Carbon Trading How does the EU Scheme function and how important is it? Tony White Head of Research Climate Change Capital

Agenda The European Emissions Trading Scheme How it works How will the markets react?

Burden sharing agreement Allocation of “pain” GHG emission performance at 2001

Emissions Trading: Background Europe has many Directives that reduce GHG emissions –Renewables –CHP –Burden Sharing Agreement Europe on track to overshoot objective by 7% Additional measures are forecast to reduce overshoot to 1% –Labelling –Energy Efficiency of Building –Biofuels Trading should close the gap European Greenhouse Gas Emissions Source: European Environment Agency, November, 2003

EU15 without Kyoto 4117Mt Mt Kyoto Excess? 4223Mt 2010e 346Mt Add’l measures 292Mt CDM supply? 50 Mt? ETS Phase I Emissions reducing projects in “developing” countries

Setting National Allocation Plans 18,000 sites covered –Energy Production > 20MWth –Bricks & Ceramics –Metals –Paper & Board Fines if emissions > allowances –€40/tCO 2 e for ; €100/tCO 2 e for –Payment does not remove obligation to deliver certificates Allocations –“free” allowances given to incumbents –>95% of allowances created for 1 st period; 90% for second –up to member states to set method of allocation –Allowances consistent with Burden Sharing Targets for ? –Targets can assume of purchase of flexibility credits (CDM/JI)

Carbon management strategies for Phase I NAPs set on –BAU minus a bit for power –BAU for non-energy  Removes any immediate requirement from the non- power traded sector to trade Power sector can meet abatement target without investment

EU-25 Abatement Targets for EU ETS NAPs have been set on the basis of BAU – a bit for power. The “bit” appears to be around 50-60mtCO 2 e per annum. 2006

Impact on Marginal Generation Cost

Impact of low allocation price Nuclear, Hydro, “take or pay” CCGTs Coal Marginal gas Oil/OCGT Demand Generation Price Proportion of year Demand Price Impact on Prices (competitive market)

Nuclear, Hydro, “take or pay” CCGTs Oil/OCGT Demand Generation Price Proportion of year Demand Marginal gas Coal Gas-coal switch Impact of higher allocation prices The Gas – Coal Switch

Price drivers Current prices suggest a price of under €10/tCO 2 e Value of allowances will move to ensure coal consumption is reduced.

Consequences EUETS will –Lead to higher energy prices –Prices <€10/tCO 2 e for Phase I –Power companies will be able to pass allowance costs through to customers –Major electricity consumers operating in global markets will be at a disadvantage (aluminium) Allocations –If markets are competitive, allowance prices will be reflected in sales prices –Sell early then buy as needed? –Allocations just determine size of windfall profit!

What will drive allowance prices? Expect strong link between allowance prices and relative fuel costs

….but what is happening! Forward prices for allowances stable – despite dramatic movements in relative fuel prices. Market currently driven by a view of policy (how many allowances issued), rather than fundamentals source: TFS

Will there be liquid markets? Will the market be “efficient”? –Is there a sufficient deficit? –“non-economic” behaviour –pre-empting Phase II allocations –auction system for new entrant reserve? Are there barriers to new entrants? –tax, credit risk, accounting treatment –transaction costs – particularly registries –susceptibility to political interference –annual-only dealing?

Conclusion for Phase I Large scale action likely to be restricted to power sector European power sector can meet abatement without investment and will enjoy “windfall” profits Non-energy sectors do not have to trade – but why give up a windfall? Trading may be limited before basis for Phase II allowances are announced A finance director may lose his job over allowance liabilities

…and phase II? Life will get tougher

EU15 with Kyoto Non-EU hot air (optimal price?) Add’l measures 292Mt 19Mt Domestic sinks 45Mt? ETS Phase I CDM supply? JI supply? Mt? ETS Phase II Mt 4117Mt Mt 3877Mt Kyoto Excess 4223Mt 2010e 346Mt DTTe EU hot air

6532Mt Mt Kyoto 6660Mt 2010e 755Mt DTTe Add’l measures 473Mt 114Mt Domestic sinks Mt Russian hot air Mt Ukrainian hot air Current CDM supply 30Mt (expected 200Mt) JI supply? 144Mt EU15, Japan, Canada, Norway, NZ, Switzerland - buyers EU accession countries hot air Hot Air could meet all DTTe (without USA) If only 20% Additional Measures are realised CDM/JI supply insufficient to satisfy demand Expect Russia to constrain supply to ensure Europe sets price Where will it be? €10-15/tCO 2 e All figures in annual CO 2 e Kyoto Balances

Flexibility Capacity Development Projects approved the Executive Board and/or the Methodology Panel: 17.9Mt/yr Projects under consideration: 12.9Mt/yr Some countries (Netherlands, Spain) have been active in purchasing flexibility allowances

Flexibility mechanisms If “additional measures” do not work, then demand for allowances would soar (10x?) if EU sticks to Kyoto Ratification of Kyoto brought in: –Supply of JI, “Hot Air”; and –Demand; Canada & Australia Consequences –Putin may be able to control supply of allowances Carbon market may be like diamonds or OPEC –Best to lock into relatively cheap “flexibility” allowances

Conclusions Phase I –Learning period –Get systems, monitoring, verification in place –Windfalls –Determine strategy for Phase II Second phase – watch out! –Much tougher –Subject to Russian influence –Arrange access to cheap allowances