Two and a half years ago in Copenhagen

We are one week before the crucial Copenhagen summit on a post-Kyoto climate policy and the prospects of getting a real deal are looking a little bit less bleak. The US and China show a little bit more enthusiasm for entering into a binding commitment for reducing greenhouse gas emissions. Last week the presidents of both countries even announced that they will personally attend the event in Copenhagen. That adds a little bit more show business to what looks set to become the biggest show geopolitics has ever seen. Mr. Obama and Mr. Hu Jintao will join thousands of other delegates in the Bella Center in Denmark's capital. Every step that they take will be followed by hundreds of camera's. Outside, the complete Danish police force will be mobilized to keep protesters away from the world's leaders. But even that is not enough. Denmark has asked Sweden to send some cops across the Oresund for reinforcement.

Two and a halve years ago, I was in the Bella Center myself. And it was for a conference on climate change. PointCarbon, the leading information source on carbon markets, uses the well-equipped conference center for its yearly gatherings of everyone that has something to do with trading carbon. I was completely awestruck by the size of the event. More than a thousand delegates flocked into conference rooms, around lunch buffets, toilet rooms. It is amazing in what short period of time, climate change abatement has become an industry of such considerable size. Despite that, it was at this conference that I came to the conclusion that emission trading wasn't contributing much to climate change abatement. The doubts which I already had regarding emissions trading were confirmed. In several contributions by price forecasters at this conference, speakers assumed that carbon dioxide emissions would continue growing at the same rate as before emissions trading was introduced. By asserting this, the speakers confirmed what I feared: that emissions trading was missing its goal of reducing emissions by industrial polluters.

Originally, I was an enthusiast for cap and trade. From a theoretical point of view, it is clear that it is the most cost efficient way of reducing industrial carbon output. By making pollution tradable and thus giving it a price, emission reduction projects would be launched where they are cheapest. To put it simply. If the price of emission rights is 20 euro per ton, and if for company A the cost of reducing emissions is less than 20 euro per ton on a yearly basis, it has an economic incentive to invest in the reduction. Company B with a more expensive project costing more than 20 euro per ton on a yearly basis will not invest. Company B will buy  the excess rights of company A. But on the road from this nice and neat little theory to practical implementation, some huge roadblocks pop up:

1/ Setting the original amount of emission rights that each company gets (allocation) is an extremely thorny issue.

2/ Implementing emissions trading entails huge complexity.

3/ Price volatility tends to be high, which means that the price signal to invest in emission reduction is confusing.

4/ Design errors can cause extreme price behavior.

5/ The only benefactors so far of the system have been the electricity producers, not the environment.

1. Allocation

Allocation unleashes some of man's most primitive economic instincts. The algebra is pretty simple. If we go back to our previous example, both company A and company B have only one interest: getting as much emission rights as possible. For company A it means that they can sell more rights. For company B it means that they will have to buy less. But for both, the amount of money is exactly the same. If the price of emission rights is 20 euro per ton, they both win 20 euro for every extra emission right that they get allocated. For company A in terms of extra rights that they can sell, for company B in terms of avoided costs for buying rights. The essence of economic behavior is to do everything that is possible to maximize profits. Therefore, it is completely rational that companies will do whatever they can to get as much emission rights as possible. The allocating authority is like the rich Westerner handing out dollars in a third world village, with a huge bunch of children fighting to get as much as possible. Only idealism could be a reason for a company not to try to get their hands on more emission rights than they actually need. I have met with one or two companies that have shown such idealism when rights were allocated for the periods of 2005 - 2007 and 2008 - 2012. Just imagine their frustration when they find out that the companies that have followed their more primitive economic instincts have won a lot of money.

The result of this is clear: over-allocation. In the files that they compile for getting rights allocated, companies will typically exaggerate their prospects for production growth ('I need more rights, because my output will grow by ten percent every year'). If a majority of companies does this, the result is a global over-allocation. It has occurred in the first trading period, with emission rights prices reduced to practically zero. It has occurred again in the second trading period. Prices haven't fallen to zero yet, as holders of excess emission rights hold on to them, hoping that they will be able to sell them at higher prices in a next phase (emission rights are bankable as of this trading period, meaning that you can hold and use them post-2012).

Many will blame the economic crisis for the over-allocation in the phase 2008 - 2012. That applies only partly. According to our analysis, it was already clear from the onset that the market would be over-allocated again. A Fortis report in 2007 pointed out that the market would see a shortage of approximately 1% in that period if emissions would continue to grow as they had done before. We never believed that this would occur. We are talking to many of the companies involved in emission trading and many of them are talking to us about their programs for reducing their energy consumption. We can see the gas consumptions of companies going down. What is even more frightening about that Fortis report, is that nobody seemed to care that emission trading is completely missing its target if emissions just continue to grow as if nothing had happened. Shouldn't the conclusion be that we better stop trading emissions if it doesn't result in substantial emission cuts? Anyway, carbon emissions were going down before the economic crisis occurred whereas the allocation was based on a world without emission reduction. Hence, the second phase was over-allocated from the start. The economic downturn has only enlarged the gap.

Greed is the reason for over-allocation. This greed will be sensible in the coming Copenhagen negotiations. Countries fight to get as much rights to emit as they can. European countries have shown most idealism so far. The American president seems willing to join them, but is held back by his congress and senate. Developing countries like China or India are so happy that they are catching up with development levels elsewhere, that the idea of limiting that development for the good of the planet looks absurd to them. Moreover, they use the justified argument that 90% of the carbon dioxide already in the atmosphere was emitted by the developed countries. It's up to the polluters to clean up, they scream. Just like companies making up their allocation file, many countries in Copenhagen will have only one objective: getting a larger chunk of the carbon pie.

To soothe his congress and senate, Mr. Obama is using an old trick in carbon dioxide policy: making tough reduction commitments for dates very far into the future. This postponement behavior is one of the reasons why environmentalist are thinking about protesting against rather than joining in the Copenhagen talks. But from a pragmatic point of view, I think this is a good policy. It has worked for Europe.

2/ Implementation complexity

During the Carbon Insights meeting that I attended, another thing that struck me, was the speed at which the carbon market had developed into a complex knowledge field of its own. I asked the question to one speaker: 'If we would go to the center of the city, arbitrarily pick up some people and bring them into this room. How long would it take before they start realizing that what we are discussing is climate change abatement?'. Implementing emissions trading is complicated. It demands a lot of legislative work. The economics of the market demand the development of new trading practices. But just try explaining what a 'CER - EUA swap' exactly is to a layman, as I have done frequently in the past years. You will understand that this complexity isn't exactly helpful in achieving the goal of abating climate change.

I am speaking against my own interests if I deride this complexity. Complex matters create the need for specialists, for consultants. The EU emissions trading directive has given birth to a whole new industry. There are now a few thousand people running around in a shiny suit, which they earn in this emissions trading market. For many of them, putting the effectiveness of emissions trading into question is beyond comprehension. The problem is that they live on a cloud, far away from the reality of climate change abatement. That reality has nothing to do with the technical details of emissions trading. It's got everything to do with a company boss deciding whether to build a cogeneration unit or not.

Many people that I've talked with in Copenhagen, were very far removed from such industrial decision-making. Most people involved in emissions trading have a banking background rather than an industrial background. Moreover, industrials are showing apathy towards the system. Approximately two thirds of all emission rights are held by purely industrial companies and one third by utilities. Those industrial companies are e.g. food processing,  textile or other manufacturing industries with an allocation of less than 20.000 emission rights per year. For them, the emissions trading scheme is just another compliance issue. They just want to avoid having to purchase extra emission rights, which they consider to be a 'fine'. So they hold on to their allocated emission rights until it is clear how much their real emissions will be, which is at the end of the trading period (end of 2007, end of 2012). Over the past years I have talked with many of these companies. They all told the same story. We are long on emission rights, but we keep them for a rainy day. What is remarkable is that many traders in this market seem to ignore this crucial piece of fundamental information. Theorists and bankers also underestimate the prediction uncertainty that these companies face. Their production could rise by 15 - 20% next year, creating the need for extra emission rights. The environmental manager doesn't want to risk having sold these extra rights so he does nothing and the excess rights only reach the market by the end of the trading period.

This apathy of two thirds of the market has a remarkable result on the pricing. The excess quantities of emission rights have mostly been allocated to these industrial companies. The utilities, which have developed much more active trading practices, mostly have shortages. So you see a market which is generally long, but with only the short parties active. The result is that everybody starts to believe that the market is short. This clearly happened during the first trading period. The market started with a massive bull run as the utilities started to buy the extra rights that they needed. The banking world jumped in and accelerated the pace at which prices rose. The bull case was firmly supported, no reports came out warning that the market could have been over-allocated. It took until the beginning of 2006, when companies started to report their real emissions for 2005, before reality became clear. And it came with a bang. The carbon trading community had gathered in Cologne the day the first reports came out that allocations were too large. I wasn't there, but I've heard from people attending it that everybody was running away in panic to get rid of his long positions on emission rights. The result was a rapid meltdown of emission rights prices. To my big surprise, the same was repeated for the second trading phase. In 2008, the market was again buzzing with rumors that the market was short and the price again hit 30 euro per ton. No wonder, again we observed that those sitting on the excess allocations were not present in the market place. But it is striking that this market has been fooled into the same mistake twice.

3/ Price volatility

One and a half year ago, the price of emission rights was around 30 euro per ton, today it is around 13,5 euro. That is big volatility. For those that entered the market at 30 in 2005, the situation was even more dramatic, the price came down to almost 0. Price volatility in this market has been very high, making it a place where investors can make big bets. It is therefore no surprise that so many speculators found their way to it, which increased volatility even more.

Let's look again to what it all comes down to: an industrial company owner that has to take a decision to make an investment in e.g. a cogeneration and the impact of emissions trading on this decision. Don't forget why emissions trading was created. To give that man an extra incentive to decide in favor of building the cogeneration rather than a traditional boiler house. If he wants to take into account this extra incentive, his obvious question will be: 'how much money will I win on emission rights in the next ten years'. Our answer to that question is: 'anything between 0 and 100 euro per ton of carbon dioxide emissions'. (And even then we are not correct, we should say, anything between 0 and infinity, as I will explain in paragraph 4.)  For that potential investor of cogeneration, this is not exactly a strong extra incentive. Uncertainty regarding the expected return is rather a disincentive for investment. Moreover, if you adopt a risk management approach to your investment decision, you will rather take the 0 than the 100 euro per ton into account. This is the exact answer that I've heard from many managers taking decisions on energy savings investments, 'If it has a value, it will come as a bonus, but for taking the decision, I don't attribute any value to emission rights savings'.

Because of this volatility and the resulting price confusion, I would say that emissions trading hasn't kept one extra gram of carbon dioxide out of the air. Companies are not investing in measures to reduce carbon dioxide emissions because of the price of carbon in the emission rights market. They are doing so because they adopt Kyoto or sustainable development policies, because of the rising price of energy, because of other regulations such as voluntary reduction schemes or environmental policy, because of subsidies, etc. So far, I haven't met with one company that says 'we are reducing our climate change impact because of the emissions trading system'. The price signal of emission rights markets is simply too confusing for this to occur.

4/ Design errors

In both trading periods we have witnessed over-allocation. The result is a run-off of prices. In the first trading period the price fell all the way to 0. The rights could not be banked into the second period, meaning that after the first trading period was over, they lost their value. Therefore, if you had any excess rights, you had but one option: selling the rights for any amount of money that you could get for it. This isn't happening yet in the second phase, even if most market participants are convinced that the market is again over-allocated. The reason is that banking is possible now. If the price drops too low, holders of excess rights might choose to keep them beyond 2012, hoping that prices will be higher then. This has kept the price at a level above 10 euro per ton up until now. But again, we should take into account that the holders of excess rights are not active in the market. The big question is what they will do with those surplus rights when the end of 2012 gets near.

So far, we haven't seen a market with a shortage of emission rights. In my opinion this would lead to extreme price behavior with prices rising to absurdly high levels. The emission trading system has been designed with the false assumption that the market could reach an equilibrium. There is supposed to be some equilibrium price at which companies invest in exactly so much emission reduction that the amount of emissions exactly matches the amount of allocations. Nice in theory, but completely impossible in practice. Participants in the emissions trading market simply don't have the necessary and timely information to collectively take the decisions to make this equilibrium possible. The result is that there will always be a surplus or a shortage of emission rights compared to the allocated volume. We have witnessed what has happened when there is a surplus. But what happens when there is a shortage?

When designing the EU Emissions Trading Scheme, policymakers have introduced a fine for those emissions for which no rights have been delivered to the authorities. If you have an emission of 20.000 tons, and you deliver only 18.000 tons to the authorities, you will pay a fine of 100 euro per ton, i.e. 200.000 euros. Normally, this 100 euro per ton should serve as a cap on emission rights prices. If the price of emission rights would rise over 100 euro, companies with shortages would choose to pay the fine rather than buying extra rights. The design default with the EU ETS is that companies that pay the fine are not relieved of their obligation to deliver the missing emission rights to the authorities. The (theoretical, I have to admit) result of this is appalling. If an overall shortage of emission rights would occur, companies would scramble to buy the rights that are not there. In theory the price would rise to infinite. In theory, this would create a strong incentive for investment in reducing emissions. But it takes several years for those investments to have results. By then the trading period would be over. So, in practice, we would see that prices rise very high as the deadline of the trading period (which will be 2017 for the third period) approaches. This would probably cause the need for authorities to intervene. But if you take into account the effect of emission rights prices on the price of a vital utility, electricity, you understand the huge disruptive effect this could have on the EU's economy.

5/ Effect on electricity markets

The production of electricity with fossil fuels is the largest single source of carbon dioxide emissions. It is therefore not surprising that one third of all rights have been allocated to such fossil-fuel fired power stations. Why these power stations have generally been allocated less emission rights than they actually emit needs a little bit more explanation. The first phase allocation plan of the UK said quite literally why most countries have opted for creating shortages of emission rights in the power sector. It said that companies in the power sector cannot move to countries with less stringent allocation regimes. Therefore, the shortages were rather created in this sector, than e.g. in the aluminium production.

As of the start of emissions trading, electricity consumers started complaining about the effect of emissions trading on electricity prices. And indeed, we have also witnessed all those days during which rising emission prices went hand in hand with rising power prices. The reason for this is obvious. In open energy markets, the price of electricity is set based on marginal cost pricing. The last MWh sets the price for all MWh's. And if you have an overall shortage of e.g. 30% (like some Western European utilities claim) you never have emission rights for that last MWh. It means that your marginal cost will always include the price for buying emission rights as if you haven't received any allocations at all. The result of this is clear. Utilities such as cited above have received free allocations for 70% of their emissions, but they can sell the corresponding MWh's as if they had to pay for emission rights for every single one of them. The result is a massive windfall profit. It's ugly but it is a logical consequence of marginal cost pricing, a principle which is always applied in any free energy market in any place of the world. The main consequence of emissions trading then is a massive transfer of money towards utilities. To their benefit, this sector can claim that they have made big investments in recent years in building renewable energy production. But again, this was mostly due to other policies, such as subsidies or environmental permit policies, rather than emissions trading itself. In countries with emissions trading but without other policies to support the development of renewable energy, you simply see a lot less investment in renewable energy. The booms occur in e.g. Germany and Spain, both countries with a very generous policy of subsidies or subsidy-like payment schemes.

Conclusion

Over-allocation, unwanted complexity, price-volatility resulting in a confusing price signal for investment, a dangerous design error that could lead to devastating price rises and rising electricity prices, that's not exactly what we expected from emissions trading. The simple conclusion that instead of leading to emission reduction investments, the system has created a windfall profit for the electricity sector should be sufficient to conclude that the system is failing on a massive scale. Still, two and a halve years ago in Copenhagen, I heard nobody less than Al Gore - a man that I greatly admire - congratulate Europe for introducing emissions trading. And I'm pretty sure that next week the same utterances of satisfaction about emission trading will be repeated again at the same place. How is it possible that the truth about emissions trading is sipping through so slowly? Is that truth too inconvenient?

To a large extent, it is. Again and again, I am surprised to find out in internet forums that many US citizens still put the human-induced climate change hypothesis in question. In any discussion on introducing a new renewable technology e.g. Americans pop up to call Kyoto policy a UN-led conspiracy against the US and it's energy-devouring habits. If you have to operate in such a context, I can imagine that for an American environmentalist a discussion on the effectiveness of emissions trading must seem like Walhalla. Moreover, many outsiders confuse emissions trading with other pieces of European emission abatement policy. As I have said before, measures such as subsidies have caused consumption reduction and renewable energy to flourish in Europe. Today, I have had solar panels installed on top of my roof. Apart from my idealism, I mainly did this because I can get 450 euro per MWh produced with them, thanks to the Belgian system of green certificates. This policy is highly effective, as I see more and more rooftops covered with solar panels in my (unfortunately rainy and cloudy) country. This has nothing to do with emissions trading, which, I admit, is probably more efficient.

Let's hope that Copenhagen will bring about a solid post-Kyoto climate change abatement policy. Maybe that could create the atmosphere for a rational discussion on what to do with emissions trading for it to become more effective.