90 steps forward, two steps back
With the flagship markets of the EU and California in difficulties, advocates of carbon trading are pinning their hopes on a slew of new markets, particularly China and Canada. Graham Cooper reports:
December’s Paris Agreement on climate change action gave a shot in the arm to advocates of emissions trading.
Of the 188 national plans for reducing greenhouse gas emissions submitted to the Paris meeting, 90 mentioned carbon markets. In addition, the Agreement itself includes several market-based approaches to facilitate international cooperation on climate change mitigation. If implemented, these should help channel public and private sector investments to where emission reductions can be achieved at least cost.
A PwC survey of members of the International Emissions Trading Association (Ieta), conducted in April, found that 82% believe existing carbon markets will expand in scale as a result of the Paris Agreement. This compares with 58% a year earlier.
“The inclusion of markets in the  Paris Agreement has boosted morale and opens the door for further opportunities for business to engage in carbon markets around the world,” said Dirk Forrister, Ieta’s CEO.
Indeed, several new markets are expected to launch in the next few years. By far the biggest is China’s national carbon market which is scheduled for the third quarter of next year. Canada is expected to launch a nationwide emissions trading system before 2020 and Ieta members also expect to see carbon markets in Australia, Brazil, Chile, Japan, Mexico and South Africa before 2025.
Brexit blues hit EU ETS
But sceptics of emissions trading might be surprised by this optimism, given the difficulties facing the world’s largest carbon markets – the EU Emissions Trading System (ETS) and its counterpart in California.
EU emission allowances (EUAs) are currently languishing at about €4.75 per tonne of carbon dioxide (CO2), down from €8.75 in October, and the UK’s potential exit from the 28-member bloc could exert further downward pressure on prices. (see box)
California’s market has also run into headwinds, in the form of a legal challenge that could prevent the market continuing beyond 2020.
In April, Governor Jerry Brown called for the California Air Resources Board (CARB), which administers the market, to set a more ambitious emissions reduction target of 40% below 1990 levels by 2030.
But, in the same month, the state’s appeal court called for more information on a 2012 lawsuit brought by the California Chamber of Commerce and others, alleging that cap-and-trade amounts to “an illegally levied tax”.
Uncertain outlook for California
This unexpected move raised fresh uncertainty about the market’s future, leading many allowance holders to sell, even at prices below the auction floor price of $12.73. As a result, only about 11% of the allowances offered in May’s quarterly auction were sold, putting a significant dent in the state’s budget.
A ruling in favour of the objectors would mean that an extension to the programme would need support from at least two-thirds of the state legislature, rather than just a CARB decision.
If the court rules against CARB, prices could again drop below this year’s floor price, says Lenny Hochshild, a San Francisco- based managing director with brokerage Evolution Markets. However, if the court rules in favour of CARB, then prices will likely trade up towards next year’s floor price which will be around $13.55, he predicts.
Erica Morehouse, senior attorney at the Environmental Defense Fund, an NGO, says “We are confident … that California courts will ultimately confirm the legislature’s broad grant of authority to the California Air Resources Board.”
California’s cap-and-trade market was introduced in 2012 to help the state comply with its Global Warming Solutions Act (AB 32) which requires it to reduce its greenhouse gas emissions to their 1990 level by 2020. State authorities are already looking into alternatives to cap-and-trade to help it meet this target, in case it loses the legal dispute, “but the options are likely to be more expensive” says Jeff Swartz, Ieta’s international policy director.
If this challenge is seen off, however, the Californian market is well-placed for expansion. Several more US states could opt for carbon trading to help them comply with the proposed federal Clean Power Plan, although this too is currently blocked by legal action.
Canada to the rescue?
Other Canadian provinces could also potentially link to the California market, following the lead of Quebec which launched its first joint auction of allowances with California in January 2014.
A variety of different measures have been introduced at province level to put a price on carbon but Canada’s new prime minister, Justin Trudeau, and his minister of environment and climate change, Catherine McKenna, have made it clear they want to introduce a federal carbon price using a carbon market, says Swartz.
“The transition to a low-carbon economy will happen by a broad suite of measures, which will include carbon pricing,” Trudeau said in March.
In mid-July, McKenna issued a joint statement with leading Canadian companies saying: “carbon pricing is one of the most efficient ways to reduce emissions and stimulate the market to make investments in innovation, and to deploy low-carbon technology.”
Canada is “a tremendously positive story in the carbon markets,” concludes Ieta’s Swartz.
But the biggest cause for optimism, trading enthusiasts say, is China. “This will be the story for the next two years,” Swartz says.
China prepares for game-changer
A soft launch of a national carbon market in June or July next year is likely, with it likely to become fully operational in the third quarter.
The government has confirmed the industrial sectors that will be covered – power, refineries, steel, non-ferrous metals, chemicals, building materials, paper making, and aviation – and that between seven and 10 exchanges will be authorised to trade carbon allowances. More than 7,000 companies will be covered by the programme, collectively emitting some 3-4 Gt/year of CO2.
Key legislation on the process for allocating allowances is expected before the end of this year, says Simon Chen, lead analyst for Chinese carbon markets at commodity research firm ICIS.
In the first phase of the market, between 2017 and 2020, the National Development and Reform Commission (NDRC) will set the cap for each province, which in turn will make the allocations to individual emitters.
As in the EU ETS, allowances allocated to the power generators are likely to fall 4-5% ‘short’ of their actual emissions. Industrial emitters, on the other hand, will probably initially be given more allowances than they need, Chen adds. But the over-allocation will not be as severe as in China’s seven regional pilot markets or the EU ETS, he says.
“They understand the problems of the EU ETS,” agrees Ieta’s Swartz. “I think they will do a good job”
In addition to their allocated allowances, companies covered by the new market will be able to use carbon offsets to help them comply with their emission caps. But use of such offsets, known as Chinese Certified Emission Reductions (CCERs) is likely to be restricted to 5%-10% of companies’ allocations, says Chen’s colleague, Sisi Tang.
The eligibility criteria governing the use of CCERs in the national carbon market have yet to be announced but sales of ‘Golden CCERs’, which are deemed to have no eligibility risk, have already taken place.
“Some OTC forwards on Golden CCERs have already been negotiated,” Tang confirms. However, she adds that the Beijing government is very cautious about exchange-traded derivatives and says she doesn’t expect to see these introduced before 2020.
Arbitrage between CCERs and National Emission Allowances is one potential trading strategy for market participants, says Chen. Other opportunities include: exploiting the spread between the price of allowances in the bilateral OTC market and on-exchange prices; and trades based on price spikes which commonly occur around compliance dates in new markets.
However, some of these opportunities may only be possible in the early stage of the market, when many compliance buyers lack trading experience, Chen adds.
It is widely expected that foreign companies will be able to participate in the market, but it is not yet clear how, analysts say.
The UK’s 23 June referendum, in which a majority of voters opted to leave the 28-nation European Union, has cast a dark shadow over the already enfeebled EU Emissions Trading System (ETS).
From the modest level of €5.69, EU allowance (EUA) prices plunged by 25% to €4.28 in the week after the vote.
“The risks for everyone in the ETS are growing,” Trevor Sikorski, an analyst at consultancy Energy Aspects, told a webinar organised by Redshaw Advisors on 12 July.
Most observers assume that the UK will remain within the ETS for at least two years after formally notifying the EU of its intention to leave, Louis Redshaw, director of Redshaw Advisors, added.
Sikorski sees two likely outcomes – the UK retains a deep trading relationship with the EU and its installations stay in the EU ETS, or it negotiates a shallower relationship and its installations leave the ETS.
In the former case, the main change would be slightly lower GDP growth in the near-term, which would lead to lower EU emissions and therefore lower EUA prices. If UK installations leave the EU ETS, however, the impact would be significantly more bearish, he says.
UK industrial emitters are net ‘long’ and they would want to sell any surplus EUAs they were holding if the UK was to leave the ETS. Furthermore, its power companies, which generally hedge two years ahead, would want to unwind their hedges and would cease buying allowances to cover their ‘short’ positions.
The net result, Sikorski says, is that, if 2017 were to be the UK’s last compliance year, about 260 million EUAs of additional supply could come to market within a year. This is approximately 12% of a year’s compliance total and “would have a really, really, significant impact on prices.”
“Even without Brexit, we are fairly bearish, but we are extremely bearish with Brexit,” Sikorski says. If the UK remains within the EU, he sees allowance prices falling from an average of €5.4 this year to €4.6 in 2018. Brexit, however, could take average 2018 prices down to €3.5, he estimates. This compares with a high of around €30 before the financial crash of 2008.
And the impact would extend far beyond EUA prices. “The UK is a big emitter and has tough domestic targets,” Redshaw noted. “It does more than most member states …. so, if the UK were out of the ETS, there would have to be tougher targets for other member states.”
And, without the UK, the likelihood of political intervention in the market would increase. “The risk of EUA price support intervention will grow as the price drops,” said Sikorski.
Another major advance in the growth of emissions markets could come in late September at the next general assembly of the International Civil Aviation Organisation (ICAO).The UN organisation was charged, at its previous assembly in 2013, with recommending a market-based mechanism to help the industry reach its goal of ensuring ‘carbon neutral growth’ from 2020.
It is estimated that emissions from aircraft represent about 2% of global greenhouse gas emissions, but they are growing fast, and technological and fuel innovations alone are unlikely to be enough to prevent growth beyond their 2020 level.
“ICAO could decide to go ahead with the design of a global market-based mechanism now, or put it off for another three years,” says Jeff Swartz at Ieta. And, he notes, the fact that aviation emissions are already included in the EU ETS and China’s national market, will complicate the creation of a new global market for airlines.
But, if agreement is reached next month, it would be the world’s first truly global market-based mechanism for carbon mitigation, observers say. In early August, however, rumours began circulating that ICAO might recommend that participation in the market could be voluntary for the first five years.
Koreas’ emissions trading scheme was launched in January last year and is nominally the world’s second largest after the EU ETS, with 568 companies covered.
But trading has been minimal, with less than 1% of allocated allowances changing hands so far. This is largely a result of over-allocation and generous flexibility mechanisms, such as the ability to borrow allowances from future years, observers say.
“It’s been a quiet market, but changes are coming,” says Ieta’s Swartz. In Phase 2 of the market, starting in 2018, fewer allowances will be issued for free and the government has acknowledged a need to tighten the overall cap after 2020.
“The government wants a good market,” says Swartz, noting that the EU agreed in July to provide financial support to help the Koreans develop their market.
“I think the market there will evolve – they just need to decide how generous to be,” he concludes.
RGGI was the first mandatory carbon market in the US and covers power plants in nine northeastern states: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont.
Like many of the early carbon markets, it suffered initially from over allocation of allowances but trading activity and prices have picked up after a dramatic tightening of the cap in 2014. Further refinements are currently under discussion.
Analysts say RGGI provides a good model for other US states looking to achieve low-cost compliance with the proposed Clean Power Plan, which aims to reduce emissions of greenhouse gases from the US power sector to 30% below 2005 levels by 2030.
Hopes were raised of a significant spread of carbon trading in the US last summer when the US Environmental Protection Agency (EPA) introduced the Clean Power Plan (CPP), which aims to reduce carbon emissions from generating facilities across the country to 70% of their 2005 level by 2030.
The mandatory measure is scheduled to begin in 2022 and would allow individual states to decide on how they wish to achieve their targets. Many were expected to adopt emissions trading, in some cases by linking with the existing carbon markets in California or the US Regional Greenhouse Gas Initiative (RGGI). (see Box)
In February, however, the US Supreme Court put the brakes on the plan, pending a judicial review. And, since then, the political environment has changed beyond recognition, with the possibility of Donald Trump being elected president in November.
The US Court of Appeals for the DC Circuit is due to hear the challenge against the CPP in late September, but a verdict is unlikely until after the presidential election.
Most observers assume that victory by Hilary Clinton would lead to implementation of the CPP, if the court rules in favour. A Trump victory, however, would make this less likely.
In May, West Virginia attorney general Patrick Morrisey, who is leading the legal challenge, said he was confident that Trump would slow, if not scrap, the CPP if he became president, irrespective of the court’s judgement.
Trump has described global warming as a “total hoax” and said he would want to scrap the EPA. Yet this may not be his final word on the subject. According to the news service Politico, he has explicitly acknowledged “global warming and its effects” in an application for permission to build a sea wall to protect one of his golf courses in Ireland.