Who has made and lost money in Europe’s cap-and-trade emissions scheme, and will the changes planned for 2012 have any effect on the way we do business?

Carbon markets, according to the European Commission, are all about choice. As environment chief Stavros Dimas puts it, the EU’s cap-and-trade emissions regime, the world’s largest such scheme, allows companies to decide “whether they reduce emissions, or pay for reductions in other companies by buying allowances”.

But perfect choice implies a level playing field, whereas the EU Emissions Trading Scheme (ETS) arena has so far been distinctly bumpy. Some polluters, such as steelmakers, are covered by the scheme, while others, such as aluminium smelters, are not. Some market participants like power firms, which operate in relatively closed domestic markets, can pass on the costs of the carbon allowances they must buy. For others, such as companies trading on more competitive international markets, it is much harder – a crucial point for the EU political debate on the future of the ETS.

Steps to flatten out the playing field should take effect after 2012, when a Commission review of the ETS comes into force. Currently under discussion are plans to bring aluminium smelters and some other left-out sectors into the ETS family. Rules on procedures, such as auctioning of emissions permits and how new entrants to the ETS are treated, are expected to be more coherently aligned across the 27 member states.

Politicians are also banking on a positive outcome from international climate talks, due to conclude at a United Nations conference in Copenhagen at the end of 2009. If non-EU nations agree to emissions-cutting measures equivalent to those taken by the EU, the international competition concerns of European heavy industry will to a great extent be addressed.

But though carbon markets might become more equal, there will still be pressure for some participants to be more equal than others. Figures from research firm Carbon Market Data indicate that, in general, power firms have so far been given fewer emissions permits than necessary to meet their needs, meaning they have had to top up by buying extra allowances on the carbon market. On the other hand, large industrial concerns, such as steelmakers, have had big emission permit surpluses.

The biggest beneficiary, according to Carbon Market Data, has been ArcelorMittal. In 2007, the world steel production leviathan had a “huge surplus” of 18.5m tonnes of CO₂ in allowances. ArcelorMittal’s power in negotiating additional carbon subsidies was demonstrated in Belgium at the beginning of 2008, when the firm said it would not reopen a blast furnace in the Liège – raising attendant concerns about lost jobs – without significant extra emissions permits. The Belgian federal and regional authorities freed these up by stripping the carbon allowances from electricity generation plants.

By contrast, the three firms with the greatest shortage of carbon permits in 2007 were all electricity generators: Italy’s Enel, Germany’s E.ON and Spain’s Union Fenosa. The three firms were 37 million allowances short, a figure expected to increase when late emissions reports are submitted.

So why are some sectors apparently coming out ahead in the developing carbon market, while others are losing out?

The carbon market

A clear winner from cap-and-trade is the carbon market itself. Trading on allowance-based markets, such as the ETS, and on project-based markets, primarily the market for offset credits created by the UN Clean Development Mechanism (CDM), more than doubled last year compared to 2006. The World Bank’s annual State and Trends of the Carbon Market report put the value of emissions allowances traded in 2007 at US$64 billion.

In the project-based market, the big winner has been China, the “pre-eminent carbon supplier” among industrialising nations, according to the World Bank. Nearly three-quarters of credits from CDM projects, through which developed world investors can generate marketable offsets by funding carbon reduction projects in developing countries, were supplied by China in 2007 – meaning in excess of €4bn went to the People’s Republic.

The flow of money is set to continue, with ETS participants allowed to buy up to 1.4 billion CDM credits during the 2008-12 trading phase (for comparison, 634 million credits from primary project-based transactions were traded worldwide in 2007). These credits are presently trading at all-time high prices of more than €19 on the European Climate Exchange, compared to an ETS credit price of around €24.

Other regions of the world profit far less. India supplies 6% of carbon credits, and the rest of Asia (excluding China) 5%. The whole of Africa, notwithstanding its huge renewable energy potential (solar power, for example), supplies only 5%.

On the buying side, London is a winner. It is, according to the World Bank, the “carbon finance hub of the world,” a position it consolidated in 2007. The United Kingdom is responsible for nearly 60% of purchases of CDM carbon credits, with London-based institutions, such as compliance buyers, project developers and banks, accounting for the bulk of this.

However, Mark Lewis, director of global carbon research at Deutsche Bank, warns that even in a time of fast growth, the market is undervaluing carbon. The ETS, he points out, allows banking of allowances between the current trading period (2008-12) and the next phase (2013-20). In a rational market, the current carbon price would therefore be based on future expectations, and supply of allowances will be less in the future because of the tightening cap. If today’s price reflected this, Deutsche Bank calculates that EU allowances are at present fundamentally worth around €40.

Despite this, says Lewis, “there is still no significant compliance buying going on”. This could mean a price spike towards 2012 – with a carbon price of up to €100 – because companies will realise they are short of allowances, but will not have other options for staying below their carbon caps. This problem will be compounded, says Lewis, because the simplest method of cutting emissions is switching by electricity generators from coal to gas, but Europe does not have enough fuel-switching capacity to meet its internal reduction targets.

Lewis believes the overall cap is tight enough to cause a shortage of credits of any type, but a
report from environmental NGO WWF [http://assets.panda.org/downloads/emission_impossible__final_.pdf ] says it is possible that companies will buy their way out of their allowance deficit using cheaper CDM credits.

Tomas Wyns, ETS expert with campaign group the Climate Action Network Europe, says that over-allocation of allowances, meaning weak compliance buying, is one reason why a revision of the ETS after 2012 is necessary, with a tighter cap and centrally allocated carbon credits.

“Previously,” says Wyns, “companies were able to play EU countries against one another, but gaming at that level will be a thing of the past,” though he adds this means lobbying will switch to the EU level. Until now, Wyns says, “we only see winners, the loser has been the environment”.

The power sector

There is a distinction in the ETS between power companies and other participants. Cédric Bleuez of Carbon Market Data explains that “the power and heat sectors are short in allowances because they mainly function on the domestic market. But iron and steel companies, for example, face very tough international competition and were given surplus allowances” to compensate for the extra costs of carbon trading.

However, this does not mean electricity producers are losers under cap-and-trade. Cédric Philibert of the International Energy Agency (IEA) says they are “big winners” because they pass on to consumers the notional carbon cost imposed on them by the ETS. “They have had large windfall profits,” says Philibert. “This is why the EU is moving to auctioning [of allowances].”

Tomas Wyns backs this up. “Manufacturers have more than sufficient allowances, while although the power sector is short, we cannot say they are losers as such. They pass on the cost of carbon to consumers. Presently, they get something for free and sell it on,” he says.

But John Scowcroft, head of environment and sustainable development for the Union of the Electricity Industry (Eurelectric), says passing on costs was an ETS objective. “Energy prices started to rise before the ETS came in, but clearly the cost of carbon has been passed through to end users,” he says.

The power sector, Scowcroft adds, has been central to the ETS. “It has had a pro-active approach to the carbon market because of the need to cover forward contracts. Power companies have been trading on the market, hedging and creating liquidity, whereas other sectors have been more compliance-driven – waiting until the end of the trading period to see what additional allowances they might need.”

Despite this, Scowcroft says the shift to renewable energy has so far been driven by support schemes in EU countries rather than by emissions trading. “The carbon price needs to increase from the current level of around €25 to €35-€40 to push onshore wind, for example.”

The general consensus is that support schemes and the carbon price reinforce each other as drivers for renewables.

Whilst the power sector has benefited from windfall profits in the short term, investment in renewables is a question of long-term strategy, says Deutsche Bank’s Mark Lewis. “Companies with a heavy bias towards coal and lignite will be in a difficult position. The market is already starting to discriminate in this respect.”

Heavy industry

To all appearances, steel makers, cement firms and other heavy industry have also been winners from carbon trading, because of over-allocation of carbon credits to large industrial concerns. Cédric Bleuez says this is partly because of sensitivities in EU countries about protecting labour forces. Until now, member states have decided which firms get which allowances within each countries overall cap. “Some local politicians had tough decisions to make,” he says.

However, Bleuez adds: “Sectors such as steel also face increases in electricity prices. Giving them more emissions allocations is a way to compensate them for this.” Eurelectric’s John Scowcroft notes that relative to domestic end users, energy-intensive industries are more vulnerable to electricity price shifts.

Jean Lasar of ArcelorMittal, the ETS participant with the single biggest carbon-credit surplus, points out that Europe accounts for half of the steel giant’s production and sales. “In our view, the ETS is not designed to pick winners or losers, it is all about the competitiveness of European industry,” he says. “The question is: can the EU steel industry remain competitive?”

Lasar argues that forcing manufacturers to buy their initial emission allowance quotas through auctions, as envisaged for the ETS after 2012, would be counter-productive. “If the expense of carbon trading led to the transfer of steel production to non-ETS countries, where many of the steelmaking facilities have higher CO₂ emission rates than the average in the EU, it would be paradoxical. That is why we argue for the continued allocation of 100% free allowances to energy-intensive industries until there is an international level playing field.”

The consumer

It is tempting to erect a vastly over-simplified model of cap-and-trade, in which heavy industry has a surplus of carbon credits, which it sells to the power sector, which in turn passes on the cost to consumers. So are consumers, stuck at the end of the chain, the losers?

Cédric Philibert of the IEA says there have been unexpected losers, such as railways. “They have to pay for electricity to run the trains, whereas trucks do not have this cost. There needs to be a comprehensive ETS or you may penalise the most virtuous system,” he says.

But he rejects the argument that consumers are losers. “Carbon has to be paid for,” he says. “I would not qualify as losers all those who have to pay because it is better to pay for climate mitigation and not climate damage.”

More than ever, the pressure is on the EU to demonstrate that effective climate-change mitigation is achievable via its emissions trading scheme.

Author: Stephen Gardner