Just hot air?

Guy Turner, director of climate change strategy at Enviros Consulting, looks at the European emissions trading scheme in practice

On 1 January, for the first time in history, industrial carbon dioxide emissions came under regulation through the introduction of the EU emissions trading scheme. The scheme has been introduced in an incredibly short time compared to the normal EU legislative process. And as with all European legislation, the final form is the result of extensive negotiations and compromises.

During its process through the Brussels policy machinery, changes were made to the sectors that should be included, access to credits generated outside Europe, the ability of governments to auction allowances, and – perhaps most importantly – the guidance that governments have to adhere to when allocating their emissions to their industries.

While there has been much debate on the technicalities of the scheme, there has been relatively little analysis of what these policy decisions will mean in terms of traded allowance prices and final impacts on business. Enviros’ analysis sheds light on some of these issues, and also assesses the effectiveness of the scheme in reducing emissions in Europe.

An increase in real terms

From an emissions point of view, we forecast that European industry will be allowed to increase annual carbon dioxide emissions by 5% during the first phase of the scheme (2005 to 2007) relative to its emissions in 2000. Additional allowances will also be available through reserves set aside for the construction of new plants. If all these reserve allowances are issued, then emissions would be permitted to increase by an additional 6%.

Stark contrast to commitments

In total, the first phase of the scheme could therefore allow emissions to increase by up to 11% relative to 2000 levels. These increases are in stark contrast to the commitments of European Member States under the Kyoto Protocol which require a collective reduction in emissions across all EU 15 countries of 8% by 2010 from 1990 levels. Modelling suggests that business as usual industrial CO2 emissions will increase by around 7% between 2000 to 2006, representing an average shortfall against the basic allocation of 2%, or 65m tonnes of carbon dioxide per year. This shortfall would stimulate a moderate degree of market activity and, based on analysis conducted in the summer, would see prices settle in the region of e5/tonne.

Implications of gas price rises

This result however, depends heavily on three key assumptions: expectations of future gas and coal prices; the availability of Clean Development Mechanism credits; and the extent to which governments release additional allowances through the New Entrant Reserves. Since the modelling was first undertaken, European gas prices have increased significantly, rising by 25%. This change could have important implications for allowance prices, potentially increasing them to e15-20/tonne (holding other assumptions constant). Acting in the opposite direction, if the growth in emissions is generated from new build plants and governments release all their reserve allowances to these new plants, this will reduce net demand and depress prices.

Supply of CDM credits

Finally, CDM projects provide access to low-cost credits that are eligible within the emissions trading scheme through what is known as the Linking Directive. The future supply of these credits is still uncertain, although it is being strongly influenced by the decisions of the CDM executive board. However, availability will materially affect the degree to which European businesses will need to engage in real emission reducing activities.

A key point is that if low allowance prices do prevail in the first phase of the scheme, there will be little incentive to make investments in the technologies that will be necessary to meet national commitments under the Kyoto Protocol. Even if allowances are tightened in Phase II of the scheme (2008-2012) and allowance prices rise significantly, it is doubtful that even this will provide the stimulus necessary for businesses to make the required investments.

This is principally due to the long asset lives of most capital assets in the energy sector (up to 30 years) compared to the relatively short period over which the EU ETS incentives will exist, and the perceived risks associated with tradable environmental instruments. Experience in the UK renewable sector, for example, shows that banks rarely give any weighting to the revenue from the sale of Renewables Obligation Certificates in their lending calculations for renewable energy projects.

This raises fundamental questions about the benefits of market-based instruments compared to fiscal and regulatory measures as a means of driving changes in business behaviour. The topic of optimal forms of regulation and incentives is hotly debated, but the key message is that for tradable allowance schemes to work and deliver the much lauded economic benefits, they need to be correctly structured and subject to minimal political interference.

Allocations must become tighter

Looking to Phase II of the scheme, assuming that countries will attempt to achieve their Kyoto targets, allocations will have to become much tighter. This has the potential to
significantly increase allowance prices over the period 2008-2012 as the demand for credits starts to exceed the supply of low-cost credits.

Low cost-credits can come from two principal sources: load factor switching in the power sector (turning gas-fired plants up and coal-fired plants down) and project-based credits such as the CDM. Load factor switching has a finite limit, based on the installed gas-fired generating capacity. Although CDM in theory offers an infinite supply, the complex and time-consuming administrative processes required to bring them to market has to date severely limited this source of supply.

A number of other factors will have important influences on future allowance prices. One factor will be government decisions on the purchasing of emissions at the international level. With Russia’s ratification of the Kyoto Protocol, European governments are effectively free to buy excess Russian allowances. Technically, the supply of Russian emissions could meet virtually all of Europe’s demand, resulting again in very lenient emission targets on European industry. Whether European governments will take this option will depend on three factors:

  • their willingness to be seen to buying their way out of their obligations – something they have been reluctant to do;
  • Russia’s willingness to sell these allowances – it may indeed decide not to sell all its surplus in order to raise prices; and
  • the stringency with which the European Commission enforces rules on allocations in the second phase of the EU emissions trading scheme.
  • Under the last option the Commission could, for example, require governments to impose targets on companies that are consistent with that country’s obligations under the Kyoto Protocol. This rule currently exists to guide allocations in the first phase, but has been given a distinctly lower priority than considerations to protect industrial competitiveness.

    An ironic outcome

    Ignoring the distraction of Russian hot air for the time being and assuming that European countries do intend to achieve their Kyoto obligations through a combination of internal reductions and purchases of CDM credits, Enviros’ base case analysis suggests that prices could potentially reach over e50t/CO2 in the latter half of Phase II if no new capital investment is made – which is a plausible scenario.

    Therefore the somewhat ironic outcome is that even with high allowance prices in Phase II – and measures to limit the purchase of hot air at the international level – this may not lead to material reductions in emissions across Europe. For this to happen, policy commitments to reducing CO2 need to be backed up with clear and unchanging legislation that sets out reduction targets for at least 15 years. This will allow a stable forward market to exist and against which investments in low carbon technologies can be financed.

    To date the experience of policy at the international and EU level has not been supportive of these conditions. The emissions trading scheme itself has been subject to extensive change to date and is likely to change further as plans for Phase II are drawn up. The more that decisions can be taken and left unaltered for a long period of time, the greater will be both the environmental and economic benefits.

    Action inspires action. Stay ahead of the curve with sustainability and energy newsletters from edie