office who can advise you with questions about the implications of the coronavirus for your company.