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What is going on with carbon prices?

by: Gareth Phillips, Managing Director, Sustainability and Forestry

Durban was a success (indeed a miracle from the perspective of what the world expected – i.e. very little – a few weeks before).  But why have carbon prices continued to slide?  The conventional response to this is that the financial crisis in Europe is overshadowing the market and until macro economic conditions improve carbon prices will continue to correlate with manufacturing output. This was the case before Durban but I do not think it is the case now.

The unconventional response to this question is that the analysts are mis-reading the situation.

There are a number of actions that are now significantly more likely to occur following Durban and taken together I believe that they will add up to a significant change in the supply demand balance. If the market does not recognize these points sooner, then I think we will see this starting to happen by May 2012 at the latest:

1)  Parties are asked to enter their commitments (QELROs) into Annex B to the second commitment of the Kyoto Protocol (KP2) by 1st May 2012. This means that by this date at the latest the EU must declare whether it will set a target of -20% or -30%. The EU’s position was that it would move to -30% if other parties took similar commitments; The EU proposed the 2015 / 2020 roadmap and parties accepted it (i.e. the Durban Platform). While Parties have not rushed to sign up to KP2, it is hugely significant that they have accepted a truly multilateral agreement in place of the KP from 2020. So for this reason alone I would expect the EU to move to -30% (or -25% at worst). There are also other factors: the EU Council of Ministers voted last year on moving to -30%. 26 out of 27 were in favor with only Poland against. Poland held the Presidency at that time. From January, Denmark takes over and can likely find a way of “compensating” Poland for changing their position. MEPs held a non-binding debate and voted overwhelmingly in favor of a move away from -20%.  While the EU was effectively going it alone pre-Durban, one could understand why the European Commission was hesitating to really get behind the EU ETS (their flagship policy). Now that the sentiment of the Parties has changed so dramatically, there is everything to be gained from pushing the EU ETS to the fore. So, I expect EU to announce a move to -30% (or -25%) before 1st May 2012 and this makes up the first part of the shift in demand.

2) The second part of the shift in demand comes through the potential implementation of a set-aside mechanism whereby the Commission would set-aside and ideally cancel a proportion of EU Allowances (EUAs) in recognition of the fact that the drop in economic output has created an excess of allowances and that a number of other un-related European Directives (notably the Energy Efficiency Directive and the auctioning of 300 million allowances from the New Entrant Reserve) have the potential create even more over-supply. While the set-aside would have been difficult pre-Durban, post Durban it would be likely to receive greater support.

The supply side is impacted by a number of different factors:

3) A new round of comitology, one of the processes by which the EU introduces new legislation, is likely to take place in the first half of 2012. The Commission has said they would complete supply-related comitology by the end of the 2012 and they are under pressure from the greens and particularly CDM Watch, to act. MEPs are now more aware of their potential to impact upon the kind of CERs which they allow into the EU ETS (we met the MEP delegation in Durban and discussed this with them) and there are several categories of supply that are “at risk”: I would highlight Russian Track 1 ERUs (apologies for the jargon) – these are effectively Russian hot air units which are laundered through the domestic JI approval process. These have zero environmental integrity and since Russia is not signing up to KP2, there is no reason to continue to allow them into the EU ETS. CERs from large hydro could be selected – CDM Watch and the International Rivers Association have mounted a very successful campaign against these projects on the grounds of additionality concerns and social and environmental impacts. Like it or not, this is one class of projects which is large enough to have an impact upon CER supply. There are 5 large super and ultra-super critical coal fired projects which were registered before the methodology was put on hold by the EB – the baseline calculations in the meth were found to be flawed, meaning that additionality concerns aside, the CER calculation is simply incorrect. It would be very damaging to the credibility of the EU ETS to allow CERs with known errors to be used to offset real emissions. And finally the EC has noted that CPAs added to non-LDC PoAs post 2012 are contrary to the spirit of the directive (I am not going to explain these acronyms!) which will reduce supply from some types of projects.

4) Others have questioned whether the move to -30% would also come with a relaxation of qualitative restrictions. In my opinion this is unlikely. There will be a relaxation on quantitative restrictions, meaning more CERs can be surrendered but I do not see the EC backing down from their desire to move towards sectoral mechanisms.

5)  The supply side is further impacted by the likely development of domestic schemes in many of the CER supply countries, particularly China. China is currently developing pilot internal ETS and plans to have a national or at least regional scheme starting 2015. It is likely that the scope of this would cover many of the facilities that are currently supplying CERs. China would have two choices: Annex the CDM participating facilities out of the internal scheme (as was done with JI projects in facilities in EU accession states which were also captured under the EU ETS) or internalize the projects and use them within the ETS. Given the Chinese Government’s current  posturing on LoAs for CDM projects, the latter course of action is more likely. This could take out a large proportion of CER supply from 2015 onwards. Because the Durban Platform expects an outcome with legal force (i.e. some form of cap), the other BASIC countries are also likely to face the same issue, although they may not be as advanced as China. So, the days of unconditional access to CERs from non-annex 1 countries are now numbered. Such actions would overlap with the impact of EU comitology under item 3 above.

6)  And then there is the USA. Their objection to the KP was that BASIC countries were not taking caps. This is no longer the case and therefore we would expect the US to start to re-engage in the process. Eight years is not that long to design and implement an emissions trading scheme, especially in an economy that seems so averse to the concept it invented! Irrespective of what they do, their presence in the Durban Platform negotiations as a signatory (rather than as an observer to the KP)  is bound to have an impact on market sentiment.

So, while the conventional response for price drivers may hold sway for a little longer, my analysis is that this will change within the next 6 months.

About Gareth Brydon Phillips
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