A Tale of Two Earths - The Future of the EU-ETS

11/10/2011 11:26 | Updated 09 December 2011

The script of former Vice President Al Gore's recent Climate Reality global web event started with the words, "Somewhere there may be an Earth where . . . . . . isn't happening" and went on to fill the blank with a series of climate events currently underway, then concluded, "But not here, not this Earth, we have to deal with reality."

Reality was also an issue at two separate events that I attended this week in Europe, an IEA/IETA/EPRI Emissions Trading seminar in Paris and the annual Platts European Emissions Markets Conference in Brussels. I was also a keynote speaker at the latter. At the Brussels event the EU Commission spoke about the development of the EU Emissions Trading System, the progress towards Phase III and even noted that the current low carbon price in the EU was a suitable reaction to the recession and that the system had responded as necessary. In the Paris event, which was under the Chatham House Rule, we heard a similar story and a description of the expanding discussions between the EU and other governments with regards linkage of emissions trading systems. One might have come away from these thinking there is an Earth where rapid progress is being made in building carbon markets and using them to quickly and effectively reduce emissions on a global basis.

There may be an Earth which is doing this, but very unfortunately it isn't this one. It should be, it needs to be, but we have to deal with reality.

The Brussels conference also heard from Mark Lewis of Deutsche Bank, who laid out a somewhat grim supply-demand picture for the ETS. Deutsche Bank estimate that the system is 400 million European Allowances (EUAs) long in Phase II, but with an additional potential for 800 million CERs (units from the UNFCCC Clean Development Mechanism) to enter the system, giving a total EUA equivalent length of 1.2 billion allowances going into Phase III (or the equivalent of 20 big coal fired power plants running continuously for the whole of Phase III). In addition, 200 million EUAs from the CCS support mechanism will be auctioned in the near future and 2012 will also see the early auction of some of the 2013 Phase III allowances. On the upside they do see that the system has the capacity to absorb all this over the coming years, to the extent that by 2020 there is a short position of 400 million allowances (i.e. reductions that will have to be found). They see this being largely absorbed by fuel switching (coal to natural gas), with existing gas turbine generation capacity allowing this to happen relatively easily. As such, they forecast a price of some €25 by 2015, with a cost of carry taking it to €28 by 2020. But there are a number of caveats to this, the two key ones being;

  • The assumption that neither the EU Energy Efficiency Target (the focus of the upcoming Energy Efficiency Directive) or the even higher profile Renewable Energy Target will be met. Of course if renewable energy supply surges as it has done in recent years thanks to the efforts in Spain (equivalent to 800 million allowances), the 400 million allowance short position will quickly evaporate.
  • The assumption that the aviation emissions trading proposal will go into full operation, with both incoming and outgoing flights covered by an expanded ETS. Their analysis reckons aviation to be some 400 million allowances short through to 2020, so if this important add-on to the ETS doesn't happen or is significantly delayed, then the whole ETS is flat through to 2020. Although there is no final ruling by the European Court of Justice, this week the Advocate General did express the view in favour of ETS implementation in response to the court challenges from a number of international airlines.
In addition, despite the gathering storm clouds, Deutsche Bank have not factored in the possibility of a second major economic downturn.

So the reality is that although the ETS carbon price has potential upside, it could well remain very weak for a number of years on the back of a long supply-demand position. This is problematic. Although the allowance based system will always ensure that emissions are reduced to the level of the cap, if this happens with a carbon price in single figures, the system will not deliver on its further critical underlying objectives, which are:

  • Long term incentive to drive technology development, in particular carbon capture and storage (CCS) and renewable energy.
  • Early trigger to begin the major task of decarbonising the power sector with a particular need to guide investment into the 2020s.
  • Assisting developing countries in beginning the task of emissions reduction
  • Demonstrating the effectiveness of carbon pricing through an ETS with the goal of encouraging similar systems elsewhere.
  • Supporting the carbon market approach agreed under the Kyoto Protocol.
The combination of reduced emissions as a result of the recession in the EU and the impact of a plethora of Member State and Community wide supplementary policies operating in the ETS space has led to this overhang of allowances.

Over a number of recent blog postings I have set out the case for the removal of allowances in the ETS. At the Platts conference I spoke about the same thing using the linked presentation below. There is no challenge here to the ETS as such, it is a fully functioning, well designed emissions trading system, but it has been hit from all sides by a series of events.

The time to correct this is now. That is the new reality the EU Parliament and Commission must face up to.