1 An Introduction to Carbon Markets Financial Markets Group London School of Economics 15 May 2008 Sam Fankhauser IDEAcarbon
1
An Introduction to Carbon Markets
Financial Markets GroupLondon School of Economics
15 May 2008
Sam Fankhauser
IDEAcarbon
2
Overview
• Why markets?
• The efficiency of markets
• Permits vs. taxes
• Carbon markets
• EU Emissions Trading System
• The Kyoto mechanisms
• Voluntary markets
• The future of carbon markets
• Creating a market
• Policy environment: the global deal
3
The need for emission cuts
From the Stern Review
4
United States
Can-Aus-NZ
Russia
Japan
W. Europe
EITs
Middle East
China
Latin America
Other Asia OtherAfricaIndia
-
1.00
2.00
3.00
4.00
5.00
6.00
0 1000 2000 3000 4000 5000 6000
Population (Million)
Em
issio
ns (
Ton
nes o
f C
arb
on
Per
Cap
ita)
South Africa
Developing country (non-Annex I) countries
Sharing the abatement burden
5
0
10
20
30
40
50
60
70
80
90
No trading Annex 1 trading Full trading
The benefits of emissions trading
Source: Manne and Richels (1998)
US$ billion
Cost of meeting Kyoto targets for the USA, 2010• Effectiveness
• Track record in reducing emissions
• Efficiency
• emission reduction at lower costs
• Integration
• Finance and technology flow to emerging markets
6
Taxes vs permits
• Economic efficiency argument
• Taxes: certain cost, uncertain quantity
• Permits: uncertain cost, certain quantity
• Optimal choice depends on the slope of marginal abatement, damage cost curves (Weitzman)
7
Taxes vs permits
Mar
g. A
bate
men
t C
ost
Flat MB curve
Mar
g. A
bate
men
t C
ost
Steep MB curve
target target
MAC
MAC
MB
MB
8
Taxes vs permits
Mar
g. A
bate
men
t C
ost
Choose tax
Mar
g. A
bate
men
t C
ost
Choose permits
target target
MAC
MAC
MB
MB
9
Taxes vs permits
• Political economy arguments are more conclusive
• International carbon tax agreement difficult to achieve
• Domestically, industry prefers (grandfathered) permits
10
Grandfathering – a source of profit
Meuro (2006)
CEZ: Revenues EBITDA Value of EUAs Net sales
5,6252,268738245
Drax: Revenues EBITDA Value of EUAs Compliance purchases
94658332640
RWE: Revenues EBITDA Value of EUAs Compliance purchases
44,2567,8612,436141
11
Overview
• Why markets?
• The efficiency of markets
• Permits vs. taxes
• Carbon markets
• EU Emissions Trading System
• The Kyoto mechanisms
• Voluntary markets
• The future of carbon markets
• Creating a market
• Policy environment: the global deal
12
More than one carbon market
• Allowance market (cap-and-trade)
• EUA EU Emissions Trading System
• AAU Kyoto International Emissions Trading
• Kyoto mechanisms (baseline-and-trade)
• CER Clean Development Mechanism
• ERU Joint Implementation
• Voluntary market
• CFI Chicago Climate Exchange
• VER Voluntary carbon offsets
13
…dominated by the EU ETS
Source: World Bank
14
Heterogeneous prices
Source: Reuters Interactive
15
• Clean Development Mechanism
• Annex I firm/country financing emission reductions in a non-Annex I country
• Joint Implementation
• Same as CDM but between entities in Annex I countries
• International emissions trading
• Trade of AAUs between Annex I parties
• Green Investment Schemes
The Kyoto Mechanisms
16
Technologies Sellers
Source: World Bank
A closer look at the CDM
17
A growing pipeline
Source: IDEAcarbon / ECON Global Carbon Report
0
400
800
1,200
1,600
2,000
2,400
Dec
-03
Mar
-04
Jun-
04
Sep
-04
Dec
-04
Mar
-05
Jun-
05
Sep
-05
Dec
-05
Mar
-06
Jun-
06
Sep
-06
Dec
-06
Mar
-07
Jun-
07
Milli
on C
ER
s
HFC & N2O reduction RenewablesCH4 reduction & Cement & Coal mine/bed Energy Efficiency Fuel switch
18
PIN rating per risk category
Kyoto and Emissionreduction framework risks
Project context andenvironment risks
Project developer riskProject definition and
execution
Project risk (Technology,Size, Complexity)
Accounting for project risks
19
Kyoto supply
Number of
Projects
PDD volume pre-2012
(mt)
Predicted delivery
(mt)
CDM - issuing 213 506 363
CDM –registered 525 490 362
CDM - under validation
1,548 1,039 715
CDM - before validation
3,600 841 505
JI - all stages 350 174 107
Total pre-2012 6,236 3,050 2,052
20
CER Supply
21
Compliance Demand
Category Purchaser Amount per year Total 2008-2012
Non-EU ETS EU Governments 108-120 540-600
Canada 14 70
Switzerland 2 10
Norway 7 35
New Zealand 7 35
Australia 0-18 0-90
Japan (public) 40-60 200-300
Japan (private) 30-40 150-200
Sub-total 208 - 266 1040 - 1470
EU ETS* 15 – 90* 45 – 450*
Total 223 - 356 1,085 - 1,920
22
• Serve public sector demand first• Less price elastic
• Price differentiation allows to charge more
• Serve private sector demand• Price elastic, demand determined by in-house
abatement options
• Downward pressure on prices
• Bank supplies into post-2012 period• Regulatory uncertainty means sale at a discount
Clearing the marketInventory is larger than potential demand
23
The 2008-12 market
24
Question mark: AAUs
Source: World Bank
EU 6.4%
US 19.3%
Japan 8.5%
Canada 23.5% Australia
15.4% OOECD 12.7%
EU-A -46.4%
OEIT -78.9%
Ukraine -83.6%
Russia -43.6%
-300
-200
-100
0
100
200
300
400
Reductions required (MtC)
Reductions required
Increases allowed
25
• 11,000 installations in 27 EU countries• Energy, refining, minerals, metals, pulp&paper
• Annual compliance requirement • Targets set in National Allocation Plans
• Mostly grandfathering, some auctioning
• Possibility to import Kyoto carbon
• At least three trading phases
• Phase I 2005-07
• Phase II 2008-12• Phase III 2013-20
EU Emissions Trading Scheme
26
Price volatility
Source: IDEAcarbon / ECON Global Carbon Report
0
5
10
15
20
25
30
35
€ pe
r tC
O2
EUA Spot price
EUA Forward price 2008
… a sign of insufficient market information
27
Collapse of phase I price
Source: IDEAcarbon / ECON Global Carbon Report
-20
-10
0
10
20
30
40
50
Mineral industry Metal industry Others Pow er & Heat Pulp & paper Refineries
mtC
O2
Surplus of allow ances in 2005
Surplus of allow ances in 2006
28
• National Allocation Plan• Both phase II and phase III through banking
• Ratio of coal to gas price• Determines fuel switching
• Marginal abatement cost elsewhere
• Weather
• Cooling / heating demand
• Hydro availability
• Output / GDP
• Process emissions in industry
• Electricity demand
Price drivers in the EU ETS
29
Prospects for Phase II
0
10
20
30
40
50
60
70
80
90
100
1,700 1,950 2,200
Emissions (mtCO2/year)
Quo
ta p
rice
(€ p
er tC
O2)
Base case
Higher growth (+1%)
5% decline in industry
Cap = 2,105 mtCO2
Cap with creditimports
30
Chicago Climate Exchange
• Self-described as “world’s first and North America’s only voluntary, legally binding, rules-based GHG reduction and trading system”
• Established in 2000 with currently 312 (voluntary) members• power, automotive, chemical industry; banks, universities,
municipalities; project developers, offset aggregators, NGOs
• Six gases, both allowance-based and offset credits
• In 2006 about 10.3 MtCO2e were transacted,
worth US$91m; as of July 2007 26.3 MtCO2e had
been traded on the exchange
31
Overview
• Why markets?
• The efficiency of markets
• Permits vs. taxes
• Carbon markets
• EU Emissions Trading System
• The Kyoto mechanisms
• Voluntary markets
• The future of carbon markets
• Creating a market
• Policy environment: the global deal
32
Growing European market
Source: IDEAcarbon, ECX
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
33
• US state-level
• Regional Greenhouse Gas Initiative (RGGI)
• Western US Initiative
• California AB 32
• US federal level
• Lieberman-Warner Climate Security Act• Before the Senate in H1 2008
• Other bills in both House and Senate
• Canada
• Intensity targets for large emitters
North America
34
• New Zealand (NZ ETS)
• Starts trading in summer 2008 with forestry
• Covering all emissions by 2013 (industrial processes by 2010)
• Australia (AETS)
• Starts trading in 2011
• Covering >70% of emissions (ex. Agriculture, forestry, fugitive emissions)
• Japan
• Focus on voluntary schemes (JVETS)
Asia - Pacific
35
• Permit allocation
• Auctioning, grandfathering, benchmarking
• Scope
• Difficult sectors like agriculture, transport
• Upstream vs. downstream
• Safety valves against price spikes
• Carbon leakage and competitiveness
• Linking with other schemes
• CDM imports
• Linking with other schemes (e.g. NZ – Aus)
Open issues
36
• Carbon markets in practically all OECD countries
• Regional schemes linked by an extended, enhanced CDM
• Underlying assets: 7.5 billion allowances, worth 200 billion?• Of which > 4 billion in a US federal scheme?
• Trading volume: 8 – 13 billion tCO2
• What is the global deal?
Long-term: Markets in 2020
37
The “global deal”
• Long-term target: a 50% cut by 2050
• For a 450 - 500 ppm stabilisation target
• Consistent with G8, EU rhetoric
• Equitable burden-sharing
• Up to 80% cut in developed countries
• Developing countries get help on technology, carbon finance
• The next 6 months are crucial
• Target: agreement by 2009, ratified in 2012
• Next step: G8 Japan (summer); COP (Poznan)