Emissions Trading – Time to Get Serious

Alessandro Vitelli, Managing Editor, Platts Emissions

The Kyoto Protocol's five-year compliance period begins in 2008. Industrialized nations around the world have pledged to cut carbon emissions, but the job seems to get harder, not easier, as 2008 approaches. Can market mechanisms make the crucial difference?

THE NEXT 12 MONTHS WILL SEE THE START of the serious business of the Kyoto Protocol.

Until now, the main focus of emissions trading has been to put in place the final pieces of the protocolthe institutions that will allow international emissions trading to actually work over the next five years–and for governments and companies to get a taste of how emissions trading is meant to work.

But on January 1, the "compliance period" of Kyoto starts, when Annex B Partiesmember countries that have accepted mandatory limits on emissionshave to account for their greenhouse gas emissions, and ensure they have enough allowances or credits to cover every last metric ton of carbon dioxide, methane, nitrogen oxides or fluorocarbons that their industries covered by the protocol emit.

Annex B groups the 27 members of the EU, plus Switzerland, Norway, Iceland, Japan, Canada, New Zealand, Russia and Ukraine.

The penalties for non-compliance are pretty tough: any party failing to reach its emissions cap has to make up the difference between its actual emissions and the cap during a second, post-2012 commitment period, plus an additional 30%.

The problem is that there isn't a second commitment periodyet. And diplomats negotiating whatever post-2012 framework does come along may well decide to draw a discreet veil over previous non-compliance in exchange for support for a new agreement.

There is one kicker, however: the United Nations Framework Convention on Climate Change can suspend the eligibility of a non-compliant signatory to make transfers under emissions trading. And while that may not sound tough, a suspension could really hurt the emissions trading business in 2008-12.

Just imagine that Germany finds itself in non-compliance in 2009 and is suspended from emissions trading in 2011. That would mean that German private sector activity under the EU Emissions Trading Scheme would grind to a halt. Millions of credits from clean technology projects in China would be stranded, since their German investors wouldn't be allowed to take delivery of credits until the suspension was lifted. German companies would likely line up to sue their government. They've already challenged their political leaders in court over the allocation of emissions allowances.

For this reason, European governments in particular are taking emissions trading very seriouslyany slip-ups will cost them and their private sectors a lot of money. Other Annex B countries have yet to set up emissions trading regimes that are anywhere near as strict as Europe's.

Pumping Up the Volume

As the various Kyoto institutions took shape in the last 12 months, many people started to look ahead to 2013 and speculate over the shape of the next emissions trading phase.

At a political level, 2007 was characterized by a steady increase in the volume and intensity of talk about climate change, as climate change believers beefed up their efforts to get skeptics and resisters on boardcapped by the Nobel committee's decision to award its 2007 Peace Prize to the UN Intergovernmental Panel on Climate Change and US activist Al Gore.

That panel in February unveiled its Fourth Assessment Report which said that "warming of the climate system is now unequivocal," and was "very likely" due to human activity.

The term "very likely" used in the report corresponds to a statistical likelihood of 90%. The third report, published in 2001, had concluded that most of the warming over the previous 50 years was "likely"a 66% probabilitycaused by human activity.

The IPCC's findings unleashed a clamor for more action and greater cooperation, just as the UK's Stern Report, published four months earlier, had done. The European Union committed itself to a 20% cut in greenhouse gas emissions by 2020, and held out the promise of a 30% GHG cut if others joined. New Zealand and Australia both announced plans to launch domestic emissions trading. Since New Zealand is a Kyoto signatory, its trading program could eventually be linked to the European ETS.

Australia spent a good part of 2007 continuing to talk down emissions trading, before Prime Minister John Howard suddenly reversed direction and announced that the country would have its own trading scheme. But because Australia has not signed Kyoto, its market could languish in isolation unless its architects can find a way to build a bridge to other markets.

Perhaps the loudest noise of all came out of the US, where the new Democratic majority in Congress immediately served notice that it would work to set up a nationwide cap-and-trade scheme for GHG emissions. No fewer than seven bills have been proposed, with targets ranging from capping emissions at 2001 levels by 2015 to cuts of 60-80% from 1990 levels by 2050.

Congress' efforts were bolstered by an ever-expanding coalition of states and Canadian provinces in the west, headed by California which has agreed to establish its own cap-and-trade scheme.

In the east, the 10-jurisdiction Regional Greenhouse Gas Initiative nears its 2009 start with participants ironing out key details. While RGGI allowances won't be issued until the scheme's launch, the first forward sale of carbon offsets to a RGGI buyer was confirmed in mid-October at a price of $5.25/mt.

Getting Everybody on Board

With the US and Australia, the Kyoto holdouts, looking increasingly likely to join a framework agreement after 2012, the focus has shifted to persuading developing countries to take on a greater role. The main argument against developing economies imposing limits on emissions has been unchanged throughoutthat to do so would place unacceptable restraints on economic growth.

China has reiterated this argument time and again, while pointing out that it is boosting investment in low-carbon renewable energy on a massive scale. India prefers to emphasize that its per capita carbon emissions are a fraction of the developed world's. According to Carbon Planet, India emits around 1.3 metric tons per capita, compared to 24.09 mt in the US.

Instead, developing countries have talked up the need for additional technology and financial resources to help them pursue economic development in a more climate-friendly fashion. At the same time, developing nations chide the industrialized world for even considering targets for developing countries before putting their own houses in order.

"The international community should first extend the first commitment of the Kyoto Protocol beyond 2012; all Annex B countries should accede to the protocol and fully implement their commitments," Pakistani environment minister Syed Faisal Saleh Hayat said in September.

The resistance to mandatory cuts from both the developing world and the US, where President George Bush has supported technology research but not emissions caps, has helped sustain a minority view that countries should be allowed to take what action they want against climate change.

The US administration has long been critical of what it calls Kyoto's "top-down" and "one-size-fits-all" approach. Bush told a climate meeting in Washington in late September that a new international agreement on climate change should allow countries to design separate strategies reflecting their individual energy usage, economic needs and state of development.

"Each nation must decide for itself the right mix of tools and technologies," Bush said.

The various discussions held at numerous international fora have, however, produced one important result: they have effectively ended the Bush administration's efforts to try to build an alternative focal point for the post-2012 climate debate. At the G8 meeting in Heiligendamm, Germany last summer, Bush agreed to a joint statement, which has been re-emphasized frequently since then, that committed to using the UN as the forum to reach a new global warming pact.

The annual Conference of Parties to the UNFCC and the Meeting of Parties to the Kyoto Protocolthe COP/MOPis slated for Bali in December, and will set the stage for the negotiating process over a post-Kyoto agreement.

While the UNFCCC meeting in 2005 was all about formalizing the rules of emissions trading and launching the market, and 2006's conference was mainly procedural in nature, the 2007 meeting will be almost entirely forward-looking. The Bali conference will hear the report of the two-year "dialogue on long-term cooperative action to address climate change by enhancing implementation of the convention," a discussion group which includes the US and Australia.

The conference will also host a further meeting of the "Ad Hoc Working Group on Further Commitments for Annex I Parties under the Kyoto Protocol," a group which includes only those countries that ratified Kyoto.

These groups, which were established due to a lack of agreement on the next steps, are expected to feed their conclusions into the negotiation process, which itself must produce a result no later than 2009, estimated UNFCCC head Yvo de Boer. With the Kyoto compliance period ending on December 31, 2012, governments need a two-year period to ratify the successor agreement and to prepare for its implementation.

Tuning Up the Market

Meanwhile, traders are trying to prove that the current carbon market works.

In the first nine months of 2007, the EU ETS has seen total trade of around 760 million allowances, called EUAs. Full-year 2006 trading's total was 827 million allowances. This does not account for certified emissions reductions, or CERs, from approved projects, trading in which has been growing rapidly from a very low base.

Today, emissions traders in Europe are watching the relative prices of EUAs and CERs, looking for the cheapest compliance options, and encouraging reluctant industrial companies to optimize their compliance strategies. Financial companies—banks, hedge funds and purpose-built investment fundsare leading traders, while utilities are the largest "natural" players, buying allowances and offsets to cover the CO₂ emitted through power generation.

Phase 1 of the EU ETSand to a certain extent Phase 2 as wellended up giving non-power generating industrial companies as many allowances as they needed, in an effort to avoid penalizing industrial sectors in international competition. In some cases, these companies were given sizeable surpluses of EU Allowances which they turned into healthy revenue streams, selling to EUA-starved utilities.

Phase 2 promises to be generally tighter in terms of EUA supply, but industrial companies will again find themselves a key source of liquidity.

EU ETS rules allow companies to provide an average 10% of their total allocation of emissions allowances in the form of CERs from Clean Development Mechanism projects.

Industrial companies which are to be allocated almost 100% of their requirements will therefore be able to swap up to 10% of their EUAs for CERs, releasing EUAs into the market which can then be bought by utilities, who once again will face the lion's share of the reduction burden.

And while the private sector is leading the way in terms of trading activity, governments are no slouches. Most EU governments have launched carbon purchasing funds of one type or another as they try to balance the effort being made by the "trading" and "non-trading" sectors of their economies. "Trading" sectors are covered by the EU ETS but the commercial, domestic and agricultural sectors must also generate carbon savings.

By the time 2012 comes around, we may see emissions trading spread to a far greater proportion of the economy. Much of this research is being carried out in the UK, where the government is planning to launch emissions trading for large non-industrial concerns, such as supermarkets or commercial developments. The Royal Society is even trialing a personal carbon account, whereby individuals account for the carbon content of their activities.

It's clear from these developments that the market is maintaining its central role in fighting climate change. Bringing emissions trading to developing countries and to the US can only reinforce that role.