What now for carbon markets? Recovering from the April 2006 price crash

2006 has been an extraordinary year for carbon trading. In April, the price of carbon dropped by almost 70% to just €9/tonne, and more trouble may be brewing as national governments get ready to set quotas for their second phase National Allocation Plans. Candida Jones looks at what effect this turbulence may have on carbon abatement projects and the next phase of the EU’s Emissions Trading Scheme.

The EU’s Emissions Trading Scheme (ETS), launched in January 2005, is the world’s first international emissions trading scheme and works on a cap-and-trade basis. The idea is to force companies to emit less carbon dioxide than their National Allocation Plan (NAP) allows (that’s the cap part) or buy carbon permits from elsewhere.

The scheme has led to a bustling market in carbon abatement schemes through what are known as the flexible mechanisms of the Kyoto Protocol – the Clean Development Mechanism (CDM) and Joint Implementation (JI). These mechanisms encourage investment in carbon abatement schemes either in the developing world, in the case of CDM, or the emerging economies of Europe, in the case of the JI. Each of these projects generates carbon credits (Certified Emissions Reductions or Emission Reduction Units respectively), which can be offset against targets in the investors’ own countries.

Carbon crash – the price of carbon fell by almost 70% in a single day as countries revealed how much carbon was produced in 2005, showing a massive surplus of credits in the market (Point Carbon)
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Both the CDM and JI have lead to investment in renewable projects beyond the EU and a flurry of new companies has emerged, keen to maximize these investment opportunities. However, since the carbon price plummeted, uncertainty has been hanging over the reliability of these markets, which are linked to the volatile EU scheme. Mark Meyrick, a carbon trader for EdF Trading who invests in the CDM, confirms that ‘we became a lot more cautious about fixed price offerings after the collapse’.

Power of industry felt

The collapse in the price of carbon came just days after carbon traded in the EU ETS had reached an all-time high of €31 per tonne, up from €6 when the commodity was launched just 15 months earlier. The crash was apparently completely unexpected by sector analysts and marked a low-point in the first phase (2005-2007) of the scheme (see Figure 1). It was prompted when companies in the scheme had to report their actual emissions in the first year, 2005.

Figure 1. Price of carbon (€/tonne) since trading began in 2006. Source: Point Carbon
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Each country’s NAP is based, at least in part, on historic emissions, or at least that’s what governments believed. However, after lobbying by industry groups, these caps were made far too lenient. Overall, actual emissions in 2005 came in well below the total cap, so there is a surplus of the tradable credits in the market.

It quickly emerged that France was long, as were the Netherlands, Germany, the Walloon region of Belgium, Estonia and Finland. Even Spain, which relies heavily on hydro generation and had suffered a drought so was forced into burning more high-carbon fuels such as coal and gas to compensate, was less short of reaching its carbon target than experts had predicted.

The impact of this was to devalue carbon, which was now clearly in abundant supply, bringing the price tumbling. The tumble caused the wholesale power market in Germany, and elsewhere, to drop, thereby affecting the share price of a number of carbon-related and energy companies.

Carbon companies suffer

Most carbon project developers found their share price immediately drop by up to 15% on news that carbon had taken a downturn, while even RWE and E.ON saw their share values reduced as the value of carbon is linked to the wholesale power market. Econergy, Ecosecurities, Agcert and Camco, all of whom develop projects under the CDM or JI, typically in Latin America, India or China, all saw the value of their shares drop.

Immediately after the collapse, there were fears that the CDM and JI markets would see significant fall-off in investments, and indeed the market was virtually silent for nearly a month. Andreas Arvanitakis, analyst with industry specialists Point Carbon, said: ‘The deals came to a halt between the beginning of May and early June after investors were stunned by the crash.’

Back in the EU market, deadlines for the setting of the second phase NAP are now looming, with the European Commission expecting, perhaps optimistically, that all countries submit their draft second phase NAPs by 30 June.

The carbon market has been successful in stimulating renewable energy and energy efficiency projects in developing countries through the Clean Development Mechanism (MHyLab/IT Power)
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It is already clear that few countries will meet this deadline, including the UK, which has said it will instead honour the 31 December deadline by which time the NAPs are supposed to have been finalized. In itself this delay should have little impact on the second phase; however, for investors, especially in CDM, ‘the sooner they have certainty on the second phase NAPs the better’, Arvanitakis asserts.

Jorgen Wettestad, a researcher at the Fridtjof Nansen Institute, an independent foundation engaged in research on international environmental politics in Norway, believes that delays are inevitable in such a relatively young scheme: ‘Delays due to political processes must be expected with the EU ETS. If you look at the history of the scheme, there have been delays all along. It is a complicated and new system to get up and running, and it will probably continue this way for a while.’

Understandably, European Environment Commissioner, Stavros Dimas, is less phlegmatic and has already warned that ‘It is essential that Member States submit these plans to the Commission by June 30 for the good operation of the system’.

Learning from mistakes?

What would be potentially more problematic than the delay is a surplus in the market second time around, especially for those effected by the carbon crash the first time. ‘There initially seemed to be a lot of determination from governments and the European Commission for the second phase not to be fundamentally long like the first phase, but early indications of the second phase NAPs from European capitals suggest that the same mistake could be made the second time around because governments appear to be setting caps higher than in the first phase in some cases,’ says Arvanitakis.

France is a good example of exactly this. In the first phase, France’s cap was 150 million tonnes (MT) of CO2/year, while its actual emissions in 2005 were 19 MT lower than this cap, representing actual emissions of 131 MT/year. According to an early draft of France’s second phase NAP, published on 26 June, this time around France is proposing a cap of 149.7 MT/year, leaving the second phase cap at roughly the same level as the first phase.

The principal reason for the fall in the price of carbon is that national governments set emissions caps too high, allowing industry to keep on polluting (Superdecor/stock.xchng)
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Although by 2012, it is assumed France’s GDP will have grown, and so too, therefore, will its emissions, this is still a worrying indication for the market, says Arvanitakis. ‘If the example of France is borne out across the EU and the second phase is fundamentally long again, then not only will the EU ETS flop, but all the momentum built in emissions trading and in the CDM and JI markets would be lost. Since the EU scheme is the jewel in Kyoto’s crown, this would have major implications for international negotiations and for what will happen after Kyoto’.

Germany also looks set to fix a lax cap in its second phase. On 28 June, Germany issued a draft of its second phase, prompting Michael Grubb, Chief Economist at the Carbon Trust, and a self-proclaimed ‘big supporter of the EU ETS’ to comment that: ‘Looking at the draft [NAPs for phase 2] so far, I can report an extreme bout of depression’. Germany is proposing a cap which is just 0.6% below the reported emissions in 2005. Germany’s Kyoto target is to cut its emissions by 21% from 1990 levels by 2008-2012. According to Regina Gunther from WWF Germany: ‘these figures are unbelievably unambitious – it is shameful that our environment minister has agreed to this’.

One country which may have bucked the trend somewhat is the UK, which on 29 June set its targets for the second round of the ETS, announcing that the annual cap would be 238 MT CO2, presenting a cut at the high end of the range outlined in the UK government’s draft proposal from March this year. The new cap marks a 7 MT CO2 reduction on the first-phase allocation, and a cut of 29.3 MT CO2 per year on the government’s business-as-usual projections. Speaking about the news Arvanitakis said: ‘With this the UK has set the standard for other EU Member States.’

Strong leadership needed from commission

What is clear is that the Commission will need to take its role as overseer of the scheme seriously. ‘The real question is whether the European Commission has the political guts to force reductions in the NAPs where it sees they are necessary,’ says Arvanitakis, a sentiment echoed by Wettestad. ‘Political decisions and considerations need to be made in the NAP processes ahead. At the moment neither the bureaucrats nor the politicians are thoroughly familiar with the EU ETS. It will become better on the bureaucratic side once routines and procedures are put in place, but the interaction with politics and political decisions will always play a role and may also delay future EU ETS processes’.

Grubb has suggested that in order to make the second phase more robust, businesses should no longer be given free allowances, but instead, allowances should be subject to an auction process. ‘Our research indicates that in the second phase introducing a percentage of revenue-neutral auctioning is the best approach to ease over supply of credits and remove entirely the perverse incentives associated with free allocations’.

This is an approach which Dimas has clearly been considering, commenting that he found the proposition of compulsory auctioning ‘very interesting and helpful’. Nonetheless, the Commission has conceded it is now too late to make changes to the rules for the second phase.

Some signs of bounce-back?

Despite the uncertainty, however, the carbon market is slowly recovering, and some participants have fared better than others, showing resilience in an otherwise volatile environment. Meyrick concedes that it is difficult to tell what deals are actually being done as ‘traders are invariably beavering away behind closed doors’, however, he confirms that EdF Trading ‘hasn’t changed its modus operandi’ and that CDM trades continue now as they did before the market slipped. Arvanitakis also confirms that recovery is well underway. ‘The number of deals is picking up again now and there are definite signs of recovery in terms of market activity. People are already trading carbon in the period covered by the second phase NAPs even though they don’t know what the exact position will be and may not know before the end of the year’ [the deadline for finalizing the second phase NAPs].

And while the large majority of project developers saw their shares dramatically slip after the crash, as trading in their shares significantly increased, Econergy managed to buck this trend, suggesting that their strategy of investment in solid renewable energy projects, as well as simply trading in carbon emission reductions (CERs), may have been a key factor in their stability.

Although Econergy’s share value also dipped slightly, trading activity in their shares remained stable. According to Tom Frost of Numis, an independent investment bank, Econergy managed to weather the storm thanks to its renewable energy assets.

Joint Implementation is another Kyoto Protocol mechanism that has benefited from the trading of carbon credits, encouraging clean energy investments in the opening markets of Europe (Biomass Technology Group B.V.)
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‘Econergy, like all project developers, saw a drop in its share value reflecting the drop in the price of carbon. However, unlike Agcert, Camco and Ecosecurities, Econergy did not see increased selling of its shares reflecting the fact that investor confidence has remained strong in Econergy shares thanks to its unique dual income approach’.

Econergy is a US-based world leader in carbon credit generation from projects in Latin America. Unlike other project developers, Econergy doesn’t just source CERs for resale within the EU’s ETS, it also invests in the projects which generate CERs, thereby allowing it to sell the renewable energy that it generates as well as the CERs.

Trevor Sikorski, Senior Analyst at Point Carbon, stressed the importance of this kind of approach. ‘If you’re financing your renewable energy project on CERs alone then this drop in the price of carbon will have had a devastating affect. As long as you sell [renewable] power as well as CERs then you should be OK’. Moreover, Sikorski believes that ‘there’s a chance that some renewable projects may struggle if they are marginal and rely only on an income from CERs.’

It is certainly the case that allowances for 2008 are now trading close to €20, a doubling of their May value, and that indeed, on 26 June, they were trading at a premium to the first phase price of €15.55 for 2007, suggesting that long-term carbon investments are back on the up. For carbon project developers and for the renewable schemes that many of them invest in, this is good news. ‘Investors in CDM and JI renewable energy projects will be getting a lower rate of return on their investments than they might have hoped during the heyday of early April prices, but the market is still ticking over,’ Arvanitakis confirms.

Tom Frost agrees. ‘Unless the Kyoto Protocol is abandoned, which it won’t be, there’ll be a price of carbon up to 2012, even if that’s at a lower price. After 2008, Western Europe will be far above its Kyoto target so there will have to be cuts, and the market will survive. There may have been a slow-down in projects being considered however, serious project developers won’t have been put off.’

Candida Jones works for Carbon International, London, UK. E-mail: candida.jones@carboninternational.com Web: www.carboninternational.com

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