After Bonn, what price carbon?

The surprise deal in Bonn means the Kyoto Protocol is back on track. But what does the compromise on ‘sinks’ and the likely US absence from the market mean for the price of carbon?
Mark Nicholls reports

Negotiators were understandably elated at the unexpected breakthrough on the Kyoto Protocol in Bonn in July. After an all-night session, a political deal was reached by 178 countries on the morning of Monday the 23rd that makes binding greenhouse gas (GHG) emissions reductions – and an international carbon market – increasingly likely for most of the industrialised world.

Officials ran out of time before they could translate the political deal into a legal document – a UN spokesman says that they needed “another day or so”.This should be completed at the next meeting, COP 7, at Marrakech in October.

Environmentalists may justly argue that the deal has gravely diluted the environmental objectives of the original 1997 agreement, under which the industrialised world pledged to reduce its output of GHGs to 5.2% below 1990 levels by 2012. And the absence from the agreement of the US, the world’s largest emitter, leaves a gaping hole in the world’s efforts to tackle climate change.

Nonetheless, the revival of the Protocol – which many expected not to survive American rejection in March – means that countries and businesses can begin putting in place strategies to help them meet their emissions targets.And brokers and dealers are keen to encourage companies to begin managing their GHG assets and liabilities by trading emissions permits.

But how does the breakthrough in Bonn affect the price of carbon? Some believe that the nature of the agreement (particularly the compromise on carbon ‘sinks’) and the absence of the US from an international emissions market throws earlier calculations of the likely cost of carbon credits into doubt.

“There’s an expectation that prices could well be lower than previously expected,” says Abyd Karmali, a London-based vice president specialising in environmental issues at ICF Consulting.

“We’ve seen a liberalisation on some of the issues [such as limits on the extent to which countries can meet their targets by trading] that would have driven the price up,” agrees Carlton Bartels, chief executive of CO2e.com, a New York-based GHG electronic marketplace. Previously, analysts had suggested that prices of “high-quality” emissions reductions might start at around $10/tonne of carbon dioxide equivalent (CO2e) once the Kyoto rules were in place, raising to $20/tonne during Kyoto’s first compliance period (2008–12). Now Karmali expects to see a range of $3–5/tonne rising to $10 by 2012. Recent trades have taken place between $2–4/tonne (see page 10).

This is because the deal in Bonn granted Japan, Canada and Russia, respectively, an additional 13 million, 12 million and 17 million tonnes of carbon (equivalent to 47.6 million, 44 million and 62.3 million tonnes of CO2) a year from carbon stored in forests towards their emission reductions targets.

Russia is already almost certain to meet its Kyoto target of stabilising emissions at 1990 levels (economic contraction since 1990 means it is likely to be a major net seller of emissions), so this compromise gives it potentially even more credits that it, alongside Ukraine, is expected to sell into the international market.

On the demand side, Canada and Japan would most likely have been heavy buyers of credits. But the compromise on sinks will significantly reduce their need to buy additional credits. Equally, the US, which would have required GHG reductions of 30% on business-as-usual projections had it signed up to the agreement, would have been a major buyer of credits.

Karmali also notes that, without a rigorous compliance regime, some countries may be tempted to ignore their targets for 2008–12. At Bonn, it was agreed that for every tonne of carbon emitted above a country’s target, it would face an ‘environmental’, rather than financial, penalty – namely, 1.3 tonnes would be deducted from its subsequent, 2013–17 target.

Because these targets have yet to be set, Karmali says some countries may decide to ignore their first targets, with the intention of negotiating less stringent future reduction targets to take any penalty into account.

Brokers, however, say that it is too early to see any direct impact from the Bonn agreement on prices. “At this stage of the market, there’s not enough activity, and therefore price discovery, to see a quick move in prices,” says Andy Ertel, president of Evolution Markets, a New York-based energy and environmental broker. Mike Intrator, managing director of global emissions markets at fellow-broker Natsource, agrees that prices have thus far shown little sign of moving.

“The price of carbon up to this point hasn’t been dictated by supply and demand. It’s more about risk management and about the likelihood that the credits will have real value,” he says.“With every hurdle that Kyoto clears, you get a better idea of what the future will look like, and a clearer price signal. I expect prices to tick up a little.”

Michael Grubb, a leading UK climate change academic, expects a future carbon market to be strongly influenced by the actions of Russia and Ukraine. They may restrict the flow of credits they sell to protect the value of what is a potentially significant asset, he says.“It’s going to be a politically imposed price.There’s an overhang of supply from Russia and Ukraine, but the solution to the problem [of a saturated carbon market] is that they don’t want the price to collapse.”

They may also enjoy at least tacit support from the European Union and Japan. Central to the original agreement in 1997 was that financial resources would flow to Eastern Europe, and, under the Clean Development Mechanism (CDM), from North to South. Without these financial flows, the international effort to tackle climate change could break down. “These participants all have a vested interest in a properly functioning carbon market,” Grubb says. The only certainty, he adds, is continued uncertainty.“It’s a complicated story as to how it will play out.The EU, probably, and Japan and other members of the Umbrella Group [such as Australia, Canada and New Zealand], certainly, will need to buy additional credits. It’s a matter of where they choose to source them.”

A low carbon price would certainly make CDM projects less attractive.The CDM, under which developed world investors can earn carbon credits from investing in clean energy projects in the developing world is a crucial part of the agreement.

However, transaction costs associated with the CDM are expected to be relatively high. And, in common with any investment in the developing world, CDM projects will carry higher levels of political risk than similar projects in industrialised countries.

But even if CDM credits are relatively costly to generate in the early years of the carbon market,many projects will be in a good position to take advantage of later price rises, says CO2e.com’s Bartels: “Many of these projects are long-lived – their credits could be worth a lot more in the second commitment period,” when it is expected that deeper reduction targets will push up demand for credits.

Other aspects of the agreement in Bonn proved positive for the CDM. The negotiators agreed on the need for a “prompt start”, including plans to elect the CDM executive board (which will approve projects) at COP 7.

Also, the executive board is to develop “fast-track” procedures for certain projects (such as renewable energy projects of up to 15 MW).“This is quite a high hurdle,” says Lionel Fretz, a director of the UK-based environmental consultancy EcoSecurities.“There’s a lot you can do with 15 MW.”

“I’m surprised at the number of good [emissions reduction] projects out there,” says Evolution’s Ertel,“but if you look at the demand numbers, the market should trend upwards.” And he adds that eventual US involvement in a carbon market cannot be ruled out – the country’s international isolation on climate change has alarmed politicians and a rethink on Kyoto, or US involvement in a parallel scheme, is a serious possibility.

One thing is clear: since the Bonn deal, emissions experts are fielding more enquiries from companies eager to find out what the agreement means for them. “More companies are getting involved to gain experience [in trading carbon], and to begin to manage their risks,” says Intrator at Natsource.

So should companies begin snapping up cheap credits now to help them meet targets in 2008–12 and beyond? It depends, says Intrator, on how their business will look going forward. “But I’d certainly encourage companies to do the analysis and begin to put together a [emissions risk management] strategy.”

Bartels agrees: “It’s important for companies to establish procurement systems and strategies – and the only way to do that is to begin to participate in the market. After all, you can’t learn to ride a bike by reading a book.” EF