Column : Will carbon prices recover

Written by mahua Acharya | Updated: Dec 12 2012, 00:20am hrs
Emissions in 2012 and 2013 are not expected to change significantly. Carbon credit surplus in 2013 could be 2 billion units

Prices of European carbon permits are 7 euro/tonne, down by 8 euros from November 2008. Certified emission reductions (CERs), or carbon permits from developing countries, traditionally follow European Union Allowance (EUA) prices and trade at a discount of 0.5-1 euro, although this spread has increased significantly over the last year. As of November 26, 2012, these developing country CERs were at 0.88 euro, their lowest ever. Volumes are minimal and purchasing in the more meaningful 5-8 euro range continues, but that is for special projects with unique environmental and social benefits, or from programs of activitiesa parallel system introduced into the clean development mechanism to make systematic reductions through various programmes.

The first major price decline was in 2009, when recalibrated growth plans forced firms in Europe to offload permits they had acquired for future usage. But the effects of the 2008 crisis were worse than anticipated and firms further offloaded credits in 2010-11, forcing prices to fall further.

Prices are a reflection of supply and demand. The emissions cap for the European Union Emissions Trading Scheme (ETS)2008-12 periodwas considered ambitious. But the 2008 crisis radically altered the picture and the ETS has since experienced a surplus of allowances and international credits compared to emissions. The number of allowances put into circulation by European governments has been higher than industry demand. Supply and use of international credits have increased. According to the European Commission (over the period 2008-11), 8,171 million allowances were put into circulation and 549 million international credits used for compliance, in total adding up to 8,720 million permits that were available for compliance. In contrast, emissions in the same period were only 7,765 million tonnes of CO2 equivalent. By early 2012, a surplus of 955 million allowances had accumulated. Even if international credits were excluded, the surplus would still have been 406 million allowances.

Emissions in 2012 and 2013 are not expected to change significantly. Therefore, the surplus at the start of the next phase, 2013-20, could be as large as 2 billion.

But the oversupply problem does not end there.

An important element of the EUs strategy for meeting its Kyoto commitment is the EU ETS. EU governments issue allowances that can be traded by companies. For Kyoto consistency, each allowance is equivalent to, and shadowed by, a corresponding assigned amount unit (AAU) in EU government national registries.

AAUs are emission rights under the Kyoto Protocol; each is a metric tonne of CO2e. For the first Kyoto commitment period (2008-12), each country with an emissions reduction target received AAUs equivalent to its permissible volume for the 5-year period. These AAUs can be traded between governments to meet targets.

Under current Kyoto rules, countries are allowed to carry forward their AAUs into the future commitment period, assuming of course that such a period would be agreed to by those countries. According to Thomson Reuters, the total surplus AAUs in the system today is around 13 billion tonnes of CO2e. Russia, the largest holder of AAUs, has said that it will not join a second commitment period, which means its 5.8 billion tonnes of CO2e gets removed. But this still leaves a surplus of 7.3 billion tonnes of CO2e that could be carried forward into the next period. Carryover rules are on the menu for the ongoing climate negotiations in Doha.

An excess of AAUs also has a bearing on CERs, albeit indirect. The CDM today is a functional system with more CERs generated than can be used in the ETS. A competing unit called an Emission Reduction Unit (from economies in transition) is also eligible for compliance in the EU ETS. All these tonnes make upward price expectations for CERs in the long term highly uncertain.

Noting the decline in prices and an oversupplied market, the European Commission began work on a series of measures to correct the system to reflect realities post financial crisis.

The most anticipated change includes delaying the supply of permits scheduled for the first three years to the back-end of the scheme (2018, 2019 and 2020), when economic growth is expected to recover. As soon as this announcement was made two weeks ago, carbon prices rose by 9%. The European Commission is also considering permanent eradication of a certain amount of EUAs from the 2013-20 period, but this remains uncertain.

A number of other proposals are under way, including limiting of access to international credits, which were allowed for use in Europe primarily to contain compliance costs. Following macro-economic developments and the fact that emissions have been substantially lower than the cap, the quantitative limit of international credits in the period 2008-20 turned out to be generous. The European Commission views this as a major driver for the build-up of the surplus, and believes that without these CERs, the surplus in the EU ETS by 2020 would be only around a quarter of the expected surplus.

What impact will the European Commissions proposal have According to Robert Dornau, managing partner of Carbon Flow and a carbon market veteran, there will be a limited positive effect in the short term as immediate oversupply is taken out of the market. However, as this supply has only simply been pushed to later, the effect will not be substantial.

The effect on CER prices is therefore uncertain. The focus is on the European Commission and member states who have to agree on the proposed measures before analysts are able to comment.

An additional complexity introduced into pricing is the somewhat broken relationship between CERs and EUAs, due to CER oversupply. Just because EUA prices increase doesnt mean CER prices will. According to some, this uncertainty is likely to stay unchanged unless there are drastic changes in international policythat countries take on deeper cuts and more parties join the international effort to tackle carbon emissions.

What does this mean for India

Credits from Indian projects registered after 2012 are already disallowed for use in the ETS, and CERs from forestry and certain industrial gas projects are excluded. The European Commission has contemplated eliminating the use of international credits after 2020, introducing further uncertainty into the use of CERs in the ETS.

As things stand today, India has a limited role to play in creating demand for CERs and influencing prices. To do this, India would need to take on emission cuts, and since that is not in national economic interest, Indian companies will simply wait and watch.

And until then, the environment loses.

The author is with C-Quest Capital, a carbon finance business headquartered in Washington, DC