A year that began with confidence-rattling fraud now heads towards a new emissions credit supply phase, updated green industry incentives and cautious hope for regional and global emissions targets.

The EU’s Emissions Trading System (ETS), the world’s first and biggest market-based carbon emissions-reduction mechanism, remains a leader in global efforts to incentivise industry and investors to fight climate change. But status and growth has had its drawbacks, perhaps none as stinging as the revelation of ETS fraud and the theft of European trading permits earlier this year, a problem that is still being sorted out even as trading has resumed.

A cautious recovery from the fraud also comes at a time when the ETS faces the structural challenges found in a maturing market. For one, participants want to roll out a new, third phase of credits in 2013, but the looming roll-out is causing supply-and-demand conditions that are holding back prices. Other factors include regulatory uncertainty and what many see as an over-allocation of trade-eligible credits from the European Commission (EC).

Aims of the ETS

The market's aim is to encourage companies to invest in green technologies and limit greenhouse gas emissions by putting a price on the rights to emit those gases, primarily carbon dioxide. Those rights, or credits, are then traded between parties that have excess credits and those who need more. The idea is thus: the higher the price, the stronger the incentive to reduce.

A global policy struggle is affecting market sentiment as well. Carbon market launch delays in other industrial majors, namely a politically divided US and Australia and an earthquake-shattered Japan, are undermining Europe’s accomplishments. Plus, uncertainty over whether the international Kyoto Protocol emissions reduction commitment will be renewed or a similar pact advanced at December meetings in Durban, South Africa, means that Europe’s market foresight is isolated, and its growth, too, may be limited without the help of the rest of the world and an international market linkage.

Shrinking carbon market

The value of the global carbon emissions market fell to $142bn in 2010 from $144bn in 2009, according to the World Bank. Its report cites continued uncertainty over the successor to Kyoto, a slower global economy’s impact in limiting emissions, and soured sentiment resulting from market fraud. Analysts said utilities – emitters that are major carbon market participants – have been forward-hedging less electricity output than previously expected.

For its part, the EU wants the Durban conference to bring into operation the UN climate agreements reached in Cancun last December. It also wants to take up key issues that stalled there, including the creation of sectoral emissions crediting mechanisms, and action to reduce aviation and shipping emissions. Emissions targets and trading solutions typically share much of the global discussions with advancements in alternative energy sources, including solar, nuclear, wind, as well complementary fuel sources such as natural gas.

Stig Schjolset, head of carbon, Europe, at Thomson Reuters Point Carbon, says he is “not very optimistic about a [Durban] international agreement that will move much beyond the Copenhagen talks… or at the least [expects] a much softer regime than Kyoto. It depends on [agreements] from the US and China.”

EU agenda

Still, outside of international talks, the EU presses on with its own agenda that largely supports market-based solutions in the long term.

“A potential move beyond the 2020 EU-wide 20% emission-reduction target has always been closely related to comparable commitments from other countries,” says Isabelle Curien, carbon market analyst at Deutsche Bank. “As such, a lack of advancement on climate policies and measures outside Europe is a hindrance to Europe committing to a more ambitious 2020 EU-wide emission-reduction target.”

She adds, however, that certain member states are clearly supporting a unilateral move and the EU parliament’s Environmental Committee recently expressed its support for a move to 30% (25% domestically). “It is possible we will see a proposal for a move beyond the 20% EU-wide emission-reduction target by the end of the year, not least because the EU parliament’s Environment Committee has called upon the EC to come with such a proposal by the end of the year.”

The EU’s proposed longer-term target calls for an 80% to 95% emissions cut by 2050. But recently, meeting those targets with a pro-market trading platform became a tougher sell. The benefits and costs of carbon trading are already politically charged topics because some critics consider it a tax, or too risky. ETS vulnerability in early 2011 certainly fuelled market detractors and punished legitimate participants.

Rebuilding confidence

The EC, which oversees the ETS, temporarily closed down the spot carbon market (which accounts for 20% of the total carbon market) for three months beginning in January after hackers stole allowances from accounts in the national carbon registries of the Czech Republic, Austria, Romania, Greece and elsewhere. The theft extended to more than 3 million EU Allowances (EUAs) between November and January. It caused chaos in the markets, as legitimate participants could not be certain whether they were trading with stolen permits. However, futures markets, which account for the bulk of trading, continued to operate.

The EC has proposed that member states boost the security of the current system, with plans including a planned single EU registry that is due to become operational next year. Other proposals include implementing a 24-hour delay on permit transfer between registry accounts; requiring at least two people to authorise a permit transfer; and tighter screening of potential past money laundering or tax fraud charges among applicants. If member states approve the measures, initial rule changes could be in effect by the final quarter of this year.

Much of the lingering uncertainty in the market at this point is largely linked to the "gaps in country-specific legal systems that would handle the return of stolen permits based on original title", says Henry Derwent, president and CEO of the International Emissions Trading Association (IETA). Some of these credits are still believed to be floating around in the market.

"Market participants are worried that, after the theft, the credits they bought weren't actually [others'] to sell – and that there could be a claim making its way though different systems of criminal law [around the EU]," says Mr Derwent.

The IETA and market participants believe the fraud investigation did not go far enough; the EC has confirmed its review but has not reported all the details. The trade group champions a full and transparent audit showing where the stolen allowances have gone, suggesting that such action will go a long way to restoring confidence. In early June, a Belgian court ruled against forcing the EC to publicly name companies in possession of stolen EU carbon permits, stating that the information was confidential and could only be given to law enforcement authorities.

“Fraud issues have been a wake-up call for European authorities and, although it was extremely negative news surrounding the market, I think people are getting more comfortable that the issues will be solved. It feels more like business as usual,” says Mr Schjolset.

Market flooded

Big-picture policy and security aside, carbon markets have some structural changes to work through. Carbon markets operate in part like other commodity hedging markets, although the major difference lies with the fixed supply in the government-mandated cap.

“In all other commodity markets, supply can adapt to changing demand, but the ETS cap has now been fixed to 2020. Moreover, about 95% of phase-two EUAs will be allocated for free,” says Deutsche Bank’s Ms Curien. “This means that even if the ETS will ultimately be short EUAs out to 2020 – and we estimate it will be – the future shortage will take a long time to be reflected in today’s price.”

In 2010, industrials started keeping a large part of their surplus in their registry accounts to cope with phase-three changes, which are set to run from 2013 to 2020. This meant they stopped buying, pushing down prices.

Others have pointed to an overly liberal qualification for credits. Earlier this year, the EC floated the idea of compensating the over-supply of EUAs over phase two by setting aside 500 million to 800 million EUAs from the phase-three cap.

This could restore the supply/demand balance envisaged when the phase-three cap was originally determined, according to Ms Curien. “The EC [has also] underlined the specific need to tighten the cap to compensate the over-supply of EUAs that should arise from additional energy-efficiency measures,” she says.

Price forecasts

Deutsche Bank projects the EUA price will reach €21 per ton by the end of the year, a forecast that takes into consideration its expected positive pricing impact from the German moratorium on nuclear power. Prices could could be boosted by about €6, should the set-aside by the EC reach the proposed target. The group currently projects a €28 price by 2018.

Yet another supply consideration is the NER300 (New Entrant Reserve) programme, a funding source for carbon-capture and storage plants and other businesses pursuing low-carbon technologies. Its first round is set to be monetised in the late autumn and will extend through to the middle of 2012.

“The NER300 and the early-auctioning procedures [the EC has stated that it will offer only 120 million phase-three EUAs under early-auctioning procedures] will together bring some 400 million phase-three EUAs to the market before the end of phase two. We think this is already well understood and that this extra supply should be absorbed by generators’ hedging of phase-three requirements,” says Ms Curien.

Mr Schjolset disagrees over valuation, saying supply issues mean he has kept his 2011 price target near the current €15 to €17 range, a level hit and held since the global economic slowing.

Potential regulatory changes add to the current uncertain fundamentals. A new Energy Services Directive targeted for late June will propose cutting energy consumption in buildings, vehicles and, more controversially, tighter controls for industry.

Industry may bristle at additional costs, but carbon market experts see this primarily as just an additional layer of regulation on top of the established ETS tool, potentially reducing demand for those tradeable permits already in circulation.

It is just one more supply – and demand – factor that carbon markets will work through in coming months as investors and industry await the Durban talks. Until then, the ongoing push-pull between the developed and developing world and the persistent debate over how best to solve emissions problems look set to continue.

Carbon price


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