The great carbon sell-off
May 11th, 2007 by Matthieu Glachant, Ecole des mines de ParisThe first phase of the EU Emission Trading Scheme which started in January 2005 will end in December 2007. Undoubtedly, the carbon price currently close to zero – €0.56 per ton of CO2 on May 3, 2007 – is the most striking fact of this period. And observers agree that it will remain at this level until next Christmas. How can this be explained? Does it imply that the first phase is a failure?
Before examining these questions, it is necessary to give a broader view on how prices have evolved during the whole period. There are three distinct phases. During the first 20 months, the CO2 price remained above €25 per ton. May 2006 saw a very sharp decrease when most countries officially reported their facilities had emitted less CO2 in 2005 than their allowances. This initiated a second period during which the price remained stable around €15 per ton until September 2006. Finally, the last period is marked by a price falling down to less than €1.
Three possible reasons are available to explain the collapse of carbon prices. First, the initial allocation of allowances may have been too generous – recall that a market price reveals the scarcity of the traded good –. Second, significant abatement efforts may have been made in 2005-2006 when the price was high, freeing too many allowances for later emissions. Third, abatement costs might have unexpectedly decreased since October 2006 – scarcity is also related to the costs borne to make allowances available for selling –. We review each of the arguments in turn.
The first thesis is made credible by a very peculiar feature of the EU Emission Trading Scheme (hereafter, ETS). While the market is European, allowances are allocated to the facilities at the member state level even though the Commission exerts ex post control over so-called National Allocations Plan (Hereafter, NAP). This obviously gives room to potential strategic behaviour. When designing NAPs, member states are certainly more prone to preserve the competitiveness of domestic firms than to sustain high ETS prices. However, there is a countervailing incentive. A country also needs to comply with the Kyoto-related target that caps its total emissions. As the ETS does not cover the whole economy – ETS sectors represents less than one half of total greenhouse gas emissions –, over-allocating allowances transfers the burden into non-ETS sectors (transport, housing, light industries and services).
Market statistics for 2005 (figures for 2006 are not yet available) clearly show that competitiveness issues have been taken into account by national governments in NAPs. Among the sectors covered by the ETS, the industrial sectors (e.g., pulp and paper, refineries, tiles, etc.) which are exposed to international competition were systematically “long”, meaning that verified emissions fell below their allowances. Conversely, the power and heat sectors which mostly operate on domestic markets were either short or less long than the others.
A close examination of how allocations have been negotiated also lends support to this thesis. A study by Buchner, Carraro and Ellerman (http://web.mit.edu/ceepr/www/2006-015.pdf) recalls that NAPs were essentially made in 2005 through bilateral discussions between national public authorities and business representatives. The involvement of NGOs was extremely limited and the EU Commission accepted the NAPs proposed by the member states without significant amendments. The time constraint was also very tight, thereby increasing the reliance of public authorities on information provided by the industrial sectors.
Consider next the second explanation. The price was sufficiently high in 2005 – around 25€ – to create incentives to make early abatement efforts. At that time, market participants did not know the level of aggregate emissions – this was disclosed in May 2006 – and one could imagine that they made too many efforts this year. However, a survey made by PointCarbon partly contradicts this story. Only 15% of the respondents answered that the introduction of carbon trading had initiated internal abatement projects in 2005. Note that the percentage is 65% for abatement projects in 2006. Verification data for 2006 will show whether this is reflected by aggregate emissions last year.
What about the last explanation concerning abatement costs? Three factors suggest that the power sector has unexpectedly reduced its emissions at low cost since October 2006. To begin with, temperatures in Europe have been exceptionally high during the winter 2006-2007, thereby reducing electricity consumption. Above normal precipitation in Scandinavia has also played a role by promoting hydro plants which do not emit any CO2. Finally, the price of natural gas has fallen significantly as compared to coal, particularly in the U.K. where it led to a substitution of coal-fired by gas-fired electricity. These factors cannot but have influenced ETS prices. But it remains doubtful that they could have led to a division of the price by 30 in the last five months!
We believe that over-allocation of allowances has been the main driver even though thorough analysis is lacking to disentangle the different effects. Does this mean that the first phase is a failure? Our answer is negative. From the outset, the 2005-2007 phase was viewed as an experiment preparing the establishment of a mature market in Phase II. Accordingly, Phase I would be a major failure if what had been learnt did not influence Phase II.
In this regards, one could be rather optimistic. All parties have clearly learnt much, in particular about the true marginal cost of abating CO2. As a result, the elaboration of the NAPs is following a very different course. So far, the Commission has made decisions on 19 NAPs. In comparison with the initial proposals made by the member states, the decisions require a very significant 9.4% decrease of the cap proposed. The low prices observed for five months have clearly helped Stavros Dimas, the Commissioner for Environment, to improve his bargaining position.
Market participants have now a rather clear view on Phase II’s NAPs. Their information on marginal abatement cost is also far more reliable than three years ago. Based on this, they are currently exchanging Phase II forward contracts for December 2008 at about €16. Much more than zero.
Matthieu Glachant and Antoine Dechezleprêtre
April 7th, 2008 at 4:34 pm
At the beginning of Phase II 2008-2012, a question could be arisen: at the end of 2012 will we face the same problems met in the Phase I?
I mean, I can accept that the Phase I could have been an experimenting period at large scale of a policy system based on “cap&trade” of CO2 commodities necessary to set a more efficient market in following years, but what have we learnt in the last 3 years? Or what kind of issues can we expect to meet in the Phase II?
First of all, it is evident that in the first period the over-allowances was the main factor dropping the CO2 price under € 1, but now, even if the allowances in 2008-2012 have been reduced, there are some new ways to get EU-ETS targets. In fact in 2006 European Commission introduced Linking Directive which lets participating actors to respect their own “caps” using certificates issued from flexible mechanisms of Kyoto Protocol, which create CERs certificates (Certified Emissions Reduction). In fact by these projects aiming to reduce CO2, companies can join their targets more easily. So doing, it will be easier to replace natural gas by coal (less expensive). And the permitted percentage of CERs certificates in Member States allowances can be up to 20-30% which is quite relevant.
But anyone could state that reducing CO2 emissions in Europe or China or India, it is not important, the main aim is to decrease it! But some experts declare that a large part of approved Kyoto projects show a “not verified additionality” which undermines the efficacy of EU-ETS with CERs interaction.
Secondly, there might be more effective system than “cap&trade” as, for example, “cap&auction” which is based on the sell by auction of CO2 permits instead of trade. In the Phase II the permits ratio, which can be auctioned, will be up to 10% instead of 5% as in the Phase I, but it is always supposed to be low ratio. In theory, the “cap&auction” system would be more efficient, would permit to avoid advantages only for participating sectors versus not-participating ones, and would keep prices more stable. But, companies complain that this system would create more disadvantages for their competitiveness in global market. We could solve the issue fixing a sort of “Green Tax” or “Carbon Tax” on goods coming from non-participating actors and in function of their carbon content, but companies could underline the risk for a world trade tension. So this shows clearly again, if necessary, the need of a global agreement about CO2 trading scheme which could include not only a group of States as foreseen in Kyoto Protocol, but all those countries which have a relevant impact on the environment with their CO2 emissions.
As consequence of what mentioned above, I have some doubts about the fact that EU-ETS, as so structured, will stimulate participating actors to invest in R&D to develop “no emissions” technologies able to reduce the CO2 emissions.