Rebooting the carbon markets

Channels: Carbon, Markets

Companies: Ieta, Energy Aspects, HSBC, Ceres, Center for Climate and Energy Solutions, Climate Action Reserve, South Pole Group

People: Julia Michalak, Trevor Sikorski, Ashim Paun, Anne Kelly, Allan Zaremberg, Janet Peace, Katie Sullivan, Aimee Barnes, Craig Ebert, Jeff Swartz

Across the globe, regulators are doubling down on their commitment to carbon trading, despite recent market setbacks. Graham Cooper reports

A new era is dawning for the world’s largest carbon markets. A major reform of the EU’s Emissions Trading System (ETS) is being negotiated and, in the US, a similar restructuring of the Regional Greenhouse Gas Initiative (RGGI) is underway. Meanwhile, in California, the world’s second biggest carbon market has recently been given a new lease of life and, in China, a long-awaited national emissions trading regime is about to begin.

In both the EU ETS and RGGI, the price of emission allowances has been languishing well below the level of most European carbon taxes, and is generally agreed to be too low to incentivise the transition to low-carbon technologies. (see Chart)

Despite these problems, however, the cap-and-trade approach to curbing greenhouse gas (GHG) emissions is still gaining ground, most notably with the imminent launch of China’s long-awaited national ETS, which could dwarf all existing markets. (see Box)

In both developed and emerging markets, politicians are backing carbon trading to help deliver the emission savings required to meet their commitments under the 2015 Paris Agreement.

The central aim of the EU ETS reform for the period 2021-30 (Phase 4) is to help the cap-and-trade market contribute to the EU’s goal of slashing GHG emissions to at least 40% below 1990 levels by 2030.

This market, which covers more than 11,000 power plants and industrial facilities, has had a sizeable surplus of carbon allowances (EUAs) in recent years due to the decline of economic activity since 2008 and the impact of other policies supporting energy efficiency and renewable energy.

A key proposal is to increase the ‘linear reduction factor’, which determines the rate at which the market’s overall emissions cap shrinks, to 2.20% / year from 1.74% / year from 2021.  This idea is backed by the European Commission, the Council and the Parliament, says Julia Michalak, EU policy director at the International Emissions Trading Association (Ieta), although the Parliament would like to go further and raise the rate to 2.40% / year from 2024.

Source: World Bank/Ecofys

Trilogue negotiations

This is one focus of the ‘trilogue’ negotiations between representatives of the three EU bodies, which resumed on 12 September after a summer break.                          

Another important proposal is to increase the rate at which surplus EUAs are removed from the market and put into the Market Stability Reserve (MSR). “We are confident that strengthening of the MSR will be part of the final deal,” says Michalak. “This is a key element to help the ETS recover.”

Julia Michalak, Ieta: 'We expect November is the latest for the [EU ETS Phase 4] negotiations to complete.'The aim of both measures would be to help create economic scarcity of EUAs in a predictable manner.

There are many other issues to be resolved in the talks – some small, some big – but they are all inter-related, says Michalak. “We have to move forward on all fronts at the same time … [but] we expect November is the latest for the negotiations to complete.”

Until a spike up to €7.72 in mid-September, EUAs – each of which represent one tonne of carbon dioxide (tCO2) – have spent most of the past 18 months, languishing between €4.5 and €6, way below their peak of almost €30 in 2008. At these levels, they are not a material concern for most companies and therefore provide little incentive to reduce emissions, analysts say.

Trevor Sikorski, head of natural gas and carbon research at London-based consultancy Energy Aspects, sees little chance of the price rising significantly this year but is confident agreement will be reached on the Phase 4 reforms in the next few months, leading to significantly higher prices from 2019. 

“It would be a surprise if a final agreement is not made before the end of the year,” he said in a recent research note. He predicts EUAs will then rise to an average of €5.5 next year, about €9 in 2019 and €15.6 in 2020. By 2021, he expects to see prices closer to €20, rising to about €38 by 2030.

Brexit – causing concern

An additional complication is the expected departure of the UK from the EU. One recent proposal, which has alarmed the European power industry and others, seeks to ensure that any allowances issued by the UK after 1 January 2018, to any EU ETS participants, will be nullified if the UK leaves the EU ETS after it quits the bloc.

However, if and when the UK does leave the EU ETS, several analysts have suggested it could develop its own cap-and-trade market which could then link to the main EU market in the way Switzerland has recently agreed to do.

“We see precedent for a UK standalone scheme to link up, should it leave the EU ETS once Brexit is finalised,” Ashim Paun, director of climate change strategy at HSBC, told clients in late August.

Other challenges facing the trilogue negotiators include: how to deal with international flights into and out of the EU and how the EU’s existing market for intra-EU aviation emissions will interact with the airlines’ own carbon market, which is due to start in 2021.

This proposed new market-based mechanism – the Carbon Offsetting and Reduction Scheme for International Aviation (Corsia) – will allow airlines to offset any growth in their emissions beyond 2020 levels using GHG reductions from other sectors. After a two-year pilot phase and a voluntary first phase from 2024 to 2026, it is intended to be mandatory from 2027.

Reforming RGGI

Similar reforms are planned in the US.

The RGGI market, which covers about 165 power plants in nine northeastern states, has seen a marked decline in allowance prices and liquidity since early 2016. Indeed, the clearing price in the quarterly auctions fell to a four-year low of $2.53 in June.

An oversupply of allowances is the main factor but, as in the EU, the success of other initiatives to promote renewable energy is also partly responsible, analysts say. An additional factor in the case of RGGI is a ‘Cost Containment Reserve’, which increased the number of allowances available for sale in recent years when prices reached a certain threshold.

A revision of this mechanism, so that it is only triggered in exceptional circumstances, has been suggested after a two–year review of the market.  Another is the introduction of an ‘Emissions Containment Reserve’ which, like the EU’s MSR, would allow participating states to withhold allowances from auction if emissions prices fall below a predetermined level.  

Other possible modifications include: accelerating the annual decline of the overall emissions cap, and new measures to deal with the supply of banked allowances.

Some participants have also called for a price ceiling, curbs on market access for non-compliance buyers, and restrictions on the sourcing of carbon offsets.

The participating states have agreed a consensus position on the reform proposals which will be presented in late September. If agreed, the clarity provided will be widely welcomed.

“RGGI currently sends a relatively weak price signal for the emissions market,” wrote Anne Kelly, senior director at Ceres, a network of investors and businesses, in a July letter to the RGGI board. “By setting an ambitious future for the RGGI programme, RGGI states will capture economic value through the creation of incentives for economic growth.”

A longer life for California

Meanwhile, in California, carbon market participants have welcomed a long-awaited confirmation that the state’s cap-and-trade market will be extended until 2030.

In July, a bill to extend the life of the market, which had been due to expire in 2020, was passed by the state senate and the state assembly.

Supporters of the bill (AB398) say it is crucial to help the state achieve its goal of cutting its GHG emissions to 40% below 1990 levels by 2030. "AB398 will provide the least costly path to achieving our climate goals," said California Chamber of Commerce president Allan Zaremberg. 

Chris Busch, Energy Innovation: 'The [California] system remains over-allocated.'Since its launch in 2012, this market, which covers about 85% of the state’s GHG emissions, has “by any measure, been a success,” says Janet Peace, senior vice president, policy and business strategy, at the Center for Climate and Energy Solutions (C2ES), a US think tank. It has proved “you can reduce emissions while growing the economy.”

But the market has faced a series of legal challenges in recent years and the vote will help businesses plan for the future, say market participants. 

AB398 retains the existing price floor for California Carbon Allowances (CCAs) but also introduces a price ceiling.

The new-look programme has been generally well received by the business community.  “It’s big news,” not just for giving certainty to business but also for other jurisdictions that are not just watching California, but replicating what it is doing, says Katie Sullivan, a Toronto- based managing director at Ieta. “It certainly sends a very important signal to other markets globally.”

The California market has been linked with its counterpart in Quebec since 2014 and is expected to link to Ontario’s new cap-and-trade programme in 2018. Its neighbouring state of Oregon is also mulling a bill which mirrors California’s programme, Sullivan adds, while Mexico is working on a pilot cap-and-trade programme that could also be linked to California.

“The extended programme facilitates links with other national and international cap-and-trade programmes,” agrees Aimee Barnes, senior advisor in the Office of the Governor of California. But, she notes, there remain some concerns and questions regarding the programme extension. 

These include a lack of clarity on threatened rules to discourage ‘speculation’, as well as measures to address the oversupply of allowances and to impose restrictions on the use of emission offsets.

Oversupply and offset concerns

“We are disappointed in the reductions in the use of offsets, especially given their proven impact to achieve real, additional, and permanent greenhouse emissions reductions; reduce compliance costs; advance the low-carbon economy; and generate important environmental and air quality co-benefits,” says Craig Ebert, president of the Climate Action Reserve, which acts as a registry for such credits.

In addition, the new bill insists that at least half of the offsets used must come from projects within California.

A more fundamental concern, many believe, is that the system remains over-allocated. Cap levels have exceeded emissions since 2013, notes Chris Busch, research director at analysis firm Energy Innovation.

Current-year CCAs went unsold in all four auctions in 2016 and just 18% were bought in the February 2017 auction. In May, however, after an April ruling that upheld the legality of the auction process, all CCAs offered at auction were sold, bringing revenues of more than $500 million for the state’s GHG reduction fund, and the clearing price of $13.80 was above the floor price – the first time this had been seen since November 2015.

This buoyant demand carried through to the 21 August auction in which all 64 million CCAs were sold at a record settlement price of $14.75, notes Busch.

But “the system’s allowance oversupply issue remains unresolved,” he warns. “The boost in near-term demand is due to emitters and speculators snapping up allowances at relatively low prices in anticipation of the aggressive post-2020 cap reductions. Additional allowances purchased today will be banked and eventually used later.

“We recommend that [market administrators] the California Air Resources Board (CARB) address oversupply sooner rather than later.”

The system is over-allocated by some 280 million CCAs to 2020, he estimates.

Most analysts expect the recent strengthening of the CCA price to continue, as compliance buyers compare the current price of allowances against the expected cost of reducing emissions in the future as the cap is tightened.

The East is (almost) ready

After a decade in which Europe and the US have dominated carbon trading, attention is now switching to Asia as China prepares to launch a national cap-and-trade market, after four years of experimenting with regional pilot markets.

Jeff Swartz, South Pole Group: China’s compliance cycle 'is more likely to begin in 2018'The proposed market will dwarf its western counterparts, although the government has scaled back its plans for the first phase of the system. It is eventually intended to cover eight industrial sectors – power, refineries, steel, non-ferrous metals, chemicals, building materials, paper making, and aviation – but most observers now expect just three sectors will be included initially – power, aluminium and cement.

The process for allocating emission allowances has not yet been agreed, and the government is still awaiting emissions data from some provinces and reviewing benchmarks for some sectors, explains Jeff Swartz, director of climate policy and carbon markets at South Pole Group. The latter “is a positive sign”, he says, as it suggests the government thinks the previous emissions benchmarks were too generous.

Other important issues to be decided include registry details and limits on the use of offsets. But, despite these important outstanding issues, a launch is expected this year, although the compliance cycle is more likely to begin in 2018, Swartz says.

The eventual aims of the national market, which builds on the experience of seven regional pilot trading systems, is to curb the GHG emissions from more than 7,000 Chinese companies collectively emitting the equivalent of some 3Gt-4Gt/year of CO2.This compares with 1.75Gt for the EU ETS in 2016, about 440Mt for California, and 79Mt for RGGI.    

Elsewhere in the Asia-Pacific region, reform is also underway in the existing markets of South Korea and New Zealand.

Significant changes in the Korean market are to be introduced in January, when it enters its second three-year phase. The first phase (2015 – 2017) saw very little trading but, “in my view – Korea is incredibly positive,” says Swartz.

As in the EU and RGGI, the government was initially too generous in its allocation process and in its rules governing banking and borrowing of allowances. But the government is committed to emissions trading as a key policy tool to drive emissions reductions across the whole economy, he adds.

South Korea is a state-planned economy, Swartz notes, and cultural factors are another reason for the lack of trading in Phase 1, he suggests.

The industry sectors covered by the market will not change in Phase 2, but there will be greater use of auctions and a wider range of offsets will be allowed. The country is also in talks with New Zealand with a view to potentially linking their carbon markets and, in time, with that of China.

New Zealand’s own nine-year old market is also preparing for an overhaul. In July, Climate Change Minister Paula Bennett announced a series of proposals “to make the NZ ETS more similar to emissions trading schemes in other countries, which will mean that it is more compatible for international linking.”

These proposals include:

  • introducing auctioning of allowances;
  • limiting the use of foreign emissions offsets;
  • reforming the current price ceiling of NZ$25; and
  • announcing allowance supply levels for a rolling five-year period.