The EU’s nascent market in greenhouse gases, along with Kyoto project based mechanisms, seem set to have an increasing influence on power company strategies.

Dirk Forrister, Natsource Europe, UK

In the first year of the EU Emissions Trading Scheme (ETS), a new CO2 market quickly emerged and gained notice around the world. Driven by the first major CO2 controls on industry, the ETS market now quotes daily trading volumes and prices. The power industry is at the heart of the system, since it bears the greatest share of reductions of covered industries. The fundamental impacts of weather, fuel cost and electricity demand on carbon emissions are now reflected in price.

Since EU Allowance (EUA) prices are higher than expected, the resulting hikes in power prices have alarmed major customers. Energy intensive industries are asking tough questions about the future of manufacturing in Europe if high power prices prevail. Investment analysts wonder whether power generators truly recognize the strategic importance of this new law – and whether they are taking decisions on CO2 mitigation that are in the shareholders’ best long-term interests.

Figure 1. The ETS has created a competitive dynamic where firms can gain or lose value for their company by how well they use the market
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These dynamics create opportunities and challenges that could fundamentally change the face of the power industry in Europe in the coming years. The carbon issue is now at the top of the charts of concern for industry executives, who realize that their legacy will be influenced by how well they perform in addressing it. The ETS has created a competitive dynamic where firms can win or lose value for their company by how well they use the law’s market mechanisms. As a result, power firms are beginning to compete in developing GHG control strategies.

Market growth

Since its inception in January 2005, EUA market traded volumes have steadily increased from 30 million units traded in the first quarter 2005 to nearly 100 million in the 4th quarter, with around 362 million allowances estimated for the year, according to Point Carbon. While only a fraction of the size expected during the Kyoto phase (2008-12), the total value of EUAs traded last year was €7.2 billion ($8.9 billion). This was part of a global carbon market in 2005 worth €9.4 billion, when CDM (Clean Development Mechanism) and JI (Joint Implementation) Kyoto mechanism markets sales are added, Point Carbon notes.

Prices of EU CO2 Allowances (EUAs) climbed from around €7/tonne in January 2005 to nearly €30/tonne in June 2005 before levelling off to trade in the €20-25 range for the rest of the year. In 2006, prices strengthened to over €30 in April – hitting an all-time high of €33.70/tonne on 19 April 2006 for vintage 2008 delivery.

The EU market is likely to grow even more robust over the course of this decade. Point Carbon suggests a possible tripling of traded volumes in 2006 from last year’s levels. Allocations to set further limits on CO2 emissions for the 2008-2012 period are currently under negotiation and set to be agreed later this year, which will provide more clarity to market participants on the longer term market prospects.

Key drivers

At its most fundamental level, this market is driven by initial allocations to industry. The European Commission (EC) and Member States agreed on National Allocation Plans (NAPs) set in line with Kyoto targets. But the initial NAPs for 2005-07 represented only a first step, with even tougher limits expected for the 2008-12 phase. In fact, European policy makers regularly emphasize that the ETS has no end date and is expected to extend far beyond the Kyoto period.

First Phase NAPs took account of the fact that the ETS allowed very little lead time for covered industries to adopt major CO2 controls. Initially, most analysts expected the ETS to drive relatively modest changes in the power generation mix: large power companies would simply adjust power plant dispatch away from coal in favour of lower carbon alternatives (gas, nuclear, hydropower and other renewables would be more economic than coal fired plants).

Figure 2. ETS volumes and prices, 2005
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But last year, market conditions made those simple adjustments difficult. Given the run up in world oil prices, natural gas prices followed and coal-to-gas dispatch changes were uneconomic. Droughts in parts of Europe meant less hydropower was available, and last summer’s heat wave reduced availability of French nuclear plants at a time when demand was high. Thus, the shifts away from coal generation did not occur, so the EUA demand rose, forcing prices upward.

Power companies are recognizing that these energy market fundamentals may not change quickly. They also understand that there are more choices than simply switching to greater use of natural gas. In recent months, E.ON UK has announced major new wind, biomass and clean coal projects, RWE has announced major new clean coal projects in Germany and the UK and EDF are exploring new nuclear plants.

Links to Kyoto

The ETS is stimulating activity outside the EU as well, through the Kyoto Protocol’s project based mechanisms. The only places ineligible to create reductions for sale into Europe are the United States, Australia and other nations that have not ratified the Kyoto Protocol.

The Clean Development Mechanism creates units known as Certified Emissions Reductions (CERs) from ‘clean’ projects in developing countries. There are vast opportunities for reducing greenhouse gases inexpensively at old factories, waste facilities and power plants in developing countries. A similar mechanism, called ‘Joint Implementation’ applies to GHG mitigation projects in the former Soviet Union, where major energy efficiency improvements could be adopted to create Emissions Reduction Units (ERUs). The EU ‘Linking Directive’ permits CERs and ERUs to be imported for use in complying with the ETS.

The ETS is boosting activity in the CDM/JI market. European companies are getting more involved in such projects, both individually and collectively. Nearly every major power company in Europe is involved in CDM/JI purchases through direct initiatives, brokered offers and Funds or Pools. For example, Natsource’s €510 million Greenhouse Gas Credit Aggregation Pool, the largest private-sector GHG purchasing vehicle, includes EDP, Endesa, E.ON UK, ESB, Iberdrola, Norsk Hydro, PPC and RWE among its 26 global members. Other companies have joined various World Bank purchasing funds.

Figure 3. More resources are to be channeled into the body responsible for processing CDM project applications after some felt it was slow and cumbersome
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Recent prices for CERs and ERUs ranged from €3 to €14, depending on the risk distribution between buyers and sellers, according to Point Carbon. The prices reflect a range of delivery risks: primarily, the regulatory risks of the CDM/JI approval process, country risk, counter-party risk and technology risk. A wide range of project types are possible under these mechanisms – and given the cost effectiveness of these approaches, the market has quickly embraced reductions in methane, HFCs and N2O.

The CDM approval process is run by a politically appointed Executive Board and the Secretariat of the UN Framework Convention on Climate Change (UNFCCC). The approval process has been slow and cumbersome, primarily because it was severely under funded with a very few staff. Parties to the Kyoto Protocol met in Montreal in November 2005 and agreed to improve the operations and devote more resources to the Secretariat so that it can process CDM projects more quickly and professionally.

Regulatory risk is one of the most challenging areas. For example, the electronic system for tracking transfers of CERs (known as the International Transactions Log) is not yet in place, so physical transfers into EU compliance registries are impossible. EUAs can be physically delivered, because they are tracked separately by the EC’s transaction log. The UN Secretariat expects completion of its ITL procurement in April 2007, but fears of delays are keeping EUA prices higher than CERs.

Developments in prospect

Four major developments expected this year could have serious impacts on future market performance.

First, as a policy-driven market, the most important developments for its future are the next round of government allocations (NAPs). With the beginning of the Kyoto compliance period quickly approaching, the EC and Member States are expected to strengthen reduction targets even further for the 2008-2012 period allocations, due to be completed by 30 June.

Second, in a few weeks time, the first emissions reports will become public, which will enable analysts to compare actual emissions with original allocations. This will shed light on the amounts of extra allowances that may exist in certain industries. Given the fact that many industries in the new EU member states have not yet become comfortable with the ETS, it is likely that some excess allowances will be evident in those jurisdictions – potentially in large amounts.

Figure 4. Percentage of traded volumes of CDM/JI by technology
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Third, there is interest in whether the UN processes will be able to create greater supplies of CERs and ERUs. The CDM Executive Board will be continuing to consider a number of new project methodologies that could be applied to large numbers of projects. Also, the JI Supervisory Committee, recently convened for the first time, will be working to create conditions to enable JI projects to launch on time to begin delivering ERUs in 2008. The market will take interest in whether it can avoid the pitfalls and delays that the CDM experienced.

Fourth, the demand side of the market outside Europe should begin to take shape. The new government in Canada is reviewing its Kyoto compliance plan, with announcements expected in the fall. Similarly, the Japanese government is actively planning its Kyoto implementation plan. Finally, in the United States and Australia, state level activity is becoming more serious. Some of the US state-based programmes hold the potential for recognizing international units (CERs, ERUs or EUAs) in the future.

Early impact

From a macro perspective, the emissions trading model offers covered industries and entrepreneurs a more business-oriented approach than would command-and-control regulations or emissions taxes. Only a year old, the ETS is still in its infancy – but it is already demonstrating that it is capable of mobilizing vast resources into the global effort to address greenhouse gases.