Monday, 23 April 2012

Who's Afraid of Low Carbon Prices? Part 1: The Compliance Market

A big point of discussion at the Africa Carbon Forum was around what today's very low carbon prices mean for market participants.  Since 2008, the price of European Union Allowances has dropped precipitously, from a high of €28 to less than €8 today.  Critics claim the collapse in prices means the market has failed, that it is not delivering emission reductions, and that it should therefore be scrapped.  Those critics are wrong, but the reasons differ depending on which carbon market you wish to examine.  Part 1 of this post will explore the issues facing the compliance market, while Part 2 will look at the voluntary market.

The compliance market is one of two main carbon markets in the world, and by far the larger.  In the compliance market, government regulators set quotas for the allowable greenhouse gas emissions from individual companies.  Firms are expected to implement energy effiency, fuel switching and other measures to reduce emissions and meet the cap.  If they outperform, they are allowed to sell any excess allowances on the market.  However, if the companies exceed their quota, they must buy allowances from more carbon efficient firms.  This cap-and-trade system is a price discovery mechanism meant to identify all of the most cost-effective emission reductions across an industry.  Cap and trade therefore lowers the cost of reaching the government's overall carbon target.  In the EU, firms also have the option of purchasing credits from carbon reduction projects in developing countries, via the Clean Development Mechanism (CDM), up to certain limits.  The CDM provides a safety valve for the compliance market, helping to ensure that emission reduction targets can be achieved without imposing excessive financial costs on important sectors of the economy.

In the voluntary market, companies go farther, with fewer tools.  They make the decision to voluntarily achieve emission reductions beyond any regulatory targets.  However, these firms lack an established cap-and-trade system that would allow them to trade carbon credits with their peers, and with more and more firms pledging to reduce emissions to zero, there would be no excess credits to sell in any event.  As a result, most companies that go beyond compliance achieve part of their zero-carbon target through in-house reductions, and the rest through outsourced reductions bought from the voluntary carbon market. We'll discuss the voluntary market in Part 2 of this post.

So what's going on with the EU carbon price?  Put simply, demand fell and supply increased.  When sellers outnumber buyers, expect the price to fall.  On the demand side, the 2008 economic collapse happened, and regulators didn't see it coming.  When the EU Environment Agency set their current emissions cap back in 2007, they assumed both the economy and emissions would continue growing every year. But they didn't.  The housing market crash hit the construction industry hard, and the steel and cement industries suddenly found themselves with many more carbon allowances than they needed to hit their targets.

Meanwhile, the Environment Agency decided to get tough on the flow of cheap carbon credits from projects in China and India that destroy industrial gases like hydroflourocarbons (HFCs), and in some cases nitrous oxide (N2O).  The EU announced a ban on the purchase of credits from those projects after December 2012 in an effort to limit supply and ensure more of the credits sold into the market came from clean energy projects.  Carbon Clear has never sold credits from industrial gas projects, and I think this was the right decision by the EU.

However, the timing could not have been much worse.  Rather than limiting supply from HFC and N2O projects, the EU's move has had the opposite effect.  Industrial gas project developers have flooded the market in an effort to get as much return on their investment as possible before the EU's ban comes into force.  The CDM has seen record flows of new credits in the past few months, in the face of lacklustre demand. This supply glut puts even more downward pressure on the carbon price.

Today's shockingly low carbon price in the EU-ETS, then, is evidence that the market is working. EU regulators set up a cap-and-trade scheme and asked the carbon market to hit its targets at the lowest overall price.  And this is exactly what the market has done.   The EU will hit its overall carbon target, and the carbon price is not driving away business or putting a heavy burden on poorer members of society.  Anyone familiar with the phase-out of CFCs and the success of the sulfur dioxide trading scheme in the USA would have expected this encouraging result.

That's the glass half-full story.

The problem, however, is that today's carbon price is not high enough to incentivise structural changes in polluting industries.  It is cheaper for many companies simply to buy allowances or international carbon credits than it is to invest in energy efficiency measures or shut down their coal-fired furnaces and switch to cleaner fuels.  What is more, firms that are making investments based on today's carbon prices may be locking us into another 30-50 years of higher carbon emissions.  We need to send a clearer price signal that encourages these firms to make a more significant clean energy transition.

What the low price of EUAs and CERs is telling us, then, is that, while the market is working as intended, regulators around the world have not been sufficiently ambitious in the emission reduction targets they have set.  The EU is achieving its original emission reduction goals at a fraction of the cost anticipated when those targets were set. For those of us concerned with avoiding catastrophic climate change, the logical next step for the EU would be to set an even more ambitious target.

Legislators in the United States, similarly, can see from the EU experience that we can encourage the transition to a low-carbon economy and achieve emission reductions far more cost-effectively than anyone believed just a few years ago. This knowledge can help overcome opposition to a national cap-and-trade system and simultaneously drive demand for international credits that contribute to sustainable development around the world.

In summary, those who argue that low carbon prices mean the market has failed have gotten it almost exactly wrong. Low prices are a good news story, showing that we can achieve even more ambitious emission reductions at a manageable price. 

What we need is the political courage to set those more ambitious targets.