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Emissions trading and the green generation

While the European politicians continue to debate the mechanics of complying with emissions-reduction targets under the Kyoto Protocol, a market in European emissions has already started to trade. Liz Bossley looks at its development

ACCORDING TO the International Emission Traders Association (IETA), worldwide transactions in carbon dioxide equivalent (CO2e) have resulted in around 200m tonnes of CO2e reductions to date.

The start of the first compliance period under the Kyoto protocol is still some five years away and many basic details of the emissions-trading programme are still on the drawing board. This suggests companies trading now are taking a regulatory risk: the instruments they are trading today may not comply with whatever international standards emerge in the global market over the next few years.

Key concepts

There are several key concepts underlying the emissions markets that are emerging around the world. According to IETA, a group of about 50 companies with an interest in emissions trading, including Shell and Nuon, these are:

Bubbles: companies from around the world can combine their total emissions targets from each source into one accounting entity and reduce these total emissions in the location that achieves a total reduction in the most cost-effective manner;

  • Offsets or credit-based emissions reduction trading: companies wishing to increase emissions can obtain offsetting reductions from companies that are in credit. Offsets originate from companies that have made voluntary, permanent, emissions reductions that are legally recognised by a regulator. Credits, or offsets, are excess emissions reductions achieved above reductions required by a regulator. The excess amount is the credit and can be sold on the market. Allowances are the unit of compliance that are traded in cap and trade programmes;
  • Cap and trade programmes: a regulatory authority can establish an aggregate cap on the emissions of a pollutant, typically based on a percentage of the emissions from a company or site at some specified date in the past. Emissions allowances are units of trade created to account for the total emissions in the system. Companies with excess allowances arising from an emissions reduction can sell them to companies expanding their emissions;
  • Baseline emissions reduction: project-based trading allows a company voluntarily to reduce emissions below an agreed baseline, compared with a situation where there is no change to the present business plan. The accreditation system is based upon the difference between two emissions forecasts - with and without the proposed project; and
  • Rate-based or relative emissions trading: based on emissions per unit of output rather than absolute emissions, this allows a company to grow and, therefore, emit more, while still achieving an increase in efficiency beyond the target levels. Excess relative reductions can be traded.

Discussions are under way within the European Union (EU) with a view to passing a law by March that allows national governments to issue tradable permits to major industrial entities, limiting the amount of CO2 they can emit. This will flesh out the bill passed at the end of 2002.

A new direction

Members of the European parliament are seeking a new directive for trading emissions rights throughout the EU. Major stumbling blocks are:

  • Calls to expand the scheme proposed by the European Commission to include all greenhouse gases, not just carbon dioxide;
  • Proposals to widen the range of industries covered by the new legislation;Whether the system should be mandatory or voluntary;
  • How emissions permits should be allocated to member states; and,
  • Whether there should be a cap on the number of permits allocated to member States.

The EU emissions trading scheme is due to start in 2005. In May, the UK's Department of Trade and Industry said: In the autumn we will publish proposals for consultation on how the UK intends to allocate emissions allowances under the [EU] scheme.

We will submit a final allocation plan to the European Commission by March 2004. 

But this market is already trading, despite there being a long way to go before it becomes clear what is being traded and how it should be valued. For example, market sources report that up to 10 trades have already occurred under the European Emissions trading scheme, the first of which, undertaken by Shell and Nuon, was reported in February 2003.

Says Garth Edward, trading manager, environmental products at Shell International Trading and Shipping: A lot of work has been done by IETA in establishing a master contract that can be applied when trading today. Companies need to get their systems geared up to trade and that can be a lengthy process of clearing internal credit limits with counterparties, trading authority levels and compliance with financial regulators. 

The trades that have occurred are experimentally small, typically involving volumes of a few tens of thousands of tonnes of CO2e, and have been done at prices of around Euro7 a tonne ($8/t) of CO2e. Sources report that there are willing buyers of around 100,000 tonnes of CO2e at Euro6/t, but there are no sellers (it is safer to buy a product where there may be a significant change in the value of what is being traded than it is to sell it).

The UK experience

On 12 May, the UK's Department of the Environment, Food and Rural Affairs published the results of the first year of trading in the UK scheme - in which almost 1,000 companies participated. Of the 31.6m tonnes of CO2e of allowances allocated to companies, 7.2m tonnes were transferred between companies.

Under the UK scheme, direct-entry participants have an agreed cap on emissions acquired through an auction mechanism, and climate-change levy agreement (CCLA) participants have either an absolute or relative target for emissions reductions. The prize for the direct-entry participants is a share in a government fund allocated to the programme. The prize for CCLA participants is a cut in their climate-change levy.

Emissions caps are enforced annually under the direct-entry scheme and target reductions are enforced biennially under the CCLA scheme. The UK scheme is voluntary, so the direct-entry participants are said to have given themselves targets that are easy to meet and, as a result, have allowances to spare that are dragging prices down. The CCLA holders are in no hurry to buy because they have a further year in which to meet compliance targets.

Says Tim Atkinson, an emissions broker with Natsource, the environmental brokers: There is no depth or liquidity in the UK emissions market. In the secondary over-the-counter market, a total of about only 1.8m tonnes of CO2e have been traded. We saw a price high of £12.40/t ($20.31/t) of CO2e in September 2002.

The move from £5 to £12.40 was achieved with about 0.5m tonnes of trades. The fall back to £5 occurred with only about 50,000 tonnes trading. Now, prices are down to around £3/t. The direct-entry participants are sellers, but the CCLA companies are not buying.

They do not have to start worrying about their next milestone compliance deadline until 2004. 

Slim pickings

This provides slim pickings for brokers hoping for a bonanza from the new market. It is rumoured that one broker, Icap, has already closed down its environmental trading desk. Says Atkinson: The value of the scheme is allowing companies to learn how to trade in emissions experimentally. Without this knowledge how can a more liquid market be expected to grow? 

Edward says: Bluntly, there is very little interest in the UK emissions trading system (ETS). The attention of all larger companies and the trading community in general is now on the development of the EU ETS - this is what people care about. 

Cogen Europe, the European association for the promotion of cogeneration, has voiced concerns about certain details of the European ETS that could penalise investments in combined heat and power (CHP) rather than encouraging the technology.

Peter Löffler, a research executive for Cogen Europe, says: There is a large untapped potential for converting installations in sectors that have to participate in ETS from heat-only production to CHP. This will naturally increase their direct CO2 emissions because they will now produce electricity in addition to heat. Yet, because this electricity replaces the more CO2-intensive electricity that previously has been produced in power plants, the conversion to CHP reduces net CO2 emissions.

No reward

But the operator will not be rewarded for this. On the contrary, if the allowances allocated to the installation are based on the lower pre-CHP emission levels, it will have to invest in emissions reduction elsewhere, or buy additional allowances on the market. It, therefore, will be penalised for having invested in CHP.

In other cases - such as building a new CHP plant, or increasing electricity output in an existing CHP plant - emissions trading is likely to favour CHP over thermal power-only generation, because specific emissions per kilowatt hour of electricity from CHP are smaller. ETS may not lead to CHP closure - existing CHP plants are likely to get at least as many allowances as existing power plants - but the scheme may prevent new CHP development.

To cover these concerns, Cogen is urging the adoption of two amendments to the European Emissions Trading Directive proposed by the European Parliament:

  • Member states should ensure indirect mechanisms to reduce CO2, such as CHP, receive consideration in national allocation plans; and
  • Member states should be asked to take into account the carbon value of savings from CHP when allocating allowances. The Commission should prepare a European guidance on the carbon equivalence for this purpose.

Contractual provisions

In the light of the extent of the uncertainty about the details of the European ETS it is difficult to understand how companies can trade at this stage. The IETA EU Emissions Master Agreement, published in March, which is loosely based on the International Swaps and Derivatives Association master agreement, takes this uncertainty into account.

Clause 2 of the document says: This agreement is conditional upon the EU Emissions Trading Scheme coming into effect in accordance with the Directive by 1 January 2008. If this condition is not satisfied, either party may withdraw from this agreement or extend the period by which this condition must be satisfied.

Upon any such withdrawal this agreement terminates and neither party has any liability to the other party by reason of that termination, except that the seller shall promptly refund any money received from the buyer in respect of the allowances with interest payable. 

In other words, companies have a get-out clause if the scheme does not receive the go-ahead. However, this is no protection against changes in the value of what is being traded today as a result of any changes in the content of the directive if it does pass into law.

The emissions market is really a market in regulatory risk. It would take a brave trader to commit to a large trading exposure in European emissions before the details of the scheme are finalised.

Fine details can lead to substantial changes in the value of the contract, as the UK experience with the impact of the different compliance periods for direct-entry and CCLA participants demonstrates.

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