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24/08/2011

What future for the CO2-allowances market after Kyoto?

In 1987, the publication of the Brundtland report gave birth to the concept of sustainable development which means "a way of development that meets present needs without compromising the ability of future generations to meet their own needs."

Afterwards, protracted debates ensued, leading to the creation of the IPCC (Intergovernmental Panel on Climate Change) and the signing of international treaties such as the Kyoto Protocol. Entered into force in 2005, the Kyoto Protocol requires that Greenhouse Gas emissions (GHG) from Annex I countries decrease by overall 5% between 2008 and 2012 compared to the 1990 levels. It also provides some tools that the concerned countries can implement to reach their commitment of reducing GHG emissions. Three mechanisms are foreseen: the exchange of emission allowances, the Clean Development Mechanism (CDM) and Joint Implementation (JI). In this article we will focus on the market for GHG emissions trading in Europe, modeled on Kyoto's emission quota system. After that, we will tackle the future of this kind of markets after the Kyoto Protocol (2012).

Operating principle of the GHG exchange system: the European system

Europe wants to carry out the leadership in the fight against global warming, therefore it has created its own emissions trading system: the European Union Emissions Trading Scheme (EU ETS) (Directive "emission trading" 2003/87/EC). To confirm this commitment and balance globally the reduction target of 5%, Europe's goal (imposed by Kyoto) is to reduce its emissions by 8% compared to the emissions level of 1990 (thus 3% above the globally fixed threshold).

The EU member states adopted the National Allocation Plans (NAP): they decided on the global allowances amount that has to be allocated to installations part of their territory and covered by the Directive. Thus, operators of these facilities (mainly industrial throughout 2008 - 2012), have a number of allowances, each one equivalent to one ton of CO2, that covers their GHG emissions. At the end of the calendar year, each operator must return, to the Public Authorities, a number of allowances equivalent to its own emissions. If he has emitted less GHG than the amount of quotas held, and has not exhausted the quotas in its possession, it will be possible for him to sell the excess.

If the operator fails to gather enough allowances, he will have to get them to cover his GHG emissions: non-compliance with this obligation may lead to various financial penalties. These quotas have an economic value: a real exchange market has been established since 2005. See below some key dates:

The GHG allowances exchange market, emerged since 2005, has nevertheless encountered some difficulties mainly due to a lack of cooperation among European states.

Efficiencies and limits of the EU ETS market

During the first two phases (2005 - 2007) and (2008 - 2012), quotas were distributed for free. Each state has defined its National Allocation Plan for (NAP). These NAPs were subsequently examined by the European Commission who, in some case, has asked to the states to review the granted ceilings. This system of allocation has not been beneficial: indeed, states have allocated a generous amount of quotas for certain companies in order to maintain their competitiveness. So, therefore concerned companies never needed to buy quotas: the major imbalance between this large supply and the weak demand led to a fall in the price of CO2 quotas in 2007.

In order to face this collapse, the European Commission has increased the levels GHG reductions for several countries which helped to stabilize the price of CO2 in 2008 to € 15. This price level, however, remains too low for companies to take it into account and launch formative decisions of ambitious emissions reduction, especially since the economic crisis has led companies to freeze their reduction plans seen the financial difficulties encountered.

In general, the CO2 price was subject to significant fluctuations: the industrialists did not have good visibility (low and uncertain prices) to invest in GHG reduction solutions. So, to reach the 20% reduction in emissions by 2020, a complete revision of the EU directive was triggered in December 2008 as part of the climate and energy package. The progressive auction of the entirety of emission allowances has been proposed for the sector of energy production. The states continue to allocate allowances for free to other sectors subject to strong international competition. The other progress of the climate and energy package is to entrust the management of the emission levels setting to the European Commission.

The international generalization remains very important and crucial. Indeed, if an equivalent system is not implemented in other parts of the world (USA, China ...) European firms will be penalized at international level. Several tracks are mentioned including that of a border adjustment in case of international agreements failure. The international consensus is always difficult to achieve and discussions on post-Kyoto illustrates the divisions of the international community.

In view of the post-Kyoto uncertainties, Europe still wants the be the driver of the negotiations

The Copenhagen summit in 2009 and the Cancun summit in 2010 have not been up to expectations: no post-Kyoto framework has been established. This represents a regulatory risk for actors such as the 'Carbon credit Fund' that would then become meaningless after the end of 2012. Today, it is difficult to define the face of the GHG emissions reduction system within the Framework of th Convention of the United Nations on Climate Change (UNFCCC): The main disagreement is between the "North Countries" and "Developing countries". The latter, are not willing to sacrifice growth points to "decarbonize" their economies. China still enjoys such status of developing country while it is the second global economy and the first country emitter of CO2. However, China still has very low CO2 emissions related to the number of inhabitants: this raises serious difficulties in the negotiations to involve China in the effort of GHG reduction and reflects the difficulty of trade to come: which indicator has to be chosen to set goals?

However, one of the concrete achieved aspect after the Cancun summit is to continue the multilateral process of negotiations on reducing emissions even if no specific, standardized and broken down by state (or region) objective has been set. A second aspect is the creation of a 'green fund' to assist developing countries in their efforts: 100 billion dollars a year are planned from 2020 to this fund. The technical aspects of financing (of this fund) have still not been defined, which still leaves major doubt s on climate negotiations.

In the absence of a post-Kyoto framework, Europe, wishing to set an example on environmental issues, has imposed more stringent reduction targets from 2013 on itself. Progressively, less and less quotas will be allocated for free , the market will be extended to other gases (NO2, fluorinated hydrocarbons per ...) and new sectors will be concerned (the aviation sector for example). To avoid various problems (encountered in the first two phases), some experts recommend the establishment of a minimum price and a maximum price to avoid the risk of a CO2 prices collapse. The European carbon market, despite errors at the 'launch' phase, could therefore be an example for the establishment of a universal CO2 price setting system over the next 20 years.

Sia Partners

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