This post initiates a series that will examine emerging problems in the European Union’s carbon market—by far the world’s largest—and the broader policy implications of those problems.  We turn first to the recent collapse in the value of European Union Allowances (EUAs), each of which represents the right to emit one ton of greenhouse gases within the EU’s annual emissions caps.  Since the second half of 2008, the price of EUAs has dropped precipitously—from over €30 ($38) per ton to below €8 ($10) per ton. While in recent weeks the price has increased again slightly, and currently stands near €12 ($15) per ton, the overall pattern is of a decline in price.  What is behind the drop, and what does it mean for the health and sustainability of the EU’s Emissions Trading Scheme (ETS)?

For some market observers, the decline evinces a market working properly, with supply and demand finding a new balance.  Some point to sharply declining industrial output in the EU, which has left many emitting facilities long on EUAs, driving prices down.  As noted by Hernkir Hasselknippe of Point Carbon, an energy consultancy, the rational response for companies in this position is to sell credits.  “If they are emitting less then they do not need the credits so much and the price of carbon will fall.”  Other observers see the declining value of EUAs as a manifestation of the credit crisis, with holders of EUAs eager to sell them to raise cash.  Notwithstanding decreased demand for EUAs, current trends suggest that the total volume of EUAs traded within the EU ETS will continue to grow significantly this year.  According to Point Carbon’s projections, the volume traded in the ETS in 2009 could reach 3.8 gigatons of CO₂ equivalent this year, up from 3.1 gigatons in 2008.

Other market observers, however, attribute the decline in the value of EUAs at least in part to ETS design flaws.  A recent Deutsche Bank analysis identifies two problematic features of the ETS:  first, that the EU has fixed the supply of EUAs through 2020 (the end of the third commitment period in the EU ETS, for which legislation was just enacted); and second, that many EUAs to date have been provided to emitting facilities free of charge, leading to a glut.  Due to these factors, the Deutsche Bank analysts contend that the real prospect of future EUA shortages, as the EU emissions caps decline, are inadequately reflected in today’s EUA prices.  These analysts are also concerned that sustained price weakness for EUAs in the months leading up to the U.N. Copenhagen Conference in December 2009 could call into question the viability of the EU ETS as the foundation for a post-Kyoto Protocol global emissions trading system.

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On December 17, 2008, the European Parliament approved a comprehensive climate and energy package for the EU, hailed by the European Commission’s President, José Manual Barroso, as a green “new deal” for Europe.  A core component of the package is a Directive on the Promotion of the Use of Energy from Renewable Sources, which mandates the increased use of biofuels in the EU in order to achieve, by 2020, at least a 20% share for renewable energy and at least a 10% share for biofuels in road transport.  While some EU Member States already produce significant quantities of biofuels, the Directive is expected to increase imports of biofuels and biofuel feed stocks into the EU, as well as spur substantial new investment in biofuel production capacity.  For now, however, the Directive and a series of EU and Member State measures are generating uncertainty in European biofuel markets—particularly in the case of biodiesel.

One source of market uncertainty is the Directive’s provisions specifying “sustainability criteria” that biofuels must meet in order to count towards the renewable fuel targets specified in the Directive.  Chief among these is the requirement that any biofuel production pathway represent at least a 35% greenhouse gas (GHG) savings over the relevant fossil fuel comparator.  For many existing biofuel production pathways, an annex to the Directive specifies a deemed level of GHG savings.  For example, rape seed biodiesel (one of the principal production pathways in Europe) is deemed to represent a 38% level of GHG savings, while soybean diesel (one of the principal production pathways in the U.S.) is deemed to represent a 31% GHG savings level.  The Directive’s 35% GHG savings threshold is likely to impact the relative market values of biofuels falling on either side of this threshold, and therefore affect trade and investment flows.

Other sustainability criteria in the Directive will also likely affect trends in biofuel markets.  For example, to count towards the Directive’s renewable fuel targets, a biofuel must not have been produced from feedstock obtained from land with a high biodiversity value or land with high carbon stocks.  Similarly, it must not have been produced from feedstock obtained from peatland.  The Directive sets forth detailed guidelines for the application of these sustainability criteria.  It also provides mechanisms for review of the effectiveness of these criteria, as well as enforcement provisions to ensure compliance by individual economic operators.  Further, reflecting the 2008 global spike in food inflation and the controversy surrounding the impact of biofuel production on food prices, the Directive calls for occasional review of the Directive’s “social sustainability,” particularly as to its impact on developing countries, and possible future revision of the Directive if warranted.

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 During a meeting of the European Union Council last month, Environmental Ministers from European Union (EU) companies met to establish the EU’s position on a post-Kyoto international climate change policy and reviewed the status of the EU’s own package of climate change legislative proposals.  While the climate policy issues were largely prospective in nature, the meeting indicated that European Ministers do not appear to be letting the current financial turbulence undermine their support for a robust post-2012 climate agreement.

Preparing for Post-Kyoto Treaty Negotiations

The next round of negotiations under the United Nations Convention on Climate Change (UNCCC) is scheduled for December 20, 2008 in Poznan, Poland.  During the EU Council meeting discussions related to that meeting, the parties reiterated the importance of achieving worldwide consensus by the end of 2009, to ensure a replacement regime for the Kyoto Protocol by the end of 2012.  Among the EU Council’s key conclusions and statements on upcoming negotiations, the Council:

• Reaffirmed its commitment to the Bali Roadmap, with a goal of completing the successor agreement to the Kyoto Protocol at the scheduled talks in December 2009 in Copenhagen, Denmark.
• Stated that any post-2012 agreement would need to limit global average temperature increase to not more than 2°C above preindustrial levels” - a limit that would require 50 percent reductions in global emissions from 1990 levels by 2050, with emission levels peaking and starting to decline by 2020.
• Called on developed countries to propose economy-wide, medium-term emission reduction targets at a “comparable level of effort” to the commitments made by the EU.
• Noted that “the least developed countries should not be subject to obligatory emission constraints” but encouraged them to link sectors, where appropriate, to the international carbon markets.
• Stressed the importance of reducing emissions from deforestation and forest degradation.
• Discussed the importance of energy efficiency and the transfer of clean technology.
• Recognized the threat to competitiveness posed by carbon leakage, and the need to achieve a level playing field between industrialized and developing countries.

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Last week, the European Commission voted to include aviation emissions in the European Union Emissions Trading System (EU-ETS), beginning in 2012.  The decision means that air carriers - of passenger and freight - landing in or taking off from the European Union must obtain and surrender emission allowances. 

Notably, aviation emissions will operate under a cap that is separate from other industries captured by the EU-ETS.  The initial cap will be set at 97% of the average emissions of 2004 through 2006.  Beginning in 2013, when the EU-ETS enters its third phase, the cap will drop another 2%.  Initially, 85% of the allowances will be distributed to carriers for free, and only 15% will be auctioned.  The European Union has the option of changing the allocation percentages once the airlines begin trading emission allowances. 

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In the run-up to the fourth session of the Ad Hoc Working Group on Long-Term Cooperative Action (AWG-LCA), China, India and Brazil have sharply reiterated their views that the burden of reducing greenhouse gas (GHG) emissions lies, in the first instance, with developed countries.  The AWG-LCA, convened as part of the U.N. Framework Convention on Climate Change (UNFCCC) Bali Action Plan of December 2007, is charged with facilitating agreement on principles for long-term action to reduce GHG emissions, extending beyond the current Kyoto Protocol obligations, which are set to expire in 2012.  This agreement on principles is, under the Bali Action Plan, expected to be reached in time for the December 2009 UNFCCC Copenhagen summit.  In preparation for the fourth session of the AWG-LCA, scheduled to occur in Poznan, Poland during the first two weeks of December 2008, governmental parties to the UNFCCC are currently staking out their negotiating positions in formal submissions to the AWG-LCA.

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After significant delay, the United Nation’s International Transaction Log (ITL) and the EU’s Community International Transaction Log (CITL) were finally connected on October 16.  The ITL tracks and trades the transfer of all Kyoto Protocol units, including Assigned Amount Units (AAUs), Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs), while the CITL, its European counterpart, tracks the trade of European Emission Allowances (EUAs) under the EU ETS. 

The linking was significant not only because of the delay in its implementation, but because it allows Kyoto credits to be transferred directly into EU installation emissions accounts.  The delay caused considerable market shakiness, as, until the link was complete, the key December 2008 CER contract could not be physically delivered and most Member States, most significantly Germany and the UK, refused to issue EUAs by the February 2008 deadline.  As such, the completion of the link eases the collective concern of traders and Member States alike, as it avoids the risk of contract default, a major concern, and encourages Member States to promptly issue EUAs.  It will also simplify contractual negotiations between counterparties, as provisions, which have been included for the lack of a connection, are no longer necessary.  All these factors will encourage a flourishing spot market, which will grow alongside the exchange and OTC markets.  The resulting increased volume and liquidity should smooth out price volatility and increase opportunities for arbitrage.  

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This week, amidst the dislocations flowing from the global financial markets, lawmakers in the US and EU advanced legislation requiring geological sequestration of CO2 emissions from future coal-fired plants.  It remains to be seen how the unfolding economic landscape may affect the viability of any significant movement on new climate change legislation.  For the moment, however, these proposals are signs that some lawmakers realize that implementing a comprehensive climate change framework in five (or twenty-five) years means laying the legal and regulatory foundation now. 

On Wednesday, October 7, the EU Parliament’s Environment Committee added carbon capture and sequestration (CCS) provisions to the comprehensive climate package scheduled for a vote by Parliament in December 2008.  The provisions establish an “emission performance standard” of 500 grams CO₂ per kilowatt hour for large power plants constructed after 2015 and establish a comprehensive scheme for regulating the carbon capture and sequestration (CCS) sites that likely would be required to meet such a standard.  As part of that scheme, CCS project developers would contribute to a CCS fund during the active life of a sequestration site, and remain liable for a 50-year period after the CCS site is closed.  

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After continued delay and controversy, the European Commission (EC) will not connect the Community International Transaction Log (CITL) to the UN’s International Transaction Log (ITL) until the second half of October. The EC, Member States and the secretariat of the United Nations Framework Convention on Climate Change (UNFCCC) are working on the last stages before establishment of a live connection between the CITL, the ITL and Member State registries. It is expected the final connection process between the ITL and CITL will commence on October 6 and take at least 10 days.

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A key component of the EU’s plan to achieve at least a 20% reduction of greenhouse gas emissions by 2020, as compared to 1990 levels, is curbing auto emissions.  A proposed European Commission directive on auto emissions, currently under review by the European Parliament, would, starting in 2012, limit average allowable emissions for new autos in the EU to 130g CO2/km.  Under the proposed directive, additional measures, including the increased use of biofuels, would be imposed to reduce auto emissions further by 2012, to 120g CO2/km.  The proposed directive also specifies a long-term auto emissions target of 95g CO2/km, to be reached by 2020.

The current level of auto emissions in the EU is roughly 160g CO2/km.  Auto emissions in the EU account for about 12% of overall EU CO2 emissions, and constitute the second-largest greenhouse gas emitting sector in the EU.  Further, as the proposed directive notes, greenhouse gas emissions from the EU transport sector continue to rise.

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After significant delay and controversy, the European Commission (“EC”) once again has promised to connect the EU’s Community International Transaction Log (“CITL”) to the United Nation’s International Transaction Log (“ITL”) in the first half of October. The ITL will track the trade and transfer of all Kyoto Protocol units, including European Union Allowances (”EUAs”), which effectively become Kyoto Protocol Assigned Amount Units (“AAUs”) from 2008 to 2012. Until now, there has been no software link between the EU and UN schemes allowing delivery of the cheaper Certified Emission Reductions (”CERs”), a link expected nearly 18 months ago.

Market participants have criticized this failure widely, sparking major jitters, as December 2008 is a key delivery date for the 2008 vintage CER contract. The contract cannot be delivered without the connection, although most contracts allow settlement to roll over until the link is complete. The delay is also considered to have contributed to the volatile EUA and CER price spread, and more generally, reduced liquidity, transparency and confidence in the market.

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