The European Union (EU) has set itself challenging targets for reducing carbon dioxide emissions, but in reality can the bloc’s carbon trading scheme incentivize power generators to make low-carbon investment decisions?

The scale of the challenge facing Europe in reducing its emissions is considerable. From 1999 to 2004 the greenhouse gas emissions of the EU-15 rose by 2.5 per cent and by 2004, emissions stood at over around seven per cent above the Kyoto target level for 2008-12.

The EU Emissions Trading Scheme (EU ETS) came into operation on 1 January 2005 as the cornerstone of the EU’s efforts to move to a low-carbon economy. It forces the member states to agree on, and implement, binding cuts in emissions.

In theory, it acts as a mechanism to ensure EU compliance with the commitments in the Kyoto Protocol. It also establishes a market for carbon abatement beyond the Kyoto compliance period of 2008-12, and can therefore be seen as providing impetus for further international agreement on action.

To be a success in reducing carbon emissions within Europe, the EU ETS must lead to behavioural change. This can come at three levels: through making better use of our existing capital stock; through choosing lower-carbon technologies, which are already available, when making new investment decisions; and through research and development (R&D) of new technologies to reduce emissions in the long term.

The scheme provides incentives for short-term behavioural change. This can include demand- and supply-side effects. If the price of carbon is passed through to end-users, it may serve to reduce demand for carbon-intensive products. On the supply-side, companies will be incentivized to use the existing capital stock in a more carbon-efficient manner. The most obvious possible change is in the use of power stations, where it may be possible to use gas stations (low-carbon intensity) more and coal stations (high-carbon intensity) less to meet demand.

However, short-term behavioural change will not deliver much of the required carbon reductions. Moving to a low-carbon economy will involve a wholesale replacement of our existing capital stock. The second effect that the market for carbon is designed to have is to incentivize investment in new facilities with lower carbon intensity.

Even incentivizing a move towards investing in existing low-carbon technologies is unlikely to deliver the scale of sustained emission reductions required to stabilize emissions at desired levels. This will require more investment in long-term R&D. A mature market for carbon reduction might go some way to encouraging such R&D, although more specific means of government support may also be required.

The story so far

In some ways, the EU ETS made an impressive debut, with national allocation plans approved, the successful establishment of registries for carbon ownership, and the facilitation of spot trading. Forward markets have developed and liquidity in exchange and over-the-counter trading is improving. By early 2006 the price of CO2 allowances reached €30 ($41)/tonne, implying a carbon market worth €60 billion per year given the 2000 Mt of CO2 in the scheme.

The publication of the first set of audited emissions data in 2006 demonstrated, however, that the first year of the scheme, and probably the whole first phase of the scheme (2005-07) was in surplus, with more allowances issued than the companies actually needed. Actual emissions from installations in the scheme were just under 1800 Mt in 2005.

However, the allowances issued in almost all member states were higher than the actual emissions, the most notable exception being the coal-heavy UK. The total allowances issued to these member states were around 1900 Mt. The result of this data was a collapse in the carbon price, and by 2007 the price for Phase I allowances was almost zero (although prices for Phase II, which runs from 2008 until 2012, have held up well at €15-€20/tonne).

Despite the eventual collapse in the price, the first phase of the EU ETS has demonstrated that carbon pricing can drive short-term behavioural change. The UK power market is the main market in which flexibility exists between coal and gas use for generation. During 2005 and 2006, UK gas prices were high and coal generation was generally cheaper in both the winter and summer. However, coal generation results in CO2 emissions of around 0.9 t/MWh, while gas generation produces only 0.4 t/MWh of CO2 or less. Taking into account CO2 prices of €20-€30/tonne, this was enough to encourage UK generators to turn on some of their gas stations before their coal stations during the summer, thereby saving CO2 allowances.

In theory and in practice

In theory, the EU ETS should provide a basis for encouraging companies to invest in low-carbon technologies. Creating a credible expectation of future carbon costs will encourage companies to pay more now to invest in technologies that will reduce future emissions, and therefore save money in the long run.

Figure 1: Carbon abatement supply and demand in theory
(source: Oxera)
Click here to enlarge image

Figure 1 shows how the cap and trade scheme should, in theory, work. The horizontal axis shows the quality of carbon abatement and the vertical axis the cost per tonne of carbon saved. Under the EU ETS, governments set the amount of carbon abatement required by giving a fixed allocation of allowances. This is shown by the vertical demand curve for carbon abatement. That is, the volume of carbon abatement demanded by the governments is independent of price.

The supply curve shows the marginal costs of delivering different quantities of carbon abatement. Some reductions in carbon emissions might have a negative cost since they represent efficiency improvements, which would more than pay for themselves, even without an extra cost of carbon (although this begs the question of why these efficiencies have not already been exploited). Progressively higher levels of required abatement are more costly to deliver, leading to an upward-sloping supply curve.

The filled-in circle shows the position of a hypothetical generator thinking about whether to invest in a new coal or gas fired power station. In this example, the coal station is thought to have a lower all-in cost (including capital and fuel), but it has a higher carbon intensity than the gas station.

Therefore, the generator will only decide to save carbon by building a gas station rather than the coal one if it expects the future carbon price to be sufficiently high. In theory, the EU ETS should provide an incentive for this investment because the generator will look at the total abatement required, and conclude that it can compete effectively with the more expensive forms of carbon abatement required to hit the target. All forms of carbon abatement which have a cost less than, or equal to, P1 should be undertaken.

This is fine in theory, but how easy is it for the generator to form credible expectations of future carbon prices? There are three main risks that might undermine the carbon price and deter the generator from making the low-carbon investment.

Potential risks to carbon price

The first concern that an investor might have is that there could be a political limit on the maximum acceptable carbon price that is not yet clear. Even if the overall cost to the economy of emission reductions is small, if marginal pricing is used to change behaviour, some customers may see large increases in price.

In the German power market, coal is the marginal form of generation and is setting prices. As coal generation has a high-carbon intensity, high EU ETS prices have a significant effect on wholesale, and ultimately retail, prices. Increases in German power prices over the last few years have sparked a political reaction. This may cause investors in the carbon market to worry about the political credibility of high carbon prices in the future.

Figure 2 below shows how such worries might be translated into our analysis. There may be a perception that there is a difference between the stated target for carbon abatement and the actual amount of abatement politicians, and ulimately consumers, are willing to pay for. Whereas, in theory, a fixed quantity of abatement is required, regardless of the price needed to achieve this (i.e. a vertical demand curve), in practice, the demand curve might be downward-sloping.

Figure 2: Potential impact of political limits on the carbon price
(source: Oxera)
Click here to enlarge image

If carbon abatement proves to be cheap, politicians might be happy to see even more done than the current formal targets. However, if it proves expensive, they might compromise and accept lower levels of abatement, perhaps by increasing the allocation of allowances for future periods to mitigate carbon price increases. In the example shown, the expected future price of carbon drops from P1 to P2, and the quantity of abatement delivered drops from Q1 to Q2. In this case the generator might still go ahead with the gas investment, but the returns are less attractive than they would otherwise have been.

A second concern for investors in the carbon market might be that special targeted instruments will be used to favour certain technologies, and that this could undermine the carbon price by allowing expensive forms of abatement to be delivered with low-carbon prices. The potential effect of this is shown in Figure 3.

Figure 3: Potential impact of targeted instruments on the carbon price
(source: Oxera)
Click here to enlarge image

In this example, certain forms of carbon abatement (such as renewable generation) might not be economic at the expected carbon price, but the government might want to encourage them regardless, perhaps because of beneficial effects on security of supply or diversity. Instead of increasing the abatement target to raise the carbon price, the government might use a targeted instrument to give assistance to renewable generation.

This effectively ensures that this abatement will happen regardless of the general price of carbon, thereby shifting part of the supply curve to the right. The danger for the fossil generator is that it may undermine the carbon price, making the investment in the gas station uneconomical, even though it is a cheaper form of abatement than the renewable generation.

Targeted instruments may be attractive for politicians because they allow some forms of carbon reductions to be achieved without needing a very high general carbon price. This might allow renewable generation to be encouraged without causing prices for steel, cement and air travel to rise excessively. The danger is that such instruments have the effect of reducing competition between different carbon abatement technologies, and might result in some cheaper forms of carbon reduction not being undertaken. It is also important to recognize that it is not only the existing targeted instruments that are significant, but also the perception that there may be more such schemes in the future.

Figure 4: Potential impact of widening the scope of the EU ETS
(source: Oxera)
Click here to enlarge image

The third risk facing investors is that the scope of the EU ETS may be changed in the future by adding more sectors and, possibly, more greenhouse gases (in addition to CO2). Widening the EU ETS to include airlines, shipping, the chemical sector, etc changes the future supply and demand curves in the market, as shown in Figure 4. The effect on price will depend on the relative balance of additional supply and demand for carbon abatement from the widening. In the example shown the widening results in an increase in the size of the market and the total amount of abatement required. However, it also flattens the supply curve for abatement. In this example, the overall effect is to reduce the carbon price from P1 to P2, reducing the attractiveness of the fossil generator’s low-carbon investment.

Minimizing the risks

The three risks outlined above are of a different nature to the general commercial risks in most markets, as they arise more explicitly from regulatory/political decisions. For this reason it is important that regulators and politicians recognize the risks and respond in two ways.

First, such risks can be minimized by ensuring that, where possible, firm commitments about market scope and scale are made, and that credibility is improved by ensuring that actions match words. Second, since regulators and politicians do need to retain some flexibility in such a new market, methods of allowing investors to hedge risks should be developed, including long-term carbon prices and the possibility of governments underwriting carbon price hedges, at least until the market matures.