Market stability reserve
The market stability reserve (MSR) is an instrument of the European Commission to better match supply and demand. This mechanism is used each year to calculate the number of emission allowances available in the market. If this number exceeds a set value, the auction volume for that year is adjusted downwards. However, if the number falls below that set value, additional allowances are auctioned. The number of allowances in circulation (TNAC) is set by the European Commission every year in May.
Surplus of emission allowances on the market
In addition to their decision to reduce the number of emission allowances, the European Commission established an MSR effective from 1 January 2019. The twofold aim of the MSR is to make the EU ETS less vulnerable to unexpected demand fluctuations and to reduce the surplus by reducing the supply of emission allowances. Although the rules governing the MSR were established as early as 2015, they were amended during the revision of the ETS Directive.
Operation: placement and removal
The purpose of the MSR is to counteract large fluctuations in supply and price. In such an event, the MSR intervenes by removing a percentage of the supply of emission allowances from the market. In order to determine the supply of emission allowances, the European Commission annually determines the total number of emission allowances in circulation during the previous year. As of 2017, the European Commission publishes this number every year by 15 May at the latest. It is based on the following calculation:
Total number of emission allowances in circulation = supply - (demand + emission allowances in the market stability reserve).
The supply of emission allowances consists of unused allowances from the second trading period (2008–2012), auctioned allowances since 1 January 2013, allocated free allowances since 1 January 2013, exchanged international credits and allowances in the reserve for new participants.
The demand includes verified emissions from installations and cancelled emission allowances.
If the total number of emission allowances in circulation exceeds the threshold of 833 million allowances, a percentage of the allowances auctioned each year by Member States will not be sold through auction in the following year, but placed in the MSR. This percentage is 24% of the total number of emission allowances in circulation for 2019 and the four years following. From 2024 onwards, 12% of the total number of emission allowances in circulation will be placed in the MSR if this number exceeds 833 million.
Conversely, it’s also possible the overall surplus in the market decreases. If the surplus in the market falls below the threshold of 400 million emission allowances in circulation, 100 million allowances will be removed from the reserve in the following year and returned to the market through auctions. In this way, the MSR aims to cushion large fluctuations in supply.
Moreover, the adjustment of the auction volume was valid for a period of 12 months starting on 1 September 2019 due to the placement of allowances in the MSR.As the MSR became operational on 1 January 2019, a proportionate percentage of 16% of the auction volume was placed in the MSR for the first eight months of 2019. Subsequently, the auction volume has been adjusted based on the number of allowances in circulation each year on 1 September.
Other placement of emission allowances in the MSR
In addition to the placement as described above, ‘backloaded’ emission allowances are also placed in the MSR. Between 2014 and 2016, about 900 million emission allowances previously scheduled to be auctioned in 2019 and 2020 were not auctioned. These were placed in the MSR. Unallocated allowances from the third trading period (2013–2020) were also placed in the MSR. This number was finalised in 2020.
Operation: cancellation mechanism
The revision of the ETS Directive added a new element to the MSR: a cancellation mechanism. This cancellation mechanism will be effective starting 2023: when the number of emission allowances in the MSR exceeds the auction volume of the previous year, the surplus will be cancelled. Simply put, the MSR volume is compared to the auction volume of the previous auction year. The surplus volume in the MSR will then be cancelled. This means these allowances will never come back on the market and will therefore be destroyed. This limits the volume of allowances in the MSR. Market analysts expect this cancellation mechanism to lead to the cancellation of around 2 billion emission allowances between 2024–2030.
The rules governing the MSR could be revised again in 2021. This would present another opportunity to agree upon new rules for the operation of the MSR.
More information on the MSR and the annual publication of the number of emission allowances in circulation is available on the European Commission website.