Environmental Economics

Lecture 7 Understanding an Emissions Trading Market

6th March 2013

INTRODUCTION

Emissions Trading

What is Emissions Trading

Carbon Market Price Fundamentals

POLLUTION CONTROL

Pollution Control

Command & Control Approach

Market-based Approach

EMISSIONS TRADING APPROACH

Form

Units & Temporal Issues

Scope

ETS Design

Allowance Allocation

Compliance Cycle

EMISSIONS TRADING FORM

ETS Form

Cap & Trade

Baseline & Credit

CAP & TRADE

Cap
Authority determine acceptable level of emissions representing an absolute emissions cap.
Cap divided into a number of units (allowance), each of which authorises the holder to emit a predetermined quantity of emissions. Allowances allocated amongst participants; quantity of allowances that a firm is allocated representing their emissions target. Firms must ensure that at the end of each year they have a sufficient quantity of allowances to cover their emissions for that calendar year

Trade
Companies that keep their emissions below the level of their allocation can sell their excess allowances. Those facing difficulty in keeping their emissions in line with their allowances have a choice between taking measures to reduce their own emissions or buying the extra allowances they need on the market. Decision determined by relative costs, i.e. market price -v- in-house abatement cost

BASELINE & CREDIT

Baseline
Participants are permitted to emit baseline level of emissions.

Baseline defined in terms of historical emissions technology standard, i.e. ratio of emissions to output

or

performance

Credit
Baseline establishes a standard against which emissions credits can be generated. Firms must ensure that at the end of each year emissions are in line with baseline Those facing difficulty in complying with baseline have a choice between taking measures to reduce their own emissions or buying the extra credits on the market.

CAP & TRADE

Cap & Trade

BASELINE & CREDIT

Baseline & Credit
Applies to emission reductions below defined baseline Only emission reductions can be traded Credits generated when emissions reduced below baseline

Applies to all emissions All emissions can be traded Allowances are allocated by regulatory authority

Certainty over emissions level

Uncertainty over emissions level

SCOPE & POINT

SCOPE

OF

REGULATION

Emissions

Type

Greenhouse Gas Emissions

Air Quality Pollutants

Global Effect =>

Localised Effects Hotspots

ETS Compatible

=> ETS Challenge

POINT OF REGULATION

ETS

Coverage

Upstream

Downstream

Indirect Emitters

Direct Emitters

=> Importers or suppliers of fossil fuels

(e.g. power sector, heavy industry)

UNITS & TEMPORAL ISSUES

UNITS

Units expressed in terms of 1 tonne of a covered pollutant; E.g. EUA = one tonne of CO2

Unit Vintage Year in which unit issued

Unit allows holder to emit one tonne of covered pollutant within a given time period, typically one year.

Trading Periods

Choice on length of trading period

TEMPORAL ISSUES: BANKING & BORROWING

Banking
Allows ETS participants to save or bank any excess allowances for future use or to sell on later.

Borrowing
Process whereby installations could exceed their allowances on the basis that they make up the difference at some point within the trading period.

Banking
Compliance flexibility exposure to price instability Safety margin against contingencies unexpected

Borrowing
Provide a safety blanket in the event of there being a substantial price spike in the units market.

ALLOWANCE ALLOCATION

Allocation

Free Allocation

Auctioning

FREE ALLOCATION

Free
Allocation

Grandfathering

Projected Profiles

Benchmarks

AUCTIONING Participants bid to purchase emissions allowances from the trading schemes administrator. In an auction buyers are pitted against one and other to ensure that the auctioned item goes to the user that values it most as expressed in what they are willing to pay. Auctioning allowances would mean that firms regulated by the trading scheme would have to pay for all their emissions, thus conforming to the polluter pays principle. A crucial choice for administrators using the auction mechanism is how to use auction revenues, which could be recycled back to bidders, used to reduce specific taxes, or put into general revenues or some combination.

THE COMPLIANCE CYCLE

Competent Authority responsible for ETS functioning & administration. Registry
Standardised electronic database that ensures the accurate accounting of emission allowances and the transactions concerning those allowances.

Facilitates:
Allowance creation (via free allocation or auctioning) in participant accounts; Allowance trading & transfer;

Surrendering of allowances for compliance to cover verified emissions and the subsequent deletion of such surrendered allowances.

THE COMPLIANCE CYCLE

REGISTRY:
ETS Participant Accounts

Allowance compliance transfer

Year 1 allocations placed in registry accounts

Annual emissions report verified, early year 2

Participant CA approved emissions monitoring plan

Emissions Trading Operations

Enforcing Compliance Firms operating in a cap-and-trade scheme they must ensure that at the end of a designated time period (normally a year) they have a sufficient quantity of permits/ allowances to cover their emissions. Baseline-and-credit firms need to ensure that their emitted emissions over the course of designated time period are consistent with their baseline level of emissions. Where participants do not surrender allowances equal to their annual verified emissions by a designated compliance date they will be liable for the payment of an excess emissions financial penalty. Payment of the excess emissions penalty shall not release the installation from the obligation to surrender an amount of allowances equal to those excess emissions when surrendering allowances in the following calendar year.

Emissions Trading Operations

Emissions Trading Compliance Flexibilities Emissions trading offers firms flexibility in complying with an emissions target and provides them with an opportunity to do so in a least cost manner. The flexibility is derived from the fact that firms can buy and sell allowances or emissions credits and that firms have different marginal emissions abatement costs. The ability to trade enables firms with high pollution abatement costs to continue polluting by buying additional allowances or credits from those firms with relatively low abatement costs. An incentive exists for those firms with low abatement costs to undertake additional abatement since surplus allowances and credits can be sold for profit. In this way, each firm can trade off the cost of controlling pollution with the cost of buying and selling allowances or credits. This flexibility allows all firms to minimise their overall abatement costs.

CURRENT ARCHITECTURE OF THE EU ETS

P1: 2005-2007 P2:2008-2012

P3: 2013-2020

Total ETS Coverage: 50% CO2 & 40% GHG

Participants: Countries:

C&T ETS

EU27 +3 Installations: 11,000

Allocation: P1 & P2 dominated by free allocation

CARBON MARKET FUNDAMENTALS

Carbon Market Price Fundamentals

What are the Market & Price Fundamentals in the EU carbon market?

Class MidtermUnderstanding the price dynamics of an emissions trading market

EUA Price (/ton carbon)

10

15

20

25

30

35

0 1/4/2008 5/4/2008 9/4/2008 1/4/2009 5/4/2009 9/4/2009 1/4/2010 5/4/2010 9/4/2010 1/4/2011 5/4/2011 9/4/2011 1/4/2012 5/4/2012 9/4/2012 1/4/2013 EUA Price

EU ETS CARBON PRICE DEVELOPMENT (08-13)

EU ETS CARBON PRICE DEVELOPMENT (08-13)

CARBON MARKET FUNDAMENTALS

Market fundamentals of the EU carbon market are similar to those in other markets they relate to supply and demand.

The allowance allocation that installations receive will influence the role that they are likely to play in the market:
Installation allocations generous relative to emissions = sellers in the allowance market.

Participating installations will be allowance buyers where their allocation is insufficient to cover their emissions needs and/or the costs of abatement exceed the allowance price.

The demand for allowances is dependent on three factors:

Allowance allocation participants receive; CO2 emission levels over the course of a given trading period; and Cost of their carbon abatement options.

CARBON MARKET PRICE DETERMINANTS

Weather

Market Sentiment & Expectations

Carbon Price

Economic Growth

Fuel Prices

CARBON MARKET PRICE DETERMINANTS

THE ROLE OF WEATHER Weather exhibits a triple effect on the price of carbon: double temperature effect & precipitation effect. Impact of weather effect on carbon price felt through the demand and supply for electric power

CARBON MARKET PRICE DETERMINANTS

THE ROLE OF WEATHER Temperature effect: Cold weather effect:
consumer demand for energy consumption, forcing power & heat generators to output to meet in demand;

Warm/hot weather effect:

use of air conditioning units in both commercial and residential buildings to cope with higher summer temperatures.

Warm weather effect linked to urban heat island effect As a result of increasing their output, power generators CO2 emissions will increase;

CARBON MARKET PRICE DETERMINANTS

THE ROLE OF WEATHER Precipitation effect:

Precipitation effect is felt through the impact on HEP production capacity;

Precipitation levels affect the share of power generated by non-CO2 emitting sources and thus emission levels; There are three regions mainly affected by unpredictable climatic events at different moments: the Nordic countries (Norway, Sweden), the Iberian countries (Spain, Portugal) and the France Switzerland area. Any shortage in hydropower needs to be compensated for by fossil fuel based power.

HEP SHARE
Member State Gross Prod. (TWh) Coal Prod. (TWh)

OF

TOTAL GROSS ELECTRICITY PRODUCTION

Nat.Gas Prod. (TWh) Nuclear Prod. (TWh) Hydro Prod. (TWh) Geo. Prod. (TWh) Solar/ Wind Prod. (TWh) 2.08 2.29 0.95 7.81 0.28 0.68 10.82 0.03 51.52 2.27 0.54 2.81 5.36 10.78 BF& Waste Prod. (TWh) 8.17 5.36 2.17 5.09 0.74 10.98 6.38 40.44 0.25 2.51 0.22 11.35

Oil Prod. (TWh)

Austria Belgium Czech Rep. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy

70.83 96.44 85.91 38.57 12.96 80.35 572.88 621.00 61.63 37.38 60.64 298.21

6.28 7.75 50.18 16.94 11.57 21.28 26.53 270.53 27.42 6.31 33.03 41.6 25.19 138.26 7.19 4.16 5.29 26.12 3.5 109.77 0.12

1.26 0.33 0.16 0.84 0.04 0.61 6.34 7.50 7.68 0.46 2.23 21.55 1.34 2.88 2.29 0.61 0.01 16.51 2.72 3.37 0.03

14.46 31.11 1.07 7.86 0.30 11.15 26.2 84.50 16.54 11.61 21.62 153.8 15.76 22.78 428.59 140.56 47.94 28.00

38.58 1.67 3.38 0.02 0.03 12.88 68.04 25.93 7.49 0.19 0.73 53.77

Lux.
Neth. Poland Portugal Slovakia Slovenia Spain Sweden UK Norway

4.59
114.73 157.54 53.08 27.47 16.43 298.41 152.98 381.25 124.46

2.92
71.31 4.81 14.82 1.92 0.55 93.38 4.27 175.55 4.89 14.57 5.66 61.79 57.57 62.14 3.97

1.47
0.11 3.48 16.55 5.63 4.70 45.32 71.51 6.71 117.94 0.20

0.08
4.19 1.66 9.31 0.04 0.01 50.58 3.49 10.04 1.05

0.13
8.64 6.46 2.73 0.54 0.22 4.71 9.91 13.67 0.43

ESTIMATED VARIATIONS

OF

POWER SECTOR CO2 EMISSIONS RAINFALL

Medium Range MtCO2

DUE TO

Member State

Low Range MtCO2

High Range MtCO2

Spain Portugal France Sweden Denmark Poland Germany Total

5.7 2.1 3.0 -0.3 -1.7 -0.7 -0.7 7.4

6.3 3.7 5.2 -0.5 -2.9 -1.3 -1.3 9.2

6.9 5.3 7.4 -0.7 -4.2 -1.8 -1.3 11.1

CARBON MARKET PRICE DETERMINANTS

THE ROLE OF FUEL PRICES Fuel prices, notably those for coal, oil & natural gas, will have an impact on the price of carbon because of the ability of power generators to switch between fuel inputs.

Fuel Switching The existence of fuel switching is important as it enables power generators to exploit short-term price differentials between fuel types. Some power generators are able to burn two or three different fossil fuels and switch between them. Changes in fossil fuel prices can change the merit order of plants using different fuels, thereby affecting the fuel mix in the short run.

Because the power sector accounts for approximately 70% of ETS emissions, the carbon-intensity of their fuel mix is potentially significant in terms of the potential impact on allowance price.

CARBON MARKET PRICE DETERMINANTS

Impact of Fuel Switching on Carbon Prices Impact on price is felt as either a demand side or supply side effect:
Power generators using coal as their primary fuel, but are able to switch to either oil or natural gas, expect a negative impact on EUA price; Switch from coal to oil or natural gas represents a switch to a less CO2 intensive fuel, resulting in a in CO2 emissions for a given level of output; As a result of the in their CO2 emissions, power generators likely to sell allowances in an attempt to make a profit;

The opposite occurs when a power generator switches from natural gas to either oil or coal; Generator now using a more emissions-intensive fuel source, emissions will relative to normal position, seek to cover in demand by purchasing additional allowances; Oil is between natural gas and coal in terms of CO2 intensity. This means that the impact on EUA prices of switching away from oil will depend on which fuel type generators switch to.

FUEL TYPE SHARE OF GROSS ELECTRICITY PRODUCTION

Member State Gross Prod. (TWh) Coal Prod. (TWh) Oil Prod. (TWh) Natural Gas Prod. (TWh) 14.46 31.11 1.07 7.86 0.30 11.15 26.2 84.50 16.54 11.61 21.62 153.8 2.92 25.19 138.26 7.19 4.16 1.34 2.88 2.29 0.61 71.31 4.81 14.82 1.92 14.57 3.97 15.76 22.78 428.59 140.56 47.94 28.00 Nuclear Prod. (TWh) Hydro Prod. (TWh) Geothermal Prod. (TWh)

(2010)
Solar/ Wind Prod. (TWh) 2.08 2.29 0.95 7.81 0.28 0.68 10.82 BF& Waste Prod. (TWh) 8.17 5.36 2.17 5.09 0.74 10.98 6.38 40.44 0.25 2.51 0.22 11.35 0.13 8.64 6.46 2.73 0.54

Austria Belgium Czech Rep. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Lux. Neth. Poland Portugal Slovakia

70.83 96.44 85.91 38.57 12.96 80.35 572.88 621.00 61.63 37.38 60.64 298.21 4.59 114.73 157.54 53.08 27.47

6.28 7.75 50.18 16.94 11.57 21.28 26.53 270.53 27.42 6.31 33.03 41.6

1.26 0.33 0.16 0.84 0.04 0.61 6.34 7.50 7.68 0.46 2.23 21.55

38.58 1.67 3.38 0.02 0.03 12.88 68.04 25.93 7.49 0.19 0.73 53.77 1.47 0.11 3.48 16.55 5.63 0.20 5.36 0.03

51.52 2.27 0.54 2.81 10.78 0.08 4.19 1.66 9.31 0.04

Slovenia
Spain Sweden UK

16.43
298.41 152.98 381.25

5.29
26.12 3.5 109.77

0.01
16.51 2.72 3.37

0.55
93.38 4.27 175.55

5.66
61.79 57.57 62.14

4.70
45.32 71.51 6.71

0.01
50.58 3.49 10.04

0.22
4.71 9.91 13.67

CARBON MARKET PRICE DETERMINANTS

Dark & Spark Spread Relationship with the Carbon Price Power generators also pay particular attention to both the dark and spark spread as well as the difference between them. Dark spread is the theoretical profit that a coal-fired power plant makes from selling a unit of electricity having purchased the fuel required to produce that unit of electricity. Spark spread refers to the equivalent for gas-fired power plants. Where the difference between these measures one would expect this to have a positive impact on allowance price because utilities will prefer to use the more CO2 intensive coal-fired power plant to the gas-fired plant resulting in an demand for allowances.

CARBON MARKET PRICE DETERMINANTS

THE ROLE OF MARKET SENTIMENT & EXPECTATIONS Market sentiment and expectations are influenced by three important factors:

EU policy and regulatory issues

Market functioning and performance issues International political and natural events

CARBON MARKET PRICE DETERMINANTS

EU policy and regulatory issues

The carbon market was created through a political decision making process.
The central policy and regulatory issue for the EU ETS is the allowance allocation process The supply of allowances is politically determined by the Commission. Commissions decisions likely to affect buying and selling in the EUA market through their effect on market sentiment or perceptions about potential supply and demand of allowances Additional regulatory issues include:

Annual release of verified emissions reports, potential to have a market impact because they indicate the position of individual market players as well as the market in general; Decisions regarding future shape of the carbon market; Amendments to market structure (Phising, VAT fraud)

CARBON MARKET PRICE DETERMINANTS

Market Functioning Issues Market functioning issues refers to factors that allow for participation in the carbon market.

Central to market participation is the full functioning of Member State allowance registries and market intermediaries (exchanges, spot market, futures market, OTC market).
Any factors that impact negatively on market functioning are likely to lead to decreased participation in the carbon market as well as decreasing the volume of allowances available for use in the market. Such factors will serve to decrease liquidity along with the potential for price volatility on account of the decrease in market activity.

CARBON MARKET PRICE DETERMINANTS

International Political and Natural Events

Natural events have the potential to have both a direct impact on price and also influence market sentiment. The impact of natural events is felt when they disrupt the international supply of oil. Reduction in the supply of oil will naturally increases its price, thereby affecting the fuel switching decisions of the power sector participants in the ETS.
Political decisions made by OPEC regarding the supply of oil influence the carbon price. OPEC decisions or announcements regarding future supply of oil can affect market sentiment as it provides a signal to the power sector about whether they will have to adjust their level of oil use and switch to other fuel sources. International political events that are likely to influence the shape and future of the global carbon market will influence price. Climate change negotiations are always watched with keen interest by those associated with the carbon market. Carbon market participants are actively looking for indications regarding the future structure of the market.

CARBON MARKET PRICE DETERMINANTS

Expectations Closely associated with the role of policy and regulatory issues is the role of expectations. Expectations play an important role in any market because of their ability to affect sentiment Expectations within a market are constantly susceptible to change as market participants continually analyse all available information related to the functioning of the trading scheme

CARBON MARKET PRICE DETERMINANTS

The Role of Economic Growth During periods of economic growth levels of economic activity and output are high. Economic growth requires higher amounts of energy consumption to support increased levels of economic output. Associated with in energy consumption is in CO2 emissions. As a result power generators will be forced to enter the allowance market to purchase allowances during periods of economic growth. While the power sector has thus always had to be active in the allowance market, their role during periods of economic growth. Industry sectors (e.g. cement, steel, aluminium etc) will also have to enter the market to purchase allowances to cover the increase in the emissions levels associated with their output. Periods of economic recession associated with in economic output and energy demands => many ETS installations find themselves with surplus allowances relative to their emissions needs.