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A Global Carbon Market? We’re Not Confident

If you had asked me yesterday, I would have said we are on the verge of a global carbon market that was shaping up to look quite attractive. Ask me today, after the EU voted down a backloading proposal, and I’m not so sure. There are other big carbon markets forming and they are starting to cross borders, but the EU’s is the largest and now it will lose its impetus, which could set back the whole thing.

Before yesterday’s vote in the EU parliament, predictions were that the global trade in carbon would grow by 13-14% this year, to reach a volume of 12 gigatons of carbon dioxide equivalent. Most of this growth would have come from the some 10 billion EU carbon permits out there. This would have represented a 40% increase in the volume of EU carbon permits. Last year, there were some 7 billion permits out there for trading. It’s an extremely speculative business with high price volatility.

EU Carbon Spot Price

The EU has been toying with a proposal to backload some 900 million permits in order to stabilize prices, which could raise the carbon permit price to just over $7.70 per ton. Last year, the price was about $9.40 per ton. The trick is to keep the volumes down enough to maintain a stable price. For this year, the EU carbon market should have been worth close to $80 billion, up about $9 billion from last year. But only with the backloading proposal in place. For 2014 and 2015, when volumes would have been reduced enough to smooth out the price volatility, the market would have been worth quite a lot more. This prediction is not likely to become reality now. 

The negative EU vote will also affect trade on a global level. As more countries jump on board the emissions trading bandwagon, and as a US carbon market is established (bit by bit), global pricing should emerge governed by free market principles, with the price of North American, Australian, European and Asia carbon emissions converging. With the EU carbon market languishing, however, this will bode ill for other countries that are linking up their carbon markets with Europe’s.

Europe: Where it all Starts

The EU’s Emissions Trading System is the biggest carbon market, accounting for 89% of the $61 billion in global carbon trading for 2012. In 2011, for instance, users emitted 140 million tons of CO2 but were allowed only 89 million tons of emissions. They had to buy 51 million tons of EU carbon permits from companies who didn’t use up their allowances, or they had to buy carbon offsets on the UN market.

EU Carbon Trading

That market is now pretty much broken (and tainted by corruption and carbon trading theft) and the backloading proposal was the solution and would have meant a revival of the market. 

Here’s how it’s gone so far: In March, the EU canceled a scheduled permit auction because prices would have come in below-market. This caused prices to drop significantly. Prices rebounded after then fell again in mid-April when traders gave way to speculation that the EU was close to pushing through the backloading policy. The decisive vote was on 16 April, and though it had broad support by everyone from environmentalists to businesses, it was rejected by the EU parliament.

If passed, the backloading policy would have withheld 900 million carbon allowances from the next round of market auctions and then released them at a later date when demand was stronger. It would also have laid the foundation for a second reform phase from 2014 that would have lent more stability to the carbon market by either further boosting demand through the cancellation of backloaded permits or a reduction in emissions caps through 2020.

Here’s the back story: Europe is running out of conventional gas, stymied over shale, and turning back to dirty coal because it can’t afford long-term gas import contracts that are linked to oil prices. Europe provides 70% of its own coal supply, but has still been buying up US surpluses at bargain prices, though that trend is decreasing. But the kicker here is that coal is becoming cheaper because the penalties for using it in terms of carbon emissions have declined exponentially. This wasn’t supposed to happen. But it has. This is why: Europe’s cap-and-trade program forces heavy polluting industries to buy pollution permits from those who release less carbon dioxide (CO2) than is allowed. Thanks to economic recession and the resultant industrial slowdown, there is an oversupply of these permits floating about. The price of carbon has thus dropped significantly because the market for these permits is lined with supply and demand. Now it’s cheaper to buy carbon credits to burn coal than it is to use expensive imported gas. The incentive to get rid of dirty coal has thus been removed. 

This is where carbon emissions trading could become a global cross-border phenomenon. If Europe wants to re-wean itself off of coal, it will have to incentivize the market for carbon permits by making it a cross-border trade to raise balance supply and demand.

On April 16, the International Emission Trading Association (IETA) released the International Emissions Trading Master Agreement (IETMA) for trading units of carbon reduction anywhere in the world. It was accompanied by the first of a planned series of schedules for European Union emissions trading phase 3, which runs from 2013 to 2020. The aim is to create a carbon pricing and emissions trading system at an international level that would allow cross-border trading, hedging and derivative instruments to foster a global carbon market.

So much for that. The excess of carbon permits has caused the price of carbon to plunge to less than €5 per ton, and now that may plunge even further; certainly it will not increase.

What lost the vote was the argument by opponents of backloading that it would end up causing an increase in energy costs. While the backloading proposal had some pretty broad support among energy companies, those industries that consume the most energy were opposed. Their view is that the low price of carbon genuinely reflects the economic reality in Europe and that backloading would create a competitive disadvantage for them in the face of US businesses who are benefitting from lower energy costs. Put simply, by withholding carbon permits from the market, it would become more expensive for these big industries to emit greenhouse gases and the response would have to be increased energy costs for consumers.

Where will this leave the carbon market? Well, some analysts fear that prices for carbon permits will now slump below €1 per ton and that along with this liquidity will evaporate. What we are most concerned about in the immediate term is that Europe’s carbon market woes will reduce confidence in the market elsewhere, just when things are getting underway in earnest.

Let’s look at some of the other emerging carbon markets:

North America

After the EU, North America is the second-largest carbon market. On a national level, the US carbon market is pretty much dead in the water since 2009, when the US House of Representatives passed a cap-and-trade program that was then killed in the Senate. So for now, it’s all at a state level.

The US has a total of nine state carbon markets. Analysts estimate that California’s cap-and-trade market alone will be worth $2 billion by the close of 2013.

Emissions trading systems have emerged of their own accord in the US, including the Regional Greenhouse Gas Initiative of 2009 with 10 states in the north-east, another trading scheme between 11 western states and Canada, and of course, California, the single-state leader in emissions trading.

In May last year, California set in motion new regulations that would allow for cross-border emissions trading with Quebec. Last week, this agreement was finalized. This is the first cross-border deal inked since 2005, when the EU set up its international emission trading system. But this also speaks to the regulatory complexity of the cross-border carbon trading system, done piece by piece, and, in the US, state by state.

California is about to gain status as a “zero” emissions state—on paper, not in reality. What’s got everyone excited is REDD credits, which are intended to reduce emissions from deforestation and forest degradation. The deal is that developed countries (or states like California) can purchase or trade credits to offset greenhouse gas emissions in return for agreements from developing countries to protect forestlands. REDD credits are not yet officially incorporated in California’s carbon market, but there is some serious lobbying in this direction and the US government seems to support the plan with similar deals in place with Mexico and Brazil.

Earlier this year, the US Supreme Court upheld a decision to allow the imposition of emissions standards should the Obama administration decide to set such standards for existing powers on a wide scale. This would significantly boost emissions trading.

But for now, there is no impetus for a national carbon-trading market in the US, so it will all be piecemeal.

Elsewhere … Stops and Starts

Japan, Canada and Russia have all opted out of the second round of quotas in the Kyoto agreement, so companies here will have no real impetus to for carbon trading on a national level because there is no permit or offset requirement without Kyoto.

Japan was earlier considering a carbon trading scheme, but sidelined it in 2010, at least on a national level. However, the cities of Tokyo and Saitama have emissions trading schemes in place.

South Korea is also planning to start its own carbon market in 2015.

New Zealand has an emissions trading scheme already in operation and there are plans afoot to link this with Australia’s carbon market.

Australia’s carbon market was launched in August, linking the country’s carbon market to the EU’s Emissions Trading System (ETS). It’ll be a couple more years before this link is operating in earnest, but while the groundwork has been done, the negative vote in the EU will make this link less attractive.  

As such, all eyes are on China’s emerging carbon market. China’s Shenzhen Special Economic Zone—south China’s financial center--will start its carbon emissions trading scheme on 17 June. There are also rumors that Beijing and Shanghai will launch ETS operations in June. Before the end of this year we could also see emissions trading schemes officially launched in Guangdong, Tianjin, Chongqing and Hubei.

There are a total of seven pilot emissions-trading schemes being tested in China’s manufacturing centers. If these pilot programs are successful, China stands to regulate up to 1 billion metric tons of emissions by 2015. This would make it the largest emissions trading scheme outside of the EU. (Probably the largest globally, though, with the EU’s system now seeing little chance of revival).

Carbon Trading Scheme in China

Shenzhen's carbon emissions trading will include 635 companies to start with, dealing on nearly 32 million tons of greenhouse gas emissions (based on 2010 figures) or roughly 40% of the city’s total emissions.

There’s a linkage here, too with Australia, as the two countries are working together to develop their carbon trading markets to pave the way for a broader Asia-Pacific market.

Bottom Line: The EU’s rejection of the backloading proposal lowers our confidence in the ability for a true global carbon market to emerge. It sends a signal from the backbone of this market, and will damage cross-border linkages that were just gaining some solid ground. While there are small, emerging opportunities for this market in the US, what we are left with really is only China, which will shape up to be the biggest carbon market very soon.

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