Europe Begins to Digest Lessons from Phase I of its Emissions Trading Scheme

Niamh Brooks, Associate Editor, Europe, Platts Global Power Report

PHASE I OF THE EUROPEAN UNION'S emissions trading scheme closed at the end of 2007, with market participants anxious to turn to Phase II (2008 to 2012).

During Phase I, which started in 2005, over-allocation of emissions credits caused the price of carbon to drop close to zero, from where it struggled to recover. A more conservative set of National Allocation Plans for emissions quotas by participating EU member governments is expected to reverse that.

Analysts were focusing not only on the price of EU allowances, or EUAs, but also on fuel prices and, to some extent, on the inflow of CERs, credits from the Joint Implementation/Clean Development Mechanism. Under these schemes, ETS participants can buy credits through investment in "clean" energy or efficiency projects in countries in the developing world.

Investment bank UBS late last year predicted EUA prices of Eur30-40 per metric ton, for Phases II and III, an increase of Eur5 on its previous estimates because of movements in fuel prices and the shift of the 2008 contract over to the spot market from the forward as the new phase takes effect. But a revised UBS forecast puts prices at Eur30/mt for 2008-2010, Eur32.50/mt for 2011, Eur35/mt for 2012 and Eur40/mt for 2013, the first year of Phase III. The bank estimated that the 2008 short position will be 215 million mt (10.5%) and 230 million mt/yr (11%) on average from 2008 to 2012. UBS also downgraded its estimate for the supply of CERs by 20% "due to news about a tougher regulatory review process with delays and an increasing refusal rate [of projects and credits]."

"We no longer see CDMs having a significant impact on carbon pricing," it said.

In mid-March EUA prices for December 2008 were in the Eur20 to Eur25 range.

Among the lessons learned during Phase I was the need for a revised emissions allocation system. Following over supply during the first phase, debate remains as to how to allocate credits, with most participants favoring a partial auction system, of up to around 10% initially. This percentage would be increased gradually, to reach 100% by Phase III.

One proponent of auctioning is Lars Josefsson, chief executive of Swedish utility Vattenfall. He wants the full auctioning of EUAs to coincide with the commercialization of carbon capture and storage technology in 2015-2020, and largely accepts partial auctioning ahead of that date.

"Over the longer term, auctioning is the correct way to go, although I believe that the transit route to full auctioning has to be very carefully laid out. The most important thing is to try and connect auctioning to technological development.

"If we look at the incentives that are needed for the industry to reduce CO₂ it is only possible to achieve that once the technology is available. So if you introduce too much auctioning too early you run two risks: you punish those who can't do anything about it and you threaten security of supply."

Generators, which bear the largest burden of emissions cuts, are arguing that auctions, should be "front loaded" during Phase II to take into account the way power producers meet demand contractually. The UK group Association of Electricity Producers said in a position paper that "[We] would favor a larger proportion of auction volumes to be auctioned off in the first [part] of Phase 2."

"This is because electricity is largely sold one to two years ahead, and generators could then cover these sales with emission certificates already; generators are expected to be 30% short of allowance allocations, as they have to bear the full shortfall under the UK cap," the AEP added.

The study also noted that CERs will become more available "towards the end of the phase." To counterbalance the later arrival of CERs, it suggested, the volume of allowances auctioned could be weighted towards the start of the phase.

The AEP said that "the way in which allowances are auctioned could have a significant impact on the carbon market and could affect the ability of certain parties to participate."

The group called for "simple, transparent, non-discriminatory and open auctions" in Phase 2 of the EU ETS, but most of all, for a rapid decision.

It recommended that the UK government should pay for the costs of the auctions from the auction revenues; should hold frequent—perhaps quarterly—auctions "to enable generators to balance their positions"; should auction spot EUA contracts only; and should not have a reserve price for EUAs.

"The government should restrict its own role to that of seller or auctioneer and avoid distorting the market, either through the strategic timing of auctions or by setting a reserve price," Porter said.

The AEP said that smaller participants should be given equal access to auctions, but the rules should not favor smaller buyers. To do this, it said, the minimum lot size should be as small as is practical.

Elsewhere, discrepancies between the allowance allocations put forward by each EU country have left comparable generators with varying credit requirements.

"[Combined heat and power generators] are net short of carbon allowances in a number of national allocation plans for Phase II of the EU emissions trading scheme, hence the fact that some operators hope for a low CO₂ price," said RWE power's head of cogeneration strategies, Ian Calvert, at a December conference in Amsterdam.

Since CHP facilities capture and use the heat created as a byproduct of their power generation processes, they are an efficient technology that "should benefit from a short market and high prices," Calvert said. "But widely differing approaches to the technology in NAPs has in some cases put it at a disadvantage."

Calvert said there had been good and bad outcomes in Phase II allocation plans, but that on balance, the sector was disappointed that the oil and coal lobbies had argued up their carbon allocations, even to the extent of surpassing allocation for more efficient technologies. "This is what happens when policy objectives get mixed up," Calvert said. "The ETS should be about cleaning things up, not propping things up—like coal via benchmarking of fuels."

"Cogen in the UK has been left net short of allowances in NAP II," he said. "Allocation is 95.14% of need, while oil refineries are getting 99%. What a waste of effort. The ETS will only work if it acts as a spur to clean technologies."

On the plus side, all the recent NAPs comprise new entrant reserves, recognizing the value of new build CHP, Calvert said. Some plans also recognize double benchmarking, ensuring CHP operators are allocated carbon quotas for their heat as well as power output. Others, such as Germany and Austria, had a CHP bonus or a reduced compliance factor.

"All these give a strong signal to investors," Calvert said. "But we need Phase III to be longer than five years, so we learn from the mistakes made."