Don't hold your breath: Carbon markets after Copenhagen
Why hasn’t the carbon price fallen further?
Feb 4th 2010 | The Economist
SOMETHING curious has been happening in the carbon markets. They are entirely political creations—even the most inventive financial engineers would not, on their own, have come up with the idea of a difference in value between the air people breathe in and the air they breathe out. Yet traders seem pretty uninterested in political cues. At the chaotic end of the Copenhagen climate summit in December, prices in the largest market in carbon-dioxide emissions, the European Emissions Trading Scheme (ETS), did drop from €14.60 ($20.50) to €12.70. But that still left the price of a tonne of carbon dioxide comfortably above its lowest level last year.
The Democrats’ subsequent Senate-election loss in Massachusetts, which dealt a crippling blow to the prospects of an American cap-and-trade system that would have greatly expanded world carbon markets, had even less effect. And the announcement this week of the commitments to carbon reduction that countries were willing to accept under the Copenhagen “accord” caused scarcely a ripple.
There are two explanations for this sangfroid. One is that the markets had already priced in the likelihood of seeing neither a deal in Copenhagen nor a cap-and-trade bill on Barack Obama’s desk. Another is that their long-term prospects remain reasonable, if humble.
The ETS is reckoned to be oversupplied at the moment because of the recession. Falling industrial output and lower electricity demand (see chart) mean that the pre-agreed amount of carbon allowances (known as EUAs) available over the 2008-2012 period will be greater than the actual amount of carbon emitted. A similar situation crashed the market in 2007 but that has not happened this time round because the EUAs issued from 2008 can be banked for use in the scheme’s next phase, which will run from 2013-2020. Point Carbon, a research firm, estimates that under current EU policy, which calls for carbon emissions in 2020 that are 20% less than those of 1990, the price in 2016 should be €20-40. If the EU opts for a 30% cut the range would be €30-60.
Becalmed as they are, however, current prices are clearly not achieving the policy aims which led politicians to create them in the first place. The most obvious short-term way in which carbon prices in the ETS can reduce emissions is by encouraging electricity generators to switch from cheaper high-carbon fuels, like coal, which require them to buy more credits, to more expensive low-carbon fuels, like natural gas. At the moment, though, with gas prices comparatively low and coal prices creeping up, any such switching is going to be done anyway, according to Sabine Schels of Bank of America Merrill Lynch.
To encourage more profound changes in energy generation, such as the development of new types of nuclear-power stations or of coal plants that store away their carbon, the carbon price would have to be a great deal higher and have a pretty firm floor. As it is, current prices may be making industrialists more aware of their carbon footprints, but they are not having a huge effect on the world at large.
The biggest effect that carbon markets have had on emissions so far, according to Kristian Tangen of Point Carbon, has been on investment in developing countries. The Kyoto protocol, a 1997 agreement on emissions, set up a “clean development mechanism” (CDM) by which reductions in greenhouse gases in developing countries could generate a carbon credit that can be traded alongside the EUA.
A successor to the Kyoto protocol could greatly increase the size of this market, as could a cap-and-trade system in America. But neither is coming soon. At the moment the Kyoto protocol is due to run out in 2012, and may take the CDM with it. “The CDM will either be consigned to the dustbin for quaint market-based approaches that couldn’t attract sufficient political will, or it will scramble to scale up massively,” says Abyd Karmali of the Carbon Markets and Investors Association, a trade body.
That level of uncertainty is chilling new investments but not driving them away entirely. “If you are not in the market then it’s rational to wait,” says James Cameron, vice-chairman at Climate Change Capital, which manages CDM investments. “However, if you are confident about the public policy purposes that drive the market, and you know the problem hasn’t been solved, your conviction drives you to continue to invest where value will be found.”
If European politicians actually wanted to raise the price of carbon in the short term, they could, says Michael Grubb, a Cambridge professor who is also chair of Climate Strategies, a network of policy advisers. New EUAs are regularly auctioned by Germany and Britain. They could set a reserve price of, say, €20. If no one were to bid, the supply of allowances would tighten until the price rose. When this idea was first raised last year, it attracted brickbats for constituting political interference. A fair criticism, perhaps, but given the political nature of the market, a redundant one.
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