The emerging endgame: The EU ETS on the road towards climate neutrality

Abstract

The 2023 reform of the EU emissions trading system (ETS) has brought to the forefront the issue of allowance market functioning in the long run. With the emissions cap set to go down to zero by around 2040, the next decade can be said to mark the ‘ETS endgame’. That is, when allowance supply approaches zero, the market is bound to undergo fundamental changes. Yet the understanding and modeling of terminal market dynamics with ever-increasing allowance scarcity is limited. We analyze possible changes in market conditions and behaviors, and discuss associated challenges in two steps. First, we use the numerical model LIMES-EU to illuminate the market dynamics instigated by the reform, i.e. key changes in allowance price formation, supply adjustment and abatement by sector. Second, we use our numerical results as a backdrop to identify potential frictions (financial, informational, distributional) that may arise or become exacerbated as the endgame unfolds. Besides shedding light on whether the ETS is fit for climate neutrality, these frictions further delineate avenues for future research to improve the understanding and modeling of emissions trading in the long run.