Straight to the point

Carbon markets increased in value by 80 per cent in 2007. IFandP discusses their future prospects with PointCarbon’s senior analyst, Dr Mauricio Bermudez-Neubauer.

IFandP: Which factors would you say have most influence on day-to-day European carbon prices?

Dr Bermudez: EUA prices are affected by fundamental and non-fundamental drivers on a daily basis. On the fundamentals side, the key factors are energy prices and policy developments, whereas the main non-fundamental driver is technical trading. The main source of potential emissions reductions in this second phase of the EU ETS (2008-12) is switching from dirtier, less efficient coal power plants to cleaner, more efficient gas plants (which produce about half the emissions).

In consequence, the relative movement of coal and gas prices – determined in turn by global oil prices, freight rates and weather, to name a few fundamentals of those markets – are a key driver of EUA prices. This factor is often referred to as the implied fuel switching price.

However, since the fuel switching potential is limited, other energy fundamentals also drive EUA price levels. In particular, Germany is the EU’s main source of emissions and, with the power sector accounting for roughly half of the ETS emissions, it is no surprise that German power prices, forward prices to be precise, are one of the clearest determinants of the EUA price. EUAs and forward German power prices are highly correlated because utilities jointly buy and sell EUAs and power on a forward basis to lock in spreads.

The value of EUAs is to a very large extent also determined by regulations, such as limits for CER (Certified Emission Reduction) use or future caps, so any significant developments on the policy front also have a direct bearing on price levels.

And, as in any other liquidly traded commodity market, technical trading accounts for a large part of the observed daily price movements.

IFandP: How do you see the carbon price developing as the EU moves into Phase III of the ETS? Also, as it becomes increasingly traded, what are your predictions in terms of volatility?

Dr Bermudez: We are fundamentally bullish in our outlook for Phase III prices. Independently of whether the EU adopts a 20 per cent or 30 per cent GHG reduction target for 2020 – the two options stipulated in its climate and energy package proposal of January this year and which are contingent on the outcome of international climate negotiations – the set of currently proposed rules will make the system tighter relative to the current phase and, as such, prices should be higher than the levels we are seeing at present. Some European industries and member states are contesting certain aspects of these proposals, such as the import limits for CERs or the auctioning of allowances, so politicians will have to juggle between their internal European agenda and the international negotiations. A difficult year lies ahead for EU policy makers and negotiators.

Whilst we cannot rule out that volatility will increase along with liquidity, especially as the market in Phase III will very probably include other sectors such as aviation and will respond to additional drivers such as long-term investments from non-power sectors, we expect the contrary to occur: higher traded volumes should, other things being equal, reduce the scope for prices being shifted around by individual trades.

IFandP: What sort of data and expertise does Point Carbon draw on when preparing a forecast?

Dr Bermudez: Point Carbon has possibly the largest team of analysts in the world working on European and global carbon and energy markets. We have an integrated suite of models, databases and analytics that range from the very short-term (intraday) products used by carbon, power and gas traders, out to long-term (30-year) carbon, power and gas scenario analysis and strategic advice for investors and planners. And of course we draw on our independent and market leading news team for the latest developments in these markets.

IFandP: Which projects do you consider to be most sensitive to the price of carbon?

Dr Bermudez: It depends on the time horizon you are considering and the geographical location of the project. In terms of projects within the EU, investment decisions concerning any energy-intensive installation will become increasingly sensitive to the price of carbon over time. This is a direct consequence of the EC’s plans to ultimately auction all EUA allocations (as opposed to hand out for free) to power plants by 2013 and, in a more gradual manner, to other industrial installations.

In consequence, the price of EUAs has become part of the capital expenditure of a project (in addition to its operating costs) and so the most carbon-intensive projects, such as coal power plants without carbon capture and storage (CCS), will be affected the most. Sending this price signal is, of course, precisely the objective of the ETS.

IFandP: Do you see a truly global carbon trading market as a possibility? What are the benefits and disadvantages of such an approach?

Dr Bermudez: We firmly believe that a global market for abatement credits will develop sometime over the next 25-30 years. Although this sounds like a long period, I am referring to a truly global market in which all countries have targets and are actively trading carbon credits. In the meantime, we think that international negotiations between now and 2013 will lead to a market where industrialised countries will commit to emissions reduction targets, whilst developing countries (the advanced and larger ones in particular) will participate in abatement efforts through a series of measures, including the existing CDM, but also through new mechanisms, possibly including credits for conservation of forests, CCS, and domestic trading and crediting of energy intensive sectors.

All policies have benefits and drawbacks and, as we learned with the over-allocated Phase I of the EU ETS, the gathering of information to set targets is a key challenge, as well as a necessary condition, for such a market to operate properly. One of the clearest benefits of a carbon market is that it allows policy makers to set the emissions caps – a crucial requirement in our efforts to stabilise GHG emissions – something that cannot easily be attained through, say, a carbon tax. Another of its advantages is that it provides companies and installations a much higher degree of flexibility in their compliance strategies and decisions.

IFandP: Given that some countries, such as Canada, are well above their emissions quota, is there a danger that the limits imposed by Kyoto will suffer from diminished credibility?

Dr Bermudez: Canada is without a doubt the stone in Kyoto’s shoe, given the administration’s lack of commitment in meeting its Kyoto objective. Whilst the Kyoto Protocol does contain mechanisms for penalising non-compliance, potentially non-compliant countries (and there are not too many of them) would also suffer from the international shame of missing their targets. We think, however, that this is unlikely to happen: there are plenty of surplus Kyoto credits in the form of the so-called “hot air” from Russia and Ukraine, so these countries could make up for their shortfall through the purchase of these “politically incorrect” credits.

IFandP: Do you think that the carbon price signal will reach the point where it will be able to support the introduction of CCS alone, without the need for mandatory legislation?

Dr Bermudez: Our forecasts indicate that phase III EUA prices will be more than enough to prompt the deployment of CCS in Europe, which analysts tend to estimate between €35-45/t CO₂. However, that signal is unlikely to be reached before the end of the current phase so it is doubtful that utilities will start to invest in this technology now (although some North European utilities currently are). In that respect, public funds and legislation could aid in supporting an earlier development of CCS.

IFandP: To outsiders, the carbon market already seems to boast an almost bewildering array of acronyms and financial instruments, with many more on the way. What do you think is the cause of this complexity?

Dr Bermudez: The straight answer is that it is a complex market requiring the description of complex terms and the use of complex instruments, although I would note that numerous acronyms are also widely employed in capital, equity and other commodity markets.

However, I completely agree that the number and non-intuitiveness of acronyms makes this already sophisticated market even harder to grasp for the layman. With the USA hopefully joining in a future international climate agreement, we will perhaps get more user-friendly CARBs (carbon acronyms from regulatory bodies)!

IFandP: With the US likely to be far more amenable to binding emissions targets, once the next administration is signed in, does this increase the likelihood of China and India agreeing to the same?

Dr Bermudez: Although it is undeniable that the scope for US participation in an international climate agreement will be increased by the change of administration, we believe the direction of causality is still the other way around: without some sort of participation by China by 2013 (less so for India), we see it as very difficult for the US to commit to any kind of international agreement.

IFandP: On a related subject, how do you feel the issues of “out-sourced” carbon emissions, such as the move of heavy industries to China and fears of carbon leakage will be addressed in future?

Dr Bermudez: The two questions are indeed very interlinked. Much of the concerns about leakage can be addressed if large developing countries take on national sectoral targets for key industrial energy intensive sectors such as iron and steel, cement and aluminium. These could be palatable to those countries if the targets are, for instance, set with a so-called “no-lose” condition, where installations receive credits (CDMs, for instance) for any emissions below a target, but are not penalised for not meeting those targets. We expect this to be one of the hottest and most complex discussion points in the upcoming international negotiations.

IFandP: While on the subject of trading schemes and leakages, the Australian carbon trading scheme is currently being thrashed out. Do you think that businesses have cause to worry or have NGOs and the media exaggerated the dangers?

Dr Bermudez: Carbon leakage is a genuine concern, not only from an environmental perspective, but understandably also from a national strategic and economic point of view. But it only becomes a concern if it is not addressed by policy makers responsible for market design. As I hinted earlier, it makes much more sense to tackle the problem of leakage internationally, in the context of a global climate agreement, than unilaterally through, say, border tax adjustments or other trade barriers.

IFandP: What kind of companies look to you for price forecasts? What sort of benefits have they achieved through greater knowledge of the market?

Dr Bermudez : Our main clients are those most active in the carbon and energy markets, such as utilities, financials, trading houses and brokers, oil and gas companies, large industrials and project developers. Although the range of impacts that our analysis has had on these is wide, varied and not always visible from our perspective, I would say we have helped them to better assess and manage their risk, and to make more sound investment decisions.

IFandP: Given that the market is growing so rapidly and that financial institutions are clamouring to offer new carbon-based products, it is clear that there is certainly a great deal of money to be made through carbon trading. However, activists still seem to be sceptical regarding its environmental benefits. Would you say that carbon trading is already resulting in significant reductions in CO₂ emissions or is this still yet to come?

Dr Bermudez: Despite the fact that the verified emissions between 2006 and 2007 within the EU ETS increased, our annual survey of more than 3700 respondents – of which roughly half trade or own EUAs – indicated that 71 per cent have already implemented or are planning to implement emissions reductions strategies for compliance with the ETS targets, mainly in the form of fuel switching and energy efficiency enhancing measures. Moreover, the fact that emissions increased does not necessarily imply that reductions have not taken place: it is possible that the efforts reported by participants have resulted in emissions below those that would have otherwise resulted in the absence of the carbon price.

At the international level, activists have targeted the credibility of reductions from CDMs by showcasing a few rogue projects, but there is wide agreement by experts that the large majority of projects have delivered reductions relative to the emissions that would otherwise have taken place.

This is still a nascent market and the bulk of reductions are yet to come. We think these will increasingly materialise as regulation becomes more certain, targets become stricter and the carbon price rises.

IFandP: How do you feel the market has changed over the past year?

Dr Bermudez: The EU ETS has no doubt matured over the past year. For one, it ended its ill-fated three-year testing phase and began the proper Kyoto compliance phase, where several fundamentals have changed. These include the possibility of banking credits into the next phase (this was not allowed in phase I) and the use of CERs for compliance, thanks to the linking of the ITL-CITL registries which is expected to take place before the end of the 2008.

It has also evolved in terms of market players’ understanding of the key drivers. Between 2005 and 2007, EUAs for delivery in the second phase were the most closely correlated with crude oil prices, which are regularly taken in other energy commodity markets as a key sentiment signal, and the UK switching price. This year, however, we have increasingly seen more frequent decoupling of EUAs and oil, with more fundamental drivers such as German forward power (which is the largest source of emissions in Europe) or developments concerning expected CDM supply having a greater effect on prices.

IFandP: Currently China receives the vast bulk of clean development mechanism projects. Do you think that this will remain the case for the medium term or are other countries likely to get in on the action?

Dr Bermudez: Given the size of China’s economy now and in the foreseeable future, it is unlikely the country will be overtaken as the number one supplier of CDM credits over the next five or six years. However, with international negotiations very likely to change China’s role in the international carbon market, we could well see it reducing its output of CDM credits as we currently understand them, although, we would still expect the country to remain the largest provider of emissions reductions among developing countries for quite a long time.

The treatment of HFC (hydrofluorocarbon) credits going forward will also quite significantly reduce the volume of credits coming from the Chinese market. Of course, as the market develops, we expect greater participation of emissions reductions from other countries currently less or not active in this market.

IFandP: Finally, if you could reform just one aspect of the current system, what would it be and what would you change?

Dr Bermudez: It is difficult to point out a single issue that would significantly improve the performance of these markets. In the EU ETS, my money would perhaps be on promoting greater transparency and frequency of information on the evolution of emissions from all installations covered.

For the international CDM market, I think I agree with many that allocating greater resources to the CDM Executive Board – the UNFCCC body overseeing CDM projects and credits – to streamline the whole CDM registration to credit issuance cycle, would dramatically help to catalyse investments in much needed emissions reductions.

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