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Time to comply with emissions-trading systems

Emissions-trading systems are here to stay. Oil and gas firms need to start budgeting for them

One of the clearest signals to emerge from the Paris climate summit in December was international support for carbon markets as a key weapon in the fight against climate change. But instead of a single, global market, industries like the energy sector face a growing number of national and regional systems.

In agreeing a global target of net carbon neutrality in the second half of the century, the countries that agreed the deal explicitly signalled that large-scale burning of liquid and solid fuels will have to end. But rather than regulate the fossil-fuel business out of existence, these countries seem willing to provide it with a path towards net-zero carbon through the use of emissions-trading systems.

The Paris Agreement’s predecessor, the Kyoto Protocol, set up the first international carbon market in 1997. But cumbersome rules and procedures, as well as its “top-down” application, rendered the UN market unpopular: the US refused to participate and Canada, Russia and Japan eventually withdrew.

The re-emergence of emissions trading in Paris, after several years of dwindling support, showed how much has changed in the past decade. Much of this has to do with the growing political consensus on climate change and the need to take action on greenhouse-gas (GHG) emissions that resulted in the Paris deal.

But equally influential is the broad variety of national and regional cap-and-trade systems that has emerged. It shows that local, “bottom-up” approaches that directly regulate industrial installations can be more effective than a single global market that only binds governments.

The inspiration for carbon markets comes from the US, where cap-and-trade was employed with great success from 1995 to reduce discharges of sulphur dioxide from power plants.

Finding the right model

The appeal of carbon trading is that it allows market forces to identify the cheapest sources of emissions reductions. Each market also reflects more accurately the structure and composition of its industrial base and prices the cost of reductions accordingly.

The alternative to emissions trading, a tax on carbon, is dismissed by many as being regressive: it guarantees revenue rather than an environmental outcome. Environmentalists point out that a tax does not guarantee that the money flowing from the tax would be spent on climate-related projects. Emissions trading ensures that investment is directed at the most efficient way to cut pollution.

The basic cap-and-trade model distributes a fixed number of emissions allowances (the total represents the limit on pollution) either free of charge or through auctions, and sometimes both. Polluters may then buy or sell additional permits according to their need, with the sole proviso that they surrender enough allowances at the end of each compliance period to cover their verified emissions.

If the price of permits falls below the cost of reducing emissions, then participants will choose to buy allowances and pass the cost on to their customers. However, if the price rises high enough, companies should be expected to invest in whatever reductions can be achieved at below the equivalent market price of carbon.

The oil industry already participates in most of the cap-and-trade systems already in place: Europe’s market sets limits for oil and gas platforms in the North Sea as well as refiners on land. California’s system goes even further, requiring suppliers of transport fuels and natural gas to buy allowances to cover the emissions that result from the use of their products.

To date there has been no significant impact on fuel prices from the inclusion of oil refining and production in any carbon market, so analysts have tended to focus more on the impact on electricity prices, since the power sector is the largest emitter. But as the price of carbon increases over time, this is likely to change. 

According to last year’s World Bank State and Trends of Carbon Pricing report, 40 nations and around 20 city or regional jurisdictions presently put a price on GHG pollution. This represents around 12% of global emissions at present, but is set to soar as countries from China to the US prepare to roll out carbon-pricing regulations.

In the US, states are preparing to comply with emissions limits for power stations set by the Environmental Protection Agency. The regulations offer jurisdictions the choice of setting rate-based (emissions per megawatt-hour of electricity generated) or mass-based (tonnes of CO2 per year) targets, and the option of setting up cap-and-trade markets to help achieve compliance.

China is preparing to establish a nationwide emissions market from 2017, building on the experience gained through nine city and provincial systems (see table). While few details of the Chinese market have yet been made public, the existing pilot systems suggest coverage will definitely extend to the power sector, and may even include refining.

It is reasonable to assume that as emissions markets mature over time, the breadth of their coverage will widen to encompass all major industrial sectors. While few emissions-trading mechanisms regulate the oil industry, that will change. Eventually, refiners will need to assume responsibility for the emissions from their products, as suppliers in California currently do.

Marked to market? 

Emissions trading has had an eventful childhood. The EU market’s experiences with VAT fraud, theft of permits and oversupply have been well-documented. However, each new controversy equips practitioners with more insight into how best to build new markets. California benefited from the EU’s early experiences, while in turn China is expected to apply lessons learned globally in its national system.

What has been a common experience and one that seems unavoidable is the oversupply of permits. Because carbon markets are governed by regulation rather than supply and demand, as oil is, the supply has been slow to adjust to fluctuations in demand. But lack of information has also played a part.

In preparation for the start of the EU market, member states were asked to provide data on industrial plant emissions on which to base the allocation of permits. But because many had not collated such information, industrial plants were therefore encouraged to exaggerate their emissions in order to be granted more allowances.  The eventual distribution of permits for the first few years was in several countries based on estimates and guesswork. 

The price of carbon depends both on the degree of ambition in each market, and on the ability of regulators to react to outside factors. Industry requires long-term clarity on the supply of permits, so that investment decisions can be based on the fullest possible information. Yet when unforeseen events – such as the global financial crisis of 2008-10 – occur, the market is ill-equipped to handle a sudden drop in demand for emission permits. 

Both the European and northeast US markets experienced significant oversupply, causing prices to plunge, and both have dealt with it in different ways. 

Regulators of the US Regional Greenhouse Gas Initiative (RGGI) acted promptly to cancel unused permits and throttle back the rate at which allowances were sold into the market, while the European Commission has enacted two fixes to temporarily withhold permits from auction, and more recently a mechanism to inject or withdraw allowances to maintain a steady overall supply in the market.

Carbon market policies

Europe’s market is widely estimated to have built up since 2008 a surplus of around 1.8bn-2bn allowances, or a year’s worth of supply, while the nine US member states of RGGI had a surplus in 2015 of around 4m permits, even after having made significant supply adjustments in 2013. These gluts led to collapses in the carbon price from which the markets have yet to fully recover.

The degree of ambition of carbon markets is also a function of political will. The European example has demonstrated that industrial stakeholders can water down the scale of emissions plans and block efforts to boost the price of carbon or to increase the speed of reductions. European politicians supportive of industry or susceptible to lobbying have managed to delay and reduce the impact of changes to the EU emissions-trading scheme, such as the new Market Stability Reserve, whose early start was rejected last year.

How will cap-and-trade regulations impact the oil industry? Even where oil refiners and producers aren’t already affected, many of them are preparing. The Carbon Disclosure Project, a non-profit group, found in 2013 that oil companies including Shell, ExxonMobil, Total and ConocoPhillips were already using a “shadow” price on carbon emissions ranging from $8 to $46 a tonne in assessing future capital spending.

As the price of emissions allowances rises over time, as it is designed to do in a well-functioning system, it will become increasingly difficult for companies to pass through the cost of carbon to customers. In California, for example, suppliers of liquid fuels are presently able to transfer the relatively low price of emissions permits without difficulty to customers through the price at the pump.

Eventually, investments will need to be made in cutting emissions at source. Flaring, power generation, process improvements and even carbon capture will likely become cost-effective as carbon prices climb. Pressure will increase as more and more sources of emissions are covered by emissions-cutting regulations and carbon markets. Oil’s challenge is to apply the same rigour and cost control to its carbon footprint as it has applied to its production and exploration.

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