While Australia has dilly-dallied over emissions trading, governments and businesses overseas have been busy engaging with carbon markets and positioning themselves to maximise their potential to prosper in the future carbon-constrained world.

Elsewhere at least, pricing greenhouse emissions is mainstream.

In 2006 global carbon markets had a huge turnover of more than $US30 million (€22-23 billion) in carbon transactions – triple the value of 2005. A volume of 1.6 billion tonnes of CO2 equivalent (CO2-e) was traded, well over twice the volume of 2005 transactions.

The World Bank and international carbon consultancy Point Carbon each recently released reports, State and Trends of the Carbon Market 2007 and Carbon 2007 respectively, about the state of global carbon markets at the end of 2006. The data that follows is sourced from these reports. The data refers to volumes and values of carbon transactions – purchase contracts where one party pays another party in return for greenhouse gas (GHG) emissions reductions or the right to release a certain amount of GHG emissions. This is to be distinguished from the creation or surrender of certificates, where money does not change hands. In general, transaction volumes are larger in more mature, liquid markets where there is more speculative activity.

According to Point Carbon, the raison d’etre of carbon markets is to “place a cost on carbon emissions, a value on emissions reductions, and to enable trade of the resulting allowances or credits”. A number of carbon markets have been formed by creating a cap or intensity target for carbon emissions and allowing liable parties to trade in allowances to meet their compliance target. These markets may differ in many aspects of design such as the stringency of the cap, the sectors involved, the type of project-based offsets allowed, allocation/auctioning of certificates and their interaction with other markets. The vast majority of carbon transactions occur because of current or anticipated mandatory carbon targets. While the voluntary market from businesses and individuals offsetting their carbon footprints is growing, it is still very small by comparison.

Carbon market transactions can be split into two main categories – allowance based transactions and project-based transactions.

Allowance-based markets

Allowance-based transactions are those where the buyer purchases emission allowances created by regulators under trading schemes. Allowances, which include those from the European Union Emissions Trading Scheme (EU ETS), the New South Wales Greenhouse Gas Abatement Scheme (GGAS), the Chicago Climate Exchange and the UK Emissions Trading Scheme (UK ETS), at 1.1 billion tonnes, accounted for 70 per cent of the total market volume traded, and 82 per cent of the value at $US24.6 billion, according to the World Bank. There will also soon be international trading of allowances (Assigned Amount Units, or AAUs) under the Kyoto Protocol between countries who have ratified the Protocol.

With just over one billion allowances at a total value of $US24.3 billion exchanged during 2006, in its second year the EU ETS was by far the dominant carbon market. It is also growing strongly with trades on this market tripling in size and more than tripling in value compared to 2005. Point Carbon reports that most of these transactions, 583 million tonnes (Mt) of CO2-e, occurred over-the-counter, with 283 MtCO2-e conducted on exchanges and the remainder through direct bilateral trades.

After the EU ETS the NSW GGAS scheme was the next largest in value and volume of allowances, with 20.2 MtCO2-e valued at $US225 million traded in 2006 – nearly four times the value and more than three times the volume of the 2005 market. Point Carbon attributes the greater volume to newly approved offset projects. The average spot price during the year was $A13.31. GGAS, a benchmark-and-trade scheme, operates in NSW and the ACT and is aimed at reducing the greenhouse gas intensity of electricity purchased by consumers. It does this by setting a legally binding obligation on electricity retailers to acquire certificates based on their market share.

With GGAS, certificates are created by activities such as demand side abatement, methane destruction, lower emission power generation, improved generator efficiency and carbon sequestration. Generation certificates dominate the GGAS market: more than 80 per cent of all certificates created (not transacted) to the end of 2005 came under this rule, though the World Bank reports that in 2006 this was slightly lower at 70 per cent. The GGAS scheme accepts only its own certificates (NGACs) or Australian Renewable Energy Certificates. GGAS has no linkage with international schemes. (For more information on GGAS see the BCSE publication Carbon Markets 2006, available to BCSE members from the BCSE website.)

The Chicago Climate Exchange (CCX) also rates a mention, with 10.3 MtCO2-e traded at a value of $US38 million, for its seven-fold growth in volume and 13-fold growth in value exchanged compared to 2005. This growth reflects the increasing interest in emissions trading following further development of the Regional Greenhouse Gas Initiative of the North-East states and draft legislation for federal schemes. Indeed, the World Bank reports new CCX members citing an interest in familiarising themselves with emissions trading. Members of the CCX have made a voluntary but legally binding commitment to reduce their greenhouse gas emissions. The first commitment period of the CCX ended in December 2006, with members committing to reduce their emissions by a total of 4 per cent compared to their baseline (emissions in 1998-2001). The other allowance scheme, the voluntary UK ETS which was initiated in 2002, expired at the end of 2006.

Project-based markets

The other category, project-based transactions, is where the items traded are emission credits from projects that can verify GHG emissions reductions. Project-based transactions, primarily the Clean Development Mechanism (CDM) and Joint Implementation (JI) (‘flexibility mechanisms’ of the Kyoto Protocol) accounted for the remaining 508 MtCO2-e or $US5.5 billion in value, according to the World Bank. Increasing the access that scheme participants have to different mitigation options, by allowing project-based credits or other schemes’ allowances, helps schemes to meet their target more cost effectively. However if these credits are from another region/country’s scheme or projects, it essentially means supporting another economy to reduce its carbon intensity rather than improving the carbon-intensity of the domestic economy.

According to the World Bank figures, the Clean Development Mechanism (CDM) accounts for the vast majority (94 per cent) by volume of project-based trades – 475 MtCO2-e valued at $US5.3 billion – double the value of 2005. Joint Implementation (JI) was substantially smaller, with a volume of 16 MtCO2-e and a value of $US141 million. The CDM enables developing countries to take part in emission reduction projects (without Kyoto caps) and to create credits (Certified Emission Reductions, or CERs) which can be traded to enable Kyoto participants to meet their targets. JI essentially operates the same way but projects are in developed countries (with Kyoto caps). Its allowances are Emission Reduction Units (ERUs). In 2006 about half the transacted CDM volumes traded were from Hydrofluorocarbon-23 (HFC-23) and adipic acid N20 destruction projects, with 13 per cent coming from renewable energy and 7 per cent from energy efficiency. With regards to JI, the most significant project types among 2006 transactions were renewables (37 per cent) including several biomass, wind and hydro projects. Energy efficiency was the fourth most common project type transacted at 15 per cent. Carbon 2007 mentions, however, that EU ETS double-counting rules practically rule out all future projects in EU ETS trading sectors for JI, which leaves mainly non-CO2 gases.

Project-based credits form the link between all the different carbon markets driven by the Kyoto Protocol, with governments and companies in all regions able to use CERs and ERUs for compliance. Carbon 2007 points out that as a result, this will ensure there is at least some indirect price linkage between the different systems.

EU ETS developments

The trading unit of the EU ETS is the EU Allowance (EUA). The price of the EUA is set by the balance of supply and demand. Demand is driven by likely fuel prices (relative prices of gas and coal, which largely determine fuel use and hence emissions), and weather (energy demand for heating and power, impacts of rainfall on hydroelectricity generation), economic growth and so on. In April 2006, EUAs reached a price peak of €31.58 for the year, based on the market’s expectations of a reasonable shortfall in allowances (a ‘short market’). But the verified emissions data for 2005 showed that the 2005 emissions cap and allowances were ‘long’, and the price of spot EUAs crashed to €9.70 in mid May. In May 2007 spot EUAs were trading at €0.30.

The verified data showed that companies in the UK, Spain, Italy, Ireland and Austria all emitted more than their cap. However all other countries had been allocated more emission rights than they actually needed, leaving the overall market in a net long position of 65.2 MtCO2-e. On a sectoral basis, the power and heat sector was the only one that emitted more than their allowances.

Despite this there were positive indications that the EU ETS was doing what it was designed to do - driving abatement. Although verified emissions for 2005 came in at 3 per cent below allocated EUAs for that year, a preliminary analysis by Ellerman and Buchner suggests that CO2 emissions were still reduced in 2005 by between 50 and 200 MtCO2-e. Point Carbon concludes that the surplus in 2005 emissions was due predominantly to generous allocation, but that internal abatement probably also played a role. In Point Carbon’s Carbon Market Survey 2007, 65 per cent of respondents said internal abatement activities had been initiated in their company in 2006 as a result of the EU ETS, compared to just 15 per cent in 2005. The World Bank attributes this change in abatement behaviour to “the high price of carbon in the first year of Phase I, combined with a heightened awareness of climate change, concerns about energy security and high fuel prices”.

While it was expected that Phase I would generate learnings on which Phase II would improve, clearly such a severe correction surprised many and had significant consequences. Following this, the European Commission assured the market that the Phase II National Allocation Plans (NAPs) would be assessed in a manner that would ensure a tighter market with a more challenging cap creating sufficient scarcity of allowances. From June to December 2006 interest on the market shifted to the December 2008 (Dec-08) EUAs. As a result of increased trading of the Dec-08 contract over the course of the year and the fact that they held their price fairly well, the overall EU ETS market value still tripled during the year. The price for the Dec-08 contract was trading at €€23 at the close of May 2007. Carbon 2007 states that: “The EU ETS Phase I is for all practical purposes over and done with.” Respondents to Carbon Market Survey 2007 cited political factors as the major price driver in the EU ETS, despite a good correlation between weather and fuel prices and the carbon price between June and December 2006.

The World Bank believes there is an emerging consensus that “the expected shortfall in the EU ETS Phase II is likely to be in the range of 0.9 billion to 1.5 billion tonnes CO2-e”. The majority (82 per cent) of respondents to Point Carbon’s 2007 survey indicated that although import of project-based credits from the CDM and JI will be allowed again in Phase II, they don’t believe this will be enough to meet the shortfall in Phase II of the EU ETS. Consistent with this, respondents also indicated that they expected levels of internal abatement in Phase II to be higher than Phase I. If this is indeed the case, Carbon 2007 points out that the price of carbon should reflect the price of fuel-switching rather than the price of CDM/JI credits. If not, CERs and ERUs should be a stronger force in determining the market equilibrium for allowances under Phase II of the emissions trading scheme.

Has the price of carbon been fully passed on to power prices? There are three major power markets in Europe – the European continental market, the UK market and the Nordic market. Point Carbon concludes in Carbon 2007 that German forward power prices (as an indication of the continental market) appear to now fully price carbon into the price of power for future delivery. It concludes that there has been a 100 per cent carbon cost pass-through in the UK power market and a 50 per cent pass-through in the Nordic power market in the second half of the year.

Outlook

Point Carbon reports that its reference scenario expects volumes in global carbon markets to grow by almost 50 per cent in 2007. It forecasts that 2.4 billion tonnes CO2-e will be transacted and that all market segments will grow except the primary CDM. Point Carbon predicts the EU volumes will be in the order of 1.75 billion tonnes CO2-e with a value of €18.5 billion, with a slight reduction in primary contracted volumes in the CDM market, mainly due to a lack of growth in non-CO2 projects. It does, however, expect energy efficiency and renewable energy CDM projects to grow.

This year is the last one before Kyoto starts. Governments are already buying project credits to enable them to meet their Kyoto targets and most countries have drawn up carbon procurement plans. The outlook post-Kyoto is beyond the scope of this article but emissions trading developments in Australia are discussed elsewhere in this issue, and previous issues, of EcoGeneration.

What has been learnt?

The experience of the EU ETS highlights the importance for all emissions trading schemes of orderly and transparent release of periodic market-relevant emissions data along with clarity on the assumptions underlying these figures, such as economic growth and baseline carbon intensity. This not only enables appropriate caps to be set, but also for realistic market expectations and price signals to be formed. The World Bank’s report concludes that regulated carbon markets can only achieve their environmental goals when policy makers set scientifically credible emission reduction targets while giving companies maximum flexibility to achieve those goals.

Carbon markets globally are growing and becoming more sophisticated. While the largest scheme operating, the EU ETS, has come under criticism, there is evidence that it is doing what it should: driving greenhouse gas abatement.