Bloomberg New Energy Finance
What do the following have in common: New Zealand, South Korea, Switzerland, Kazakhstan, Quebec, Alberta, Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, Vermont, California, Beijing, Guangdong, Hubei, Shanghai, Shenzhen, Chongqing, Tianjin, Tokyo, Kyoto, Saitama and 28 countries in Europe?
The answer is, they all have (or are part of) some form of carbon emissions trading scheme. No fewer than eight new cap-and-trade markets kicked off in 2013 alone, and there are national markets currently being planned in Brazil, Thailand and China. That is in addition to 12 countries around the world that have carbon taxes.
All this suggests – contrary to what you might read in the generalist press – that there is fairly strong momentum worldwide toward carbon pricing. That does not mean a single global carbon price, but a system of carbon pricing nevertheless.
On paper, emission trading is the most efficient way for policy-makers to reduce emissions and so tackle climate change – what economist Professor Ross Garnaut famously called our “diabolical policy problem”. Using the power of thousands of individual decision-makers, all trying to minimise their costs, carbon markets reward innovation and help the world exploit the cheapest abatement options available.
In practice, however, carbon markets have promised a lot and delivered little.
First, the politics of carbon are brutal. As the financial crisis demolished the balance sheets of rich countries, the ongoing debate between long-term climate risk and short-term costs swung toward the latter. It was the financial crisis and the rise of Tea Party Republicans that killed off a national cap-and-trade market in the US. And even in a country that did not go into recession, Australia, the effort to price emissions poisoned and polarised the national debate, bringing a premature end to the political careers of three Prime Ministers in six years. In July 2014, Australia became the first country to repeal a carbon price, following just two years in operation.
More importantly, however, carbon markets are underperforming. Almost everywhere we look, carbon prices are equivalent to just a fraction of the projected emission costs of climate change, and well below levels needed to drive material shifts in the energy system.
In New Zealand, carbon currently costs just $4 per tonne of CO2e, in California its $12, in the US RGGI scheme carbon trades at $5, in Kazakhstan $2, and in China’s seven pilot trading schemes carbon costs between $3 and $7. While it is true that even a low carbon price can be an adequate disincentive for investment in long-lived, emissions-intensive infrastructure like coal-fired power stations, low prices do very little to reduce emissions from existing facilities.
Nowhere is the malaise more evident than in Europe where the region’s flagship climate policy, and the world’s largest and oldest emissions trading scheme, has been at death’s door. In the EU ETS, carbon currently trades at around EUR 7/t. In contrast, the carbon price needed in Germany to switch from emissions-intensive coal-fired power generation to cleaner natural gas – considered by most to be the cheapest abatement available – is EUR 42/t.
Fix the EU ETS and confidence in carbon markets will grow and a market solution to climate change could once again be serious business.
What went wrong in Europe?
In 2009, the global financial crisis hit Europe hard. By the end of the year steel production had fallen 30%, cement production was down 20% and electricity production was down 5.4%. This translated into an overall 4.4% contraction in Europe’s economy and an 13% drop in emissions. As emissions fell, so did the carbon price.
The EUA price had reached EUR 28.34 at the end of June 2008. Just over six months later it was below EUR 10. And while there was a bounce-back to around EUR 15 through the rest of 2009 and 2010, by mid-2011 the price crashed through its support levels, reaching EUR 3.16 per tonne on 26 April 2013. At the same time the carbon price required for coal-gas fuel switching in power generation was EUR 36. A year later the carbon price had recovered to around EUR 6, but the fuel switching price was approaching EUR 50/t. By this stage, the glut of carbon allowances had put a massive wedge between the market price and its fundamental drivers.
As the price declined so did interest from market participants, many of whom had already been burned by the collapse in prices in 2007 as phase one of the programme drew to a close. Watching the market go south again confirmed for many that carbon prices were too volatile and that the market was riddled with political and structural risk. In addition, new banking regulations and capital requirements in the wake of the financial crisis curtailed commodity businesses that trade carbon.
By the end of 2013, Barclays, Deutsche Bank and UBS had closed their carbon desks, and JP Morgan, Morgan Stanley and others had scaled back, absorbing carbon specialists into gas and power teams. Overall, the number of London City workers employed on carbon desks fell 70% to just a couple of hundred, from close to a thousand at the start of 2010.
While the recession has been by far the biggest cause of the market downturn, two other factors have made matters worse. First, between 2008 and the end of 2014, over 1bn tonnes of cheap carbon offsets were imported into the EU ETS from the UN Clean Development Mechanism and Joint Implementation programmes. Second, renewable energy capacity rose dramatically throughout the period, even as power demand was falling. In total, $599bn was invested in renewables in Europe between 2008 and 2014: some $166bn of that in Germany alone, another $92bn in Italy, and $77bn in the UK. Annual investment in Europe peaked at $121bn in 2011. In terms of capacity, this seven-year period saw a 158GW increase in zero-emission wind, solar and small hydro, partly to displace more emission-intensive coal and gas generation.
By the end of 2014, the EU ETS was oversupplied by more than 2.2bn tonnes of carbon. That is around 112% of the annual emissions covered by the scheme. Allowed to work through naturally, it might be nine years or more before prices begin to rise.
So is it broken or isn’t it?
From one perspective it may seem obvious that Europe’s carbon market desperately requires an overhaul to avoid a spiral into policy oblivion. However there has been a debate as to the true purpose of Europe’s carbon price.
The EU ETS began in 2005 with two central objectives – to cap emissions, and to drive low-carbon development in Europe. For three months at the start of phase two in 2008, the market appeared to do exactly that. The price was consistently over EUR 25, driving some operational abatement and providing a robust price signal to investors. Every forecasting house – Bloomberg New Energy Finance included – thought prices would go north. However, as the recession hit, emissions and prices both fell and these two central objectives suddenly became mutually exclusive. So what is the real purpose of the EU ETS?
One side argues that we should only worry about emissions and that adjusting the scheme now to raise prices would be akin to moving the goal-posts during play. Price is a means to an end, not an end in itself. It is a fair point: emissions covered by the EU ETS are down 11% since 2008 – a much better outcome than Europe had originally planned, whatever the cause. Among those pushing this argument are Europe’s big industrial groups. Few of these companies are natural commodity traders, and most consider the EU ETS a threat to international competitiveness. This view is maintained despite ongoing free allowance allocation and no evidence of so-called ‘carbon leakage’. Also in this camp are EU member states with strong coal industries, including Poland, which has consistently argued against intervention.
Others, however, say that price is key: that if the market cannot deliver a robust price signal that reflects the real cost of abatement, then it will dwindle to nothing. Reducing emissions is a long game, and near-term price failure threatens the cost effectiveness of the scheme and puts the whole market-based approach at risk.
Critically, Europe’s biggest five economies by GDP and population – Germany, the UK, France, Italy and Spain – support this view. In this camp are also the majority of market makers, traders, utilities, intermediaries and investors. Utilities want a higher, less volatile price signal that can spur and support investment in new gas-fired capacity, and replace the myriad of renewable energy policies that have pushed down wholesale prices, hurting the profitability of their thermal assets. Energy traders will come back to the market “if things get interesting again”, according to one trading manager. By “interesting” he means, “higher prices”. And while investors are expert in managing commodity price risk, a higher, more stable carbon price could better support new low-carbon investment decisions. To date, carbon has simply been too volatile and weak to bank investments on.
Reform will ultimately require change to the EU ETS Directive and 65% of votes in the European Council. And it looks very much like the reformers have the numbers.
A temporary fix
There are two stages to reform. The first is a change to regulations that withholds 900Mt of carbon allowances which would otherwise be auctioned in 2014, 2015 and 2016, and releases them again in 2019 and 2020. This process has been called ‘backloading’ and was adopted in December 2013 as a way of putting immediate upward pressure on prices while a more permanent solution could be designed and negotiated.
In terms of long-term market fundamentals, backloading looks a lot like rearranging deck-chairs on the Titanic. But withholding 900Mt should create scarcity and raise prices. This is because the market is not quite as long as it first looks. Of the 2.1Gt surplus of carbon in the system, 1.1Gt is tied up in the forward hedging the utilities, refiners and other liable entities do to manage future carbon price risk. These forward contracts are offered by counterparties who de-risk those trades with purchases in the spot market. This means there are significantly fewer surplus carbon allowances available. Stripping out 900Mt does not technically make the market short, but it does mean that cement, steel, glass and other industries will need to sell to balance demand. For that to happen, prices will need to rise. Bloomberg New Energy Finance analysis from August last year suggests that prices could rise to EUR 15/t or more by the end of 2016 to ensure enough supply for the market.
Backloading is a short-term fix and, without further intervention, prices will certainly crash back down as the 900Mt is returned to the market in 2019 and 2020. Permanent reform would need not just to deal with this volume, but also make the market more resilient to shocks and minimise the chance of a future debilitating structural imbalance. One idea that has been an ongoing discussion between carbon wonks since well before the financial crisis is a carbon bank.
On 22 January 2014, the European Commission tabled a discussion paper on a mechanism called the Market Stability Reserve. The MSR is type of carbon bank that acts to withhold and return supply to the market based on the number of allowances in circulation. If the surplus is too big, supply is withheld. If it sinks too low, supply is returned. In this way, the MSR pushes the market towards moderate scarcity and a carbon price sufficient to drive abatement. Unlike a central bank, the MSR would operate entirely according to pre-defined rules, leaving no discretion to the Commission or member states in its implementation.
The Commission’s original plan was for the MSR to begin in 2021, but a counter proposal supported by the EU Parliament’s Environment Committee would see it start in 2018, immediately loaded with the 900Mt backloaded and unallocated allowances from the 2013-20 phase three trading period. Negotiations are ongoing. A conciliation committee is due to meet on 30 March for the first in a set of trialogue sessions where officials from the European Parliament, European Council and European Commission will meet to find common ground. Although the risk of a blocking minority remains, we expect major decisions to be made before the end of May.
The best thing about the MSR is that it should actually work. Feeding a range of extreme scenarios into our model, we conclude that the MSR will almost certainly result in carbon prices sufficiently high to achieve the policy goal for which they were designed, namely shifting Europe off its high-carbon diet.
How high would carbon prices go? The answer to that depends to a large extent on the spread between European coal and gas prices – but very likely over EUR 30 per tonne.
The World Bank has suggested that a robust global solution is required to revive private sector confidence to invest in carbon markets. In our view, that is to perpetuate the myth that a single global carbon price is necessary and sufficient to get the world onto a two-degree trajectory.
The truth is that confidence in carbon markets will be achieved not by signing another generic agreement in Paris and waiting until 2020 to see the details, but by fixing the EU ETS as soon as possible. And though it has been a long time coming, a fix now looks within arm’s reach.
Then carbon markets might be seen as an idea whose time has come. Again.