Back in December, when the Copenhagen Summit failed to produce a binding global agreement on tackling climate change, the European carbon market slumped.
On Monday, analysts at Bank of America Merrill Lynch point out that Phase II of the European Trading scheme may be facing greater challenges still.
Namely, it looks like the recession could see the scheme end up with more permits available than actual emissions — the situation which afflicted Phase I, and led it to expiring a failure in 2007.
As the analysts noted:
A string of bearish signals is currently hanging over the European and global carbon markets like a big dark cloud. After closing last year at a 25% loss, European allowance units (EUAs) have fallen by 9% since the peak of EUR14.70/mt during the Copenhagen Conference in December. Since then, prices have regained some of their losses but have otherwise struggled to find much direction .
Economic factors will weigh on carbon
Following the economic recession and the sharp drop in output since 2008, the EU will likely find it easier to meet its goal. Germany, the largest emitter in the Eurozone, just reported weaker-than-expected GDP figures for 4Q09. While our economists still expect 2010’s recovery to be strong relative to previous recoveries, some states—such as Spain, Greece, Italy and the UK—are conspicuously lagging in the recovery process.Phase II is in surplus
In the short-term, that means the market is structurally long, even before importing CERs or ERUs (Chart 4). On our estimates, CO2 emissions from the use of fossil fuels fell by 9.5% last year in Europe, mirroring the decline in industrial activity (Chart 5). According to some estimates, German CO2 emissions fell by 9% to the lowest level since 1990, the biggest yearly fall since 1991. By the same tune, the US just reported a 6.1% drop last year. Declines in energy consumption in the industrial sectors due to the sharp economic downturn combined with a higher burn of natural gas versus coal drove the decline in CO2 emissions.
The analysts further note that industrials are likely to start selling length in even greater volumes shortly — this, after holding back at the end of last year on fears of legislative changes, which have since been removed.
If the Guardian is to be believed (H/T Kate Mackenzie over at FT Energy Blog), there are also jitters about the market for carbon offset credits, or CERs, which can be substituted for carbon allowances.
According to the newspaper, banks and investors are already pulling out of planned clean-energy projects in the developing world on a large scale because of the lack of certainty over international carbon trading rules after 2012, when the Kyoto protocol expires, while the recession is blamed for dampening demand for credits under the current regime. Staffing levels on carbon trading desks, meanwhile, are reportedly also beginning to be cut.
While this more specifically relates to the CER market — carbon credits from clean energy projects — Merrill Lynch notes the connection to EU ETS as follows:
Evaluating the potential supply of CERs into the EU ETS is an extremely hard exercise as it also hinges on developments in the global carbon markets. However, with progress stalled in both the US and Australia, there is now likely to be less competition for offsets going forward. At the same time, after years of sustained growth, companies last year cut back aggressively on spending to reduce carbon emissions. Hence, the demand for offsets from CDM1 or JI offsets stalled last year.
The UN just cut for the sixth time its forecast for the total volume of CERs likely to be available up until the end of 2012, by 5%. The new estimate now stands at 1.092 billion mt of CO2 equivalent. So far, the total volume of CERs issued stands at 358 million mt (Chart 13). On the ERU side, Russia is set to release about 30 million mt of ERUs by the end of this year, from a series of offset projects starting up.
There is, however, one potential lifesaver to the scheme this time round — the fact credits can be banked into Phase III.
As the Merrill analysts noted:
Still, the fact that the EU system will be long during Phase II is effectively irrelevant. Given that it has a continuous trading period, up to at least 2020, full banking between Phase II (2008-2012) to Phase III (2012 plus) will ensure a shortfall. Moreover, auctioned volumes will likely increase sharply in coming years. Utilities, for instance, will have to buy 100% of their EUAs through auctioning from 2013 onwards, although there are some exemptions2.
Which is why EUAs have weakened, but not collapsed this time round.
Related links:
Carbon cop-out – FT Alphaville
Carbon indulgences – FT Alphaville
Uncool carbon markets – FT Energy Source