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CO2: A 200% increase in 18 months

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05/10/2019 | 11:04am EDT

On the eve of the European elections, debates on raising Europe's climate ambitions are intensifying. A handful of countries recently made a joint call for acting “now” at the Sobiu summit. While the subject divides Member States, which do not have the same energy mix, the objectives remain unchanged: to reduce greenhouse gas emissions by 20% in 2020, then up to 40% in 2030, all compared to 1990 emissions. This is an opportunity to review one of the EU's main tools in this area, the carbon market.

How does the carbon market work? Established by the European Union in 2005, the Emissions Trading Scheme (ETS) remains the first but also the largest of the world's carbon markets. In addition to a wide range of environmental taxes, this system is the cornerstone of European policy in terms of combating greenhouse gas emissions.

Instructions for use:

First, the European Commission defines an emissions cap, which is then shared between different market players in the form of tradable allowances. As such, a quota corresponds for an industrial company to the authorization to emit an equivalent ton of CO2. The categories of actors concerned naturally remain energy-intensive industries, such as coal or gas power plants, steelmakers, cement plants, etc. At the end of each period, polluting actors must justify a balance between the allowances they hold and the emissions for which they are responsible.

In principle, stakeholders who own allowances are likely not to emit exactly the amount they have been allowed to emit, some will emit more, while others will emit less. On this basis, the system allows those who have too many quotas to sell them to those who do not have enough, around a market price. At the end of the period, non-compliant companies (i.e. companies with actual emissions in excess of their authorization to pollute) will be sanctioned with a fine. On the other hand, if they are not sold on the market, a company that has an excess of quotas will be able to keep them for years to come.

In short, a real market driven by supply and demand, linking thousands of European companies (12,000 covered installations affecting 8,000 firms in 31 countries), representing together no less than 45% of EU emissions.

A little history…

On paper, the idea is brilliant. With a market mechanism, Europe can influence the strategic decisions of the main polluting actors, without destroying their competitiveness through other rigid actions such as a heavy carbon tax. Nevertheless, to the great dismay of those advocating a rapid ecological transition, the European carbon market, which operates in different phases, is making only slow progress towards achieving its objectives.

Phase I (2005-2007). The fiasco: the first phase of the ETS served as preparation and learning for the following phases. The launch was catastrophic, in the absence of precise data on the emissions of the companies subject to the scheme, the quantities of allowances allocated free of charge were significantly higher than the actual emissions. As a result, the price of allowances fell to zero in 2007, as did incentives to invest in cleaner energy.

Phase II (2008-2012). The crisis is going through this: if the second phase introduces new rules such as reducing the cap on allowances, auctioning part of the permits issued (3.6% of the allowances were allocated by this procedure) and broadening the categories of actors subject to it (including the aeronautics sector), there again, the ETS has difficulty proving effective. The 2008 crisis and its various consequences, such as the decline in industrial activity and consumption at half-mast, are to blame. What appears to be good news in terms of CO2 emissions is less so in terms of encouraging stakeholders to change their carbon footprint. In other words, the fall in greenhouse gas emissions, inherent in a decline in economic activity, is accompanied by a surplus of unused pollution rights, which ends up being sold on the carbon market without any real demand. The supply-demand imbalance remains, and with it, the low price of carbon emissions.

Phase III (2013-2020). Key reform in 2018: improvements continue in the third phase: lowering of the ceiling, expansion of the sectors concerned and generalization of auctions, among others. However,  a high quantity of unused allowances coexists with a low carbon price, below EUR 10 per tonne, at least until 2018, when Europe, forced by these many failures, undertakes more binding reforms. In general, the introduction of a stability reserve that automatically modulates the quantity of allowances auctioned according to the quantity of allowances in circulation makes it possible to withdraw a significant number of permits. A range of quotas is thus set: when the number of quotas in circulation is lower or higher than this range, it is automatically adjusted. In the event of a significant deficit, allowances will be taken from the reserve and added to the future volume to be auctioned. Conversely, in the event of an excess of allowances on the market, allowances will be added to the reserve and deducted from the volumes to be auctioned.

Ultimately, the objective of the European authorities remains, beyond controlling the impacts of external shocks such as an economic crisis, to act on rising carbon prices.
Spot price of CO2 emissions (€/EUA*)
*EUA: european emissions allowance (tradable emission permit of one tonne of CO2)

Light at the end of the tunnel?

There is no denying the catastrophic beginnings of “right to pollute” markets, nor can we overshadow its many dysfunctions. The price per tonne of carbon has long remained too low to encourage industrialists to invest and achieve significant emission savings.

Despite these repeated failures, capitulation is not an option. In this respect, the ability of European authorities to learn from their mistakes should be highlighted. The implementation of the reserve mechanism is clear evidence of this. Although it may be implied that these latter reforms more or less alter the market instrument of the ETS, since the carbon price is no longer entirely a result of the supply-demand balance, it would be the price to pay to see the market for pollution rights (finally) work.

Proof of this: since the EU has equipped itself with these more active regulatory tools, CO2 prices have risen sharply to reach almost EUR 26 per tonne today; and studies predicting a carbon price above EUR 40 are flourishing.

Jordan Dufee
© MarketScreener.com 2019
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