Emissions trading: will it work?

January 1st 2005 sees the beginning of the European Union’s Emissions Trading Scheme (EUETS) under which up to 15,000 energy intensive ‘installations’ will trade carbon dioxide emissions allowances within limits set by the EU Commission. But how will the EUETS actually work? Lionel Fretz, head of Financial Products for the specialist merchant banking firm Climate Change Capital, gives his view.

Emissions trading does not in itself reduce emissions, as it is an economic and not an environmental tool. However, trading emissions should allow emission reductions to take place relatively cheaply. This will satisfy business, but environmentalists will only be satisfied if actual real emission reductions are mandated through the setting of the caps.

Setting a cap that imposes an obligation to reduce emissions – or ensuring the market is short – would appear to be the only way to ensure trades take place and emissions are cut. Market logic suggests that the environmental policy objectives can, and will, only be achieved by creating a market that has scarcity. Without this, from an environmental policy perspective, there is not much point in having a trading scheme as no reductions would take place.

One only has to look at the prices in the UK Emissions Trading scheme and the Chicago Climate Exchange to realise that the only companies to sign up to voluntary schemes are those who either know they will meet the targets, or those that have a surplus to sell. The net result is a price that disincentivises early action and undermines the environmental policy objective.

However, the absence of mandatory reductions does not necessarily mean that the market will not work. For a start, long markets do not always know that they are long due to a lack of clear information and natural variability in weather, transmission capacity, and fuel prices; all of which are the normal market drivers.

Market multiples or “churn”

It is generally the case that in traded commodity markets the traded volume is a multiple of the physical consumption, known as the “churn”. The UK Gas market trades at between ten and twenty times consumption, the churn in the UK power market is around five times, and the churn is twice in the USA SO2 market. There is no reason to think that the EU market could not trade to these sorts of volumes in due course. This of course becomes significant in the second phase when allocations are expected to be tighter. Throw in cross commodity trading, the interest of hedge funds and banks in the sector, the ability of fuel suppliers to compete to supply fuel with allowances to gain competitive advantage, and it is clear that this market could be of a very significant size.

Traders wanted!

Of course the emissions market will not thrive without traders willing to trade. You can have all the brokers you like, but if there are insufficient traders, there will be less liquidity. The flexibility that a trading scheme brings is worthless if there is no liquidity or depth, and therefore participants cannot trade in the volumes that they need. The EU market has a strange structure – over 90% of the installations with allocations have less than a million allowances, and it is generally considered that the industrial sectors are long. The power generation sector, 2% of companies with around 50% of the traded sectors emissions, will manage carbon price risks actively. This is because carbon is now part of the cost of production and they would be unwise to generate power, and have profits eroded by subsequent movements in the value of allowances. As a result, a two-tiered market may well emerge, with energy traders, banks, oil and gas and steel companies trading actively, and the rest for compliance, which some may do more frequently than others.

Regulatory certainty

Like all markets, success is to a large part dependent on regulatory infrastructure and policy certainty. Already the UK has witnessed its market in Renewable Obligation Certificates, which had similar though more modest objectives to the EU’s emissions trading market, practically grind to a halt. Despite government statements about policy, and attempts to reassure participants, the UK’s market in Renewable Obligation Certificates has not flourished because the market and the banks do not believe it will. This problem of market confidence has also been compounded by private sector default causing a loss of confidence and a poor market design which has resulted, for example, in a ROC redeemed in Scotland being worth more than one redeemed in England. Conversely, the EU scheme appears to have many of the features needed, although the interpretation of allowances as property rights ideally should be harmonised. Registries have been demonstrated to work, but more work needs to be done for the market to progress from over the counter to having a proper settlement system, similar to those used in securities markets.

Inherent flaws?

Although market confidence should be high due to well-established regulatory structures and the Commission’s objective of establishing a short market, the EU scheme does have some inherent flaws. France and possibly Poland aside, the fact that allowances cannot be banked into the second phase may lead to a significantly increased risk of unnecessary volatility in the market, and of resultant market instability.

As the trading period nears its end, or possibly well before, it will be clear that the market is either long or short. If, as is more likely, the market is long then with no banking, participants will be faced with the option to “use it or lose it” and can be expected to dump their allowances on the market, with the attendant possibility of a price collapse. This could make for a much greater price differential between phases one and two, which industry will strongly resist.

The converse could also occur in a short market, and the political consequences of very high prices for companies to comply would also be damaging. In addition, the ability to borrow (allocations for the following year are received and can be used before the compliance date for the first year) could mean that the majority of participants can simply rest on their laurels until 2007.

However, when faced with the potential volatility indicated above, it would be very unwise for a company to be exposed to this risk.

There has also been much debate about flaws inherent in National Allocation Plans, many of which should be ironed-out by the Commission and may prove to be unfounded in any case. For example, although the new UK NAP is 1% more generous than it was in January, causing criticism and prompting worries about a flat market, UK emissions rose by 3% last year suggesting that trading should, in fact, be brisk.

So, will the market succeed and will emission be cut?

Market liquidity, sufficient traders and solid regulation will not alone ensure the EU’s emissions market will get the kick-start it needs. In practice a number of other fundamentals will drive trading such as weather patterns, economic growth, transmission constraints and outage levels, affecting prices on a daily and seasonal basis. For all these reasons, and possibly more, there is a high level of confidence surrounding the nascent EU emissions market and its ability to function well.

Whether this well-functioning market will result in any significant emission reductions, however, will of course always remain in the hands of governments.

Climate Change Capital

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