Carbon trading. Cleaning up

Date: 06/05/06

Power companies and shorting traders have done better than the environment

MARKETS are naturally volatile; but when they are new, thin and involve governments, they are especially capricious. So it is with the market for carbon-emission permits created by the establishment of the European Union Emissions Trading Scheme (ETS) in January 2005. The price of permits, which had tripled since the scheme's launch, dropped by more than half in the last week of April.

The ETS is designed to cut greenhouse-gas emissions so that European countries meet the targets set for them by the Kyoto climate-change agreement. Some 13,000 factories and power stations in five different industries may emit carbon only if they have a permit. At the start of the scheme, they were given permits worth around 2.2 billion tonnes of carbon dioxide per year. Those permits may be used up as fuel is burned and carbon generated, or they may be traded. Around euro10 billion-worth ($12.4 billion-worth) of permits were traded last year. This year the figure will probably be three times that.

When the scheme was originally established, politicians expected the permit price to hover around euro10 a tonne. Instead, it rose to a peak of euro30. "The gas-coal spread is mostly responsible," explains Anthony White of Climate Change Capital, a specialist investment bank. The power-generation business dominates the carbon market, because it emits so much pollution. In Europe, gas and coal are the main fuels used. When the gas price rises, power companies tend to switch to coal. Coal is dirtier than gas; so, as power companies switch to coal, they need more permits, and the price rises.

Then, in late April, several countries, including France and Spain, announced how much carbon they had emitted last year. The numbers were surprisingly small. Suddenly, the future demand for permits looked lower than expected--and the price crashed. Unfortunately, the numbers reflect not the scheme's success in cutting pollution, but industry's success in getting itself allocated more permits than actual emissions warranted when the scheme was launched. Dieter Helm, an energy economist at Oxford University, questions the way the information was sprung on the market, and the degree of competition (or lack of it) in the market. "It ought to be investigated," he says.

So far, the ETS has done more for power-generating companies than it has for curbing pollution. Because carbon permits were handed out free, rather than auctioned (as most economists said they should be); and because the carbon price has been unexpectedly high, permit-holders found they were sitting on unexpectedly valuable property rights. IPA Energy Consulting, in a report for the British government on the scheme, says it reckons that the British power-generation sector has profited to the tune of pounds 800m ($1.5 billion) a year.

Meanwhile, there's no sign that the permit regime has brought about a switch to cleaner fuel--indeed, the reverse has been happening. That's not just because gas has been so much more expensive than coal, but also because the first phase of the ETS lasts only three years. Beyond that, nobody has any idea how many permits will be issued, and therefore what the price might be. And since investments to reduce emissions have pay-back periods of five or more years, nobody is going to start investing on a three-year view.

The ETS's troubles do not mean markets are no use in curbing emissions--but they do mean that markets need to be part of a scheme that has been well designed. The ETS hasn't.

Criticism of the EU's Emissions Trading Scheme after one year of operation.