Middle East Economic Survey

 

VOL. XLVIII

No 12

21-March-2005

 

Emissions Trading: If You Can’t Beat Them, Join Them?

 

The Kyoto Protocol entered into full force and effect on 16 February 2005, ironically on the same date as the annual Institute for Energy dinner in London. The energy sector is cited as the biggest offender in the production of greenhouse gases and is the sector that will, arguably, suffer most from legislation to arrest global warming. Liz Bossley CEO of energy markets consultancy firm the Consilience Energy Advisory Group Ltd (CEAG) examines the evolving emissions market. Ms Bossley is also a member of the executive committee of the London Climate Change Services group.

 

It has been a long and tortuous road from the establishment of Intergovernmental Panel on Climate Change (IPCC) by the World Meteorological Organisation (WMO) and the UN Environment Programme (UNEP) in 1988 to the entry into force of the Kyoto Protocol on 16 February 2005. There is still a long way to go before a truly worldwide emissions trading market is firmly established, but if the European Emissions Trading Scheme (EU ETS) is anything to go by, love it or hate it, emissions trading is here to stay.

 

The IPCC estimates that global temperatures will rise by 1.0-3.5% by 2100 if there is no attempt to curb emissions. This, says IPCC, is likely to be accompanied by a 15-to-95-centimeter rise in sea levels and catastrophic damage to forests, deserts and other ecosystems. According to the World Energy Council, CO2 represents over 70% of all anthropogenic (man-made) GHG emissions, and fossil fuel combustion accounts for over 80% of anthropogenic CO2 emissions, so the oil, gas and coal industries will bear the brunt of legislation to slow down and eventually, it is hoped, stabilize global warming.

 

The History

The UN Framework Convention on Climate Change (UNFCCC), a global initiative to address global warming, was adopted at the Rio Earth Summit in 1992. The supreme body of the UNFCCC is the Conference of Parties (COP), a regular meeting of all the states that have ratified the convention. The most significant COPs to date have been COP3, in December 1997, at which the Kyoto Protocol was adopted and COP7, in November 2001, when the Marrakech Accords were agreed.

 

The Kyoto Protocol proposed legally binding targets for developed (Annex 1) countries to reduce emissions of GHGs by at least 5.2%, compared with 1990 levels, between 2008 and 2012.  It suggested a 7% cut by the US, the world’s biggest emitter, 8% for the EU (spread unevenly through an intra-EU agreement ‘Burden Sharing’), 6% each by Canada and Japan, stabilization by Russia.  Increases of 1%, 8% and 10% were to be allowed by Norway, Australia and Iceland, respectively compared with 1990 levels.

 

Three mechanisms were envisaged for achieving target reductions:

Although Kyoto applies to countries, not corporations, each country will comply with its Kyoto cap by delegating responsibility for action to domestic companies through national policy instruments.

 

When the US said that it would not sign-up, citing an absence of targets for Developing Countries,  notably  China, Kyoto looked dead because its adoption needed ratification by 55 countries, including those countries responsible for 55% of 1990 emissions.

 

COP 7 in Marrakech salvaged the Kyoto process after the US opted out. 160 countries agreed on more detailed rules for implementing the Kyoto climate treaty and rules on a compliance regime with enforceable and binding consequences for countries that do not meet their Kyoto commitments.  It also detailed a package for reporting and reviewing countries' inventories based on IPCC methodologies and stated the intention to ratify Kyoto by the World Summit for Sustainable Development in September 2002.

 

In fact it was not until the Russian Duma agreed to ratify the Kyoto Protocol on 22nd October 2004 that the 55 country/55% of emissions pass mark was reached and the protocol entered into full force and effect on 16 February 2005. In the war against global warming, the Kyoto Protocol is a feeble weapon, with its insubstantial target cuts and its tortuous bureaucratic processes. But it may be regarded as only a preliminary and pragmatic laying down of battle lines: the real fight has begun with attempts to bring countries such the US and Australia into the fold and to agree more meaningful cuts for the post-2012 period.

 

The backdrop for discussions is the wider political and economic debate on achieving sustainable development in the poorer countries of the world and the dichotomy between adaptation to and mitigation of the effects of global warming, ie lessening the harm caused by global warming or curbing GHG emissions. At best mitigation is a long-term strategy, but there are many countries suffering the effects of global warming now who argue for a shift in focus by developed countries to more immediate aid.

 

Countries for whom petroleum revenues form a substantial proportion of GDP, notably those in OPEC, can acquire at seat in the debating chamber by ratifying Kyoto; and some have already done so. Saudi Arabia argued vigorously at the 10th COP in December 2004 that OPEC countries deserve compensation from the adaptation fund to cushion the impact of an international attack on the raw material on which their economies are based.

 

The Clean Development Mechanism

CDMs are one of the three key planks of the Kyoto Protocol designed to promote sustainable development, reduce GHG emissions and help developed countries meet their Kyoto commitments cost-effectively. CDM projects are based on voluntary participation approved by each Party involved, real, measurable, and long-term benefits related to the mitigation of climate change, and reductions in emissions that are additional to any that would occur in the absence of the project.

 

The paperwork and administrative procedures for approval are onerous. Projects must be independently validated, then registered with the CDM Executive Board (EB) before the verification, certification and the eventual issuance of tradable CERs can take place. The review and agreement of new baseline measurement and monitoring methodologies alone can take up to four months. The EB is under-funded and requires additional resources to speed up and simplify the certification process.

 

At the moment projects that involve cutting CO2 alone are unlikely to pass the ‘additionality’ criteria of the CDM EB and at the same time be worth the delays involved in acquiring CERs: any project that can demonstrate successfully that it cannot proceed without CERs is unlikely to convince investors that it is sufficiently economic to be the best investment available in the market. In the case of projects that involve cutting some of the more ‘potent’ GHGs (ie gases with a high Global Warming Potential – GWP), such as hydrofluorocarbons (HFCs), the CDM process is more compelling. This is because the reduction of 1 metric tonne of CO2 earns 1 CER, whereas the reduction of 1 metric tonne of HFC can earn hundreds or even thousands of CERs, depending on the specific HFC involved.

 

Oil producers who wish to cut CO2 by, say, reinjecting it into depleted reservoirs are unlikely to find the economics much improved by CERs and must also weigh the benefits of improving reservoir flow rates to justify the project on purely financial grounds.  This of course depends on the price of oil and/or gas and the relative sales price of CERs. At this time CERs trade at a discount to other tradable allowances because of the uncertainty of the CERs actually being issued and in recognition of the lobby to limit the extent to which developed countries can comply with their Kyoto reduction targets, as opposed to taking steps to limit domestic emissions. In time this should change because CERs are bankable and can be used to comply with future emissions reductions targets, whereas other tradable allowances, such as those generated by the European emissions trading scheme cannot.

 

To take advantage of the CDM process, countries need to have ratified Kyoto and put in place a Designated National Authority (DNA) to create eligible CDM projects.  There is no need, for example, to have foreign investors holding an equity ownership share of the CDM project, if that is in conflict with domestic policy, so long as all the CDM sustainability, additionality, eligibility and compliance criteria have been met. Before an Annex I party, a developed country that has signed the UNFCCC, can buy CERs from such a project from an account within the CDM registry, it must submit a letter of approval to the CDM EB in order for the CDM Registry administrator to be able to forward CERs from the CDM registry to the Annex I national registry. 

 

Joint Implementation

‘Activities Implemented Jointly’ (AIJ), now shortened to just JI, involves one developed country investing in emissions abatement measures in a second developed  country or economy in transition in return for credits which it may use in meeting its own Kyoto abatement target. The host country for the project receives foreign investment and advanced technology, but not credit toward meeting it own Kyoto emissions caps. This has been operating in pilot phase since 1995, but no ERUs have so far been awarded.

 

The operation of JI is almost as complicated as that of CDMs but eventually the need for time-consuming international oversight will be eliminated once all of the countries involved have set up emissions registries into which ERUs can be placed and once approved GHG inventory mechanisms are set up. It is anticipated that the largest recipients of JI financing are the FSU countries.

 

International Emissions Trading

The third plank of Kyoto, IET, is arguably the most controversial. The principle underlying emissions trading is that countries that cannot meet their emissions reductions targets by cutting domestic emissions or by buying CERs and ERUs, can remain within their Kyoto cap by purchasing allowances from countries who have cut their emissions by more than the Kyoto-proscribed amount and therefore have a surplus to sell.

 

IET is an allowance-based system and what is bought and sold is any part of an assigned amount (AA), the national cap of an Annex B country under the Kyoto Protocol. Each assigned amount unit (AAU) is a right to emit 1 tonne of CO2, ie what is being traded is the right to emit 1 metric tonne of CO2 equivalent (CO2e), not CO2 itself, as this is not a commodity. This is arguably a market in regulatory risk: companies/countries are trading to avoid a penalty or tax, or to gain a subsidy. The market supply and demand fundamentals reflect changes in regulations and ultimately how companies and consumers react to these regulations.

 

The Kyoto process does not include provisions for how the IET market will trade and it is anticipated that the shape of market will emerge from the needs and wishes of the companies that trade in it. A strong signal about the nature of this market can be found in the rapidly-evolving market in European Emissions Allowance Units (EAU).

 

The European Market

The European Emissions Directive arose from the UNFCCC and the Kyoto Protocol and its target of an 8% reduction relative to 1990 EU GHG emissions by the period 2008-12. Whilst the Directive gives EU Member States (MS) responsibility for allocating emissions allowances through a National Allocation Plan (NAP) the EC retains responsibility for ensuring that national allocations are objective and transparent and do not distort the scheme. The 1st phase of the scheme operates from 1 January 2005 to 31 December 2007 and the 2nd phase will be from 2008-12, coinciding with the first Kyoto commitment period.

 

For Phase 1 (2005-07), roughly 95% of allowances have been allocated free of charge. For phase two (2008-12), this will be reduced to 90%. The remainder may be auctioned. Allowances have been set aside by each MS for new entrants to the sectors covered by the scheme. These are:

 

Combustion activities exceeding 20mw (power stations, on-site generation etc); Oil refineries; Coke ovens; Cement production; Glass manufacture; Ceramic products manufacture (roofing tiles, bricks, porcelain etc); Pulp production; Paper and board production; and Ferrous metal production and processing.

 

From 1/1/2005 some 12,000 companies must measure their emissions, report levels on an annual basis and have these verified by an approved independent third party. Firms must surrender sufficient allowances for a given year by April in the following year. Sites failing to do so will pay a penalty, in addition to having to submit the allowance shortfall the following year. The penalty is €40 / tCO2e for the first three-year period rising to €100 / tCO2e in the second phase. CDM CERs may be used to meet European targets in the 1st Phase and both CERs and JI ERUs will be acceptable in the 2nd Phase.

 

Member states, individually or collectively, have established registers for the issue, holding, transfer and cancellation of allowances, whilst the EC acts as Central Administrator of the transactions log. Any person may hold allowances (eg traders, financial institutions etc) and trade in the scheme.

 

An over-the-counter (OTC) forward market in EAUs has been trading since 2003 and the volume and liquidity of this market have risen substantially since the beginning of this year when the scheme commenced officially. (See Graph). Currently the main barrier to trade is establishing credit lines for so many new entrants to this new market and establishing contractual documentation between the counterparties. This latter task has been complicated by the existence of three competing sets of general terms and conditions of trade: ISDA, EFET and IETA terms. An industry working party is currently at work to harmonise these conflicting terms to remove contractual basis risk from the OTC forward market.

 

It only became possible to trade for ‘physical delivery’, ie transfer of title to an allowance in a national registry, from 28 February 2005, when the allowances were placed in the registry accounts of the effected installations. It is anticipated that the majority of the 12,000 companies involved in the ETS will confine there trades to dealing in the physical market for compliance purposes rather than hedging or speculating in the OTC forward market.

 

A futures market in EUAs is already trading on the Nordpool exchange and a number of different exchanges are also planning futures contracts including: a joint venture between the IPE and the European Climate Exchange; EEX; EXAA; Powernext in partnership with Euronext and Caisse des Dépôts et Consignations; EEeExchange; and, Sendeco2.

 

Nymex are also rumoured to be considering a contract.

 

 

Source: Barclays Capital