The global financial crisis and subsequent decline in industrial activity have done more to curb greenhouse gas emissions than permit trading. So, what lies ahead for ETS, a concept once lauded as saviour of the planet, but whose very survival is now in question after a damaging and costly spate of systematic criminal attacks? Chris Webb considers its future.

Chris Webb

The European Parliament in Strasbourg. The European Union’s Emissions Trading Scheme has been beset by fraud, theft and corruption, while questions remain over the whether the carbon market is flawed Source: Karel Jakubec

Barely six years into its existence, the European Union Emissions Trading Scheme (EU ETS) is fighting for its survival. Embroiled in a quagmire of criminal activity where fraud, theft and corruption have struck at the very heart of the system, the ETS faces a crisis of confidence, struggling to shrug off a tainted image and rebuild global confidence. But, with some of the biggest and most polluting countries bluntly refusing to join the party, does ETS have a credible future?

Its integrity has suffered a severe blow in recent months with the theft of carbon credits, which temporarily shut national registries, and earlier VAT fraud scams. But are these the death throes of the ETS, or the non-fatal writhing of a fledgling market still finding its feet?

These questions have haunted the EU ETS, Europe’s trail-blazing platform for trading carbon allowances, hammered by critics from all sides from its beginning. In truth, the key mechanism to reduce emissions and incentivize investments in low-carbon technologies has enjoyed success and failure in equal measure, depending where you stand in the carbon debate.

The jury may still be out as to what extent, in its brief six years of operation, the EU ETS has cut emissions, the ultimate benchmark of its success or failure. World Bank figures suggest that Phase One of the scheme cut emissions by 2–5 per cent. Sandbag, a climate change action group, says Phase Two will achieve a reduction of less than 0.3 per cent.

Carbon trading has done nothing

In Britain, Tim Yeo, chair of the Parliamentary Environmental Audit Committee and a vehement believer that markets hold the key to curbing climate change, has admitted trading has done nothing useful to guarantee a carbon price high enough to persuade power companies to cut emissions.

Meanwhile, the price of carbon allowances that can be bought and sold, giving owners the right to pollute, continues to fuel the debate over what the cost must be to encourage or force power companies to switch to low-carbon technologies.

Will €16/tonne ($24/tonne) be enough? Should it be much higher, say €25/tonne? So far, argue the market’s critics, the ETS has failed to produce a carbon price high enough to provide the necessary incentive to invest enough in low carbon to meet climate change targets. Others disagree. But it is one argument that led the UK government, for example, to introduce a ‘carbon floor’ price in its Electricity Market Reform (EMR) proposals.

All of these issues, of course, are overshadowed by recent events that have had a far more damaging impact – if not on the actual workings then certainly on the perception of carbon trading and its previously untarnished respectability. Stricken by a tidal wave of criminal attacks including VAT fraud and carbon allowance thefts, the EU ETS, once hailed as capitalism’s answer to saving the world, is seen as having succumbed to corruption. Its architects have moved swiftly to stem the tide of market abuse. At least, its staunchest supporters believe, measures to prevent further malpractice are now firmly in place.

Connie Hedegaard, European Commissioner for Climate Action, says: “Following the criminal activities earlier this year, tightening the security of the registries system has been the top priority. All registries are now up and running with enhanced security measures in place.

“Together with Member States and through a regular dialogue with stakeholders, we are working on a set of measures to further improve security on all fronts such as a delivery delay mechanism, improved management of registry accounts and detection and quick response mechanisms. With these measures and a more unified approach for the third phase of the ETS due to start in 2013, we have definitely strengthened the integrity of the European carbon market.”

So far, so good, but let us look at the birth of the ETS, widely acknowledged as having been pioneered in Britain. After abandoning plans for a direct tax on carbon, a measure that European policymakers had entertained and discussed for almost a decade, the EU ETS was formally launched in 2005 and works on the ‘cap and trade’ principle.

This means there is a ‘cap’, or limit, on the total amount of certain greenhouse gases that can be emitted by the factories, power plants and other installations in the system. Within this cap, companies receive emission allowances which they can sell to or buy from one another as needed. The limit on the total number of allowances available ensures that they have a value.

At the end of each year companies must surrender enough allowances to cover their emissions, otherwise heavy fines are imposed. If a company reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another company that is short of allowances. The flexibility that trading brings ensures that emissions are cut where it costs least to do so. The number of allowances is reduced over time so that, in theory at least, the total emissions should fall. In 2020 emissions will be 21 per cent lower than in 2005.

Carousel VAT fraud attracts attention of the authorities

So far, so good. Then, the EU ETS’s problems really began. In August 2009, officials of the UK’s HM Revenue and Customs arrested nine traders after investigations into alleged illegal transactions related to so-called ‘carousel fraud’, where VAT charged on sales of EUAs is diverted for criminal use.

All were released on bail after questioning, but investigations are ongoing. Later, HMRC officers reported they had arrested a further four people in a suspected £38 million ($62 million) carbon trading fraud investigation. It followed the arrest of 22 people in raids in the UK linked to fraudulent trade in EU emissions allowances (EUAs).

In a separate incident, the European Commission was forced to suspend acceptance of greenhouse gas emissions allowances and international offsets for compliance within the EU ETS. The move was taken to prevent international offset credits already submitted once for compliance from illegally re-entering the trading scheme, a problem that originated in Hungary.

Then came thefts of carbon allowances, arguably the most damaging of all the market abuses during ETS’s fragile young life, which saw the emergency closure of all national registries holding EU emission allowances under the EU ETS to prevent further thefts from the spot market.

Although the ETS registries system has now fully returned to normal operations, the phishing attack which saw an estimated 250 000 permits worth over €3 million stolen from the system will have owners and traders on their guard for many months to come.

Phishing scams, which redirect people to a fake website via an e-mail, are common in the banking industry. But they were a new phenomenon to carbon trading. The scam, which hit a number of German companies, was perpetrated by criminals believed to have created fake emissions registries. They then sent e-mails to thousands of firms around the globe, including New Zealand, Norway and Australia.

“It was a worldwide action,” Hans-Juergen Nantke, head of German emissions registry DEHSt, told the Reuters news agency. Seven out of 2000 German firms targeted fell victim to the scam, handing over registration details which allowed the thieves to steal their emissions permits. “Of the seven, six have been subject to theft,” said Mr Nantke. Illegal transactions have also been reported in the Czech Republic.

Registries in nine countries, including Belgium, Denmark, Spain, Italy and Greece, closed after details of the attacks emerged. Registries in Austria, the Netherlands and Norway were temporarily suspended but reopened the same day. Emissions trading continued via the European Emissions Exchange.

Rebuilding the EU ETS’s credibility will take time, and Stig Schjølset, a senior analyst at Point Carbon Thomson Reuters, says the stolen allowances scandal has badly damaged the market’s integrity. But he is also confident that swift action by the EU and subsequent measures taken to tighten up access to the market and, crucially, IT procedures will be enough to solve the problem, at least in the short term.

In the long term, discussions are progressing on how to classify carbon allowances, and whether they should be regulated as financial instruments, a process that would see carbon allowances come under much stricter regulatory control than at present.

New regulatory rules mooted

Earlier this month, that likelihood seemed a step closer when carbon market participants called for new rules to govern spot trades in a bid to boost the market’s integrity and transparency following the thefts and fraud. At a meeting in Brussels, EU officials and stakeholders debated whether to tighten regulation by classifying all CO2 permits as financial instruments or by way of a tailor-made regime for EUAs that would build on existing financial market rules.

In hindsight, the market was waiting for criminal activity to happen, some observers say. It was just a question of when, not if. “The market is currently very open and it’s easy for anyone to be accepted to trade,” Schjølset said. At any rate, he believes the damage done to the ETS has been largely contained.

“If you look at the volumes involved, it is not significant. Three million allowances were stolen from the market out of an annual allocation of 2 billion. That’s 0.15 per cent of the market, so in terms of actual impact on the market it is very limited.”

But he acknowledges that there has been a significant “reputational” impact on the market. “If you’re a policymaker considering a cap-and-trade scheme and all you hear from the European market is news of criminal activity, it’s bad news.”

Schjølset points to the fact that, throughout the difficulties, the price of carbon has remained relatively robust; proof in itself that the market continues to operate effectively. “We’ve seen the price increase this year from €15/tonne to €17.5/tonne, so the market is functioning as expected.

“If you have a coal plant in Europe, you still have to pay, so overall the market has not been [substantively] affected. And let’s not forget that it is a relatively new market and there are still some teething problems. And the market was set up, essentially, by environmental regulators, not financial experts. So there is a steep learning curve and improvements to be made.”

Eivind Hoff is the director of Bellona Europa, the Brussels branch of the environmental NGO Bellona. He says most of the problems could have been avoided. “The problem is that the security around trading has not been commensurate with the value involved in carbon trading. In a way ETS has been a victim of its own success.

“I think all of this is being sorted out. Our main concern about ETS as an international instrument for incentivizing investment in low carbon and energy and solutions across industry is getting the cap right. So we’re glad the Commission has proposed setting aside a number of allowances to tighten the market. The intention is to put up prices.”

Hoff believes, also, that additional measures taken on a national level will help to achieve climate change aims. “There’s a dawning realization that something needs to be done, and measures proposed under the EMR in the UK for a carbon floor price are the kind of direction in which we need to go and we’re working with the Commission to encourage other Member States to do this sort of thing.”

Overall, Hoff believes ETS is the “best bet” for a common European action on climate change – a “foundation”, as he calls it – while individual countries themselves can do still more, as the UK is doing with EMR.

Criminal activity within the ETS scheme has particularly alarmed stakeholders interested in promoting new, low carbon technologies. Jeff Chapman is chief executive of the Carbon Capture and Storage Association (CCSA).

“It’s a great pity that the system has been brought into disrepute and this has been quite systemic throughout the time it’s been there,” he said. “First the VAT scams and then the full unadulterated theft through access to the registries, it has all created a lot of uncertainty.”

Carbon market has failed

Chapman, who was involved in ETS from the very early days of its development, says the European market has failed on its promise to incentivize low carbon investment. “It’s taken supplementary measures to provide the incentives for people to invest in low carbon investment – and here I’m talking about renewables – with feed-in tariffs and Renewable Obligation Certificates as far as the UK is concerned.” Additionally, says Chapman, he feels the UK government has recognized the shortcomings of the ETS in its pursuit of a carbon floor price under EMR.

Drax coal fired power station in North Yorkshire, in the UK, which is capable of co-firing biomass and petcoke Source: Alstom

“Everyone thought it would be the forerunner of ETS schemes throughout the world. Most OECD countries have toyed with the idea of having an ETS scheme, ultimately fungible with the EU ETS. The US and Canada are effectively off the agenda and it hasn’t happened in Australia. In Japan the business community is against an ETS. Without an international agreement the prospect of the EU ETS scheme could be limited.”

There are concerns that the performance of the EU ETS is artificially inflated – or masked – by a much more potent downward pressure on carbon emissions being exerted by the effects of the global financial crisis, a factor that has curtailed industrial output in industries such as steel and cement manufacture and, ultimately, power generation.

Recession drove EU greenhouse gas emissions down by a record 7.2 per cent in 2009, putting the bloc ahead of schedule in making promised cuts, EU data showed. “Although the ETS directive made a very well intentioned formula to continually restrict the supply of allowances over time, it assumes business as usual and doesn’t take account of external events – certainly not of the magnitude of those we’ve had in recent years,” says Chapman.

The argument is that it is difficult for ETS to demonstrate it alone has been responsible for cutting emissions. And that uncertainty alone could mean ETS is failing to trigger investment. “So if you’ve invested a lot of faith in the ETS as being able to stimulate investment [in low-carbon technologies], you lose a lot of time. It was hoped EU ETS would deliver the incentives to invest in CCS in the long run. Clearly that isn’t going to be the case.”

Mark Lewis of Deutsche Bank is rather more sanguine about the future for ETS. “In the last few months there have been elements that have been frustrating and damaging. And there have been some structural design flaws which the Commission would do well to remedy, but overall it is achieving what it is meant to achieve, which is to redirect investments from high carbon intensive fuel sources to low carbon intensive fuel sources. So, despite all of the problems, there is a general trend towards the objectives of the scheme.

“The big flaw is that this is the only market in the world where the demand is variable but the supply is fixed, because the cap is set years in advance. The problem that gives rise to is that when you have a demand shock, you’re not able to modulate supply in response.

“In every other commodity market when there is a change in demand the supply side varies its response accordingly. We’ve been living with over-supply for the last three years, set against a backdrop where ultimately the public policy objective is to achieve a consistent pricing signal for the future that incentivizes low-carbon investment.

“If you’re trying to develop CCS, for example, what you need as an investor is a degree of predictability that in five to ten years’ time the carbon price is going to be where it needs to be to make your investment competitive with traditional power generation. When the price collapses in the way that it did and you don’t get a clear price signal, it delays the move to a low-carbon future.”

What is needed, Lewis believes, is for the EC to set up some kind of institutional mechanism that would enable policymakers to intervene in the market to modulate supply within the parameters of the existing public policy objective, in much the same way as, for example, the central banks in many countries intervene in the foreign exchange markets to bring their currencies into line with their stated monetary policy objectives.

“If you take the recession as an example, the central bank would see a very severe drop in demand for EUAs, and step into the market and buy up those EUAs, ensuring that ultimately prices were moving in step with the stated public policy objectives,” says Lewis.

Overall, Lewis believes the ETS concept will survive the test of time. “I think if this market was to collapse and Europe was to go back on the idea of a CO2 market, it would have happened by now. Personally, I think it’s inconceivable. The power companies have started to make billions of investments predicated on the notion that there is going to be a carbon market in Europe for good.

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