Concerns are growing that big emitters covered by the EU emissions trading scheme (EUETS) are putting off long-term investments in low-carbon technology due to low prices and extreme volatility in the market for EU greenhouse gas allowances (EUAs) (ENDS Report 408, p 7).
Worse still, key long-term investment decisions necessary now to renew the European Union’s power infrastructure could lock the bloc into high-carbon generation for decades.
World Wildlife Fund UK’s head of climate change Dr Keith Allott warned of impending "sub-prime investment in a new generation of coal plants", with some 70 gigawatts of new coal capacity proposed across Europe.
This suggests that so far even previously buoyant prices for carbon allowances and tighter caps agreed for phase III of the EUETS, which starts in 2013, have done little to dissuade investors from high-carbon investments, with the market tending to discount higher future carbon prices.
Throughout early 2009, closing prices for EUAs have hovered just above €10 per tonne of CO2 with substantial recovery not expected by most for a couple of years.
The underlying cause of the steep fall in EUA prices is the recession. Falling industrial output and energy consumption and therefore falling emissions has meant fewer EUAs are needed in the short term. Distress selling of allowances has sharpened the decline.
Credit lines for investors and short-term borrowers in the energy-intensive industries have all but dried up. As a result, cash-strapped firms in the cement and steel sectors facing large cutbacks in output and therefore emissions have sold surplus EUAs to raise money. The Engineering Employers Federation told ENDS that both large and small steel producers have been under pressure to sell EUAs to maintain liquidity.
Another concern is that national rules implementing the EUETS in some member states could allow plants that have been mothballed for long periods to continue receiving EUAs - leading to more surplus allowances being dumped on the market. But the Environment Agency, which regulates the EUETS in the UK, told ENDS: "To date, we have not seen any evidence to indicate that operators have tried to manipulate the plant closure rules [of the trading scheme] to maximise the number of allowances for sale to the market."
Few predicted a recession as deep as the current one and even fewer considered its effect on the carbon market and investment incentives during negotiations on the final version of the EU climate package in December (ENDS Report 407, pp 4-5).
Yet delayed investment in low-carbon technology due to the recession and low carbon prices could lead to serious long-term problems for manufacturers once production recovers. They may have to buy back many EUAs, causing prices to spike in phase III, or be forced to invest in plant in a hurry and therefore at higher cost.
Power generation utilities that will get no free allowances in phase III are thought to be picking up EUAs at low cost as a result of distress selling. But they too could find themselves in a similar position if they fail to invest ahead of time.
The concern now is that generous free allocation of allowances combined with slackening demand will see EUA prices lower than predicted throughout phase II, and even into the stricter regime of phase III as large volumes of surplus EUAs and international carbon credits are carried forward for use from 2013. Head of global carbon markets for Deutsche Bank Mark Lewis stressed: "Governments should have realised that free allocations distort incentives."
Over phase II - which runs from 2008 to 2012 - recessionary pressures could see some 500 million tonnes less CO2 emitted, according to forecasts from market analysts Point Carbon, reducing effort needed to achieve reduction targets in the near term.
Most carbon market stakeholders are confident the EUETS in phase III from 2013 (ENDS Report 408, pp 38-41) offers a clear framework for cuts within tightening caps and increased auctioning to reduce carbon price volatility. But they are divided on the necessity of price intervention or other reforms to boost investment.
Vincent de Rivaz, chief executive of energy utility EDF, broke ranks this month to call for more market certainty in the EUETS to support investment in highly capital-intensive low-carbon technologies, if necessary by more regulation. But deputy director-general of the EU’s DG Environment Jos Delbeke has rejected any intervention in the market on the grounds that this would lead to distortion and expectation of further interventions.
There are in any case few options for intervention by the EC or member states under the directive underpinning phase III of the EUETS. In extreme cases, there is provision for bringing auctions forward or for auctioning unused allowances in the New Entrants Reserve, which sets aside EUAs for major expansion and start ups among energy intensive industries. But these are intended to deal with sustained high market prices - not price collapses - and would require agreement from all member states.
Individual EU nations could theoretically delay auctions of EUAs during periods of low prices, but such action would have very limited impact across the EU. Auction dates need to be announced well in advance, and failure to issue sufficient EUAs in time to meet agreed national allocations would lead to an infringement of the EUETS Directive. As a result, this course of action would be risky and is very unlikely even in phase II.
The UK Department of Energy and Climate Change (DECC) also opposes intervention in the EUA market. It maintains the key has been to set "the right long-term regulatory framework with a tightening cap on emissions" for phase III, bolstered by targets and measures within the UK Climate Change Act 2008.
But while there is still wide support for the system of reducing caps under the EUETS, pressure is building for intervention in the carbon market by means of a minimum "floor price" for EUAs.
This was rejected in the December deal in Brussels, but German economics minister Michael Glos came out strongly in favour of a "price corridor" including a minimum and maximum range in February, shortly before resigning. DECC remains opposed.
The threat posed by a carbon price slump to the investment needed for a low-carbon economy was also recognised in the recent report of the government’s advisory Committee on Climate Change (ENDS Report 407, pp 14-15).
It suggested buttressing the market with a floor price for carbon. Chief executive David Kennedy told ENDS the EUETS alone would not provide strong enough signals to pull through new technology or even current options such as nuclear, wind, and conventional tidal technologies until the 2020s at least without additional policy and funding measures.
There have also been unsuccessful efforts within the EU to launch a tough Californian-style CO2 emissions performance standard for new plant, capping emissions at 500 grams per kilowatt hour. This would effectively outlaw investment in non-CCS coal-fired plant. But Denmark has imposed its own EPS standards for new plant.