The future of carbon trading

Carbon prices are rising slowly after a recent fall in the markets. But questions remain about the role of carbon trading in rich countries – and in developing countries like China, writes Yu Jie.

The price of carbon seems to be rising slowly, closing on May 27 at 15.24 Euros a tonne. For the past several months, the price on the European Climate Exchange fluctuated around the nine-Euro mark. Current prices are slightly better than predicted last year, but still far off 31 Euros – the price in August 2008.

Climate change and the economic crisis share one crucial feature: the importance of financing mechanisms. In every climate-change proposal, emissions reduction and climate-change adaptation require funding that runs into the tens of billions of dollars. Finding and allocating that money will be the core of any climate deal reached at the United Nations conference in Copenhagen in December. But the ongoing crisis has highlighted the problems of carbon markets, and forced a re-examination of their role in any future deal.

In 1997, the Kyoto Protocol established a system of rights over environment resources that created a market mechanism known as a cap-and-trade system. People hoped that carbon trading would solve a global “tragedy of the commons”. Certainly, it is hard to imagine the energy industry making changes without the right economic incentives in place. But with the financial crisis darkening an already bleak outlook, will carbon trading come to a premature end?

In April, the European Union published emissions figures for its 27 member states. Overall emissions for the EU were down 6% on the previous year, at 2.11 billion tonnes. Emissions from the concrete, chemical, glass and paper industries had fallen significantly – a drop of 9% – while emissions from power-generation fell by 6%. Industry analysts believe that this was not only caused by the implementation of the Kyoto Protocol, but also the fall in production triggered by the financial crisis.

Carbon markets may be non-traditional, but the laws of supply and demand still hold true and the price of carbon reflects overall economic trends. Lower emissions reduced businesses’ need for emissions quotas and some dumped those that they held. Meanwhile developing nations sold off their emissions quotas, which were of no more use to them than hot air, exacerbating the problem of oversupply. The market plummeted.

In 2005, a crash in the carbon market saw prices drop close to zero. This was due to the EU miscalculating national emission levels and issuing too many quotas, thus killing demand. This year however, the economy was to blame.

In discussions about post-Kyoto mechanisms, there is a tension between truly equitable, and more competitive, price-setting mechanisms. Long-term considerations about carbon pricing are thus a major factor in discussions about the impacts of emissions reduction. A carbon price that fluctuates within a reasonable range is of interest to developed governments and investors. But for developing countries participating in Clean Development Mechanism, a low carbon price is unfair and unhelpful in reducing emissions.

Prices for traditional products are set by supply and demand. But what worries investors about carbon is the important role of political priorities in price-setting. Policy will determine the outlook for long-term investment in infrastructure, manufacturing and technology. Investors have been calling for a “Three-L” policy signal: long, loud and legally binding. This is also the case for venture capital and private equity. But the carbon market is even more risky, since it is heavily reliant on multilateral political agreements.

Specialist carbon investment funds that emerged in recent years have struggled; some have pulled out or switched funds to other markets. The first phase of the Kyoto Protocol ends in 2012, and there is not yet a plan for moving from the current carbon market framework to a new global deal. Negotiations that take place over a five-year basis do not fit with normal investment cycles. Investors look at carbon markets, but do not act.

China is the country with the most emissions reduction quotas under the CDM – and a battlefield for investors. In the last two years, with the market expected to rocket, most quota purchase agreements were priced at 10 Euros or more. Average project development costs are around one Euro per tonne of carbon, while the cost of carbon hovers around the 11 to 12-Euro mark. Therefore there is no guarantee of a reasonable return. This year the slow pace of negotiations and the low price of carbon have slowed down progress on projects. Add in the other failings of the CDM, and there is a pressing need for change.

Low carbon prices do not only present an obstacle to investment in the low-carbon economy, they also exacerbate differences between political groupings.

At recent UN-led climate talks in Poznan, Poland, the British and German environment ministers emphasised the role of carbon markets as a funding stream in the future. For the EU, the current 2% tax on income from the CDM remains the main source of funds. As long as there is still a market, these funds will flow. Politically, this is an easier option than increasing carbon taxes, and the system is already in place – it only needs to be expanded. Meanwhile, financial institutions and large businesses will welcome the investment opportunities.

However, some of the major developing nations oppose the expansion of carbon markets in their countries. Current proposals would see the EU cut emissions by 30% from 1990 levels by 2020, with half of that reduction coming from the purchase of quotas from the developing world: a form of offsetting. But this raises worries among industrialising nations. Developing countries will lose the opportunity to make cheaper reductions in emissions, as requirements increasingly target energy-intensive industries.

Moreover, fluctuations in the carbon price mean the funding for emissions reduction and adaptation provided from developed nations to the developing world is unpredictable. This tends to make carbon trading politically unsaleable. Negotiations are deadlocked on these issues, and there is not a clear road ahead.

But despite these disagreements, carbon markets are expanding. In the United States, some regional markets are in operation; Australia and Japan are working on similar plans. Meanwhile the emissions reduction projects in developing nations as part of the CDM system have provided an important reference for a future agreement. But technical problems are easily resolved; it is political agreement that is elusive.

There is also a complex relationship between the cost of carbon and the cost of oil. When the oil price is high, the price of carbon rises as more people seek out alternative energy sources. Lower oil consumption during the economic crisis has reduced emissions, but the low price of carbon has weakened investment in emissions-reducing technologies. The way to restore investor confidence is the addition of public funds to put the market back in order – and help push forward the low-carbon economy during the economic crisis.

Yu Jie is head of policy and research at Climate Group China.

Homepage photo by freefotouk