Carbon Emission Trading:A New Financial Market

Laurent ViguierINV – Buy-side Equity ResearchApril 19, 2007

Spring Meeting 2007 Oïkos International“Sustainable Development: What role to play for finance”

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Timetable

1. Climate Change: Scientific Evidences and Economic Impacts

2. The Kyoto protocol: Architecture and Commitments

3. Why Should We Trade Emissions?

4. CO2 Trading in Practice: The EU ETS

5. Conclusion

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1. Climate Change: Scientific Evidences and Economic Impacts

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Evidence from Direct Observation of Climate Change

> The total temperature increase from 1850 – 1899 to 2001 – 2005 is 0.76°C.

> Global average sea level rose at an average rate of 1.8 mm per year over 1961 to 2003.

> Mountain glaciers and snow cover have declined on average in both hemispheres.

Source: IPCC WGI Fourth Assessment Report, 2007

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Projections of Future Changes in Climate

> For the next two decades a warming of about 0.2°C per decade is projected for a large set of emission scenarios

> For the low scenario (B1) surface warming for the end of the 21st century is 1.8°C

> For the high scenario (A1FI), the best estimate is 4.0°C

Source: IPCC WGI Fourth Assessment Report, 2007

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The Impacts of Climate Change on GDP Growth

> Economic models agree that the effects of warming above 2 - 3°C would reduce global welfare

> Models also agree that poor countries will suffer the highest costs

Tol, equity

-11-10

-9-8-7-6-5-4-3-2-10123

0 1 2 3 4 5 6

Mendelsohn, output Nordhaus, output

Nordhaus, population Tol, output

Global Mean Temperature (oC )

Percentage of World GDP

Source: Smith et al., 2006

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Costs of Stabilizing Greenhouse Gases Concentrations> The GDP costs of stabilizing GHG concentrations are expected to be

high

> For 2025, costs range from 0 to 3.5% of GDP

Source: Barker, 2006

% Reduction from Reference in Global GDP in CO2-Only (solid) and Multigas (dashed) Scenarios

-12%

-10%

-8%

-6%

-4%

-2%

0%

2000 2025 2050 2075 2100

AIMAMIGACOMBATEDGEEPPAFUNDGEMINI-E3GRAPEGTEMIMAGEIPACMERGEMESSAGEMiniCAMPOLESSGMWIAGEMAIMAMIGACOMBATEDGEEPPAFUNDGEMINI-E3GRAPEGTEMIMAGEIPACMERGEMESSAGEMiniCAMPOLESSGMWIAGEM

Source: EMF21, 2006

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Flexibility is necessary

> Uncertainty and irreversibility Temporal flexibility

> Cost divergence across sectors and regions Spatial flexibility

> Emission Trading contributes to:– Spatial flexibility: trading of permits across regions

– Temporal flexibility: i.e. banking and borrowing of permits

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2. The Kyoto Protocol: Architecture and Commitments

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Basics of the Kyoto ProtocolAfter Russia’s ratification, the Kyoto Protocol became a legally binding agreement in February 2005, committing signatories to greenhouse gas (GHG) emission limits

The Kyoto Protocol:• Targets emissions of the six main GHGs:

– carbon dioxide (CO2), methane (CH4), nitrous oxide (NOx), hydrofluorocarbons, (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6)

• Represents 55% of developed countries’ GHG emissions of 1990 levels• Does not include the United States or Australia

Commitments of Phase I of Kyoto Protocol (2008-2012):• EU Average -8% (with Germany and Denmark -21%, Portugal +27%)• Japan -6%• Annex I countries (most developed countries) average -5.2%

Emissions Reduction Targets are relative to 1990 (base year)

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Members of the Kyoto Protocol

Non-Annex B Countries = No Commitments

Annex B Countries with Commitments

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Reaching the Kyoto Targets: The 3 Flexible MechanismsAnnex 1 parties must establish domestic policies and measures to cut GHG emissions (‘Green policies’) and establish national agencies to monitor and report emissions

Countries can meet their emissions targets using the three Flexible Mechanisms:1. Emission Trading- Annex I countries can buy and sell emission rights

– The EU Trade Allowance (EUA) represents 1 tonne of CO2

2. Clean Development Mechanism (CDM)- Annex 1 Parties implementing emission reducing projects in non-Annex 1 countries (i.e. developing countries).

– The Carbon Credits are called: CERs = Certified Emission Reductions

3. Joint Implementation (JI)- Annex 1 Parties undertaking net greenhouse-gas emission reducing projects in other Annex 1 countries (often emerging economies).

– For the current EU-ETS Phase I until 2007, only CDMs are permitted.– The Carbon Credits are called: ERUs = Emission Reduction Units

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The Kyoto Mechanisms

Annex B Country

(industry)

Annex B Country

(industry)

Exchange of CO2 quotas

Annex B Country

(transport, etc)

Non-Annex B country

(All sectors)

Emissions Trading (EU ETS)

Joint Implementation (JI)

Clean Development mechanism (CDM)

Clean Development mechanism (CDM)

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3. Why Should We Trade Emissions?

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Tradable Emission Permits (QET)

> John Dales (1968)

> Maths by David Montgomery (1972)

> First experiments in the USA since 1974 (SO2 from electric utilities)

> Main argument for TEP:

Minimize the economic cost while reaching the global environmental target

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The Problem of Allocating Abatement

Assumptions:

> Two emitters> Damages are additives: DT = D1+D2 (ex: CO2)> Marginal costs of reductions differ among emitters (i.e. technology,

resources, etc)> Global reduction target is 50%> How to allocate the effort? 50% each?

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Polluter 1 (High MACs)

Δ150 Abatement

Dollars

Polluter 1

50% reduction Marginal abatement cost is P150

TOTAL abatement cost for polluter 1 is the pink triangle

Δ10

MAC1

P150

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Polluter 2 (Low MACs)

Δ250 Abatement

Dollars

Polluter 2

50% reduction Marginal abatement cost id P250

Total abatement cost for polluter 2 is the pink triangle

Δ20

MAC2

P250

MAC1

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Inefficient Allocation

Δ250 Abatement

Dollars

P150 > P2

50

Global cost of the total reduction is not minimized

Δ20

MAC2P150

MAC1

P250

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Equilibrium in the Emission Market

Abatement A1

Francs

MAC1

ΔA1

P*

ΔA*

At the equilibrium, Supply = Demand and the price is P*

Every polluter gains from the exchange of quotas!!

Gains of the buyer

MAC2

Gains of the seller

Abatement A2 ΔA2

Volume of traded quotas =

ΔA* - ΔA1

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Efficient Allocation under different instruments

> Tax:

Uniform tax rate applied to all emitters optimal reductions

> Standard:

Optimal targets that equalize MACs among pollutersInformation problem + equity issues

> Emission trading:

Whatever the initial allocation, the MACs are equalized through the market and the optimal solution is obtained

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Example of MACs for CO2 in Japan, Europe and USA

0

50

100

150

200

250

300

350

400

0% 5% 10% 15% 20% 25% 30% 35% 40%

Carbon emissions reductions (in %)

Ca

rbo

n v

alu

e in

US

$9

5/ t

C

USAEUJPN

Source: Viguier et al., 2001.

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4. CO2 Trading in Practice: The EU ETS

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European Emissions Trading Scheme (EU ETS)

Phase I runs from 2005-2007Only CO2 emissions from large emitters:

Power stations

Boilers > 20MW thermal input

Oil refineries and Coke ovens

Iron and steel plants > 2.5 t/hr

Glass factories > 20t/d

Ceramic, bricks and porcelain factories

Cement factories > 500 t/d

Wood pulping and paper manufacturing > 20t/d

2.2 bn allowances allocated annually.

Phase II will run from 2008-2012Other industries that might be affected:

The transport sector, especially Aviation

The petrochemical industry

Aluminium smelting

Waste disposal

Agriculture

EU-ETS Phase II corresponds to the

Kyoto Protocol Implementation Phase

From January 1, 2005, the EU has operated an emissions trading system:

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Carbon Market Dynamics

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CO2 Quotas Traded since January 2005(cumulative, MtCO2)

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CO2 Price in the EU Market

0

5

10

15

20

25

30

35

9.3

.05

9.6

.05

9.9

.05

9.1

2.0

5

9.3

.06

9.6

.06

9.9

.06

9.1

2.0

6

9.3

.07

CO

2 p

rice

(€

/tC

O2

)

Spot price (contract Dec.07)Future price (Dec. 08)

First emission inventories no shortage!

Two different markets: No banking

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Why the spot price collapsed?> Structural reasons:

1. In May 2006, the market understood the phase to be long (initial allocation was too generous)

2. No banking prices will necessary end up at a very low price at Dec. 07

> Short term trends:

1. Climatic conditions (hot winter)

2. Energy market: coal/gas spreadCoal price

Gas price

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5. Concluding Remarks

> Kyoto did not collapse after US withdrawal

> The EU successfully implemented the first international ETS:

> Improvement are required tor reduce uncertainty and volatility in the EU ETS: i.e. NAPs, reserves for new entrants, banking, etc

> CO2 commodity “Business-As-Usual” for the financial market

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