2007: Make or Break for Emissions Trading

Alessandro Vitelli, Managing Editor, Platts Emissions

With the Kyoto Protocol's first compliance period beginning in 2008, much of 2007 will be focused on implementing the institutions needed to ensure the Protocol's effectiveness. The big unknown is whether governments and international bodies can make tough decisions in time to let the emissions market function effectively to reduce greenhouse gases.

THE YEAR 2007 IS WIDELY REGARDED AS the make-or-break year for emissions trading and for the Kyoto Protocol. The Protocol's first compliance period begins in 2008, and the UN Framework Convention on Climate Change parties (UNFCCC) will be working flat-out to ensure the regulatory and institutional structures are in place to allow the Protocol to function.

At the same time, parties to the convention are holding talks on future compliance periods after the first one ends in 2012, and there is a growing hope that hold-outs from the first period—notably the U.S. and Australia—may be brought into the fold.

But even as parties enter the run-up to compliance, one existing member shows signs of withdrawing on grounds the target, to reduce greenhouse gas emissions to 1990 levels, can't be hit without damaging its economy, and other countries see reductions coming from developing nations rather than their own.

Canada's new conservative Harper government has been taking steps to back off its Kyoto commitments, short of actual withdrawal though that is rumored. Environment Minister Rona Ambrose recently stated that her country's emissions target is "impossible" to achieve, while Commissioner of the Environment and Sustainable Development Johanne Gélinas said Canada's current efforts to reduce GHG emissions will save an estimated 5 million mt in 2010. The Kyoto target is around 270 million mt.

Some observers have suggested that the current Canadian government may even formally withdraw from the agreement, though Canadian lawmakers have given a second reading to a bill that would force the government to respect Canada's Kyoto commitments.

But even in Europe, where the European Trading Scheme was meant to prepare the continent for Kyoto with three years' experience with caps and trading, some governments are facing hard choices in placing carbon limitations on their economies.

Kyoto Machinery to Be Put in Place

For 2007, the focus will be squarely on making sure that the institutions that Kyoto needs are in place. Foremost among these is the International Transactions Log (ITL), a database which will record creation and ownership of carbon credits generated by Clean Development Mechanism (CDM) and Joint Implementation (JI) projects.

According to the UNFCCC, the ITL is scheduled to be functioning by April 2007. The ITL will transfer the credits from projects' accounts to purchasers' accounts, allowing private-sector companies engaged in European emissions trading to import Certified Emission Reduction (CER) credits from CDM projects to help comply with their own emissions caps. The ITL will also enable emissions trading between the private sector and Kyoto party governments.

However, the timely delivery of the ITL may not itself be the critical path event for international emissions trading.

According to Article 17 of the Kyoto Protocol, industrialized, or Annex 1, countries must fulfil a number of eligibility criteria before they and their industries can utilize carbon credits from CDMs and JIs. Industry sources are concerned that the Article 17 process could extend beyond the January 1, 2008 initiation of the Kyoto compliance period, which could impact emissions trading.

The eligibility criteria, detailed in the Marrakech Accords, require that Annex 1 states must have set up a national system for estimating emissions, established a national emissions registry and submitted the most recent inventory of greenhouse gas emissions.

Most importantly, however, Annex 1 countries must have calculated their Assigned Amount (AA)—their total greenhouse gas emissions—and it is this element that sources say is the key obstacle. The calculated Assigned Amounts must be submitted to the UNFCCC secretariat no later than December 31, 2006.

According to lawyer Anthony Hobley of Climate Change Capital, failing to meet the criteria will mean that CERs and Emission Reduction Units (ERU) from JIs cannot be traded among Annex 1 countries.

"Most Annex 1 countries have met many of the requirements, but the assessment of the Assigned Amount is not easy. [States] have to come up with a complex assessment of what the sources of their emissions are," Hobley said. "Like National Allocation Plans in the European Union Emissions Trading Scheme (EU ETS), these reports will form the basis of their AAs and will determine how much work each country has to do to meet its Kyoto target."

The UNFCCC's Compliance Committee has 16 months to study each country's report on AAs which, given the December deadline, might mean that a decision on the acceptability of some reports will come after the Kyoto compliance period has started. Article 17 rules automatically approve a report if the UNFCCC does not rule in 16 months.

The EU ETS's Phase 1 is operating as an independent system, but starting in 2008 it will come under UNFCCC jurisdiction when it assumes the status of a flexible mechanism under the Kyoto Protocol. EU Allowances, which so far have been treated as a separate "currency," will be treated as AA Units.

The compliance rules mean that in addition to Canada, Japan, Iceland, Croatia, Monaco, Norway, Russia, Switzerland, Ukraine and New Zealand, all 27 (as of 2007) EU member states—which are also Kyoto Annex 1 states—must submit their AA calculations to the UNFCCC in time to ensure a verdict before 2008. That opens the risk that if any EU state has not achieved full compliance with Article 17 by January 1, 2008, its installations will not be able to trade in the ETS, let alone trade CERs and ERUs internationally.

Artur Runge-Metzger, head of the ETS unit at the European Commission's environment directorate, conceded that "there is a risk" that some countries may not reach compliance by the deadline, but added that the EU states will be undertaking the compliance process as a group. "We don't fear this risk," he said. "Member states are aware that they have to fulfil these criteria. We've said before that the EU will [carry out compliance] together, and we will submit our AA calculations by the end of this year."

According to Morgan Stanley, one of the mainstays of the market, the timely launch of the ITL and the completion of Article 17 compliance are vital. "If the member states working with the EU Commission and the UN ensure that the ITL goes live as scheduled, and the member states are Article 17 compliant by early 2008, the secondary CER market should develop with confidence," the company said in an October statement.

But said one trader, "The ITL launch and Article 17 compliance are issues that have been holding back development of the secondary CER market." He said compliance buyers are nervous about governments falling behind in the Article 17 process.

The potential delay of up to a year before any Annex 1 country is eligible to commence trading means that CERs may have to be held for an extended period. Hobley of Climate Change Capital said this delay is known as "stranding" of CERs. "The UNFCCC may, through Article 12, allow CERs to be transferred from the host country to the purchasing country, but unless the purchasing country has met the eligibility requirements of Article 17, it will not be able to sell those CERs outside its own national registry," he said.

Various government sources also acknowledged that the emissions market faces a potentially disruptive period between the launch of the ITL and the confirmation of Annex 1 countries' eligibility to trade. Eligibility delays could mean a "freezing" of emissions trading into spring of 2008.

EU ETS Phase 2: Long or Short?

The EU Emissions Trading Scheme, the only international trading regime currently operating, was launched in 2005, but 2006 brought the market face-to-face with the possibility that European states had nearly all over-allocated allowances to their industrial installations, rendering the market structurally long and without incentives for hard emissions reductions.

When 2005 verified emissions data was released in May, it showed the EU countries had emitted some 81.9 million mt less of CO2 than the EU had issued in permits for. The data unleashed a bear run on the CO2 market that drove prices from just over €30/mt to €8.50 in 16 trading days.

Traders and analysts generally say the market is likely to remain at low levels for the balance of Phase 1, through 2007, though one or two dissenters believe the market may end up almost 100 million mt short by the end of 2007.

Key will be the publication of verified emissions data for 2006 in mid-May 2007. The data will either confirm European countries' over-allocation or show a sharp drop in the surplus.

Some observers point to what is called "front-loading" of the Phase 1 allocations. "Many countries allocated more to installations in the first year of Phase 1 than in subsequent years," an analyst explained.

The main players in the European CO2 market have been fossil-fueled power generators. Because generators tend to sell their output up to a year in advance, they also need to buy the fuel and the CO2 allowances to cover that generation.

In 2006, generators were selling power for 2007 delivery, and buying forward coal, gas and oil, and forward EU (emissions) Allowances (EUA). But the EU ETS Phase 1 ends and Phase 1 EUAs will hold no value after December 31, 2007. Forward power sales for 2008 must be hedged with 2008-delivery EUAs.

As a result, demand for 2007 EUAs is expected to be considerably lower than for 2006 EUAs. Sources estimate that power companies will sell around 90% of their generating capacity in advance—some of that covered by EUA allocations from their governments—and their demand for 2007 EUAs will be only to cover marginal output.

And first quarter 2007 is when the EC will shape the allowance market for the Kyoto compliance period, when the EC is to issue its verdicts on member states' National Allocation Plans (NAP) for Phase 2.

In its Phase 2 guidelines, the EC advised member states that an average 6% cut from the Phase 1 allocation would be required to meet the EU's collective Kyoto target. But many NAPs submitted so far have proposed increases from Phase 1, leading a number of market players to call on the EC to cut the NAPs back. About half the EU countries are already below their 2012 targets, while others, like Canada, have seen carbon emissions increase with economic growth, making availability of CDM and JI credits for compliance especially important.

One key difference between the two phases is a limit on importing CDM and JI credits. While Phase 1 had no limit on using CERs or ERUs for compliance with installation-level caps, in Phase 2 member states must decree a limit. So far, the limits have ranged from around 7% in the UK to 50% in Spain and Ireland, and the higher limits have led to accusations that some states are not working within the spirit of the Kyoto Protocol.

Across the Atlantic, despite the federal government's continuing rejection of the Kyoto approach, emission markets' advocates were encouraged by the passage of legislation in California to establish limits on carbon emissions and agreement by state governors to develop a link between California's plan and the Regional Greenhouse Gas Initiative in the northeastern states.

There have also been moves to try to link U.S.-based, non-Kyoto emissions cap-and-trade schemes to the European ETS, particularly through the voluntary Chicago Climate Exchange.

But the real effort in 2007 will be to engage the U.S. in international discussions over what to do after the Kyoto Protocol expires in 2012.

There is a body of opinion that it would be better to wait and try to engage the next U.S. president after George W. Bush steps down in January 2009. But the environmental lobby is expected to maintain the pressure on the U.S. in the hope of forcing a U-turn by the Bush administration in its lame-duck years.