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Is ETS approaching its final phase?

By Benedict De Meulemeester

By Benedict De Meulemeester on 20/07/2012

As the current trading phase under the European emissions trading system (ETS) is nearing its end, there is no certainty at all about what ETS will look like post 2012. Everything in this market seems to be about rumors and speculation, but what Europe will exactly come up with remains unsure. Last week, carbon prices plummeted. They had risen earlier in the year on speculations that next phase allocation would be much more severe. However, rumor has it that the European Commission will come up next week with guidelines on next phase allocation without any exact number about how much rights will be auctioned instead of handed out. Auctioning instead of allocating was considered to be the main instrument for creating emission rights shortages for the next phase. If the Commission isn’t firm about auctioning, the probability of having yet another over-allocated phase has increased markedly, hence the nosedive in the markets.

Readers of this blog know that I have lost my original enthusiasm for emission trading. It remains a great idea, but bringing it in practice has turned out to be impossible. The realities of energy consumption economics are simply too complicated. And the main weakness of European ETS design is the fact that overall allocations are ultimately decided in a negotiation between national ministers on the rations that each country can get. Around this table, it is quite simple too see what is at stake. If, as a national minister, you manage to negotiate over-allocation for your country, it means that you are organizing the transfer of money from other European countries to your businesses. Being idealistic and negotiating a shortage, means you are condemning the companies in your country to subsidize the companies in countries that are more, well, how shall I put this? Pragmatic? Realistic? Protectionist? Cynical? Egoistic? With solidarity feelings inside Europe already under a lot of pressure due to the sovereign debt crisis, we might see a lot of pragmatism – realism – protectionism – cynicism – egoism around the table when allocations for the next phase are being discussed. Is this the reason why the Commission is dragging its feet regarding its proposals?

If the next phase is again over-allocated, somebody in Brussels needs to gather courage and pull the plug out of emission trading. That will be painful. Europe wants to be front-runner in climate change policy. And we have gone from conference to conference priding ourselves on the fact that we were trading emission rights. But with prices of emissions at 6 or 7 euro per ton, all you do is flipping money from some people (the unlucky companies with shortages allocated, the electricity consumers) to other people (the companies with excess allocations, the electricity producers and the thousands of people with a job in the emission trading industry). 6 euro per ton means that you are reducing your emission rights costs by 1,2 euro for every MWh of gas consumption that you avoid. With an all-in gas price of approximately 30 euro per MWh, this means that emission rights savings add 4% to your overall savings. Nobody will give an energy efficiency investment that was previously red-lighted the green light because of 4% of extra savings. Moreover, because of the unpredictability and volatility of emission rights prices, most companies I know, don’t even bother calculating emission rights savings in their economic evaluations of energy saving projects.

Which doesn’t mean that I am in favor of under-allocation. Like I have said before, under-allocation could cause unprecedented spikes of emission rights prices. The whole ETS idea is based on a misconception that demand and offer in this market can be matched exactly. This will never happen. In case of under-allocation, companies will be scrambling for emission rights that are not there. This could cause prices to rise to hundreds or thousands of euros per ton. Just think back about what happened in 2006 and 2008, when markets started to realize that there was under-allocation. Well, on the downside there is a bottom, to the upside there is no limit. Under-allocation could cause extreme price shocks that cause severe damage to the European economy. Are we willing to risk that? In today’s economic circumstances? Is that why the Commission is dragging its feet?

Btw, auctioning is another example of a great idea that could cause a nightmare when implemented. If auctioning is introduced, companies will have to take a decision. Buy the missing rights in the auction or wait for the market? That means making a forecast on the price in the auctions versus the future market prices. That can be perfectly done if you have perfect access to accurate data about allocations vs. future emissions. This will never be the case. Lack of visibility on what emissions were really doing was the main reason of the 2006 and 2008 crashes. Misjudging the auctioning can cause some serious financial problems for some of the companies concerned. How will politicians react when a company decides to shut down a factory because of this?

Which brings us to the next question: why would we continue this experiment in Europe? Why would we take the risk of emission rights cost increases that severely uproot our economy? Isn’t the European economy fragile enough as it is? Shouldn’t we be more careful? Especially as the rest of the world isn’t really following us. The recent summit in Rio has shown that the spirit of Kyoto is completely dead. The reason is quite simple. News broke out this week that China is now emitting more carbon per capita than Europe. However, Europe is Annex A and China is not. We have binding commitments, China, as a “developing nation” has none. How long will we continue to sponsor Chinese “Clean development” through CER’s? Again, shouldn’t we be a little bit more protective about our economy?

Don’t think that I’m pessimistic about the whole climate change policy. On the contrary. I see a decreasing trend of energy consumption in Europe. I see rapidly increasing production of renewable energy. I’m convinced that we will reach the 20-20-20 targets. Kyoto has managed to bring about a serious mind-change across the planet, maybe most actively in Europe. And no Rio summit failures will bring this to a halt. Some of the attendees pointed out that the side-events on the conference still breathed a lot of energy for reducing our carbon footprint. This bottom-up approach might work better than the top-down approach of the Kyoto protocol. If we want to support it, we need to cut away money-destroying, inefficient policies such as ETS. Europe’s successes in reducing its carbon emissions were largely based on more traditional policies: subsidies, taxes, caps without trading. Seven years ago, when ETS was still an idea, I was also an enthusiast about its potential to deal with climate change in a more cost-efficient way than these traditional policies. But we have to face the reality, it’s great idea that we cannot get to work.

Talking about reality. Do you know which country on this planet is now on track with its Kyoto commitment? The USA, yes indeed, the USA that under Mr. Bush torpedoed the Kyoto protocol. The USA that is treated like a pariah on every climate conference for doing this. And what is the main reason? Shale gas. US power production is massively switching from coal to natural gas, reducing the US’ carbon footprint remarkably fast. And where is the coal produced in the US currently going to? To Europe. Which is seeing an increase in its carbon emissions due to this. An increase which is accelerated as European gas prices rise as the production of gas in Europe is going down. Because the same environmentalists that want to stop climate change are also against shale gas, because they have seen a movie called “Gasland” that suggested shale gas was very bad for the environment. The Green Knights of Europe are beaten by the Black Knights of the USA due to the shale gas weapon. Isn’t that a powerful sign that realistic environmentalism often breeds much better results than the much more common idealistic variety? Isn’t that a sign that we need to consider natural gas as one of the keys to a better climate change future?

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