The volume of carbon trading has fallen heavily since the 2009 Copenhagen agreement, and market participants are advocating radical steps to revive the market.
Carbon trading may yet have its day, but dawn seems a long way off. The market has had a truly dismal year and, as permit prices languish and carbon offset projects dry up, many banks are reducing or eliminating their commitment to it.
The global carbon market was worth $142bn in 2010, as reported by the World Bank. The following year it was down to $95bn, according to Bloomberg New Energy Finance (BNEF), and in 2012 it slumped to $61bn. The market’s story is inseparable from the story of the UN Framework Convention on Climate Change (UNFCCC), which has its own special shorthand – the names of the cities where the UNFCCC crowd have staged their annual meetings. They include Bali, Cancún, Durban and Doha, but anyone wishing to keep it brief need only mention Kyoto (1997) and Copenhagen (2009). The carbon market was effectively born in the former and began to unravel in the latter.
That, of course, is only shorthand and the story is not entirely that simple. But the current struggles of the market can be traced back to Copenhagen. The Kyoto Protocol laid down the first phase of greenhouse gas reduction targets for developed countries, from 2008 to 2012. Targets beyond 2012 were supposed to be agreed at Copenhagen – but were not. Given a bountiful supply of carbon permits, the lack of binding targets after 2012 has done nothing for demand.
From Kyoto with love
The Kyoto agreement entered into force in 2005, with binding targets for the signatories which had to be met through national measures or via three market-based mechanisms. The first and most important is international emissions trading, as part of a cap-and-trade regime. Country allowances (‘assigned amounts’) are apportioned to individual energy and industrial emitters. Companies that produce fewer emissions can bank their surplus allowances for future use or sell them to those that have exceeded their targets. Each trading unit, known as an ‘assigned amount unit’ (AAU), represents 1 metric tonne of carbon dioxide and the price at which it changes hands is otherwise known as the carbon price. Clearly, the higher the price, the higher the incentive to reduce emissions.
The world’s largest cap-and-trade programme by far, accounting for nearly 90% of world activity, is the EU’s Emissions Trading Scheme (ETS). Last year it traded record volumes of some 10 billion tonnes of carbon, though at historically low prices. Its version of the AAU trades as the EU Allowance (EUA). Another mechanism is the Clean Development Mechanism (CDM), which allows developed countries with Kyoto commitments to earn carbon credits by building emission-reduction projects in developing countries. CDM credits are known as certified emission reductions (CER) and can be used to meet a limited percentage of assigned amount targets.
The UNFCCC’s idea was that CDMs should simultaneously promote emission reductions and sustainable development, while giving industrialised countries some flexibility in how they meet their reduction targets. It was thinking of, say, rural solar electrification projects. However, the scheme attracted criticism for funding fraudulent projects that needlessly produced greenhouse gases so as to get paid to eliminate them. There have also been objections to qualifying projects such as hydroelectric dams that would have been built anyway, regardless of the CDM.
The third mechanism, a variant of the CDM, is Joint Implementation (JI), which allows developed countries to benefit from offset projects in other developed countries. The resulting carbon credits are traded as emission reduction units (ERUs). JI schemes typically involve the more advanced transition economies such as Russia and Ukraine, and ERUs are the least traded of the three carbon credit types. IntercontinentalExchange, A network of regulated exchanges and clearing houses for financial and commodity markets, which has more than 90% of the secondary European carbon market, reported average daily volumes in tonnes for September 2013 of 27.7 million EUAs, 1.5 million CERs and 483,000 ERUs.
Changing circumstances
It is all the sort of complex, fiddly contraption that could only have been designed by a large committee – or two of them. When those committees are the UN and the EU, it means that when things go wrong or circumstances change, modifying the contraption can take a very long time indeed. And of course things have gone wrong and circumstances have changed rather dramatically.
When the ETS was designed and allowances were being calculated, the world’s economy was booming. Today the allowances remain fixed while the European economy stutters. The economic slowdown and consequent fall in output has reduced carbon emissions from industry (although not from energy producers, who have been burning more cheap coal instead of gas). So demand for carbon credits is down.
The same is not true of supply. During phase one of ETS (2005-07) permits were allocated for free. Because the EU was keen to bring doubters such as Poland on board, and to discourage ‘carbon leakage’ – emitters moving their factories outside Europe to escape regulation – the hand-outs erred on the side of generosity. Such was the generosity that in 2012 alone the surplus of EUAs more than doubled to 2 billion, according to the European Commission (EC).
Indeed, heavy industry was given permits for more carbon than it actually emitted. While emissions totalled 9.7 billion tonnes from 2008 to 2012, heavy industries received free credits for 9.9 billion tonnes. According to the EC report compiled by BNEF, EU steelmakers received 1.15 billion free permits, but emitted only 729 million tonnes. Ceramics manufacturers belched out a mere 49 million tonnes of carbon, while benefiting from 94 million free credits.
Price crash
The effect of all this on prices has not come as a surprise. From a peak of more than €30 per tonne in 2008, the price ended 2012 at less than €5. It went lower still as the market realised that the flow of free permits onto the market might not abate. ETS phase two (2008-12) saw the introduction of permit auctions, while phase three (2013-20) cuts down further on freebies. From now on, western European utilities will have to buy all their permits, for example, though eastern European generators must pay for only 30% of them, rising to 100% in 2020.
In mid-2012, European climate action commissioner Connie Hedegaard put forward a proposal to hold back between 400 million and 1.2 billion permits from auction over the following three years. They would not be scrapped, merely postponed in an exercise known as ‘backloading’. "On backloading, this is a no brainer," Ms Hedegaard said at the time. "This is an overflooded market. Would it be wise to continue to overflood it?"
Much of European industry, however, likes cheap carbon. Many manufacturers made useful profits by selling their free but unnecessary credits during the downturn to power companies that continued to need them. Now they claim that, in the present climate, the carbon market is a cost burden which threatens to make them uncompetitive. BusinessEurope, the EU’s federation of industry federations, argues that at least some of the excess supply was caused by plant closures, and that demand will recover along with the European economy and industrial output.
Enough members of the European Parliament were swayed by the industry’s argument to vote down the backloading proposal in January 2013. Carbon prices promptly fell 40% to their all-time low of €2.81 per tonne. Some commentators said that EAUs had become 'worthless'. It got worse in April, when MEPs again rejected a plan for temporary withdrawal of 900 million permits. Prices touched €2.63.
One carbon analyst, Stig Schjølset of Thomson Reuters Point Carbon, describes the ETS as “politically dead”. “We do not envisage prices rising much above the current €3 mark and they may well drop lower,” he says. “Certainly this vote makes the EU ETS irrelevant as an emissions reduction tool for many years to come.”
Part of the reason for this stalemate was that Germany was divided on the issue. Backloading was opposed by economics minister Philip Rösler, chairman of the business-oriented Free Democratic Party (FDP), then still a partner in Germany’s ruling coalition. It was supported by environment minister Peter Altmaier of the Christian Democratic Union, with chancellor Angela Merkel sitting on the sidelines.
Thanks not least to Ms Hedegaard’s unrelenting efforts, the European Parliament finally approved the 900 million permit backloading plan in December. Since the FDP failed to shine in Germany’s September elections, its coalition slot has been taken by the SDP, which favours intervention in Europe’s carbon market. That is cause for hope among campaigners for deeper reform.
Tackling the surplus
Reform advocates insist that something more radical than temporary backloading is required. The EC accepts that if nothing is done, the structural surplus of 2bn allowances will persist for most of phase three. It has identified a number of possible options for tackling the surplus. One is the permanent cancellation of some of phase three’s auction quota. Another is to increase the EU’s greenhouse gas emissions target for 2020 from 20% to 30% below 1990 levels. Extending the ETS to other, less cyclical sectors has been suggested, perhaps bringing fuel consumption into the scheme.
Other possibilities include setting a price floor in permit auctions – as the UK has done since April – or using a price management reserve. This would absorb or release auction permits to drive prices up or down. One variant of this is proposed by BNEF chief executive Michael Liebreich. He suggests managing carbon credits as a currency is managed. “That means creating an independent Carbon Central Bank, with powers to undertake open market operations and to create and cancel credits,” he says. “You charge the chief...with maintaining a certain price – say, €20 for the next five years – plus or minus a fixed trading range.”
There is an east-west divide on the subject of intervention. “Western European member states are pushing to get the system tightened,” says Trevor Sikorski, head of natural gas, coal and carbon at Energy Aspects, a research consultancy. “The more central European members are reluctant to see change. With their heavy industrial base, they say ‘the higher the carbon price, the worse for us. We’re meeting our 2020 targets so why change?’.”
Poland is the cheerleader for such opposition, so intervention needs German backing if it is to have any chance of success. “Very little passes the European Parliament without German support,” says Mr Sikorski. “If something is opposed by Germany as well as Poland, it won’t happen.”
General malaise
All this is of concern only to Europe. But if the EU ETS is on its knees right now, the international CDM carbon trading market appears to be stone dead. It has not been insignificant, prompting more than 4500 projects in 75 countries, helping to cut 1 billion tonnes of carbon emissions and generating more than $200bn of investment in developing countries. However, the market has depended on having somewhere to trade CER credits – thank you, EU ETS.
The use of CERs in European compliance has restrictions, so the CER price has always trailed that of EUAs, and they have been similarly affected by weaker industrial demand. More damagingly for demand, the EU placed a cap on the number of CERs it would accept to 2020, and that cap has been all but reached. Having traded at about €20 per tonne in 2008, CERs have recently dipped below 50 cents. ERUs are trading below 30 cents for similar reasons. New offset projects have dwindled accordingly.
In the absence of a binding agreement on post-2012 emission targets at Copenhagen, there is no post-2012 carbon demand to reinvigorate the market for offsets. The vision was for a global network of carbon markets trading a fungible product, but so far the only schemes of any size are in Australia and California. While the Australian market is scheduled to link with EU ETS in 2015, the country’s new government has promised to ditch carbon trading altogether in favour of ‘national measures’ to meet its targets. In the Californian market, only North American projects qualify for offset credits. A pilot market in Shenzen (the first of seven in different Chinese cities) is limited to Chinese offsets.
Banking retreat
Banks have seen the writing on the CDM wall for some time and generally stood down their related activities. JPMorgan sold its emissions offset development unit, ClimateCare, as far back as 2011, having acquired it only three years earlier. And there has been a general cooling on carbon over a broader front. Deutsche Bank closed down its carbon trading operations earlier this year, a decision no doubt accelerated by police inquiries into an alleged tax evasion scheme involving carbon permits. While most banks retain a carbon trader or two, those who have palpably reduced their presence include Barclays and Morgan Stanley.
Unlike the UN’s offset mechanisms, EU ETS is certain to survive in form, if not in vigour. No matter where the price of permits sits, power generators and steel companies will still need them to comply with the regulations. “The market is growing,” says George Waldburg-Wolfegg, director emissions markets at ICE Futures Europe. “Hedging forward is moving further out – two years is now normal. Three years is exceptional but it is happening.”
It is prices that need to recover, if this politically inspired scheme is to retain any political or market significance. When the European economy starts to pick itself up off the floor, carbon prices should do likewise. Reform of the system would help. “Most of the hope for prices lies in some form of intervention,” agrees Mr Sikorski.
