Carbon trading

The global carbon market appears to be in trouble. In the European Union's Emissions Trading System (ETS), the world's most advanced market, carbon prices are too low to stimulate investment in low-carbon technology. The recession is driving CO₂ output below the EU level cap, placing further downward pressure on price. Writing before the United Nations Climate Change Conference in Copenhagen, Giles Drury explains the importance of a global agreement being reached and its effect on carbon trading.

World leaders are gathering in Copenhagen in December in an attempt to agree a new global framework for tackling climate change. The first commitment period of the Kyoto Protocol, which was initially adopted in December 1997 and came into force in February 2005, expires at the end of December 2012. Under the Protocol, industrialized countries agreed to reduce their collective greenhouse gas emissions by 5.2 percent by this date. The stakes at Copenhagen are high: without a further agreement, there will be no international framework for pursuing further greenhouse gas reductions.

One of the key mechanisms endorsed by Kyoto, and one which will play a key role in any successor agreement, is emissions trading. This is a cap-and-trade mechanism. Major energy users and emitters of CO₂ receive permits allowing a specified amount of emissions. Those who reduce their emissions below their cap can sell surplus permits on a recognized exchange to those who fall short of the target. By careful limitation of the total number of permits issued, the market price for permits is driven up to a point where further investment in measures to reduce emissions is economic.

The world's most advanced CO₂ emissions trading system began operation in 2005 in the European Union, before the Kyoto Protocol came into force. The EU ETS covers more than 10,000 major installations in heavy industry and energy generation. Each of these installations is allocated emissions allowances (one permit is equivalent to the emission of one tonne of CO₂). Surplus or additional allowances may be sold or bought over the counter or traded on the spot market through, for example, the European Climate Exchange (ECX). An initial phase (2005-07) was followed by Phase II, which was deliberately scheduled to conclude in 2012 at the same point as the Kyoto first period. But while the mechanism of the EU ETS has proved the practicality of the system, its actual achievements have been limited and some commentators argue that it is fatally flawed.

Phase I of the EU ETS was explicitly intended as a trial phase ('learning by doing'), to prove the concept and test-drive the trading and accounting mechanisms. Nevertheless, the fact that permit allocations, which were given free to installations covered, were in aggregate higher than total emissions before the scheme began, made the notion of a 'cap' academic and damaged its credibility. Despite this, a market price for carbon was established, since some companies needed to buy permits. Unfortunately, this allowed some energy producers to increase prices to consumers on the basis that they were passing on the costs of carbon permits. Some critics complained about windfall profits.

The underlying weakness of the Phase I market caused dramatic fluctuations in the spot price for permits, which rose rapidly to begin with, to about €30 per tonne, then collapsed in 2006. By the end of 2007, the carbon price was effectively zero. The ETS appeared to be neither limiting total emissions - they actually increased over the period - nor encouraging rational economic investment in emissions control technology.

During Phase II, many of these criticisms have begun to be addressed, principally by tightening the aggregate level of the cap. National allocations are now set at an average of 6.5 percent below 2005 levels, in line with what the EU as a whole, and individual member states, need to achieve to meet their Kyoto commitments. Unfortunately, the economic crisis has severely disrupted the operation of the system. The recession has resulted in major reductions in output in energy-intensive sectors. CO2 emissions have fallen naturally with reduced industrial activity. In addition, oil prices fell dramatically, roughly halving between mid-2008 and mid-2009, as the global slowdown bit - although recently prices have rallied and many commentators predict a surge in commodity prices as recovery kicks in over the coming years. As a result, the carbon price has fallen from €22-24 per tonne during 2008 to around €14 during 2009.

The UK's Committee on Climate Change, chaired by Lord Turner, concluded in October 2009 that:

"We cannot . be confident that the EU ETS will deliver the required low-carbon investments for decarbonization of the traded sector through the 2020s. Given this risk, the Committee recommends that a range of options for intervention in carbon and electricity markets should be seriously considered."¹

The EU ETS has, then, been a qualified failure in practice. Beyond this, critics argue that the concept has more basic flaws. One is that companies may in effect generate additional credits by investing in emission-saving projects undertaken in third countries under Kyoto's Joint Implementation and Clean Development Mechanisms (JI/CDM). The emission-control benefits of such initiatives are notoriously difficult to account for. A more fundamental problem is that without a truly global framework, emissions trading schemes simply result in 'carbon leakage': heavy CO₂ emitting activities are shifted to poorer, emerging countries which lack such schemes, with zero net impact on total global emissions.

Many of these defects can be remedied. One of the most important aims of Copenhagen is to establish a global agreement which will limit carbon leakage. The EU is proposing progressive tightening of the overall ETS cap, a much higher proportion of permits to be auctioned rather than allocated free and tighter restrictions on the use of JI/CDM credits. But it is the role of the US and of China - the world's largest CO₂ emitters² which will be critical to the future of emissions trading. President Obama is committed to introducing a mandatory federal carbon cap-and-trade system in the US, despite strong opposition. China has so far resisted the idea of an explicit cap on its CO₂ emissions.

The negotiations at Copenhagen will be complex and extremely challenging. The timing of the conference could not be worse: it will take global leaders immense political will to push through meaningful targets for emissions reductions at a time when the world economy is still reeling from the credit crunch. The fact that global temperatures have actually been declining since 1998³ while CO₂ emissions continue to rise, and the fact that many leading scientists have declared the methods underlying the Intergovernmental Panel on Climate Change (IPCC) projections of global warming to be invalid, could undermine further the effort to reach an agreement which will rescue carbon trading.

Article Author

Giles Drury
Senior Manager
KPMG in the UK +44 20 7311 5367 Giles Drury View all other articles by this author

1. Meeting Carbon Budgets - the need for a step change, Progress report to Parliament Committee on Climate Change, October 12, 2009.
2/*. 'China overtakes US as world's biggest CO2 emitter', by John Vidal and David Adam, The Guardian, UK, June 19, 2007.
3. 'Drop in world temperatures fuels global warming debate', Robert S. Boyd, McClatchy Newspapers, Washington, August 19, 2009.