Tag: Geographic Europe

In late January, the European Union unveiled a proposed two-pronged scheme for reducing greenhouse gas emissions once the Kyoto Protocol expires at the end of 2012. The scheme is designed to bring the world on board a post-Kyoto emission reduction regime, but participants say it will kill off many clean development projects in poor countries and raise the cost of reducing emissions in Europe. The Ecosystem Marketplace examines the impact of these latest proposals on the future of the CDM.

4 February 2008 | “To be or not to be” – that is the question posed by Shakespeare’s Hamlet, and the Danish Prince’s sempiternal question lends itself well to the survival or extinction of the Kyoto Protocol’s Clean Development Mechanism (CDM), which, fittingly, may be determined at the 15th Conference of the Parties to the United Nations Framework Convention on Climate Change (COP 15) in Denmark at the end of 2009.

The CDM is the mechanism that companies in Kyoto-compliant countries use to offset emissions at home by spending money on clean development abroad. By all accounts, it is one of the Protocol’s most stunning successes, promoting the transfer of billions of euros in development funds from the European Union to the developing world, and offering European companies an opportunity to reduce emissions more cheaply than they could if they were limited to abatement programs within the EU.

But the EU’s latest attempt to bring the world on board for a post-Kyoto agreement leaves the future of the mechanism in serious doubt, say project developers.

CDM: A Backgrounder

CDM projects yield so-called Certified Emission Reduction (CER) certificates, each representing one metric ton of CO2 or equivalent offset, which can be sold into regional cap-and-trade schemes.

So far, the only regional cap-and-trade scheme up and running for Kyoto compliance is the European Union Emissions Trading Scheme (EU ETS), but other schemes are in the works across the globe.

Coming out of COP 13 in Bali, Indonesia, the only question seemed to be how the mechanism can be expanded, although all topics under the CDM were placed in brackets, meaning they were set aside for future negotiations commencing in June before COP 14 takes place in Poland in December.

In January, however, the European Union threw down the gauntlet to the rest of the world with a challenge designed to create an incentive for a global emission reduction scheme.

The EU Challenge

The European Union has already vowed to extend the EU ETS through a third phase, to run from 2013 through 2020. Phase II, which we are in now, runs from 2008 through the end of 2012.

In laying out its proposals for Phase III, the EU presented a conditional plan that depends on whether or not the rest of the world agrees to “comparable” binding targets by the time COP 15 rolls around at the end of 2009.

If no global targets representing emission reductions comparable to those of the EU are agreed to, the EU says it will reduce its emissions to a level 20% below those of 1990 by the year 2020. If global reduction targets of 20% or more are in place, however, the EU will reduce its emissions to a level 30% below 1990 levels by the year 2020.

As for EU ETS, the EU Commission will gradually reduce the allowances it issues to a level 21% below the 2005 level by 2020 if the EU goes it alone, and to a level 31% below the 2005 level if there is a global regime in place. The reason for using 2005 instead of 1990 as the baseline for EU ETS is that 2005 was the year that legally-binding third-party verification on emissions was introduced.

Either way, the EU ETS will be expanded to include sectors currently not obligated to participate, while participants in some sectors – mostly the power sector – will have to buy their allowances at an auction, rather than receiving them for free.

The Big Stick

In an effort to entice developed nations and major developing world emitters into signing up to “comparable emissions reductions,” the EU’s new proposal prevents CERs generated by clean development projects after 2012 from being sold into EU ETS if binding global reduction targets of 20% or more are not in place.

“Under the current regime, a total of 1.4 billion metric tons (of CO2) can be offset via the CDM between 2008 and 2012,” says Patrick Weber, who heads the environmental trading books at Dresdner Kleinwort Investment Bank in London. “The Commission is saying that if there is no global framework beyond 2012, then it will extend the limit of 1.4 billion metric tons through 2020 – essentially meaning no more CERs allowed, but you can bank the unused ones received in phase II and sell them for potentially more at a later stage.”

Adrian Lima, a researcher at the UNEP Risoe Centre on Energy, Climate and Sustainable Development (URC) in Denmark, says 2.1 billion CERs are already in the development pipeline and scheduled for delivery by 2012, but Weber points out that, paradoxically, the freezing out of new CERs after 2012 would actually drive prices of European Union Allowances (EUAs) up, despite the lower overall targets, because companies would lose the low-cost abatement option. Indeed, he says, many participants may choose to bank their CERs from Phase II and sell them in Phase III – leading to surge in prices for CDM projects already in the pipeline, but a drop-off for projects that won’t come due until later.

Another URC analyst, Joergen Fenhann, says 5.4 billion CERs are already in the pipeline for Phase III – and project developers say many of these are now in danger.

The Little Carrot

There is, of course, and upside: if a global scheme emerges to reduce emissions by 20% or more, the EU will allow post-2012 CERs to be sold into EU ETS – but only an amount equal to 50% of the difference between the 20% that the EU is volunteering already and whatever the global target is.

Ecosecurities policy analyst Miles Austin points out that even if the world agrees to a regime reducing emissions 30%, the EU’s proposal means CERs can cover just 17% of emission reductions after 2012 – a far cry from the 50% overall allowed in today.

Estimates among traders and carbon financiers as to how many CERs will be required in Phase III seem to vary widely, but Austin predicts only 110 million CERs per year would be permitted compared to a potential 230 million CERs per year in the current phase.

The Assessment

Companies working on clean development projects from China to Brazil have praised the idea of an incentive, and welcome the fact that CERs are still a viable currency in the EU post-Kyoto system. A consensus is clearly emerging, however, that the limits placed on the use of CERs are just too tight – even if the most generous levels are reached.

“Strict limitations on the post-2012 CDM market will kill many emission reduction projects, because investment horizons for many CDM projects that are dependent on CER buyers are unclear now after this EU proposal,” says Sascha Lafeld, managing director of German carbon asset manager 3C Group, who adds that the current proposals also fly in the faced of the intent of Kyoto.

“The core idea of Kyoto is to promote emission reductions where it is cheapest, and these strict limitations on CERs are the opposite of that,” he says. “If the EU wants to get countries like China and India on board for a post-Kyoto agreement, it should definitely not limit the CDM market, but instead do the opposite. It should give evidence that emissions trading, and especially the CDM, are efficient market-based climate protection instruments.”

None of the project developers contacted by Ecosystem Marketplace have cancelled projects, but all say they’re scrambling to do the math on riskier projects that may or may not deliver.

Milo Sjardin, Head of New Carbon Finance North America, says the CDM is now dependent on significant take-up of CERs from emerging cap-and-trade markets such as those in Australia, Canada and the US. Without such take-up, he says, there will be a glut of CERs available at low cost, the result being little start-up in new international CDM projects.

The Alternatives

The United States hosted a closed-door “Major Economies” meeting last week in Honolulu, attended by representatives of the Group of Eight industrialized nations as well as China, India, Australia, Brazil, Indonesia, Mexico, South Africa, South Korea, and the European Union. On the eve of the meeting, James Connaughton, Chairman of the White House’s Council for Environment Quality, stressed the importance of technology transfer and the need for tariff elimination.

The CDM, he admitted, is an “important useful way for assistance between countries” but, estimating the CDM’s value at only $3 billion last year, Connaughton is adamant that all “financing streams” need to be looked at to mobilize “private capital.”

The Americans’ proposed International Clean Energy Fund would be worth far more than the CDM, Connaughton stated – the implication being that the US may propose a completely new market scheme. If that happens, then the value of CERs as fungible instruments that can be sold into all schemes is in question, as is the value of starting new projects.

Felix von Geyer is a freelance sustainability journalist based in Montréal. He can be reached at: [email protected].

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The 13th Conference of the Parties to the United Nations Framework Convention on Climate Change (COP 13) is more than a month behind us, but plenty of debate lies ahead as advocates and opponents of using forestry to combat climate change air their opinions in the lead up to COP 14 later this year in Poland and COP 15 next year in Denmark. Jeff Horowitz and Robert O’Sullivan of Avoided Deforestation Partners take stock of the Bali Roadmap and what it means for avoided deforestation.

25 January 2008 | In December, more than 10,000 politicians, scientists, NGO representatives, and academics inundated Bali, Indonesia, for two full weeks. The goal was to negotiate, lobby, and struggle through the increasingly complex web of international climate change policies. At the end of it all, an agreement was reached as part of the “Bali Action Plan” to spend two more years negotiating a future agreement that should include reducing deforestation in developing countries – something that currently accounts for a whopping 15 to 25 percent of global greenhouse gas emissions.

Critics have dismissed this round as being too technical and too soft on action, but a closer look at the Bali decisions shows that the event yielded significant decisions that will impact future US engagement in international climate policy and the future of millions of hectares of tropical forests. Surprisingly, this in turn becomes significant for US companies.

The US did not ratify the last treaty to address climate change – the 1997 Kyoto Protocol. The Clinton administration agreed to the text of the agreement in 1997, but the Bush administration pulled out before it became binding in the US, arguing that developing countries were not required to do enough to reduce their own emissions under the agreement, which meant this would hurt the US economy.

Despite the bashing it receives in some quarters in the US, the Kyoto Protocol was ratified by over 175 countries and is regarded as one of the most revolutionary and successful pieces of international environmental law ever passed. The treaty has created a multi-billion dollar market for trading emission-reduction credits and helped trigger billions of dollars of underlying investment into renewable energy and other projects in developing countries that reduce greenhouse gas emissions.

The Costs of Deforestation

The Kyoto Protocol did not, however, address the critically important issue of deforestation in developing countries, which contributes more carbon emissions than the entire world’s transportation sector. If these emissions are not reduced, then all the efforts of all those well-meaning people buying renewable power, driving a Prius, or turning down the thermostat this winter will come to naught.

And stopping deforestation is about more than just climate change. It’s about saving the homes and livelihood of indigenous people and preserving fragile swathes of biodiversity that have taken centuries to evolve. These are being permanently decimated at a rate that, if unabated, will wipe out Indonesia’s entire orangutan population in 20 years.

But the real damage is less visible. Loss of plant biodiversity, for example, disrupts the chemical composition of the atmosphere and, with it, weather patterns. There is some evidence linking reduced biodiversity and the resultant shifts in weather patterns to drought in Latin America, and we have all heard of the lost opportunities to find new medicines as valuable species perish.

The Bali Solution

The agreement on deforestation incorporated into the Bali Action Plan is remarkable as it offers hope that something will be done to stop this destruction. Equally important, the Bali outcomes contain a possible way forward to addressing concerns the US had with the Kyoto agreement.

First, a number of developing countries have stated in the Bali decisions that they may be willing to take action to reduce deforestation. Second, reducing emissions from deforestation is the most cost-effective way to reduce emissions globally. New technologies are not needed and deforestation can be reduced now.

One of the favored sources of finding the $10 billion or more per year it is estimated is required to significantly reduce deforestation is to expand the booming emissions trading market created by the Kyoto Protocol. If this increased supply is met by increased demand this expansion is good. Including deforestation in the emissions-trading market will reduce the overall costs of cutting emissions globally, making it a win-win situation for the economy and the world’s forests.

Many US companies are already faced with state-based legislation to reduce their emissions, with expectations that more federal legislation will follow. Most reductions need to happen domestically, and many cost-effective options are available. However, if US companies are able to partially use the international carbon market, they will be able to meet overall reduction targets more cost-effectively. This will help reduce the overall costs to the US economy that many fear – correctly or not – may be incurred if the US embraces emission caps.

The Bali Action Plan is significant as it opens the window to engage the US and US companies to become part of the global response to avert a climate catastrophe and save the world’s rainforests before they disappear forever.

Jeff Horowitz and Robert O’Sullivan are founding partners of Avoided Deforestation Partners (www.adpartners.org) an independent network and think tank on deforestation policy. Robert is also the Executive Director, North America for the consulting firm Climate Focus. AD Partners were intimately involved in the recent international treaty policy negotiations in Bali regarding the inclusion of provisions to use carbon trading to save tropical forests.

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The European Parliament’s Environment Committee on Tuesday called for tighter post-Kyoto emission caps than previously proposed and the recognition of forestry offsets for the first time under an EU-sanctioned cap-and-trade regime. But it also said companies that take full advantage of offsets today might lose their right to use them for future compliance – something that has project developers crying foul.

7 October 2008 | First Climate Group Executive Board Member Urs Brodmann sees plenty of things to like in the 25 compromise amendments (see link, right) that the European Parliament’s Environment Committee inserted into a bill that could – if voted into law – govern the European Union Emissions Trading Scheme (EU ETS) after the Kyoto Protocol expires in 2012.

He likes, for example, the inclusion of afforestation, reforestation and forestry offsets for the first time. The new bill, approved Tuesday, says companies can use forestry offsets to cover up to 5% of their emission reduction requirements post-2012 (during which offsets of all kinds can total 4% of 2005 emissions – more on this later).

He also has no qualms with tighter overall caps than those proposed by the European Commission in January.

But he says the parliamentarians blew it as far as offsets from the Kyoto Protocol’s Clean Development Mechanism (CDM) are concerned – and he’s not alone.

“There’s a lot of, well, angry discourse in the CDM community,” said another project developer, echoing others who didn’t want to be on the record until they had time to review the documents.

“They basically moved the goalposts,” says Brodmann, who has had time to review the documents and says the angry discourse flows from an amendment that will essentially bar any company that takes full advantage of the program as it exists today from using offsets to meet its EU ETS obligations after 2012.

Don’t Buy that Offset!

Specifically (and brace yourself, this gets complicated), the amended bill says that any company that uses CDM offsets totaling more than 6.5% of its 2005 emissions to meet its EU ETS obligations this year – or in any year through 2012 – will not be allowed to use offsets purchased after 2012 to meet its EU ETS obligations in the next phase of EU ETS, which runs from the end of 2012 through 2020.

Neither, for that matter, will companies that buy offsets now and bank them for the next phase.

Not that banking is disallowed – indeed, it is explicitly permitted under current rules – but companies that do choose to buy CDM offsets now for use in the next phase will be forced to gobble up as many as they can before the end of 2102 – because they won’t be allowed to use any post 2012 offsets for compliance purposes (no word on what happens if companies retire their banked allowances voluntarily).

Companies that neither cross that 6.5% threshold in this phase nor try to cash in banked allowances next phase will, on the other hand, be allowed to buy and use offsets from 2013 through 2020, during which they can annually purchase and use offsets equal to 4% of their 2005 emissions.

Avril Doyle, the Irish Member of European Parliament who is steering EU ETS legislation in Parliament, says the bill simply presents a choice for companies: load up now, or hold your peace through 2020.

“This wording ensures that all operators can use JI/CDM of a high standard where the host countries have ratified the Copenhagen climate agreement, in the period 2013-2020,” she wrote in a June draft of the current legislation. “Companies will obviously do whichever gives them the largest entitlement.”

Bait and Switch?

Brodmann says that’s not the point.

“It calls into question the principle of legal certainty,” he says. “In the current phase, member states are allowed to set their limits, and most have limits above 6.5%. This is a violation of good faith and creates a lot of uncertainty in the market, because now installations don’t know what the next penalty will be.”

What’s more, project developers have been using the current rules to promote the idea of buying allowances now and banking them for the future – something they say incentivizes early action and starts funneling money into developing world reductions today, rather than three or four years down the road.

The Reasoning

Advocates of the amendments say the new bill promotes reductions inside Europe, and some even argue that domestic abatement is cheaper in the long term than is promoting clean development in the developing world.

As for the 6.5% figure, it first showed up in its current context in a June draft of the bill, when Doyle argued that the European Union’s average annual reduction in the period 2008 through 2012 will be 6.5% of 2005 emissions, and that companies shouldn’t be encouraged to use offsets for an amount greater than the pan-European reductions over that period.

That came from a January European Commission proposal encouraging legislators to learn from past mistakes in drafting new legislation.

“Approved NAP (National Allocation Plans) decisions show an absolute emission reduction of 6.5% compared to 2005 verified emissions, thus ensuring that the EU ETS, designed as a cap-and-trade system, will deliver real emission reductions,” the report stated. “However, experience of the 1st period and the NAP assessment of the 2nd period gave strong reason to believe that the overall functioning of the EU ETS could be improved in a number of aspects.”

The Words in Question

Interestingly, the contentious amendment comes in a section of the bill designed to promote predictability (amended sections in boldface):

In order to provide predictability, operators should be given certainty about their potential after 2012 to use high-quality CERs and high quality ERUs that incentivise the linking of trading systems. Operators should be allowed to use such credits up to an average of 4% of their emissions, during the period from 2013 to 2020, provided they use less than 6,5% of ERUs and CERs compared to their 2005 emissions during each year of the 2008-2020 period and they do not carry over entitlements under Article 11a(2) of Directive 2003/87/EC. This system should ensure that over the period 2008-2020 up to 40% of the effort can be achieved through the use of CERs and ERUs.

Which was amended from:

In order to provide predictability, operators should be given certainty about their potential after 2012 to use CERs and ERUs up to the remainder of the level which they were allowed to use in the period 2008 to 2012, from project types which were accepted by all Member States in the Community scheme during the period 2008 to 2012.

The Council of Europe, meanwhile, is working on its own amended bill, and key members of the Council and Parliament will then hammer out a compromise bill that will be presented at one of the 12 four-day plenary sessions of European Parliament in Strasbourg.

If a compromise is rejected, or if no compromise is reached, the whole process begins again, says Tuomas Rautanen, First Climate’s Senior policy manager in charge of methodology and risk – adding that he’s optimistic it won’t end that way.

“We still don’t have the Council position,” he says. “That will come out in a few weeks, but it’s most likely not going to be one that will retroactively change the rules.”

In theory, the Council and Parliament have equal footing when it comes to hammering out a compromise bill, but in reality the Council usually gets its way, he says.

“In that sense, if the council does its homework, as they traditionally do, there is a slightly higher chance that the Parliament position as adopted today will not pass.”

Steve Zwick is Managing Editor of the Ecosystem Marketplace. He can be reached at [email protected].

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Additional resources

The voluntary carbon market has spawned more than twenty offset standards over the past year – enough to keep even the most diligent market participants feeling a bit overwhelmed. WWF has responded with a 105-page guide to the ten standards that have been around the longest, and the Ecosystem Marketplace takes stock of their efforts.

13 March 2008 | Anyone struggling to keep up with the slew of new carbon offset standards proliferating across the voluntary world will find it worth their while to download the WWF’s recently-released 105-page brochure Making Sense of the Voluntary Carbon Market: A Comparison of Carbon Offset Standards (pdf). It’s a clearly-written document that delivers on its promise of comparing voluntary standards – and although it doesn’t necessarily “make sense” of the voluntary market, it does provide a good primer for beginners and an adequate refresher for veterans.

As the title implies, the meat of the document is its analysis and comparison of ten voluntary standards currently in existence – a difficult task, because each standard has different objectives. The three authors (Anja Kollmuss and Clifford Polycarp of the Stockholm Environment Institute and Helge Zink of Tricorona) deal with this by using the Kyoto Protocol’s Clean Development Mechanism (CDM) as the benchmark standard against which the voluntary standards are measured – an iffy premise, as critics of the CDM can attest, and as the authors themselves make quite clear.

“Although the CDM additionality tool is well respected, it does not guarantee that only additional projects are approved,” they write early on. “Recent reports have shown that despite the fact that the additionality tool is required for all CDM projects, it is likely that a significant number of non-additional projects are registered.”

Analysis and Objectivity

The authors have also bent over backwards in their efforts to remain objective – despite WWF’s own involvement in and vocal support of the Gold Standard.

“The report itself needed to be as neutral as possible, and having a credible, neutral report was in WWF’s own interest,” says Kollmuss. “If WWF wanted to publish an advocacy piece, they could have done it in-house.”

The authors do leave room for their own subjective analysis – which they clearly label and delineate from the objective treatment that comprises the bulk of the document.

“I found the whole field is so complex that you can’t really make simplistic conclusions,” says Kollmuss. “There is no way to come up with a perfect standard because the way you define perfect depends on what your goal is—at the same time I wanted a space where I could write my opinions but wanted to make sure readers knew they were our opinions.”

Laying the Foundation

They also chose not to wade directly into the sticky territory of direct comparisons until providing a simple but dense summary of the CDM itself, and the result is an introductory section that serves as a tremendous aid if you understand the basics but aren’t clear on, say, the interplay between voluntary and compliance markets, or how exactly a project is designed and implemented, or when to call an offset a credit, and visa-versa.

The basic information on standards is woven into the narrative of the first half of the document itself – so, before giving you a chapter on each standard, they deliver chapters on concepts like “Additionality and Baseline Methodologies”, and then, within this, sub-chapters on “Additionality Requirements for Each Standard” and “Baseline Requirements for Each Standard”.

This provides a solid foundation from which to segue into a discussion of implementation procedures, and finally into the detailed analysis of each standard on its own – a section that takes up roughly half the document and wraps up with a summary matrix.

“The matrix was a little bit artificial,” says Kollmuss. “It took a long time for us to pull it together because we needed to go into quite a bit of detail to really divvy out what the differences are.”

Steve Zwick is managing editor of Ecosystem Marketplace. He can be reached at s[email protected].

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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 [email protected]

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.