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Europe's emissions trading forum has 'tiny' impact as companies prepare for auctions

After five years of price volatility, market uncertainty and regulatory experimentation, the European Union's Emission Trading System, or ETS, has succeeded in its main goal to put a price on carbon dioxide pollution.

But it has also raised some difficult questions: Is it forcing European businesses to take carbon dioxide emissions into account in their investment decisions? Is this the best way for Europe to reach its goal of cutting greenhouse gas emissions to 80 to 95 percent below 1990 levels by 2050? Is it a good example for the United States to emulate if and when Congress reconsiders cap-and-trade legislation?

The ETS has quickly become, by far, the world's largest carbon market. Most observers agree it has led to modest emission reductions without hurting economic growth or chasing heavy industry out of Europe and into developing countries. By setting up the trading, the European Union hoped to give companies an incentive to reduce emissions below targeted levels. In return, these companies could turn their surplus pollution rights into cash by selling them others who need them to meet government-set targets.

"It does have an impact already, but it's rather tiny," said Per Lekander, head of global utilities research at Swiss bank UBS. "Set a tight cap, and you'll get lots of emissions savings. It's just a matter of how much that would cost the industry."

The ETS is currently in its second phase, which runs until 2012. A third phase stretches between 2013 and 2020 and will entail increased auctioning of carbon allowances. In the pilot period, from 2005 to 2007, power plants, refineries, steel mills and other heavy industry facilities received free allowances and had to give back enough of them to cover their CO2 pollution.

One E.U. allowance, or EUA, is equivalent to 1 ton of carbon. Companies that pollute more than their allowance have to pay a penalty or buy EUAs on the market, where they trade now now for close to €15 a metric ton. Most experts estimate that carbon capture and storage (CCS) technology, for example, would need a carbon price of at least €40 per ton to be profitable. (One euro is currently worth $1.325.)

"It's a very complex system with rather limited results," Lekander said. "It has required an enormous amount of work."

Roller-coaster price action

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When the first hard data came in on actual emissions by industry, they were lower than expected, and the price for carbon fell quickly to zero. Later, the price rose to as high as €30 per ton before falling again.

"There is too much volatility," Lekander said. "First the price went up, then it crashed, then it went up again before crashing once again. It means that non-subsidized power systems don't know how to invest. You cannot build coal plants because you have no idea what your costs will be. The safest thing is to invest in gas, from a risk-management perspective."

Limited use of Certified Emission Reduction credits (CERs) achieved via the United Nations' Clean Development Mechanism in developing countries was approved but led to fraud in some cases and is now getting a second look from regulators.

"Free allocation is a nightmare," Lekander said. "It means there's a fight within an industry to get this allocation, and it leads to fraud, or at least to actions that are on the borderline of fraud."

The first stage of the program led to emissions reductions between 2 and 5 percent, or 120 million to 300 million tons of CO2, according to Denny Ellerman, a former senior lecturer at the Massachusetts Institute of Technology's Sloan School of Management and the lead author of "Pricing Carbon," a book on the E.U. ETS. The cost of this abatement was minimal -- just 0.01 percent of the European Union's gross domestic product, Ellerman calculated.

Last year, E.U. emissions fell almost 12 percent to 1.87 billion metric tons, compared with an allocation of 1.97 billion tons of permits, according to European Commission data. It's impossible to estimate how much of that was due to the ETS, as a severe recession engulfed the continent and reduced industrial activity. The three biggest CO2 emitters in Europe last year were RWE, Vattenfall and E.ON.

The total value of the global carbon market grew 6 percent in 2009 to $144 billion, according to the World Bank. By far the largest contributor was the European trading system, which accounted for $118.5 billion, up from $101 billion in 2008. The largest carbon trading system in North America is the Regional Greenhouse Gas Initiative in some Northeastern and mid-Atlantic U.S. states, which grew to $2 billion from $276 million.

Money for nothing for utilities

Granting allowances for free has been strongly criticized by environmentalists for allowing European utilities to reap windfall profits.

The process works like this: If an electricity producer makes 1 megawatt-hour of power at a cost of €50 by burning 1 ton of coal and emitting 1 ton of CO2 in the process, it will have to surrender one EUA. The company received the EUA for free, but if it trades for €15 on the ETS, it could have sold it on the market to pocket €15 even without producing electricity.

Thus the actual cost of producing the 1 MWh of power is not €50, but €65, so the utility will price its electricity accordingly.

"Free allocations become windfall profits, and that's unfair," Lekander said. "Auctions would alleviate this."

In the third phase of the ETS, carbon-intensive producers will lose their windfall profits because they will have to buy the allowances they used to get for free. Meanwhile, carbon-free producers such as solar or wind farms will still enjoy them because the price of the power they sell would still rise even as they won't have to buy allowances.

The auctions will bring €15 billion per year in revenue to member states, according to the European Union. Some of it will be earmarked to support green technologies like carbon capture and storage, floating offshore wind turbines, high-efficiency photovoltaics, smart grid solutions, and geothermal and wave power.

Still, the criticism continues, because only power plants in Western Europe will pay for all carbon permits starting in 2013. Eastern European utilities will only buy 30 percent of their permits at first. It won't be until 2020 that they will have to buy 100 percent.

A ticket to China for trade-exposed companies?

Heavy industry gets even more protection, with auctions not phased in fully until 2027. Even so, companies in energy-intensive and trade-exposed industries such as cement, glass, paper and pulp, petrochemicals, refining and aluminum argue that they won't be able to keep up with competitors that don't have to worry about buying carbon allowances, such as Chinese and Indian firms.

Steel companies especially have been vocal in saying that the only way to avoid having European heavy industry move en masse to China is an international agreement that would include all the major producing countries. So far though, not a single factory has moved out of Europe because of the ETS.

"Companies in the E.U. ETS seem to be understating the reductions they will need to make by 2020," Connie Hedegaard, E.U. climate change commissioner, said in a speech in Brussels last month. "Of course, the ETS emissions cap we have set for 2020, which is 21 percent below the 2005 level, ensures that overall emissions will indeed be reduced by this amount. But companies would do well to be realistic now about what this will mean for them individually. Otherwise they risk having to make unexpectedly deep emission cuts -- or unexpectedly large purchases of allowances -- at some point in the future."

The European Union is also introducing carbon trading to the aviation industry from 2012, enlarging the European emissions cap by 15 percent. Aviation trading will cover all airlines flying in and out of the European Union and will be linked with the ETS, so that an airline will be able to buy European allowances from there, but won't be able to sell aviation allowances into it. The emissions cap for airlines will rise to 5 percent below average emissions from 2004 to 2006 by 2015.

Another problem has been used carbon offset credits being resold illegally on the market. In March, Hungary sold 800,000 CERs and informed the European Union's regulatory arm on the transaction. But some of the credits nevertheless ended up on the BlueNext exchange after a trader resold them. The confusion resulted in trading being halted on the exchange for a brief period.

Theft, fraud and abuse

There have been repeated attempts to steal CO2 allowances from various European companies. After phishing attacks on Jan. 28 that revealed passwords to several CO2 accounts, 250,000 allowances with a market value of $4.2 million were stolen, Germany's Federal Environment Agency said. Most recently, the Romanian unit of Holcim, the world's second-biggest cement maker, said this week that 1.6 million EUAs worth $19 million were stolen from its account.

The company said it recovered 600,000 of the electronic certificates and posted the serial numbers of those still missing on its website. It said the stolen EUAs have been transferred to accounts in Liechtenstein, Italy, Britain, the Czech Republic and France.

In a different scam known as the VAT carousel, in which carbon traders collected value-added tax and disappeared before turning it over to countries in which they operated, the European Union lost a total of $6.6 billion in revenue for the 18 months ending in December 2009, according to Europol.

Then there is the $2.5 billion Chinese scam involving the deliberate production of greenhouse gases which the fraudulent manufacturers are then paid to destroy. Many Chinese chemical companies manufacture HCFC-22, a refrigerant gas. Some critics say it is only because it has as a byproduct HFC-23.

This is a greenhouse gas that, when destroyed, can earn allowances under the U.N. offset scheme via the Clean Development Mechanism. Destroying the HFC-23 can be worth five times the value of the refrigerant gas the plants are ostensibly set up to manufacture. Now Hedegaard wants the practice banned because of its "total lack of environmental integrity," she told the Guardian newspaper.

Would a U.S. system improve things?

If Europe bans offsets from such industrial gas projects, they may end up in New Zealand's tiny carbon trading program, an analyst at IDEACarbon said. "Beyond Europe, New Zealand is currently the only established marketplace for HFC-23 CERs," said Matthew Gray, an analyst at IDEAcarbon, in a research note. "The New Zealand market will quickly be flooded by foreign CERs looking for a home."

There are 19 projects cutting HFC-23 under the CDM program, mainly in China and India. They represent less than 1 percent of all registered U.N. offset projects, but account for more than half of the 476 million CERs issued so far, according to U.N. data.

Despite its steady growth, the ETS is a lot less effective without a similar carbon-pricing tool in the United States, analysts say.

"The more global a cap-and-trade system, the better," Lekander said. "Ideally, it would include some emerging countries."

A U.S. carbon trading system would likely need several years to link to the ETS, as at first the two programs won't recognize each other's allowances and carbon emission offset provisions.

Lekander actually would prefer a tax to a cap-and-trade system. "A straight tax would accomplish the same emission reduction with less hassle," he said. "They should try not to create too much volatility. There needs to be a stable mechanism. I'd compare it to a monetary system, where the central bank has a target, but here, no one is giving guidance. It needs a price floor and a price cap."

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