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The Covid-19 crisis has caused an economic downturn that may reverberate throughout the European carbon market. This makes a review of the EU ETS supply mechanisms imperative.

In the previous economic crisis, the carbon price in the EU ETS dropped to very low levels as supply-demand imbalances increased. Today, the Market Stability Reserve (MSR) operates to prevent significant allowances surpluses from accumulating.

We estimate whether the MSR will be able to address additional surpluses under different emissions scenarios, following recent years of already rapid emissions reductions. Our analysis shows that the MSR’s original withdrawal rate of 12% will not prevent supply-demand imbalances from increasing under any scenario, and that even the temporarily doubled rate may be insufficient.

The MSR review foreseen in the legislation offers an opportunity to revisit the design of the MSR. Besides calibrating the MSR parameters there is also the option of introducing alternatives such as a carbon price floor, as suggested recently by France and Germany. A carbon price floor would offer the benefit of a more stable carbon price to guide investments, but it may require significant political capital to agree on an appropriate level.

Any change to the ETS’ supply management systems should also consider the impact on automatic allowance invalidation. Even with a growing allowance surplus, the number of allowances removed permanently from the market may exceed 3-4 billion. Hybrid solutions between the quantity control of the MSR and the price impact of price floors could also be considered.