Carbon Commerce

Since its launch in January 2005, the European Union’s carbon trading system has exploded into a market totaling nearly US $20 billion, providing a model for countries seeking to limit carbon dioxide emissions. The Europeans have demonstrated beyond doubt that the right to emit CO2 is destined to be a major internationally traded asset—but their experience to date also exemplifies some of the pitfalls the rest of the world faces in establishing such trading systems. The price for the right to emit a metric ton of carbon has fluctuated wildly in Europe’s carbon markets, from a high of ¤30 (US $39) in early 2006 to a low of ¤3.40 in January 2007, amid much controversy about the system’s basic design and regulation.

”It is an obvious and crucial point,” says James Cameron, vice chairman of the London-based investment bank Climate Change Capital, ”that this is a policy-driven market. It can’t be made to work unless governments impose the proper constraints on greenhouse gas emissions.”

In the United States, Congress is considering several bills to establish a cap-and-trade system for carbon, with action expected now that the Democratic Party has taken control of both houses. On 22 January, the day before President George W. Bush’s annual State of the Union speech to Congress, a coalition that included both top U.S. environmental groups and Fortune 500 companies like DuPont, General Electric, and Duke Power, called for carbon regulation, including a trading system [see photo, ”Carbon Futures”].

A concern among some energy company executives in the advanced industrial countries that have not yet joined in the international program to reduce carbon emissions—notably the United States and Australia—is that they will suffer a competitive disadvantage as their counterparts in Europe and other regions gain experience with carbon trading systems.

”It is a real concern for American and Australian companies, and you are seeing many of them pressuring for national legislation on greenhouse gases,” says Henrik Hasselknippe, who is head of the department that analyzes the European trading system for Point Carbon, a power and carbon market consultancy based in Oslo. ”They want certainty on this issue now. They don’t want to have to play catch-up later with European companies that are increasingly experienced in the carbon market.”

In cap-and-trade systems, a ceiling is set on a country’s total emissions from certain activities. Rights to emit specific amounts of carbon dioxide are then allocated to the organizations engaging in those activities. Over time the ceiling is lowered, which makes emissions allowances scarcer and more valuable. Industry tends to like the cap-and-trade approach because of the flexibility it offers: those finding it easiest to reduce their carbon emissions can sell allowances to those finding it harder, so that the total reduction aimed for is achieved at the lowest possible aggregate cost.

A disadvantage to cap-and-trade systems like Europe’s is that they generally cover only part of a jurisdiction’s total emissions and initially rely on historical emissions patterns, so that in effect those that have emitted the most carbon are rewarded. In some European countries like Germany, the advent of carbon trading has allegedly caused electricity prices to climb sharply, prompting complaints from big industrial energy users.

Of course, any system that raises the cost of emitting carbon in a given country will arouse concerns about impacts on the country’s competitiveness vis-à-vis countries not restricting emissions.

The European Union’s Emission Trading Scheme (ETS) was created in response to the United Nation’s Kyoto Protocol, which calls for advanced industrial countries to meet emissions targets by 2012 relative to a 1990 baseline, in a phased process. In the system, each member state is required to create a national allocation plan setting greenhouse gas emissions limits. Each state plan must be in line with the EU’s overall Kyoto emissions target, which calls for emissions to be 8 percent below 1990 levels.

Each European state in turn assigns emissions caps to installations in its energy-intensive industrial sectors, representing about half the EU’s total greenhouse gas emissions. Entities in the transport, light industry, and commercial sectors are not subject to caps at present.

In the system, each carbon allowance (known as a European Union Allowance, or EUA) represents the right, strictly speaking, to emit the equivalent of one metric ton of carbon dioxide. Other greenhouse gases are normalized in terms of carbon, depending on their warming potentials. Although some allowances are traded directly, company to company, the lion’s share of them—more than 70 percent—are broker traded. The remainder are traded on exchanges, about three-quarters on the European Climate Exchange, a fully electronic trading system managed out of London.

The art of setting caps at an appropriate level has been an ongoing challenge for policy-makers. In the earlier days of trading, when the price of allowances soared, it was because of what turned out to be an artificial scarcity. ”The market was skewed as power companies with the greatest need to reduce their emissions became active [buyers] in the market, while those who had the allowances to sell were absent from it,” explains Point Carbon’s Hasselknippe. ”Many of [the latter] were not used to trading in this way, and they didn’t have [in-house trading] desks set up.”

According to Hasselknippe, when the actual 2005 emissions data were released in the spring of 2006, it became obvious that the nonpower sector had been allotted overly generous caps for the first phase of Europe’s Kyoto reductions (2005 to 2007). Expectations developed that the market would soon be flooded with these excess carbon credits. The price of allowances subsequently collapsed to less than ¤10 in May 2006. As this article went to press in mid-March, an allowance for delivery in December 2007 was trading at ¤3.85.

Recognizing that a sufficient scarcity of the commodity traded is a precondition of a functioning market, the European Commission responded in November by slashing Phase 2 emissions caps for energy-intensive industrial installations to an average of 7 percent below proposed levels for the first 10 nations that submitted plans. It brought formal proceedings against countries that failed to submit plans by the 30 June 2006 deadline, and it announced that the same stricter standards would be applied to them. The commission also ruled that any allocated allowances that were not used under Phase 1 could not be carried over to raise Phase 2 caps.

The commission has also moved to put brakes on participation by European states in the fast-growing but controversial Clean Development Mechanism, an institutional element of the Kyoto program. Under the CDM, entities in industrialized countries can purchase carbon emissions credits by investing in approved emissions reductions projects in developing countries that are not subject to Kyoto emissions targets. The CDM has fast become big business. According to Point Carbon, which tracks CDM deals, the equivalent of more than 370 million allowances were traded in 2006 under the CDM, versus a total of 817 million allowances traded as part of the European system.

The CDM has come under sharp criticism at both ends. For allowance-purchasing Europeans, it has evolved into a relatively cheap source of carbon credit and, some argue, has discouraged big emitters from undertaking more expensive internal CO2 reduction projects. The main selling countries—Brazil, China, and India—stand accused of using the mechanism as a means of extracting money from industrial countries and, ironically, as an excuse to pollute even more.

To be sure, CDM projects must meet certain rigorous tests. ”You can’t set up a CDM project that is already technologically common practice or economically feasible in the [developing] country,” explains Miles Austin, a commercialization manager with the emissions trading broker Ecosecurities, in Oxford, England. ”You have to prove that the carbon reduction associated with the project would not have happened in the ’business as usual’ case.”

Yet complaints persist that unscrupulous factory operators in developing countries are stepping up production specifically to sell emissions credits. For example, CDM projects in China that abate HFC-23 gas, a noxious by-product of the production of an ozone-depleting refrigerant, HCFC-22, have come under fire. This is because the sale of their associated emissions credits may allow the owners of the refrigerant plants to sell emissions credits for much more than the emissions abatement actually costs to implement, thus allowing them to reap excess profits. As a result, these CDM projects have reportedly encouraged the production of more HCFC-22.

Responding to such concerns, the European Commission has created a new rule for the CDM and a similar program called the Joint Implementation: carbon credits from projects in those programs cannot exceed 10 percent of a given installation’s emissions allotments in Phase 2. The Joint Implementation, which at present is far less popular than the CDM, allows parties in industrialized countries to purchase emissions credits by investing in emissions reduction projects of counterparties in other industrial countries.

The United Nations also has taken measures to address this concern. ”New rules demand that historical production patterns be taken into account,” says Austin. ”So you can’t, for example, just turn on the tap and run your HCFC-22 factory 24/7 to churn out more HFC-23 gas for abatement.”

Should emissions caps be set more tightly, and should more sectors of the European Union’s economy be forced to comply with them? Would auctioning emissions allowances rather than allocating them for free create a more efficient market? The answers to these questions may be ”yes” in the best of all possible worlds [see box, ”Lessons Learned ”], but Cameron of Climate Change Capital argues that the European Trading System, while imperfect, is better than the alternative of inaction.

”One of the great, real problems with addressing climate change apart from its complexity,” says Cameron, ”is that the good guys tend to make perfection the enemy of the good, and the bad guys have used complexity as a reason to do nothing.” Cameron is optimistic that the EU trading system is providing the template and a training ground for an efficient global carbon market ”where vast sections of the world’s economies will be connected to a common carbon price, and millions of decisions made every day will have a carbon price built into them.”