Power sector derogation – Modernisation Fund likely to grow

This analysis has originally been published for ICIS EU carbon subscribers on 17 Jun 2019 13:48 CET.

Main points

• As already possible during TP3, also in TP4 some member states have the possibility to grant a limited number of free allocation to their power sector (as defined by article 10c of the EU ETS Directive)
• Under Article 10c, member states with a GDP below 60% of the Union average in 2013 are allowed to support their electricity sectors with free allowances. For this, the entitled member states are allowed to use up to 40% of their auction share
• Member states have the option, instead of allocating the allowances in form of free allocation, they could instead also move parts or all allowances foreseen for derogation purposes to the Modernisation Fund
• In addition, 16 member states can move parts or all of their auction volume related to solidarity purposes (10% of the overall auction volume, 705m allowances) to the Modernisation Fund

Announcement and rumours on TP4 derogation

• On 13 May 2019, the Czech Republic announced it will no longer make use of the 10c provision (“derogation”) of the ETS Directive as of 2021 and that it will transfer the full derogation volume to the Modernisation Fund
• On 6 June 2019, media outlets stated that Poland “will probably” stop the use of derogation but did not specify if the volumes would be transferred to the Modernisation Fund
  • To our knowledge, no final decision has been made within the Polish government on the issue but this should be soon announced as two deadlines are looming

Why would this make sense? Interaction with market stability reserve

• The MSR regulation determines that the share every member state has to feed to the reserve depends on the country’s share of the auction volume.
• The absolute annual MSR withdrawal volume is based on the 24% withdrawal rate (or 12%) of the TNAC if the MSR is triggered.
• However, until the end of 2025 the MSR contribution will only be deducted from member states’ regular auction volumes, while the solidarity volume is not accounted for as a basis until then.
• This implies that member states with a solidarity volume will lower their relative share regarding the MSR contribution.
• Further, the volumes in the Modernisation Fund are shielded from MSR accounting until 2030. Hence, it seems considerable for member states to decrease their MSR-accessible auction volume for the period 2026-2030, as in this period the MSR withdrawal is also based on the solidarity volumes.
• Therefore, itis likely that some member states will use the option to shift some of their solidarity auction volume to the Modernisation Fund at the latest for the latter half of TP4 in order to decrease their MSR contribution and “safeguard” some of their auction volumes from the MSR.

Next key deadlines

• By 30 June 2019, member states aiming to use derogation volumes must publish a framework for the process
• By 30 September 2019, member states which want to transfer derogation or solidarity volumes to the Modernisation Fund must inform the European Commission of the amounts in question

Analysis

Czech Republic, maybe Poland, any others?

• While the Czech Republic has officially confirmed its position on derogation volume and Poland is rumoured to follow that process, no other member states have yet stated their position
• According to our sources, discussion within the ministries are still ongoing, including Poland
• However, the Czech Republic’s move and Poland’s alleged position, point towards a possible trend not to use derogation volume during TP4. We believe that the majority of the concerned member states will follow this approach
• However, there will likely be some differences in the approaches of the eligible member states on the use of derogation volumes, solidarity volumes, and how those are distributed between regular auctions and the Modernisation Fund

A snapshot at the numbers

• The Modernisation Fund is determined by 2% of the TP4 cap. Excluding the UK from the cap, this would lead to total fund volume of 274m allowances.
• In addition, there is a provision for a flexible part of the cap in order to limit or prevent a CSCF. In case this flexible element is not required, which we assume, part of that flexibility element (0.5% of the cap or 68m allowances) is transferred to the Modernisation Fund. This results in the Modernisation Fund to have a total volume of 342m allowances for TP4.
• Accounting now for different scenarios of filling the Modernisation Fund with additional allowances, Table 1 and 2 below show the different volume options for member states and their maximum effect on the fund volume:
  • Adding derogation volume
    • potential maximum 10c derogation volume with Poland (275m), Czech Republic (112m), and Romania (114m) having the highest absolute volume
    • Czech Republic’s announcement means that it will transfer all derogation volume (112m) to the Modernisation Fund
    • If all other member states were to follow the Czech Republic on that approach, the Modernisation Fund would be boosted from 342m allowances to 900m allowances

Table 1: TP4 derogation volumes available to member state beneficiaries

Adding derogation and solidarity volume

• If all member states who are entitled to proceeds from the Modernisation Fund and have solidarity volume at their disposal would move that volume into the Modernisation Fund, the fund’s volume could swell to 1.5bn allowances
• In case member states wanted to protect their solidarity volume from the MSR only during the second half of TP4, the fund’s volume would still be significantly increased to 1.2bn allowances

Table 2: Modernisation Fund volume

• One key element to consider in the context of the solidarity volume is Article 1 (5) of the MSR legislation, which states that until 31 December 2025, solidarity volumes shall not be taken into account when determining member states’ shares contribution to the MSR
• This means that member states benefiting from solidarity volumes are shielded from the MSR biting into their solidarity pot until the middle of the decade – this will most likely incentivize member states to transfer their solidarity volumes to the Modernisation Fund at least as of 2026

Supply and demand impact: Timing matters

• If a member states transfer their derogation volume to the Modernisation Fund, it has neutral fundamental implications for the supply and demand balance
  • Demand: Concerned utilities not receiving free allocation via derogation see their short fundamental position increase
  • Supply: Auctioned EUAs increase via the additional volumes in the Modernisation Fund
• If a member state transfers its solidarity volume to the Modernisation Fund, it also has neutral fundamental implications
  • Demand: No impact
  • Supply: A simple volume shift between EUAs being auctioned as regular auctions and EUAs being auctioned through the Modernisation Fund
• With that said, on a traded basis, both scenarios above have the potential for impacting the EUA price depending on the timeline of auctioned EUAs through the Modernisation Fund and how utilities hedge moving forward
  • The Czech Republic, is transferring its derogation volume to the Modernisation Fund
  • Assuming an equal distribution of these additional volumes over TP4, we assume this to be slightly bearish for most of TP4 against our base case where we assumed the volume would be held back from the market and likely not fully distributed with a push of that volume coming to market during the last years of TP4
  • Over the entire TP4 period however, the effect would likely be smoothed out

Poland will auction unused derogation volume in 2020

• Meanwhile, Poland announced that it will auction 49.52m unused TP3 auction volume allowances in 2020 instead of transferring them to TP4
• This concerns the allowances not provided for free to the power sector during the period 2013 to 2018
• These allowances will be added to the regular Polish auction volume during the last year of TP3 with Poland’s auction calendar being finalised in the coming weeks and published by the European Energy Exchange (EEX)
• The unused derogation volume for the period 2013 to 2019 will be auctioned in 2021, we estimate that volume to be 17.2m allowances

Marcus Ferdinand is Head of European Carbon & Power Analytics at ICIS. He can be reached at Marcus.Ferdinand@icis.com.

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