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Credit Prices Down the Drain?
By Catrinus J. Jepma
Over the last few months the price of emission allowances (EUA, for delivery in December of this year) dropped to levels below €1. In other words, an EUA has become worth virtually nothing. Although some commentators have tried to give this event a positive twist - “O.k., credits went down, but this is just a learning phase” - the credit price collapse is dramatic. It illustrates, as feared by some beforehand, that the allocation process is the weak spot of the trading scheme and hard to be done correctly, because:
a) bureaucrats/politicians who take decisions about allocations, suffer from information asymmetry as the best information about realistic allocations is with the installations, not with them. The management of the installations knows which mitigation technologies can be introduced, are available, in the pipeline, etc., or what their investment plans are; bureaucrats can only guess.
b) it is not in the installations’ interest to provide the bureaucracy with all such information. Instead, they have an incentive to show that emission reductions will be very difficult to realise and costly.
c) if allocations are made nationally and only loosely co-ordinated internationally, as seems to be the case in the EU ETS, many national authorities may be afraid to adversely affect the competitiveness of their national industries, and be susceptible to lobbies for lenient allocations.
d) the combination of a-c will likely lead to over-allocation of allowances and therefore to a potential drop in credit prices.
e) credit traders want to do business. At the start of a scheme, they leave market players with the impression that credits are scarce and thus induce nervous players to buy credits early in order to be sure about compliance later on. The players ‘with the strong nerves’ will probably wait until prices have been driven up sufficiently for their credit sales, but once prices start falling, they may fall over each other and make prices collapse. We have seen this process happening during the first phase of the EU ETS.
Of course, the above chain of events does not need to take place by definition, but it is a fact that this stylised description is similar to what has happened since the start of the EU ETS in January 2005.
The next key question is whether something similar could happen during the EU ETS second phase (2008-2012). In fact, it could. Similarly, there are fairly strong arguments to support the view that even during the Kyoto Protocol’s commitment period (which coincides with the EU ETS 2nd phase), a similar pattern of slightly rising but eventually almost collapsing credit prices may take place.
That would be dramatic. After all, both the EU ETS and the Kyoto Protocol have been based on a cap-and-trade system: by fixing the emission quantities and introducing an emissions credit market, a credit price results from the system as an endogenous variable. This price is ultimately determined by: the allocation rules, compliance, and the supply and demand mechanisms resulting from the emission caps. Consequently, credit price development is uncertain beforehand. At the same time, however, these credit prices are supposed to be the key driver for mitigation decisions and policies. In other words, although cap-and-trade systems aim to put a price on GHG emissions and stimulate investments in cleaner technologies, they fail to do so in actual practice due to low credit prices.
Why is it not unlikely that both the second phase EU ETS and the Kyoto Protocol will eventually face low credit prices and that in fact the entire system may fail to put a serious price on GHG emissions? This question can be answered by assessing the likely scarcity situation that will develop on the worldwide carbon credit markets. Let us focus on net demand and supply under the Kyoto Protocol first.
Although it is not easy to make an estimate of cumulative demand for credits during the Kyoto Protocol commitment period, the data so far suggests that only three Annex I Parties are likely to exercise a serious demand: Canada, Japan and the EU-15. Based on the available data for the period 1990-2004 (more recent data is not yet available) , a fairly stable annual demand can be expected from Japan and the EU-15: around 350 Mt CO2-eq. (=350 million credits) taken together. The demand of Canada, instead, has fluctuated fairly strongly and reached its highest level in 2004, some 350 Mt CO2-eq., as well. Recently, however, political pressure on the Canadian Government to improve its mitigation record has strongly increased: for instance, last February, the prime minister of Ontario said that “his administration will soon unveil an ‘aggressive’ plan to curb GHG emissions.” This would reduce Canada’s emissions and could reduce Canada’s demand for credits during 2008-2012. Anyhow, taking a rather conservative assumption, namely that the 2004 assigned amount deficits of Canada, Japan, and the EU-15 would continue until during the commitment period (around 700 Mt CO2-eq. annually), leads to an overall expected five-year credit demand of 3.5 billion.
How does this demand figure relate to net supply of credits under the Kyoto Protocol which basically originates from three sources: 1) CERs via the CDM, 2) ERUs via JI, and 3) trading of AAUs via Article 17 of the Kyoto Protocol, for instance through green investment schemes (GIS)?
First, as I have argued before (see JIQ, Vol. 11, No. 4)1, CER supply is developing extremely well. The about 1,700 projects in the CDM pipeline (of which 591 have in the meantime been registered, as per 05/04/2007) are likely to generate about 1.9 billion CERs up until 2012, even if the rather conservative assumption is made that only 85% of the projects that appear in the pipeline between now and 2012 will be registered, and that only three-quarter of the expected credits will actually materialise (both assumptions are roughly in line with CDM experiences so far).2
Additionally, it is fair to assume that, even in the absence of any clarity at short notice about a post-Kyoto regime, a significant number of additional CDM projects will enter the pipeline during the coming years. If the current annual supply of CERs of about 1 billion (Fenhann, 2007; see footnote 2) repeated itself only once, which is a very conservative assumption given the present growth of the market, then total CER supply during the commitment period would amount to (1.9 + 1=) 2.9 billion. Obviously, this amount will increase if the present success of initiating new CDM projects continues during the commitment period (for instance, if negotiations on a post-Kyoto regime are favourable for the CDM).
Second, the expectations about ERU supply seem to be fairly modest. This is partly because JI projects can only be credited during 2008-2012 and partly because the initially expected JI potential has reduced due to the EU accession of countries in Central and Eastern Europe which now have to comply with EU standards and have become part of the EU ETS. Should all JI projects presently in the pipeline be registered and their expected ERUs issued, this would result in a net supply of around 150 million, if we - once again - take a conservative approach.
Finally, the key question in drafting this demand and supply picture for the Kyoto Protocol is what the net supply of AAUs will amount to during 2008-2012. Particularly important in this respect are surpluses within the assigned amounts of some Central European countries, especially Poland, Ukraine, and the Russian Federation. Several authors have tried, through extrapolation and taking into account economic growth and energy efficiency projections, to make guesstimates of the cumulative supply of AAUs (either directly tradable, or via GIS) of these Parties during the Kyoto Protocol commitment period.
An authoritative source is Haites (2004)3 who combines information available from various sources (mostly countries’ National Communications submitted to the UNFCCC secretariat with emission projections for 2010) on the potential AAU supply (several sources since then have shown a roughly similar picture). He projects an overall cumulative AAU supply potential of about 6.75 billion AAUs during 2008-2012! In other words, if this potential supply would enter the market and be combined with CER and ERU supply, overall credit supply under the Kyoto Protocol would probably become twice or three times as big as demand! Under these circumstances, market competition would prevent credits from reaching any serious level.
In order to remain on the conservative side, one could assume, as Haites does, that credit suppliers would carry out cartel-like action by effectively limiting the actual supply of AAUs4 to, say, 40% of the potential supply only (honestly, I don’t think that credit suppliers can organise this). But even then supply would still amount to 2.7 billion AAUs. Combining this with CER and ERU supply (as projected above), cumulative supply (some 5.8 billion) would still outreach demand (some 3.5 billion) by at least a factor 1.5! (See Table 1 for a summary of these figures.) Of course, this does not come as a surprise as the withdrawal of the US in 2001 has created a big gap on the demand side of the global carbon market.
Therefore, while a conservative estimate of cumulative credit demand during the commitment period leads to figures probably anywhere between 3 and 4 billion, an even more conservative estimate of supply results in figures over 5 billion credits. Relaxing the assumptions typically reduces demand and increases supply, which enhances the general picture of a commitment period characterised by a structural oversupply of credits. This can only lead to potentially volatile, but eventually low, if not very low, credit prices during the commitment period of the Kyoto Protocol. If this would happen, the Kyoto Protocol can, with hindsight, be characterised as a lost climate policy decade during which the opportunity to put a serious price on GHG emissions has been missed.
Sadly enough, the Linking Directive rules for the EU ETS second phase are such that the expected net demand under the EU ETS scheme can easily be met through JI and CDM credits (in fact, the accepted limits to using JI and CDM credits under the ETS are so wide that most installations can most likely cover any deficits through these credits). Through the Linking Directive, low credits prices under the Kyoto Protocol will push down second phase EU ETS prices. Also for the EU the opportunity to put real prices on carbon will then be lost.
Maybe it is time to seriously consider an alternative to cap-and-trade systems and make costs an exogenous variable within climate policy. As I suggested in earlier JIQ contributions5, a solid, reliable and predictable GHG tax could be such an alternative. That would provide the incentive we are looking for.
Catrinus J. Jepma
Chief editor
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2 Fenhann, J. (2007), ‘CDM Pipeline Overview’, UNEP Risø Centre, April. Downloadable from: http://www.cd4cdm.org/Publications/CDMpipeline.xls.
3 Haites, E. (2004), Estimating the Market Potential for the Clean Development Mechanism: Review of Models and Lessons Learned, Washington DC, PCFplus Report 19, June. Downloadable from: http://carbonfinance.org/docs/EstimatingMarketPotential.pdf.
4 While banking the remaining amount for a future commitment period.
5 See e-JIQ No. 7 & 8, downloadable from: http://www.jiqweb.org/dljiq.htm.
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