Carbon TradingCarbon Trading

How does the EU Scheme function and how How does the EU Scheme function and how important is it?important is it?

Tony White

Head of ResearchClimate Change Capital

Agenda

• The European Emissions Trading Scheme• How it works• How will the markets react?

Burden sharing agreement

Country1990 Emissions

Reduction per burden share agreement

Spain 286,428 15.0%Italy 522,132 -6.5%Germany 1,222,765 -21.0%Belgium 143,125 -7.5%Netherlands 210,342 -6.0%

Denmark 69,360 -21.0%Austria 77,388 -13.0%

Ireland 53,430 13.0%

Portugal 65,106 27.0%UK 742,492 -12.5%Greece 104,755 25.0%

Luxembourg 10,836 -28.0%Finland 77,093 0.0%

Sweden 70,566 4.0%France 551,805 0.0%

4,207,623 -8.0% -20 -10 0 10 20 30 40

Denmark

Spain

Ireland

Austria

Belgium

Finland

Portugal

Netherlands

Greece

France

Italy

Luxembourg

Germany

United Kingdom

Sweden

EU15

Distance from target (%)

additional

existing

Allocation of “pain” GHG emission performance at 2001

Emissions Trading: Background

• Europe has many Directives that reduce GHG emissions

– Renewables

– CHP

– Burden Sharing Agreement

• Europe on track to overshoot objective by 7%

• Additional measures are forecast to reduce overshoot to 1%

– Labelling

– Energy Efficiency of Building

– Biofuels

• Trading should close the gap

European Greenhouse Gas Emissions

Source: European Environment Agency, November, 2003

EU15 without Kyoto

4117Mt2001

3877MtKyoto

Excess?

4223Mt2010e

346MtAdd’l measures292M

t

CDM supply?

50 Mt?ETS Phase I

Emissions reducing projects in “developing” countries

Setting National Allocation Plans

• 18,000 sites covered– Energy Production > 20MWth– Bricks & Ceramics– Metals– Paper & Board

• Fines if emissions > allowances– €40/tCO2e for 2005-2007; €100/tCO2e for 2008-2012– Payment does not remove obligation to deliver certificates

• Allocations– “free” allowances given to incumbents– >95% of allowances created for 1st period; 90% for second– up to member states to set method of allocation– Allowances consistent with Burden Sharing Targets for 2008-12?– Targets can assume of purchase of flexibility credits (CDM/JI)

Carbon management strategies for Phase I

• NAPs set on – BAU minus a bit for power– BAU for non-energy

Removes any immediate requirement from the non-power traded sector to trade

• Power sector can meet abatement target without investment

EU-25 Abatement Targets for EU ETS

-10

0

10

20

30

40

50

60

GermanyGreeceIreland

Italy LuxHollandPortugal

SpainSweden

UK

EU 15 Total

Czech EstoniaCyprusLatviaLithuaniaHungary

MaltaPolandSlovenia

SlovakTotal:

MtCO

2

NAPs have been set on the basis of BAU – a bit for power.

The “bit” appears to be around 50-60mtCO2e per annum.

2006

0

5

10

15

20

25

30

35

0 5 10 15 20 25 30 35

Allowance Price (€/tCO2e)

Change in Marginal Cost (€/MWhe)

coal

gas

oil

Impact on Marginal Generation Cost

Impact of low allocation price

Nuclear, Hydro, “take or pay” CCGTs

Coal

Marginal gas

Oil/OCGT

DemandGeneration

Price

Proportion of year

Demand

Price

Impact on Prices (competitive market)

Nuclear, Hydro, “take or pay” CCGTs

Oil/OCGT

DemandGeneration

Price

Proportion of year

Demand

Marginal gas

Coal

Gas-coal switch

Impact of higher allocation prices

The Gas – Coal Switch

Price drivers

Current prices suggest a price of under €10/tCO2e

Value of allowances will move to ensure coal consumption is reduced.

EU - 25 Abatement Cost Curve

0

2

4

6

8

10

12

14

16

18

20

13 23 33 43 58 73 88 103 118

Abatement in mt CO 2e

€/tCO

2e

Gas @€3.77/GJ

Coal $60/t

likely price range

abatement

Consequences

• EUETS will– Lead to higher energy prices– Prices <€10/tCO2e for Phase I– Power companies will be able to pass allowance costs through

to customers– Major electricity consumers operating in global markets will be at

a disadvantage (aluminium)

• Allocations – If markets are competitive, allowance prices will be reflected in

sales prices– Sell early then buy as needed?– Allocations just determine size of windfall profit!

EU abatement curve

0

5

10

15

20

25

13 23 33 43 58 73 88 103 118

MtCO2 abated against BAU

Euro/tCO2

Gas €3.12/GJ Coal $35/t

Gas €3.34/GJ Coal $35/t

Gas €3.34/GJ Coal $45/t

Gas €3.77/GJ Coal $45/t

Gas €3.77/GJ Coal $55/t

Gas 3.77€/GJ Coal $60/t

Gas €4.54/GJ Coal $60/t

?

What will drive allowance prices?

Expect strong link between allowance prices and relative fuel costs

….but what is happening!

Forward prices for allowances stable – despite dramatic movements in relative fuel prices.

Market currently driven by a view of policy (how many allowances issued), rather than fundamentals

source: TFS

0

25,000

50,000

75,000

100,000

125,000

150,000

175,000

200,000

225,000

250,000

275,000

02-Jul-0322-Sep-0310-Dec-0319-Jan-0404-Feb-0424-Mar-0401-Apr-0407-Apr-0415-Apr-0526-Apr-0429-Apr-0413-May-0402-Jun-0424-Jun-0401-Jul-0407-Jul-0413-Jul-0416-Jul-0423-Jul-0429-Jul-0405-Aug-0416-Aug-0420-Aug-0402-Sep-0407-Sep-0410-Sep-0415-Sep-0421-Sep-0424-Sep-0429-Sep-0404-Oct-0407-Oct-0413-Oct-0419-Oct-0422-Oct-0427-Oct-05

tons

00.511.522.533.544.555.566.577.588.599.51010.51111.51212.51313.514

€/t

Will there be liquid markets?

• Will the market be “efficient”?– Is there a sufficient deficit?– “non-economic” behaviour– pre-empting Phase II allocations– auction system for new entrant reserve?

• Are there barriers to new entrants?– tax, credit risk, accounting treatment– transaction costs – particularly registries– susceptibility to political interference– annual-only dealing?

Conclusion for Phase I

• Large scale action likely to be restricted to power sector• European power sector can meet abatement without

investment and will enjoy “windfall” profits• Non-energy sectors do not have to trade – but why give

up a windfall?• Trading may be limited before basis for Phase II

allowances are announced• A finance director may lose his job over allowance

liabilities

…and phase II?

Life will get tougher

EU15 with Kyoto

Non-EU hot air (optimal price?)

Add’l measures292M

t

19MtDomesticsinks

45Mt? ETS Phase I

CDM supply?

JI supply?Mt? ETS Phase II

800-1000Mt

4117Mt2001

260Mt

3877MtKyoto

Excess

4223Mt2010e

346MtDTTe

EUhot air

6532Mt2002

5905MtKyoto

6660Mt2010e

755MtDTTe

Add’l measures

473Mt

114Mt Domesticsinks

800-1200Mt

Russian hot air

200-400Mt

Ukrainianhot air

Current CDM supply30Mt (expected 200Mt)

JI supply?144Mt

EU15, Japan, Canada, Norway, NZ, Switzerland - buyers

EU accession countrieshot air

Hot Air could meet all DTTe (without USA)

If only 20% Additional Measures are realised CDM/JI supply insufficient to satisfy demand

Expect Russia to constrain supply to ensure Europe sets price

Where will it be? €10-15/tCO2e

All figures in annual CO2e

Kyoto Balances

Flexibility Capacity Development

• Projects approved the Executive Board and/or the Methodology Panel: 17.9Mt/yr

• Projects under consideration: 12.9Mt/yr

• Some countries (Netherlands, Spain) have been active in purchasing flexibility allowances

Recent development of CDM project pipeline

0

5

10

15

20

25

30

35

Jun-04 Jul-04 Aug-04 Sep-04

Oct-04

MtCO2e/year

Approved by CDM EB

Methodology approved

Methodology underconsideration

Total

Flexibility mechanisms

• If “additional measures” do not work, then demand for allowances would soar (10x?) if EU sticks to Kyoto

• Ratification of Kyoto brought in:– Supply of JI, “Hot Air”; and – Demand; Canada & Australia

• Consequences– Putin may be able to control supply of allowances

• Carbon market may be like diamonds or OPEC– Best to lock into relatively cheap “flexibility”

allowances

Conclusions

• Phase I– Learning period– Get systems, monitoring, verification in place– Windfalls– Determine strategy for Phase II

• Second phase – watch out!– Much tougher– Subject to Russian influence– Arrange access to cheap allowances