ETS seeks carbon credibility

The European Commission has released figures for the first year of Europe’s carbon trading scheme. The data indicates that this fledgling market is not quite ready to take flight.

Siàƒ¢n Green

Carbon prices fell sharply in May after the European Commission released the first verified data for installations participating in the European Union’s Emission Trading Scheme (ETS). The market’s reaction to the report – which showed an overall excess of allowances in the market – was severe and followed earlier price falls in late April when five EU states released emissions data early.

The European Commission’s registry shows that the 21 Member States that have completed the reporting process emitted 67.5m t less CO2 than they were allocated in the 2005 trading period. This means that a 3.4 per cent surplus of emission allowances were issued, and caused prices to fall from around €13/t CO2 to €8/t CO2 in one day.

The EU emissions trading market had already witnessed strong volatility in the preceeding weeks in anticipation of this data. In mid-April prices fell from around €30/t CO2 to €19/t CO2 within the space of a week following the release of data by the Czech Republic, Estonia, France, the Netherlands and Sweden showing an excess of allowances.

Countries with a surplus of allowances include Germany (26m t CO2), France (19.1m t), Czech Republic (15.8m t), Finland (11.5m t) and Denmark (10.8m t). Some states emitted more than their allowances, including the UK (31m t CO2), Spain (9.1m t), Italy (5.7m t), Ireland (3.1m t) and Austria (1m t).

The release of this data is an important milestone in the ETS, which is in its infancy. The scheme is the central pillar of the European Commission’s plan to meet its Kyoto commitments. It covers around 11 000 installations accounting for nearly half of the region’s CO2 emissions.

The importance of the ETS may therefore go some way to explaining the market’s reaction to the data. However, the level of surplus allowances has raised questions as to the robustness of the market and the allocation of emission allowances in the National Allocation Plans (NAPs) for Phase 1, running from 2005-2007. The debate is particularly topical as Member States are now in the process of preparing NAPs for Phase 2, which runs from 2008 to 2012, and which coincides with the Kyoto Protocol’s compliance period.

Volatility in the carbon market: daily closing prices for CO2
Click here to enlarge image

A number of environmental groups have expressed concern that Member States have granted far too generous emission allowances for Phase 1 and have called on the European Commission to make sure that the NAPs for Phase 2 are more stringent.

“The market can only become functional and create incentives for cleaner industries if the amount of allowances is set at a level which is in line with the Kyoto targets,” said Stephen Singer of WWF’s European Climate and Energy Unit. “A loss of credibility of the EU ETS will also undermine the credibility of the EU in the negotiations for new Kyoto targets after 2012.”

In the UK, the Corporate Leaders Group on Climate Change has called on the government to toughen up emissions targets in order to stimulate investment in low carbon technology. It has also advocated broadening the scheme to include sectors such as aviation, and the provision of incentives for countries outside the EU to participate.

One of the biggest criticisms of the scheme has been the fact that installations are given the majority of their allowances free of charge, and that if they have surplus allowances to sell, they will be able to profit from the scheme. The power sector, in particular, has gained from this and there have been calls for utilities’ carbon trading ‘windfalls’ to be taxed, and for a greater proportion of allowances to be auctioned rather than given away.

Due to the way that allowances are allocated, power utilities are natural ‘shorts’, i.e. they are continuously trading and closing their positions on a daily basis, says Henrik Hasselknippe, senior analyst with Point Carbon. This means that they are the main drivers of the price of carbon, in contrast to the industrial sector, which has an overall surplus of emissions and which tends to hold on to allowances in order to ensure compliance.

But in addition to driving the price of carbon, utilities have been able to pass the cost of allowances through to the consumer. “They receive 95 per cent of their allowances for free, so they have to buy some, but they get this cost back several fold,” says Hasselknippe. Industrial end-users have been particularly critical of this practise, but ironically they would have greater influence over carbon prices, and therefore the cost of electricity, if they traded more dynamically.

This does not point to an imbalance in the market, maintains Hasselknippe, as the skewed allocation of allowances between the two sectors was intended. Policymakers realised that reducing emissions from the power and heat sector would be easier than from the industrial sector; in addition, governments do not want their industrial sectors – which face tough international competition – handicapped by stringent emissions targets. The industrial sector therefore has a surplus of allowances. “So it’s more of an imbalance in behaviour and the approach to trading,” notes Hasselknippe.

There is not likely to be any change in the structure of the ETS in this first phase, but the European Commission will have to take on board lessons from this crucial first year to ensure that the market can help the region meet its Kyoto goals. The generous allocations of Phase 1 will not be repeated in Phase 2, and an increased level of auctioning is also likely, says Hasselknippe.

“When the Commission assesses NAPs for Phase 2, it will certainly look at whether Member State can achieve their Kyoto targets,” says Hasselknippe. “Member States will also have to specify their allocations for each sector and their plans for reducing emissions from the transport sector.”

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