Will Emission Trading survive the first period?.......

By Axel Posthumus, CEO New Values

‘Will Emission Trading survive the first period?’ was the theme of the 2007 New Values Master Class in February of this year. Speakers from McKinsey, Barclays, the European Commission and KNMI (the Royal Dutch National Weather Service) presented their views on this topic.

 (Source:New Values)

Such an awkward question, you may think. Of course, it will survive. Just look at the trading volumes of 2006 and look at the second phase prices and volumes which are currently traded. The trading mechanism is working and for the first time in history pollution has been given a price. The only conclusion to be drawn is that there is a market and emission trading is here to stay.

A result Europe can be proud of indeed and the correct conclusion; this opinion was seconded by most of the speakers at the Master Class. We do have to ask ourselves however if emission trading is realising the reason it was set up for: reducing carbon emissions and combating climate change.

My proposition is that emission trading itself can be seen as successful, but that it did not reach the industry which was the target yet. The medium sized and smaller industries have leaned back and waited, which is why the EU ETS cannot be labelled as successful yet.

Yes, the volumes traded have been immense, but on close expection there are a couple of issues which ask for our attention.

First of all, most of the trading occurred away from the open and visible market and only a small number of players got involved. According to our calculations, in 2006 around16% (370 Mton) of the allocated allowances in Europe (2.273 Mton) were traded over exchanges, of which only 2% (49 Mton) was traded as spot contracts and the remaining 14% (321 Mton) were traded as forward contracts. A veelheid was traded OTC and nobody knows the exact numbers.

Apart from this we learned that while talking to our target group, the industry, the majority of these companies which received allocations, did not do anything yet. And why should they? There was no real need to become active since they had sufficient rights to play safe concerning their emission balance. After the drop in prices in May 2006, the commercial incentive fell away also. In order to be able to talk about a successful mechanism, we also need the remaining majority of the industry to be active and involved.

Further research reveals that the relatively few installations which were active were the utilities who benefited immensely from this new market and to some extent even took advantage of it. Utilities received the majority of the allocated rights, and were over-allocated (which means they had more than enough rights to cover their needs) and (like everyone else) they received the rights for free. To a large extent, they created the market up until now, defined a ‘transparent’ price to the rights and determined the value of the rights. Transparent is in this case a disputable concept, because when only a small proportion of the companies trade, they can strongly influence the seemingly transparent price. And last but certainly not least the utilities did add the cost of carbon to electricity prices.

Still, I do strongly believe that carbon trading is a good instrument to solve the environmental problem. But to realise this they have to become scarce and all industries have to start being active, which will automatically balance the current dominance of the utilities. Also, the market has to mature and more volume will have to be traded in a real transparent way.

In order to overcome these flaws in the system the allocations must be reduced considerably in the second period and there should not be the opportunity to compensate this shortage entirely with importing CERs or ERUs.

On the market, I regularly hear a sentiment that ‘if we do not have access to sufficient emission rights from outside the EU ETS, we will not be able to solve the environmental problem and make emissions trading work’. I believe this reasoning is not contributing to the solution. We should first and also be able to reduce carbon pollution ourselves and not depend fully on other countries like China who have not signed the Kyoto protocol and are looking to make money out of it. So, utilities and industries should be supported to focus on lowering their carbon pollution and use European Allowances as an instrument to support the business case of projects to do so. Only then, the price of European Allowances start to reflect the real price of carbon. CDM and JI projects can at that point be considered as alternatives, if a business case cannot be implemented in Europe and not as just another instrument utilities use in their advanced position to buy and set up projects abroad and sell the credits to industries who are not yet active or trade them among each other.

If scarcity is created and imports capped, then the 80% of industries who are not active will also have to become involved. Auctioning (part of) the allocations could even contribute to this, even though it creates other problems to solve. This, however, will hurt and it may even get some industries into problems. The European Commission is currently moving in this direction, but the question is if governments are willing to accept this. In the National Inventory Report 2006 (NMP) the Dutch Government completely focuses on reaching environmental targets by buying CERs or ERUs. They did not take into account, nor did they expect the trading mechanism to have a positive effect. This is may be good for the conscience of some politicians but certainly not good for the environment in the Netherlands or Europe. If this is the direction then sooner rather than later the EU ETS will be under pressure.

So from our side, we really hope the European Commission will continue their strong stance to create scarcity and cap CER/ERU imports (and maybe even introduce auctioning), because only active participation of allparties involved will make the EU ETS credible.

Axel Posthumus,CEO