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EU Carbon Prices Crash as Trading Begins

Mark Nicholls

Barely four weeks after the launch of the EU Emissions Trading Scheme, the market has already gone through one collapse in the price of carbon allowances. The Ecosystem Marketplace takes a look at the EU ETS, its teething troubles, trading strategies, rain gods, and the weather in Scandinavia

Barely four weeks after the launch of the EU Emissions Trading Scheme, the market has already gone through one collapse in the price of carbon allowances. The Ecosystem Marketplace takes a look at the EU ETS, its teething troubles, trading strategies, rain gods, and the weather in Scandinavia. On the first of January, 2005, the European Union's Emissions Trading Scheme (EU ETS) came into being. It marked the birth of the world's first international carbon dioxide (CO2) emissions market and–depending on which newspaper you choose to read–was either the beginning of a brave new era in the effort to halt global climate change, or represents little more than a large environmental distraction that is bound to collapse and will have little or no environmental impact. Under the EU ETS, the EU's 25 national governments were charged with setting CO2 targets on around 12,000 industrial installations across Europe. The scheme was designed to move the EU towards meeting its 2008-12 greenhouse gas reduction targets under the Kyoto Protocol, which itself will establish an emissions trading system as of 2008. The principle is that the EU ETS–in common with all such 'cap-and-trade' schemes–sets limits on emissions, allocates allowances, and then lets participants trade allowances in order to meet their regulatory requirements. In so doing, the system effectively establishes a price for carbon, encouraging investments in emissions reductions, either to meet installation targets, or to generate credits that can be sold in the market. And it is the behaviour of the market that is causing some to claim that the scheme is in trouble. According to prices tracked by Carbon Finance magazine, the price of an EU Allowance (EUA)–which confers the right to emit a tonne of CO2–collapsed by 25% between January 1 and January 10 of this year: going from €8.40 to €6.35, before recovering to near €7 by the end of the month. Before that, prices had been as high as €13/tonne, in forward trading early last year. Ironically, it was the environmental groups, and not the financiers, that were hinting at a market downturn: Just before the scheme's launch, conservation group WWF warned that governments had been so generous in their target setting, that the entire scheme was threatened. "Because of the over-allocation of allowances, there are hardly any incentives for industries to reduce emissions more than business-as-usual," said Oliver Rapf, senior policy officer in WWF's European policy office, last December. "As a result, the CO2 emission market will most likely see low prices and the environmental effectiveness of the system will be reduced." "If you look at price developments, it's a sign that we were more or less right with our analysis," Rapf said in mid-January

Does it Matter?

However, officials at the European Commission—the executive arm of the EU, which was responsible for setting up the ETS—are sanguine about the price movements. "I don't share the NGOs' concerns," says Peter Vis, the acting head of the Commission's industrial emissions unit. "I would caution against reading too much into price movements—the market is still very much in its early days," he adds. "And we're satisfied with the performance of the scheme so far. For the first time, an incentive has been created for companies to reduce carbon dioxide emissions, and extract value from reducing emissions." "An obligation on companies to monitor their emissions has been introduced, and this has led to a comprehensive review [by EU governments] of their [progress towards their] Kyoto targets," he continued. "That they've done this now—rather than later—is because of the 2005 start of the scheme." His views are shared by Lee Solsbury, practice leader for energy and climate at Environmental Resources Management, a US and UK-based consultancy. "The scheme has led to a focus on carbon emissions in a way that never existed before. The fact is that we've monetised emissions—they are on the balance sheet, on the accounts. "It's now a major issue–we should recognise that CO2 is becoming integrated in risk planning in a way that it wasn't before," he added. Others note that, since the scheme's official launch, traded volumes have jumped considerably. "The scheme is definitely a success—turn-over has increased dramatically in recent weeks," says Marcus H ¨wener, managing director of 3C, a climate change consultancy spun out of German financial services group Allianz Dresdner. According to figures from consultancy Point Carbon, more than 5 million EUAs changed hands (via forward trades, as allowances have yet to be delivered into company trading accounts) between the start of the year and 28 January. This is more than twice the highest monthly volume prior to the scheme's launch, in November.

Will Prices Continue to Fall?

But Solsbery acknowledges that there is a possibility that prices in the EU carbon market could fall even further. "One way of looking at the market is that there is a presumption that the national allocation plans [NAPs] have not been that tight, given apparent supply and demand fundamentals," he says. Furthermore, he says, because of the scheme's design, most companies won't need to trade until 2007. Although compliance with targets is measured on an annual basis, companies will be granted their 2006 allowance before they are required to surrender allowances for 2005—meaning they can effectively 'borrow' allowances from next year's allocation. Under that situation, the price could collapse. "It's certainly a scenario," he continues, "but there's an opposite picture, with two big unknowns: rates of economic growth, and the market power of those companies with surpluses, who will try and exercise that power by restricting the supply of allowances onto the market." "Furthermore, if Norway were to join we'd see significant new demand," he adds. Although not a member of the EU, Norway is able to join the scheme as a result of its membership of the European Economic Area, and it is in advanced talks with the European Commission about signing up. H ¨wener at 3C believes that the second scenario is more likely. "This is a very attractive level to jump into the market—it will definitely go higher from here." He bases this view on discussions with companies in Germany. "When we speak to our clients, they say they are ok with 2005-06, but from 2007 they will be in trouble, and will have to go and buy allowances."

The Driving Forces

But what, ultimately, drives the price of carbon? As might be expected in such a fledgling market, opinions are divided. Even before the scheme had officially begun, environmental markets specialists such as Garth Edward, the head of environmental products at Shell Trading, were arguing that allowance prices had begun to move in line with prices in related energy markets. While some believe energy fundamentals drive the price of carbon, others blame the weather. Following the drop in the price of carbon, there was speculation that heavy rainfall this winter in Scandinavia contributed to the allowance sell-off, given that it has filled the reservoirs that feed the hydro generation in the region—promising a surfeit of zero-emission electricity over the coming months. Also, the mild winter across Europe has dampened energy demand—and by extension allowance prices. Benedikt von Butler, at energy and environmental products brokerage Evolution Markets, however, argues that it is premature to draw lessons from more mature markets. "People are trying to find explanations for what's happening, and are inventing rain-gods," he says. "For example, the rainfall in Scandinavia explanation came about because some Scandinavian power companies began selling allowances. But it's been a cold winter in Spain, so plants are running at full capacity, and emissions are up. But the Spanish aren't trading yet, so it's not driving the market. We're seeing fractions of the bigger picture.

NAPs and Uncertainty

"On the margin, if all other things are equal, variations in the dark spread will have an impact. But there's still huge regulatory uncertainty," he adds, referring to the fact that several countries' NAPs have yet to be approved by the Commission, meaning that thousands of installations across Europe don't know—for certain—what their final allocations will be. See box below. "Poland is crucial," says Martin Collins, London-based managing director of origination and brokerage at Natsource, another environmental broker. "What it ultimately allocates is going to be a major determinant of how short the market is going to be." "The outstanding NAPs certainly aren't helping," agrees Louis Redshaw, head of environmental products at UK-based investment bank Barclays Capital. "Larger companies, such as the utilities, have a reasonable idea if they're going to be long or short, but the rest of the companies [covered by the scheme] are less inclined to transact." He adds that the market is also being held back by a lack of standardisation of trading contracts. Three main contracts are in use in the market: that of the International Swaps and Derivatives Association, which tends to be favoured by financial institutions; the European Federation of Energy Traders; and a contract drawn up by the International Emissions Trading Association. Anthony Hobley, an associate with law firm Baker & McKenzie in London, confirms that many companies have yet to put the legal underpinnings in place to allow them to trade allowances. Some companies, on the other hand, are beginning to look beyond the EU's borders for credits. A special "Linking Directive" agreed upon by European governments allows (with some limitations) companies covered by the scheme to fulfil their ETS obligations using credits from emissions reduction projects in developing countries that qualify under the Kyoto Protocol's Clean Development Mechanism (CDM). "We're seeing lots of corporates putting in place purchase agreements for CERs [certified emission reductions, the unit used by the CDM], although some have paused on the prices they're paying, given the recent drop in EUA prices," Hobley says. "Nonetheless, we're starting to see the connection between the EUA and the CER market," he adds. It is likely that this connection will only become stronger as the scheme develops. EUAs can't be 'banked' between the first and second phase of the ETS, which starts in 2008 (except, to a limited degree, in France). CERs, on the other hand, can be used in both phases, and many companies are likely to buy CDM credits as a hedge against the tighter allocations expected in phase two. Where to Now? So where does this leave the EU ETS? It is likely that uncertainty will continue to plague the market in 2005, but as the situation regarding the NAPs (see box below) is worked out—and as the second phase of the programme approaches—the market fundamentals could change considerably. Besides, while most governments have been generous in their allowance allocations up to 2007, industry is likely to face tougher targets as the EU enters the Kyoto target period. And some are already arguing for the Commission to take greater control of the process. "A proper analysis of the environmental effectiveness of the scheme would have to come to the conclusion that the allocation process could be improved," argues Rapf at WWF. "Of course, this is a learning phase, but it's important that we really learn from it. There should be more guidance in the directive, and allocations should be harmonised across Europe," he concludes. Mark Nicholls, a regular contributor to the Ecosystem Marketplace , is the London-based editor of Environmental Finance magazine, and consulting editor to its sister publication, Carbon Finance. He can be reached at mark@environmental-finance.com

Allocation process drags on According to the terms of the directive that established the ETS, EU member state governments were due to have submitted their 'national allocation plans'—which provide a list of all the installations covered by the scheme, as well as their emissions targets—by last May. The Commission then gave itself three months to assess each of the plans, to ensure they complied with the directive's requirements—most importantly, that they put the respective country on a path towards its Kyoto target, and that they don't breach State Aid rules. By October, industry was supposed to have known its targets, in advance of trading beginning on 1 January. As of 28 January, companies in the Czech Republic, Greece, Italy, Poland and the UK were still awaiting their final allocation, the German government had taken the Commission to court in an action that could yet see its companies have their allocations changed, and Spain was awaiting final sign off from the Commission. Of the six, Italy is the furthest behind. It has published an overall—very generous—target, but has yet even to supply the Commission with a list of installations. The Commission is assessing Czech, Greek and Polish plans, but has not yet said when it expects to announce its decisions. On 21 January, Spain published changes to its plan, largely in line with requests that the Commission had made. A Commission official said that the changes were likely to prove acceptable. However, the UK's plan has perhaps proved the most controversial. It was the first country to submit a draft NAP and, unlike most of its peers, the UK government demanded real (although not severe) emission cuts from its industry. This was despite the fact that the UK is already on course to hit its Kyoto target— unlike most other EU member states. This NAP was approved by the Commission in July but, three months later and after intense lobbying by industry, the power sector was awarded a substantial increase in allowances to, according to the government, take into account revised energy projections. Environmentalists were incensed, and the Commission nonplussed. The UK government is arguing that this plan is merely a revision, and doesn't require reassessment. The Commission disagrees, and is awaiting a full list of installations, with new targets. After a number of delays, this is now due to be published on 7 February. But this leaves the UK—a self-styled leader in the fight against climate change—lagging the rest of Europe. The final fly in the ointment of the allocation process is a legal dispute between the German government and the Commission. One of the rules in the directive is that no 'ex post' allocations should be made—to ensure certainty to business, allocations cannot be changed after the phase begins. The German plan, however, includes a provision that allows the government to confiscate allowances from companies that supplied inaccurate historical emissions data. Berlin argues that this would defend the environmental integrity of the scheme. The Commission argues that it's against the rules. The European Court of Justice is to hear the case. Although no timetable has been set, lawyers say that this court case—and rumours that the UK government is also considering suing the Commission—will not delay or derail the scheme per se. However, they may delay the delivery of allowances to companies in the UK and Germany, and they are already adding a degree of uncertainty to a process that is already complex and uncertain enough.

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