Thursday, May 24, 2012

Break the mould

By Joost Kanen, May 11, 2012

Sustained low carbon prices in the EU Emissions Trading System have been blamed on the ongoing economic crisis – but there may be more fundamental design issues at play, argues Joost Kanen

The economic crisis and lower energy demand are adding to the oversupply of EU allowances (EUAs) in the EU Emissions Trading System (ETS), but other, more structural flaws that have to do with the design of the programme are augmenting these problems. Of course the EU should still be lauded for its pioneering carbon market, but it’s time to raise the bar as new carbon markets come into existence in California, Australia and China – some of which are better designed than the EU ETS.

There are several design errors in the EU ETS. The first and foremost is that the EU ETS is imbalanced because the buy side is far more concentrated than the sell side. One could almost speak of an oligopsony situation at the moment.

One cause of this is that allowances are allocated to installations instead of to companies – often one company has many installations, and in various countries. Yet the economic actors in the carbon market are not installations but companies.

The second cause is that the electricity sector is really the only sector that is substantially short in EUAs. The volume needed by electricity companies is far larger than the volumes of the sellers and their long positions, and this puts market power in the hands of the buyers. Every buyer may need 20 sellers to match his demand, and this creates a large negative price bias.

The short position is not only concentrated in the electricity sector but also in one country: Germany. Actually it is mostly German electricity generators, which own many installations both in Germany as well as in many other EU member states, who are short. This is unlikely to change much in the 2013–20 third phase.

In addition, there is also concentration in timing of the trading. The cause for this is the discrepancy in the storage value of goods between the carbon market (EUAs are valid for eight years and can be banked, borrowed and rolled over) and the underlying electricity markets (electricity can’t be stored and has to be traded instantaneously), which creates concentrated trading in specific periods and volatility in the carbon market as it is far smaller than the underlying electricity markets. In particular industrial companies, that often see the EU ETS only as a regulatory burden, will postpone their market activity. The electricity companies make the market. This all causes trading to be concentrated in specific time periods, spot markets that are illiquid and price formation that is unclear and volatile.

The buy-side concentration, the size difference and the concentration of trading also allows the electricity companies to incorporate the carbon cost into the price that it charges its customers. This undermines the carbon market as this is done via concentrated electricity companies, which are often still monopolists in their own national electricity markets, and it lowers the visibility of the carbon market to citizens.

A second problem with the EU ETS is that it only applies to large-scale organisations, thus creating a disconnect with individual citizens, who often wish to contribute themselves to reducing emissions. The scale threshold for participation also puts off entrepreneurs and innovators that are often in smaller start-up companies. The scale aspect is logical from an organisational perspective, but it hides the politics driving the EU ETS. The inclusion of road transportation, as in the Californian programme, would bring emissions trading down to the level of citizens and make the political effort that is driving the EU ETS much more visible. This is important to continue the political support for carbon trading as a policy instrument.

Thirdly, the EU ETS is unfriendly for innovations, especially for those (often large-scale) innovations that have not been put on the government agenda by industry lobby groups. Grandfathering – the process of giving free allowances based on historical performance – financially rewards existing/old technology. Rewarding old technology increases barriers for innovations that haven’t been lobbied for, were unplanned and thus don’t receive EUAs for free.

In Phase III of the EU ETS, grandfathering continues for industry, while auctioning increases for utilities, which simply pass these costs on to their captive customers. The prospects for innovation will be little improved, given this continued free allocation to industry, while the passing through of costs to consumers also deters innovation. What should have been done is auctions to electricity generators but neutralise the indirect cost pass-through by compensating their customers (including industrials), and at the same time start auctioning to industrials, creating more balance between the buy and sell side in the ETS, making it less of a paper market, and spurring industrial innovation.

Finally, the EU ETS is too much of a financial game, without enough focus on the production infrastructure itself. Many countries love to stimulate their financial sectors, but a financial market is only a support for the underlying real economy. The ultimate aim of the EU ETS is to cause changes and innovation in the production infrastructure in Europe and, via export of newly developed low-carbon technologies, also in the rest of the world. Auctioning to industry will have that effect, not giving free allowances.

We believe that the California ETS is better designed than the EU ETS. The California programme is regulated more from the demand side instead of from the production side. The California ETS includes transport, is less exclusively large-scale, and avoids carbon leakage by placing the cap closer to the end-consumer. For example, allowances in the California ETS will be grandfathered to electricity distributors which will auction the allowances to electricity generators from inside and outside the state border, and the proceeds of these auctions will be used to compensate electricity users for increased power prices.

Besides the above-mentioned design errors, there is of course also the political uncertainty surrounding the ETS itself and the form of the extension of Kyoto Protocol after Durban. This negatively affects carbon price formation and investment decisions. But political uncertainty can never be avoided in an artificial market like the EU ETS. Policy interaction with the EU ETS also negatively affects carbon prices, especially the national renewable energy targets and the energy efficiency goals.

The EU ETS is in bad shape but can be improved and it can be done in a more sophisticated manner than just cancelling 1.4 billion EUAs, as has been talked about.