Greenhouse Gases: Reviewing the European Trade

Deck: 

Lessons from the EU Emissions Trading Scheme emerge after two years.

Fortnightly Magazine - February 2007

Despite assertions to the contrary, the European Union Emissions Trading Scheme (EU ETS) is working. Industry has changed both short-term behavior and longer-term plans to reduce compliance costs—the driving down of greenhouse-gas emissions being the intended and achieved result. In this article, we review examples of the ETS affecting both planned and actual behavior. The other side of the coin is how regulatory and political uncertainty undermines this. We also note how forward market prices can deviate from expectations of future spot prices, how the market’s design caused this, and how it could be avoided. We believe that despite any criticism, cap-and-trade is easily the most cost-effective method of achieving societal environmental goals and the issues presented so far may be addressed readily.1

The European ETS was set up to achieve compliance with European commitments to reduce emissions under the Kyoto greenhouse gas treaty. In operation for almost two years now, and covering only a subset of those industries producing greenhouse gases (GHGs), its success is driving calls for expansion to cover other sectors within the EU.

Large industry and the utility sectors must participate in the EU ETS. The ETS is broken into two phases. Phase 1 covers 2005 through 2007. Phase 2 covers 2008 through 2012 and coincides with the initial Kyoto compliance period. Phase 1 certificates, absent changes, generally will not be fungible into Phase 2 and either must be used or will expire. Certificates are denominated in metric tons of carbon dioxide, but each type of greenhouse gas is assigned a factor to convert it to the same deemed level of effectiveness (tonne-equivalent) as carbon dioxide in acting as a greenhouse gas.2

The scheme is sizeable and well worth studying for lessons in how markets develop and operate. Meeting GHG emission-reduction targets involves long-term investment, as well as short-term operating decisions, so this market offers valuable lessons in how spot and forward markets operate and interact.

Rationale

A market-based system ensures the lowest societal cost of compliance with the Kyoto targets. No central planner could as accurately select the mix of lowest-cost reductions nor the sharing of costs. Cap-and-trade legislation simply creates the target number of allowances. These allowances or emission rights may be legally bought or sold, but ultimately, each polluter must surrender the right number against actual emissions. The allowance market provides an observable allowance-market price. Those who can reduce emissions at a cost lower than the market price of the allowances will do so. The remainder prefer to buy allowances.

The last allowance bought will be that which sets price and is equal in price to the lowest in cost of all remaining compliance methods. So all required reductions are made at a cost lower than the allowance price. Those who can’t spend less than the allowance price to reduce emissions buy allowances instead. In this way, the reduction options available are ranked and the set of lowest-cost compliance projects is implemented.

Consider a small system of four polluters, A, B, C, and D. The following table illustrates the GHG produced by each and the cost of reducing that production:

If a “fair” allocation of mandatory reduction were to be made of, say, 10 percent to each, the reduction would be 45 tonnes and the total cost to society would be EU570.

If each were given an allowance allocation of 90 percent of its emissions, the starting point looks like this:

Now C can reduce GHG production at a cost of EU7/T and B has a cost of EU20/T so B should try buy from C or D. If B buys 15 from C; and A buys 10 from C; and D buys 15 from C then the end point looks like:

So the overall cost of compliance went from EU570 under proportional mandated cuts to EU315 under cap-and-trade irrespective of how the costs were shared among those affected.

Allocations

Allowances were granted to participants to mitigate financial hardship. In theory, the initial allowance allocation is not relevant to the efficiency of the outcome. It matters not who first owns the allowances, nor even whether they paid for them. It matters only that they are traded freely. Freely traded allow-ances will find their way into the hands of those for whom reduction cost exceeds allowance cost. As we shall see later, the assumption that they are freely traded is an important one. Separate from any argument of windfall gains from allocation, allocation to those who do not actively trade them can lead to market-price distortions.

Size and Windfalls

Approximately 2.2 billion tonne-equivalent of allowances are allocated per year under the EU ETS. When prices were in the mid EU20 per tonne-equivalent, this equated to roughly EU 50 billion or one half of 1 percent of European annual GDP.

Industry and utilities receive most of this as a free allocation. The opportunity cost of surrendering an allowance instead of selling it is well known because the allowance market prices are public. This is reflected in power producer bidding behavior and so is collected through energy prices. The effect of this allocation plus this unsurprising, in fact, desirable bidding behavior created a substantial transfer payment from end consumers to utilities and industry with some associated controversy.

Information Effects

In late April 2006, the EUA market collapsed. Prices were more than EU30 per tonne on a Friday and dropped dramatically over the following Monday and Tuesday, trading in single digits at times. The EU had released the 2005 compliance figures, showing a larger-than-expected surplus of allowances—or equivalently, lower-than-expected emissions. Amongst all the accusations of “cheating” and impugning of national character that ensued, one point stood out: The market was operating on insufficient information. Most independent information services consistently had predicted shortfalls based on their fundamental analysis. The market liked the story.

As always, it was easy to point fingers afterward but the problem really lay with the lack of interim information. Compliance information was coming into the verifiers3 rateably over time, but there was no information released until that fateful two days in April. This volatility was disruptive. To avoid a repeat, information needs to be more rapidly disseminated.

Uneven Participation

Forward markets price out quite apart from consensus expectations of future spot markets. Why? Because it takes a lot of capital to bet on future outcomes. The other side of the bet requires assurance that you will pay if you lose. Capital is expensive, so arbitrageurs rarely plan to carry a long dated bet to maturity. Instead, the balance of supply and demand sets the clearing price in a forward market just like in the spot market. Forward prices deviate from expectations of future spot prices when buyers are more motivated to transact forward than are sellers, or vice versa.

So, after the crash in EUA prices over new verification figures, and despite widespread belief that Phase 1 was oversupplied, prices crept up again. Forward prices went into the high teens and only lately have dropped despite perceived fundamental oversupply. What gives? The simplest explanation is that industrials with length are not motivated to sell forward but utilities with short positions could not sit still. Utilities run sophisticated risk-management systems modeled on those of financial speculators and market makers in financial markets. These systems demand that open exposures are covered. When EUA prices dropped, coal became a far more attractive fuel relative to gas. Coal, however, requires almost twice as many EUAs per gigajoule burned than does gas. Utility risk management required extra allowances be bought to cover this.

But industrials did not have to sell. Industrials are motivated differently. They do not consider emissions-price risk to be a core risk and simply view their allocated allowances as a means of achieving compliance. Any forward sales may indeed increase risk if their production estimates are wrong. Nor is any serious senior management time or expertise devoted to maximizing the revenue from such sales. It is simply not worth their time. To add to this, the controversy surrounding windfall profits from allowance allocations may make industrials doubly cautious about selling excess EUAs.

Structurally, we thus had in mid-2006 an excess of demand over supply in the forward market but not in the future spot market.

In 2007, as we come closer to the end of Phase 1, industrials see less risk from selling a more certain excess from known production figures. They do not likely want to see the excess expire worthless. Selling has thus pushed spot prices down. EUA prices for forward delivery thus seemed artificially, but explicably, high.

Those contemplating new rules and new trading schemes in other countries should keep this in mind. A very practical solution comes to mind from the transmission markets of New England. There, incumbents with grandfathered rights are allocated auction revenue rights (ARRs) instead of transmission itself. Certainly they could use the ARRs to fully offset the cost of buying the grandfathered transmission at auction to achieve the same result as simply giving the transmission rights in the first place. This does not seem to happen. What otherwise would be an opportunity cost becomes a real cost and seems to focus more attention on value leading to more efficient price setting. So, GHG allowances should all be auctioned with an allocation of ARRs in lieu of allocating allowances themselves.

Impact on Emissions

Notwithstanding the debate over whether the system is long or short, the protocol clearly is causing changes in observed operating behavior. In the short term, the major opportunity to reduce GHG emissions is by substituting gas for coal, especially in power production. All other methods take time. They involve capital investments. But if you simply run gas plants in lieu of coal plants then GHG emissions drop.

There are two reasons for this. First, natural gas produces approximately half the CO2 of coal for a given amount of heat released. Second, many gas plants are more efficient than coal plants, which further increases this advantage. Normally, though, gas prices are so much higher than coal prices that coal will tend to be burnt in lieu of gas. When EUA prices are sufficiently high, the economics are reversed. Then one would expect gas to be burned in lieu of coal. And this is exactly what is observed.

New Investment

Evidence of any ETS impact on new investment is limited. Much of the blame for this can be laid at the door of regulatory uncertainty. Phase 2 ends in 2012, which is well within the payback horizon of most new capital investments. The lack of certainty has profound impacts. Will there be a Phase 3? What will it look like? Until these questions are answered, a liquid forward market will not exist. Without a forward market, the price signals that do exist to change short-term dispatch are missing when it comes to choosing between new technologies for investment.

In conclusion, the EU ETS is having a clear impact on greenhouse-gas emissions, providing efficient economic incentives to modify the day-to-day behaviour of emitters. Implementation has not been free of issues however. Chief amongst these have been uneven participation between net buyers and net sellers, negative public reaction from windfall gains from higher electric prices, and unnecessary volatility as a result of poor information flow. All of these issues readily can be addressed, and expectations are that Phase 2 will proceed more smoothly, a Phase 3 will be announced, and that more sectors of the economy will be pulled in. The sooner a Phase 3 is announced and its details published, the sooner the ETS can begin to motivate long-term investment in carbon-neutral technology.

 

Endnotes

1. A cap-and-trade scheme is a market in which the legal right to produce an undesirable byproduct is traded between producers. Legislators limit the number of these rights and the market price determines where mitigation occurs. Those that find it cheaper to mitigate do so and the others buy allowances.

2. This is no small feat. Each gas has a different half-life as well as a different effectiveness in trapping heat. Is a gas that is twice as effective in trapping heat but half as long lived equivalent to the same mass of CO2?

3. The auditors of the emissions data for each facility produce the numbers that determine what actual emissions were, and thus how many allowances must be surrendered.