European carbon market to shift gears

As the EU ETS starts its fourth trading phase (2021-2030), market participants are looking for direction on how new carbon legislation will affect the market in the coming years. Amid the large number legislative processes in the pipeline related to the EU ETS, the Market Stability Reserve (MSR) review and the EU climate law stick out as the most prominent discussions this year.

The MSR review and the EU ETS reform need to be considered in tandem, as the interplay between these policy measures is significant. While the 2030 emission reduction target determines the overall ambition of the market, the MSR remains an important price driver for the period until this change happens. Decisions taken in this regard will be critical, as they will determine whether the MSR plays a more prominent role increasing market scarcity or stays in the back to be activated only in times of systemic shocks.

In order to simulate the interplay between MSR parameters and cap trajectories, we run a consistent set of 26 scenarios. Further, we introduce a self-adjusting MSR setting, adjusting withdrawal rates as a function of oversupply and decreasing thresholds accounting for a continuous decarbonising economy.

Our modelling suggests that a review of the MSR settings remains particularly important for the middle part of the fourth trading period (TP4), mainly defining the market balance during the years 2024 to 2026. With the 2030 cap setting being revised, the MSR reduces its impact on the market balance and remains in place as a backstop in case of a system shock. Our modelling highlights that re-basing the cap at an early stage results in the most steady price trajectory bridging towards a higher climate ambition and decreasing the importance of the MSR as a scarcity provider.