Carbon allowance auctioning -- EU tries to find the right balance

EU states are hoping to auction more allowances in Phase II of the EU emissions trading scheme, but how far are they prepared to go and what are the pitfalls? Mike Scott investigates

When Lithuania auctioned 552,000 carbon allowances last month, it became the last of the four countries in the European Union’s Emissions Trading Scheme (ETS) – the others are Ireland, Denmark and Hungary – to sell off allowances in Phase 1 of the scheme.

But the sale price Lithuania achieved, €0.06 per tonne, or a total of €33,120, barely covered its administrative costs and only served to demonstrate the pitfalls of the auctioning process.

Off to a slow start

Member states were allowed to auction up to 5% of their allowances during Phase I of the ETS, rather than allocating them freely, but, according to investment bank Lehman Brothers, only Denmark has been auctioning up to that

In fact, none of the four auctioning countries made the most of the opportunity, given that carbon prices at their highest in Phase 1 of the scheme exceeded €30 before crashing when the 2005 figures revealed that allocations had been too generous.

The auctioning states did not sell when the price was higher partly for logistical reasons, according to Andreas Arvanitakis, a market analyst at Point Carbon. “Ireland, for example, only has eight people to deal with the ETS. They simply had other things to do first, including deciding on the rules for the auction, while they also had to allow a lead time for companies to prepare for the auction.” As member states get used to auctioning, sales are likely to be more evenly spread out.

Denmark sold 3.3m tonnes through the brokered market in February, when the price ranged from €0.90-€2.20 and has a further 1.7m tonnes available to sell, while Ireland sold 963,000 tonnes at €6.87 in December 2006. Hungary’s experience also illustrated the vagaries of the market: it sold 1.2m tonnes in the same month at €7.42, while a similar amount sold three months later in March 2007 fetched just €0.88.

The auctions are open to anyone with an interest in the market, from installations needing to cover shortfalls in allowances to financial players.

According to Sascha Bloemenhoff, chief commercial officer at New Values, which operates the Climex exchange that sold the Lithuanian allowances, many of the sales were more about gaining experience than raising money.

One of the goals of allowance auctioning is to make it cheaper for heavy industry to invest in carbon-abatement technology than to buy carbon credits. For renewable energy utilities, auctioning is good news because it adds extra costs to high-carbon energy. Once a cost of carbon of around €15 a tonne is passed onto the consumer, the price of green energy will become more evenly matched with brown fossil-fuel energy.

Auctioning is set to feature more strongly in Phase II of the ETS, which runs from 2008-2012. The allowances that members will be permitted to auction will double to 10% in the second phase.

Windfall profits

Enthusiasm for auctioning has been boosted by the behaviour of utilities in the first phase. They were given their allowances for free, but passed on the cost of the carbon to customers, earning windfall profits in the process.

Arvanitakis explains that although auctioning was allowed in the EU directive that established the ETS, many countries opted not to do it in Phase 1 because of strong lobbying by business, which wanted free allocations. “However”, he adds, “because of the resulting over-allocation and the windfall profits made by the power sector, they don’t have a leg to stand on now.”

He says that the strongest advocate of auctioning in the ETS is the UK, even though it auctioned no allowances in Phase 1.

“It is our long term goal to move to full auctioning to make sure that the price of carbon is taken into account and resources are allocated more efficiently,” says a spokeswoman for the UK Department of Environment, Food and Rural Affairs (Defra). “Passing on the higher costs of carbon to consumers is a desirable outcome, but enriching utilities is not.”

However, the spokeswoman added that it would be impractical to move immediately to 100% auctioning, because it would cause massive market disruption. “We need to phase it in so that business has time to adapt.” No date has been set for 100% auctioning.

According to Defra, UK power generators saw windfall profits of £800m in Phase 1. As a result, the UK’s auctions in the second phase will target that sector. While about 7% of UK allowances will be auctioned, allowances for the auction “pot” will be deducted from the large electricity producers sector only.

The case for auctioning

Lehman Brothers’ recent report, “The Business of Climate Change II”, argues that auctioning as opposed to grandfathering (the free allocation of allowances to existing businesses) is the preferred option of most economists. The reasoning is that auctioning lends to more efficient distribution of carbon allocations as well as a stable carbon price.

Many more countries are planning to use auctioning from 2008, including the UK, Germany, Italy, Austria, Poland, Luxembourg and the Netherlands. Overall, about 3% of allowances in the 2008-2012 scheme – a minimum of 389m tonnes – will be auctioned, with about half of ETS members planning some kind of auction.

There has been talk that in the third phase of the ETS, all countries will have to auction a fixed percentage of their allowances, or sell off a minimum of 10%. However, a meeting of EU officials in September raised the bar significantly higher when it announced that it expected 100% auctioning in the third phase.

Yet Bloemenhoff of New Values warns that governments are still at an early stage with auctioning plans. “For many governments the legal framework is not yet in place. In many countries, there is more than one ministry involved and it takes time to get everyone pointing in the same direction.”

Auctioning in the US

Auctioning is likely to play a bigger role in emissions trading schemes in the US – in the Regional Greenhouse Gas Initiative for utility providers in ten north-eastern US states, many participants have announced that they will auction 100% of allowances.

If all allowances were auctioned, it would raise more than $2.8bn, assuming a price of $3-$5 per tonne, according to the GHG Coalition, a group set up to help businesses deal with climate change policies. The money will be spent on clean technology programmes, energy efficiency, or to help lower-income households meet the increased cost of electricity.

However, GHG warns: “A 100% auction of allowances has never been implemented before in an emissions cap and trade programme anywhere in the world. Therefore, the allowance price, secondary allowance market and electricity market impacts of a 100% auction approach are unknown.”

Milo Sjardin, senior associate at New Carbon Finance, a carbon market analyst, argues that the US greenhouse gas initiative is going for full auctioning because the Americans are more financially sophisticated and already have experience of the SOx (sulphur oxides) trading scheme.

Co-ordination key to success

Even proponents of auctioning admit that there can be problems, says Arvanitakis. “Some people talk about auctioning disrupting the market – you would expect strong players to drive down the carbon price immediately before an auction.”

Speaking about the current system in the EU, which is completely ad-hoc, he says, “this is not a sensible way to go about it – things can go horribly wrong”. There is nothing to stop countries from auctioning allowances on the same day, for example, and no rules on what type of auction should be used.

For auctioning to be a success in Europe, member states need to co-operate and co-ordinate policy. Arvanitakis says the SOx system in the US has been a success in this regard. “There is a great deal of transparency – participants know the scheme’s targets at least ten years ahead and that on a certain date every year, a certain amount of allowances will be auctioned.” This means there is less scope for speculation and it allows companies to calculate the cost efficiency of abatement investments on a ten-year time frame.

Bloemenhoff agrees. She wants to see agreements between EU member states on the percentage of credits being sold and on the frequency and type of auction. “However, I think it will be very difficult for them to reach that stage by 2008,” she says.

The Facts:

  • EU states are allowed to auction up to 10% of their emissions allowances in ETS Phase II
  • Half of the total number of EU states is expected to auction during Phase II
  • No formal date has been set for 100% auctioning of allowances in the EU ETS
  • Currently no formal plan sets out the timing of the EU member states’ allowance auctions

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