1. 1 An Introduction to Carbon Markets Financial Markets Group London School of Economics 15 May 2008 Sam Fankhauser IDEAcarbon

2. 2 Overview Why markets? The efficiency of markets Permits vs. taxes Carbon markets EU Emissions Trading System The Kyoto mechanisms Voluntary markets The future of carbon markets Creating a market Policy environment: the global deal

3. 3 The need for emission cuts From the Stern Review

4. 4 United States Can-Aus-NZ Russia Japan W. Europe E ITs Middle East China Latin America Other Asia Other Africa India - 1.00 2.00 3.00 4.00 5.00 6.00 0100020003000400050006000 Population (Million) Emissions (Tonnes of Carbon Per Capita) South Africa Developing country (non-Annex I) countries Sharing the abatement burden

5. 5 The benefits of emissions trading Source: Manne and Richels (1998) US$ billion Cost of meeting Kyoto targets for the USA, 2010 Effectiveness Track record in reducing emissions Efficiency emission reduction at lower costs Integration Finance and technology flow to emerging markets

6. 6 Taxes vs permits Economic efficiency argument Taxes: certain cost, uncertain quantity Permits: uncertain cost, certain quantity Optimal choice depends on the slope of marginal abatement, damage cost curves (Weitzman)

7. 7 Taxes vs permits Marg. Abatement Cost Flat MB curve Marg. Abatement Cost Steep MB curve target MAC MB

8. 8 Taxes vs permits Marg. Abatement Cost Choose tax Marg. Abatement Cost Choose permits target MAC MB

9. 9 Taxes vs permits Political economy arguments are more conclusive International carbon tax agreement difficult to achieve Domestically, industry prefers (grandfathered) permits

10. 10 Grandfathering – a source of profit Meuro (2006) CEZ: Revenues EBITDA Value of EUAs Net sales 5,625 2,268 738 245 Drax: Revenues EBITDA Value of EUAs Compliance purchases 946 583 326 40 RWE: Revenues EBITDA Value of EUAs Compliance purchases 44,256 7,861 2,436 141

11. 11 Overview Why markets? The efficiency of markets Permits vs. taxes Carbon markets EU Emissions Trading System The Kyoto mechanisms Voluntary markets The future of carbon markets Creating a market Policy environment: the global deal

12. 12 More than one carbon market Allowance market (cap-and-trade) EUAEU Emissions Trading System AAUKyoto International Emissions Trading Kyoto mechanisms (baseline-and-trade) CERClean Development Mechanism ERUJoint Implementation Voluntary market CFIChicago Climate Exchange VERVoluntary carbon offsets

13. 13 …dominated by the EU ETS Source: World Bank

14. 14 Heterogeneous prices Source: Reuters Interactive

15. 15 Clean Development Mechanism Annex I firm/country financing emission reductions in a non-Annex I country Joint Implementation Same as CDM but between entities in Annex I countries International emissions trading Trade of AAUs between Annex I parties Green Investment Schemes The Kyoto Mechanisms

16. 16 TechnologiesSellers Source: World Bank A closer look at the CDM

17. 17 A growing pipeline Source: IDEAcarbon / ECON Global Carbon Report

18. 18 Accounting for project risks

19. 19 Kyoto supply Number of Projects PDD volume pre- 2012 (mt) Predicted delivery (mt) CDM - issuing213506363 CDM –registered525490362 CDM - under validation 1,5481,039715 CDM - before validation 3,600841505 JI - all stages350174107 Total pre-20126,2363,0502,052

20. 20 CER Supply

21. 21 Compliance Demand CategoryPurchaserAmount per yearTotal 2008-2012 Non-EU ETSEU Governments108-120540-600 Canada1470 Switzerland210 Norway735 New Zealand735 Australia0-180-90 Japan (public)40-60200-300 Japan (private)30-40150-200 Sub-total208 - 2661040 - 1470 EU ETS*15 – 90*45 – 450* Total 223 - 3561,085 - 1,920

22. 22 Serve public sector demand first Less price elastic Price differentiation allows to charge more Serve private sector demand Price elastic, demand determined by in-house abatement options Downward pressure on prices Bank supplies into post-2012 period Regulatory uncertainty means sale at a discount Clearing the market Inventory is larger than potential demand

23. 23 The 2008-12 market

24. 24 Question mark: AAUs Source: World Bank

25. 25 11,000 installations in 27 EU countries Energy, refining, minerals, metals, pulp&paper Annual compliance requirement Targets set in National Allocation Plans Mostly grandfathering, some auctioning Possibility to import Kyoto carbon At least three trading phases Phase I 2005-07 Phase II 2008-12 Phase III 2013-20 EU Emissions Trading Scheme

26. 26 Price volatility Source: IDEAcarbon / ECON Global Carbon Report … a sign of insufficient market information

27. 27 Collapse of phase I price Source: IDEAcarbon / ECON Global Carbon Report

28. 28 National Allocation Plan Both phase II and phase III through banking Ratio of coal to gas price Determines fuel switching Marginal abatement cost elsewhere Weather Cooling / heating demand Hydro availability Output / GDP Process emissions in industry Electricity demand Price drivers in the EU ETS

29. 29 Prospects for Phase II

30. 30 Chicago Climate Exchange Self-described as “world’s first and North America’s only voluntary, legally binding, rules- based GHG reduction and trading system” Established in 2000 with currently 312 (voluntary) members power, automotive, chemical industry; banks, universities, municipalities; project developers, offset aggregators, NGOs Six gases, both allowance-based and offset credits In 2006 about 10.3 MtCO 2 e were transacted, worth US$91m; as of July 2007 26.3 MtCO 2 e had been traded on the exchange

31. 31 Overview Why markets? The efficiency of markets Permits vs. taxes Carbon markets EU Emissions Trading System The Kyoto mechanisms Voluntary markets The future of carbon markets Creating a market Policy environment: the global deal

32. 32 Growing European market Source: IDEAcarbon, ECX

33. 33 US state-level Regional Greenhouse Gas Initiative (RGGI) Western US Initiative California AB 32 US federal level Lieberman-Warner Climate Security Act Before the Senate in H1 2008 Other bills in both House and Senate Canada Intensity targets for large emitters North America

34. 34 New Zealand (NZ ETS) Starts trading in summer 2008 with forestry Covering all emissions by 2013 (industrial processes by 2010) Australia (AETS) Starts trading in 2011 Covering >70% of emissions (ex. Agriculture, forestry, fugitive emissions) Japan Focus on voluntary schemes (JVETS) Asia - Pacific

35. 35 Permit allocation Auctioning, grandfathering, benchmarking Scope Difficult sectors like agriculture, transport Upstream vs. downstream Safety valves against price spikes Carbon leakage and competitiveness Linking with other schemes CDM imports Linking with other schemes (e.g. NZ – Aus) Open issues

36. 36 Carbon markets in practically all OECD countries Regional schemes linked by an extended, enhanced CDM Underlying assets: 7.5 billion allowances, worth 200 billion? Of which > 4 billion in a US federal scheme? Trading volume: 8 – 13 billion tCO2 What is the global deal? Long-term: Markets in 2020

37. 37 The “global deal” Long-term target: a 50% cut by 2050 For a 450 - 500 ppm stabilisation target Consistent with G8, EU rhetoric Equitable burden-sharing Up to 80% cut in developed countries Developing countries get help on technology, carbon finance The next 6 months are crucial Target: agreement by 2009, ratified in 2012 Next step: G8 Japan (summer); COP (Poznan)

38. 38 Contact Details sfankhauser@ideacarbon.com Tel +44 20 7664 0205 www.ideacarbon.com