Carbon 2008: Post-2012 Is Now

Carbon 2008 Post-2012 is now

11 March 2008

TO THE POINT Global carbon markets worth €40 billion in 2007, up by 80 percent from 2006. The total traded volume increased by 64 percent from 1.6 Gt (1.6 billion tonnes) in 2006 to 2.7 Gt in 2007. The EU emissions trading scheme saw a traded volume in 2007 of 1.6 Gt and a value of €28 billion. This represents a volume growth of 62 percent and a value growth of 55 percent from 2006. The EU ETS now holds 62 percent of the physical global carbon market and 70 percent of the financial market. The CDM market increased to 947 Mt and €12bn in 2007. This is an increase of 68 percent in volume terms, and a staggering 200 percent in value terms from 2006, constituting 35 percent of the physical market and 29 percent of the financial market. The market for secondary trading of CDM credits is the fastest growing segment. From limited activity at the start of the year, over 2007 the market saw around 300 Mt of sCER trades, much of this related to EUA-sCER swaps. Two-thirds of survey respondents say EU ETS will result in internal abatement. Taken together, our surveys in January and April 2007 and January-February 2008 indicate that at least two-thirds of EU ETS companies are involved in or are planning emission reductions of some kind. Carbon prices important for investment decisions. 73 per cent of EU ETS survey respondents agree that the carbon price is relevant to investment decisions. Only 6 percent say the carbon price has no impact on new investments. Survey respondents expect a carbon price of €24 in 2010, and €35/t in 2020.This is up €6 for the 2010 price and €10 for the 2020 price, compared to last year. A federal US ETS likely, according to respondents. They expect it to be less strict than the EU ETS Phase 2, however, despite the ambitious bills now before the US Congress. Borrowing could be widely used. Nearly half of the survey respondents could borrow from 2009 allocation to use for compliance in 2008. Voluntary market is small and non-transparent. Only 10 percent of the respondents consider the voluntary market to be transparent, yet 50 percent think it is more mature now than one year ago. Integrated global market by 2020? Seventy-three percent of our sample think that there will be a global reference carbon price in 2020.

This report was published at Point Carbon’s 5th annual conference, Carbon Market Insights 2008 in Copenhagen 11 - 13 March 2008. For more information, see www.pointcarbon.com

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Carbon 2008

About Point Carbon

Providing critical insights into energy and environmental markets Point Carbon is a world-leading provider of independent news, analysis and consulting services for European and global power, gas and carbon markets. Point Carbon’s comprehensive services provide professionals with market-moving information through monitoring fundamental information, key market players and business and policy developments. Point Carbon’s in-depth knowledge of power, gas and CO2 emissions market dynamics positions us as the number one supplier of unrivalled market intelligence on these markets. Our staff includes experts in international and regional climate policy, mathematical and economic modelling, forecasting methodologies, risk management and market reporting. Point Carbon now has more than 15,000 clients, including the world’s major energy companies, financial institutions, organisations and governments, in over 150 countries. Reports are translated from English into Japanese, Chinese, Portuguese, Polish, French, Spanish and Russian. Every year, Point Carbon’s Carbon Market Insights conferences gather thousands of key players for the carbon community’s most important annual conferences. Point Carbon also runs a number of high-level networking events, workshops and training courses.

About the report:

This report was written and edited by Kjetil Røine, Endre Tvinnereim and Henrik Hasselknippe. For citations, please refer to: Point Carbon (2008): ”Carbon 2008 - Post-2012 is now” Røine, K., E. Tvinnereim and H. Hasselknippe (eds.) 60 pages.

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11 March 2008

Executive Summary This report presents an overview of the carbon market in 2007, our outlook for 2008, and expectations for the remainder of first Kyoto period and beyond. It is based on the results of the largest survey ever conducted into the carbon market. We received 3 703 responses to our web-based questionnaire and 1 462 of the respondents trade or own European Union Allowances (EUAs) or Certified Emission Reductions (CERs). The survey results are complemented by analysis undertaken by Point Carbon. The global carbon market is consolidating at a time of ever-increasing attention to climate change. Last year was another record one in the market, with an increase from 1.6 bn tonnes in 2006 to 2.7 Gt in 2007. The total traded volume increased by 64 percent. As global temperatures and media coverage increase, so does the volume of emission allowances and credits. In value term, the growth was even steeper in 2007. The global carbon markets were worth more than €40 billion in 2007, up by 80 percent from 2006. The EU Emissions Trading Scheme (EU ETS) is still dominating the global carbon market. EU ETS saw a traded volume in 2007 of 1.6 Gt and a value of €28 billion. This represents a volume growth of 62 percent and a value growth of 55 percent from 2006. The EU ETS now holds 62 percent of the physical global carbon market and 70 percent of the financial market. The higher share of the value of EU ETS compared to the volume is due to the high prices in EU ETS compared to other markets. The CDM market comes second, both in volume and value terms. It increased to 947 Mt and €12bn in 2007. This is an increase of 68 percent in volume terms, and an astonishing 199 percent in value terms from 2006, constituting 35 percent of the physical market and 29 percent of the financial market. The market for secondary trading of CDM credits is the fastest growing segment. From limited activity at the start of the year, the market saw around 300 Mt of sCER trades over the course of 2007, much of this related to EUA-sCER swaps. This emphasises the dominant position of EU ETS in the global carbon market last year. Traded volumes in the Joint Implementation (JI) market almost doubled from 21 Mt in 2006 to 38

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Mt in 2007. Higher prices in 2007 compared to 2006 meant that the value of the JI segment more than tripled, from €95m in 2006 to €326m in 2007. The direct market participants were not, however, left by themselves last year and there were significant activities in the political arena. The climate change challenge was at the top of the political agenda, and the UNFCCC summit in Bali in December succeeded in starting negotiations on a post-2012 agreement, with the aim of signing the agreement at the COP meeting in Copenhagen in 2009. In our survey, we asked whether a global post-2012 climate agreement will be reached before 2012. Around 70 percent of the respondents think there will be an agreement. Of these, 80 percent think there will be a post-2012 agreement, regardless of whether the US participates and around 60 percent of the respondents (N=3013) think that the US will join an international agreement. Interestingly, more than 75 percent believe that Canada is also likely to join the agreement, despite currently being a long way from meeting its Kyoto target. Second, the European Commission (EC) ruled on the National Allocation Plans (NAPs) for Phase 2. The overall impression was that the EC had learnt from Phase 1 and was sufficiently tight on the EUA cap, but that it was more generous when it came to the credit limit. Hence, taking into account the amount of carbon credits allowed to be used for compliance in Phase 2, it seemed that no emission reductions were needed within the EU over the period. This was to a large extent corrected in January 2008 when the EC proposed its revision of the EU ETS Directive. If a “satisfactory” international agreement is not reached, the EC proposes that the credit limit for Phase 2 (2008-20012) should be valid for both Phase 2 and Phase 3 combined (2008-2020). If, however, a satisfactory international agreement is reached, the credit limit would be increased by half of the additional reduction efforts going from the 20 percent reduction scenario up to, at most, a 30 percent reduction from the 1990 level. A third crucial development in the political arena in 2007, which indeed will continue to develop in 2008 and beyond, was the emission trading initiatives that are being taken on at both state and federal level in the US. RGGI will start on 1 January 2009

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(with some early auctions in 2008), while initiatives in the West and Mid-West will take a few more years to materialise. Most important, however, is the Lieberman-Warner Bill now going through the Senate. The bill suggests establishing an emission trading scheme covering around 75 percent of GHG emissions in the US, with a cap more than 2.5 times higher than in EU ETS Phase 2. This will decrease by around 100 Mt a year towards 2050. If it becomes a reality, this will be the largest emission trading scheme in the world. Moreover, the bill suggests allowing international credits to be employed for compliance purposes, primarily EUAs and Kyoto credits. This indicates that there will be a close bond between upcoming regional emissions trading schemes and existing schemes, primarily the EU ETS. The carbon market is still, and will remain, a politically driven market, as supply and demand for credits are determined to a significant degree by political decisions The proposal for a federal US ETS indicates a tighter scheme than we see in the EU ETS. It is interesting then, that most of our survey respondents do not think that a federal US ETS will be particularly ambitious. Two-thirds of our survey respondents say that EU ETS will result in internal abatement. Taken together, our surveys in January and April 2007 and JanuaryFebruary 2008 indicate that at least two-thirds of EU ETS companies are involved in or are planning emission reductions of some kind. These efforts are yet to be seen in the verified emission data.

The importance of the carbon market for its participants is clearly seen from the long-term investment perspective. 73 per cent of EU ETS survey respondents agree that the carbon price is relevant to investment decisions. Only 6 percent say the carbon price has no impact on new investments. Besides the compliance markets, primarily connected to the Kyoto Protocol, a voluntary carbon market has emerged. Although it is still limited in size, only 10 percent of the respondents to our survey find the voluntary market to be transparent. Moreover, less than 30 percent think the voluntary carbon market produces real emissions reductions, while more than 40 percent believe that the voluntary carbon market poses a risk to the reputation of the compliance markets. Having said that, a majority of the respondents think that the voluntary market is more mature now than it was a year ago. It is fair to say that the main activities and trades in the carbon markets years ahead will be in connection with compliance schemes - either determined through an international agreement or national or regional schems independent on an post2012 agreement. Given the development of an increasingly interlinked global carbon market, we asked our survey recipients the following question: “Will there be a global reference price for CO2 emissions in the year 2020? The existence of such a price (regardless of its level) would be a reliable indicator of policy success. Seventy-three percent of our sample think that there will be a global reference carbon price in 2020.

The respondents expect the EUA prices to rise towards 2020. In Carbon Market Survey 2007, the respondents estimated that the EUA price in 2010 would be around €18/tonne. This year, the average EUA price forecast for 2010 has increased by €6 to €24/tonne. Going further, the average EUA price in 2020 was estimated by last year’s respondents to be €25/ tonne, while the 2020 price estimate given this year has increased to €35/tonne. Thus, there is a bullish impression of carbon market development in the last year, both from a short term (2010) and a long term perspective (2020).

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11 March 2008

Foreword Developments witnessed over the past year, as well as developments so far in 2008, signal a new era for the carbon markets. We have now entered the first year of the first commitment period under the Kyoto protocol, and also the first year of the second phase of the EU emissions trading scheme. Companies operating in the European carbon market now (at least in most cases) know their compliance requirements until 2012, and can base their trading and investment decisions both on day-to-day changes in fundamentals and expectations about the future. The recent proposal from the European Commission also provides greater insight into the development of the market until 2020, although the uncertainties will remain for still some time. When we published the previous version of this report, in March 2007, we noted that climate change and carbon markets were the subject of “record high public interest”. Little did we know that the rest of 2007 would bring with it even greater interest from media, decision makers, and the general public. Particular mention should be given to the Nobel Peace Prize being awarded jointly to the Intergovernmental Panel on Climate Change and Al Gore, our keynote speaker at last year’s conference. We are both honoured and privileged to have chairman of Nobel laureate IPCC, Dr. R. K. Pachauri, with us for this year’s conference. The results from our annual survey, and presented in this report, highlight three things in particular. First, there seems to be a generally bullish sentiment on carbon, not necessarily reflected in current market prices. Survey respondents now on average expect the 2010 price to be €6 higher than they did a year ago. The expectation for a 2020 price has increased even more, and now stands €10 higher than it did last year. In our view, this demonstrates that market participants now realise that the EU ETS will face a real and considerable shortage, and that much of this will have to be met through reductions taking place in Europe.

upon before the end of the Kyoto period. In our view, getting the United States on board will be vital for a new agreement. Interestingly, survey respondents do not necessarily agree, with about 77 per cent expecting an agreement to be reached regardless of whether or not the U.S. participates. However, more than half of the respondents expect the U.S. to take on reduction commitments and to participate in a new agreement. Finally, the results from our survey confirm that carbon prices are now seen as an important factor in the operating and investment decisions of companies. Over two-thirds of survey respondents claim that the EU ETS has caused emission reductions of some kind, either already implemented or at the planning stage. While this might be good news for the development of greenhouse gas emissions in Europe, we expect to see similar developments in other places around the world in the years to come. Over 72 per cent of the survey respondents expect there to be a global reference price for carbon by 2020. As the world increasingly takes into account the cost of emissions, and the value of reductions, the carbon market will continue to incentivise investments in cleaner technology and emission reductions. And in the end, that is what this market is supposed to lead to. You can read more about these findings, and a lot more, in this report. We believe that this report presents the most up-to-date and comprehensive analysis for the carbon market as a whole. It certainly represents the global analysis work that takes place in Point Carbon every day, and we hope you will find it both interesting as well as inspirational.

Per-Otto Wold CEO Point Carbon

Secondly, once again the survey respondents seem optimistic that we are moving towards a global carbon market and that the international community will be able to agree on a new climate agreement from 2013 onwards. More than 70 per cent of respondents see it as likely that a climate agreement for the post-2012 period will be agreed

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Carbon 2008

Table of contents 1

Introduction

1

2

Carbon markets and policies in 2007

3

2.1

Overview

3

2.2

EU ETS

6

2.3

CDM

17

2.4

JI

19

2.5. Voluntary markets 3

Carbon markets towards 2012

3.1

Expectations for global 2008 volumes

3.2

and trends EU ETS

3.3

CDM market in the Kyoto period

3.4

JI - existing market, deliveries now?

3.5

AAU - large potential, limited supply?

3.6

Regional Greenhouse Gas Initiative (RGGI)

20 23

23 24 33 36 37

39

4

Carbon markets beyond 2012

41

4.1

Towards a new global climate

41

4.2

agreement Carbon markets in North America

44

4.3

Other upcoming markets

46

4.4

Towards a global market?

47

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1. Introduction The initial year of the first Kyoto commitment period (2008-2012) has now begun. Starting this year, the countries listed in Annex B of the Kyoto Protocol (apart from the US) will have to measure, estimate and account for their greenhouse gas (GHG) emissions. Annex B comprises those countries that were considered industrialised in 1992, when the UN Framework Convention on Climate Change (UNFCCC) was negotiated. Phase 2 of the EU Emissions Trading Scheme (EU ETS) also commenced this year, and is scheduled to run alongside the first Kyoto period. Moreover, January saw the release of the EC’s proposal for the structure of Phase 3, extending the EU ETS horizon to 2020. With new financial products and trading strategies, the EU market is about to come of age.

3703 participants in our web-survey this year, up from 2250 in 2007 And yet 2008 is not only the year of Kyoto. This year we expect important developments in US carbon markets in particular. At the state level, we have just seen the first ever GHG compliance trade under the ten-state Regional Greenhouse Gas Initiative (RGGI), and expect much more to come.

At the federal level, a comprehensive and ambitious cap-and-trade is awaiting a Senate floor vote this year, while all the 2008 presidential candidates with a reasonable chance of winning are in support of emissions trading as part of an active climate agenda.

1406 respondents buy, sell or hold EUAs or project credits This report is our third annual presentation of the status of the carbon market. We aim to provide a comprehensive overview of all compliance markets currently in operation, as well as other markets that we believe are imminent. Given the wealth of data available for the Kyoto markets — in particular the EU ETS and Clean Development Mechanism (CDM) — these will be discussed in the greatest detail. However, we will also consider the developments that have been made in Japan, Russia, Ukraine, Australia and — of course — the US. Our report includes information derived from a number of sources. The primary source is Point Carbon’s annual Carbon Market Survey, which ran from 18 January to 6 February 2008, using a web-based survey tool. In total there were 3 703 respondents, compared to 2 250 last year and 800

Figure 1.1: Trading EUAs and CERs N=1462. Respondents saying they buy/sell/hold EUAs and/or CERs CER project developer/aggregator Company with emissions regulated under the EU ETS Financial institution/bank

Other

Government Company covered by CO2 regulation other than EU ETS 0%

5%

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

Source: Point Carbon

1

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Carbon 2008

Figure 1.2: Most of the respondents come from... Top 15 countries (out of 101 with responses). N=2291.

United States

12.7% 12.3%

United Kingdom 6.2%

India 4.7%

Germany France

4.1%

Australia

3.8%

Canada

3.8% 3.2%

Brazil

2.8%

Japan Netherlands

2.8%

Norway

2.7%

Italy

2.7% 2.4%

Spain China

2.2%

Belgium

2.1% 0

50

100

150

200

250

300

350

Source: Point Carbon in 2006. Of this year’s respondents, 1 462 (~40 percent) stated that they are involved in European Union Allowance (EUA) or Certified Emission Reduction (CER) trading, or own EUAs/CERs. Figure 1.1 below shows the distribution of respondents among this subset. Of the 1 462 respondents holding or trading EUAs/ CERs, 473 work for companies with emissions regulated under the EU ETS, with about the same number for CDM project developers/aggregators. Some 220 respondents represent financial institutions.

Almost 50 % of respondents located in Europe, down from 55 % last year Our typical respondent has a degree in either engineering or finance/economics, while 13 percent hold a PhD. Two-thirds are between the ages of 25 and 44. The largest number of respondents is found in the US — a total of 292; the other countries with

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three-digit response totals are the UK (281), India (142) and Germany (107). In total, 101 countries are represented and almost 50 percent of the respondents are located in Europe.

Carbon Market Survey 2008 is the main source of information In addition to the Carbon Market Survey 2008, this report is based on Point Carbon’s in-depth analyses of international climate policy and the carbon market in our publication series: Carbon Market Analyst (CMA), Carbon Market Monitor (CMM), Carbon Market Brief (CMB) and Carbon Policy Update (CPU) in particular; as well as on Point Carbon’s proprietary databases, models and applications: Carbon Market Trader (CMT) and Carbon Project Manager (CPM). The outline of this report is as follows: Chapter 2 provides a review of carbon market developments in 2007. We report traded volumes and values, price drivers and evaluations of the EU

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11 March 2008

ETS, CDM and Joint Implementation (JI) markets. We also provide statistics on buyers, sellers and project types in the CDM. The chapter ends with a discussion of recent developments in voluntary carbon markets, emphasising the US position.

2. Carbon markets and policies in 2007

Chapter 3 presents our expectations for the global carbon market in the Kyoto period and for 2008 in particular. We discuss the policies providing the framework for the EU ETS and much of the CDM and JI markets, with a focus on decisions and proposals by the European Commission (EC). We also suggest what to expect from the RGGI market in 2009, and discuss the likelihood that Assigned Amount Units (AAUs) will start trading in 2008.

Climate change was at the top of the global agenda in 2007, most notably following publication of the Intergovernmental Panel on Climate Change’s (IPCC) fourth assessment report (4AR). The report stated that climate change was “unequivocal” and made it extremely difficult for anyone to remain a climate sceptic.

Chapter 4 looks at the emerging landscape of the carbon world after 2012. We begin by presenting our analysis of the events of the Bali conference in December 2007. Recognising that US action is a sine qua non for serious international action on climate change, we then outline domestic proposals for emissions trading in the US, both at the federal and state level. We also assess the likelihood of domestic emissions trading in other countries, notably Japan. Finally, we ask whether a global carbon market will exist in 2020, and if so, what the price of carbon might be 12 years from now.

2.1 Overview

Moreover, former Vice President Al Gore’s documentary film, An Inconvenient Truth, brought the climate issue to the masses worldwide. Governments across the world have been forced to take action as a result of the change in public opinion on climate change and increased media coverage.

2.1.1 The carbon markets In the carbon market, equally important events have taken place. The total traded volume in the global carbon market grew from 1.6 Gt (1.6 billion tonnes) in 2006, to 2.7 Gt in 2007 — an increase of 64 percent (see Figure 2.1). The value of the carbon traded grew even more, by 80 percent in the same period, from €22bn ($33bn) to €40bn ($60bn).

Figure 2.1: Stairway to ‘07 Annual contract volumes 2005-07 in billion tonnes (Gt) CO2 equivalen 5

4

Other 56%

Annual volume (Gt)

JI 3

CDM total EU ETS total

64%

2

104% 1

0 2005

2006

2007

Source: Point Carbon

3

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Carbon 2008

The EU ETS is still by far the largest carbon market worldwide, with 62 percent of the physical market and 70 percent of the financial market (Figure 2.2). The EU ETS grew over the course of 2007, with a traded volume of 1.6 Gt and a value of €28m. This represents a volume growth of 62 percent and a value growth of 55 percent from 2006.

EU ETS still by far the largest carbon market worldwide Activity within Kyoto’s flexible mechanisms — specifically the Clean Development Mechanism (CDM) — grew more than expected in 2007. In total, the CDM market increased from 563 Mt and €3.9bn in 2006 to 947 Mt and €12bn in 2007. This is an increase of 68 percent in volume terms, and a staggering 199 percent in value terms from 2006, and in total constituting 35 percent of the physical market and 29 percent of the financial market. Within the CDM, the growth of the secondary CER (sCER) market has been the most impressive, starting in the first months of 2007 and growing to around 300 Mt over the whole year. This represents a remarkable increase from 2006, much of which is related to EUA-CER swaps. With the growth in sCER trading, the total CER market could well overtake the EUA traded volume in 2009 or 2010.

ERU volumes almost doubled in the Joint Implementation (JI) market, from 21 Mt in 2006 to 38 Mt in 2007. Furthermore, higher ERU prices meant that the value of the JI segment more than tripled, from €95m in 2006 to €326 in 2007. Financial players joined the carbon market in force in 2007. We have seen US hedge funds take positions in the market, especially in options and long CER

CDM market increased to 947 Mt and €12bn in 2007 positions. Towards the end of the year, NYMEX, the world’s largest physical commodities futures and options exchange, announced that it would join the market by launching its own CO2 emission products. This move by NYMEX indicates at least two things: First, carbon trading is about to enter the mainstream in the US. Second, major market players are confident that GHG emission trading is about to take off in the US, whether at the state level (RGGI, the West and Midwest), at the federal level, or both. That being said, current activity in existing Australian and US carbon markets did in fact decrease from 2006 to 2007. Most significantly, total traded value is down 63 percent, to €186m in the mandatory New

Figure 2.2: Still dominated by the EU ETS Distribution of 2007 traded volume (left) and financial value (right) across the main market segments.

Total financial value: €40bn

Total volume: 2.7 Gt

CDM secondary 13%

JI 1%

Other 2%

CDM secondary 14%

JI Other 1% 0.5%

CDM primary 15% CDM primary 22% EU ETS 62%

EU ETS 70%

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11 March 2008

South Wales market and on the voluntary Chicago Climate Exchange. With total volume almost unchanged, this fall is largely due to carbon price drops in both markets and the fall of the US dollar.

2.1.2 Carbon policies Although we are just at the start of EU ETS Phase 2, the ongoing review process for Phase 3 has already produced a number of concrete suggestions from the European Commission (EC). For example, it already seems clear that the cap will be considerably tighter than in Phase 2, as the overall emissions in the EU ETS in 2020 are expected to be capped at around 21 percent below the 2005 level.

EC suggest EU ETS emissions to be 21 percent below 2005 level In addition, the EC suggests reducing the level of free allocation linearly towards zero in 2020. All allowances allocated to the power and heat sector will be auctioned as early as 2013. Moreover, before a new international agreement is finalised, the credit limit for the 2008-2012 period is effectively extended to also cover the 2013-2020 period, and no additional import of credits is permitted. Once a future international climate agreement has been reached, CERs from countries that have ratified the

agreement will be accepted in the EU ETS up to a limit. In general, 2007 has been a good year for the EC. Having had to endure criticisms over its initial handling of the EU ETS, the Commission showed determination in cutting allocations and credit limits in Phase 2 NAPs, as well as in pushing for the inclusion of the aviation sector in the trading scheme.

No additional import of credits permitted unless satisfactory agreement At the beginning of 2008, the EC also finally seemed much more likely to succeed in harmonising the total EU cap and auction a much greater share of allowances in Phase 3 – an agenda it has been promoting for years. Outside the Kyoto markets, important progress was made towards domestic emission trading, in the US in particular. At the state level this is due to the Regional Greenhouse Gas Initiative (RGGI), the 10-state scheme due for launch in 2009, and in the Western region led by California. A federal capand-trade bill sponsored by Senators Lieberman and Warner moved through both subcommittee and committee in November and December.

Figure 2.3: Ups and downs in 2007 Quarterly volumes and values in the EU ETS 2007, million tonnes and € million 450

8,000

3% -12%

17%

400

14%

7,000

8% 350

6,000 80%

300

4,000 200

€ mill

Mt CO2

5,000 250

3,000 150 2,000

100

1,000

50 0

0 Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Source: Point Carbon

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Carbon 2008

Crowning the events of the year, the Bali climate summit produced a mandate to launch negotiations for a global post-2012 framework. At the summit, all UNFCCC member countries — including the US — agreed to negotiate a successor to the Kyoto protocol.

Australia and the US turned towards climate regime in 2007 This feat was made possible by a change in the US position earlier in the year. The turnaround was first evidenced at the G-8 summit in June, when the Bush administration announced its intention to return to the negotiating table. While this decision may not be rooted in a heartfelt desire to take decisive action on climate issues, it is certainly a positive step towards kick-starting the international process under Bush. If nothing else, laying the groundwork in this way will make progress faster under the next administration and progress with the Lieberman-Warner bill will facilitate this. The new Australian Government is also planning to speed up the introduction of a national ETS.

2.2 EU ETS The EU ETS was the main driving force of the global carbon market in 2007. This dominance was underlined by the trades in sCERs — estimated at around 17 percent of the market in 2007 — as this market is propelled by EUA – sCER swaps. Although the excitement of Phase 1 was long gone by 2007, it was still an important year for the EU ETS.

Secondary CERs took around 17 percent of the market in 2007 The final rulings of the National Allocation Plans (NAPs) were made, and the EU ETS review crucial for the shape of Phase 3 was finalised. Hence, much of the uncertainty for the future phases of the EU ETS was removed, although the final agreement on the Directive review is still at least 1 year away.

2.2.1 Volumes and values 2007 saw healthy growth in the OTC market and on the exchanges, with a daily average traded volume of around 5.6 Mt. As shown in Figure 2.1, volumes have increased annually since 2005. The total volume traded in the 2007 EU market, excluding exclusive direct bilateral trades (company-to-company) , was 1 443m EUAs. Of this, around 1 Gt (~70 percent) was

Figure 2.4: No changes on the exchanges Monthly EUA volumes transacted on exchanges. Last year’s figures in parentheses. 50 45 40

ECX Powernext Nord Pool EEX EXAA

86.7% (75.6%) 5.5% (13.3%) 6.3% (7.4%) 1.4% (3.1%) 0.0% (0.1%)

35

Mt CO2

30 25 20 15 10 5 0 Jan

Feb

Mar

Source: Point Carbon

6

Apr

May

Jun

Jul

Aug ECX

Sep Powernext

Oct

Nov

Nord Pool

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Dec EEX

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11 March 2008

Figure 2.5: Volumes and prices in the EU ETS 2004-07 Daily OTC prices using Point Carbon’s bid/offer methodology.

Volume

EUA 2007

30

EUA 2008

sCER08

20

€ / tonne

25 20 10 15 10

Million EUAs traded

35

5 0 1/12/04

0 6/9/05

14/6/06

21/3/07

28/12/07

Source: Point Carbon's Carbon Market Trader

traded in the brokered over-the-counter (OTC) market and the remainder was traded on the exchanges. Quarterly volumes were relatively stable, with a peak in Q3, while the value of transactions increased as Phase 2 contracts took over and prices increased — see Figure 2.3.

European Climate Exchange (ECX) accounted for 87 percent of market Of the exchanged volume, the London-based European Climate Exchange (ECX) accounted for 377 Mt, or 87 percent. This was up from 76 percent in 2006, thus cementing its dominance in this market – see Figure 2.4. The other exchanges consequently show lower volumes, but Oslo-based Nord Pool (6.3 percent) was the second largest in 2007, with the French Powernext third, with 5.5 percent. The share of the exchanges has increased in recent years, with 20 percent of the market in 2005 and 30 percent in 2007. In addition to OTC transactions and trades on the exchanges, there still is a significant volume traded bilaterally (company-to-company), and the combined total of all transactions in 2007 was around 1 650 Mt.

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2007 also marked the end of Phase 1 of the EU ETS, falling from a €4 level at the beginning of the year to €0.03 in December. As seen from Figure 2.5, the fate of the EUA Phase 1 allowances was sealed as early as April 2006 and reconfirmed through the verification of 2006 emissions in April 2007. Since October 2006, Phase 2 contracts have been the only ones that have deserved any attention. Over the course of 2007, Dec 08 EUAs traded in a range between €12.25 and €25.28. The contract closed at €17.55 on the first trading day of the year, then declined to the year’s lowest point on 20 February. The Dec 08 EUA then grew rapidly, at over €4 per month, until the high of €25.28 was reached on 29 May. Subsequently it fell below €19 twice, in July and August, before remaining largely within the €20-24 range for the rest of the year and closing at €22.43 on 31 December.

Around 1 650 Mt traded in EU ETS in 2007, sCER excluded The decline in the EUA price early in the year was caused by falling power and gas prices, which produced lower coal-to-gas switching levels, as well as by a mild (or even absent) winter that depressed both Phase 1 and Phase 2 contracts.

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Carbon 2008

Figure 2.6: UK carbon-adjusted dark and spark spreads in 2007 Forward prices for delivery in Q2 and Q3, 2008. The chart shows the theoretical profits from standard coal and gas power plants, based on fuel, power and carbon prices. 30

20

25 15

€ / tonne

 / MWh

20

15

10

10 5 5

0

0

2-Jan-07

7-Mar-07

15-May-07

20-Jul-07

Dark spread summer 08

25-Sep-07

Spark spread summer 08

28-Nov-07 EUA Dec 08

Source: Point Carbon's Carbon Market Trader

Figure 2.7: German carbon-adjusted dark spread Forward prices for delivery in 2008. Dates: 11 Dec 2006 -- 20 Dec 2007

25

30

25

20

15 10

€ / tonne

€ / MWh

20 15

10 5

5

0

0

11-Dec-06

14-Mar-07

20-Jun-07

Clean dark spread Cal 08

19-Sep-07

19-Dec-07

EUA Dec 08

Source: Point Carbon's Carbon Market Trader

8

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11 March 2008

Figure 2.8: EUA price correlation with fuel and power Correlations with the EUA December 2008 contract

1 0.8 0.6 0.4 0.2 0 Feb-07 -0.2

Apr-07

Jun-07

Aug-07

Oct-07

Dec-07

-0.4 German cal 08

-0.6 -0.8 -1

Correlations: Cal08: 0.78 NBP: 0.42 Crude oil: 0.26

As can be seen from Figure 2.6, gas was in the money against coal for most of 2007, and particularly in the April-October period. Carbon-adjusted profits for coal generation (dark spreads) and gas generation (spark spreads) for UK power delivered in the summer of 2008, traded mainly inside a band of £5-10/MWh until mid-November, when both shot upwards.

Cal08 and Dec08 EUA correlated fairly well in 2007 The subsequent bull-run came on the back of a lingering hot summer scare, pushing up German power for Q3 2007 and Cal 08 delivery, and Dec 08 EUAs along with it. A strict ruling by the EC on the Italian NAP, as well as other NAP cuts, boosted the bullish sentiment as Phase 2 looked progressively more likely to be short. In addition, there were fears of a possible CER crunch in 2008, including but not limited to worries about delivery through the international transaction log (ITL). After the peak in May, the trading range narrowed for the rest of the year, as the NAP process had established the Phase 2 allocation while coal, gas,

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NBP summer 08 Crude oil front month

oil and power prices balanced each other in keeping the EUA stable. Forward prices for delivery in Q2 and Q3, 2008. The chart shows the theoretical profits from standard coal and gas power plants, based on fuel, power and carbon prices. The German carbon-adjusted dark spread for the 2008 calendar year saw a different development, declining steadily through the year, see Figure 2.7. The highest price of the year – €19.10/MWh – was seen on 11 January. On 27 November, however, the profit made by German generators of coal-fired power was down by more than two-thirds at €7.21/ MWh, the year’s lowest price. The vast majority of EUA trading activities in 2007 were forward contracts for Phase 2. Figure 2.8 shows the correlations between fuel and Dec 08 EUA contracts. The Cal 08 contracts correlated quite well with the Dec 08 EUA contracts, being 0.78 on average in 2007. Gas and oil correlations were considerably lower at 0.42 and 0.26, respectively. Correlation to Dec 07 contracts were absent as the price for these was marginal throughout the year.

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Carbon 2008

Figure 2.9 Assessing the EU ETS Share of respondents agreeing with the given statements (options 4 and 5). The number of respondents is between 800 (in 2006) and 3,479 (in 2008).

2008 2007 2006

EU ETS is a mature market

EU ETS is the most costefficient way to reduce emissions [in the EU]

EU ETS facilitates emissions reductions [in the EU]

EU ETS is a success

0%

20%

40%

60%

Source: Point Carbon

The Dec 08 sCER closed at €15.70 on 21 May, when our records began. It traded at a discount of more than €7 to the Dec 08 EUA for most of June, with the spread going as high as €7.98 on 4 June. The average Dec 08 sCER price in 2007 was €16.37. The other OTC sCER contract tracked by Point Carbon, the “Kyoto strip” for delivery each December of the 2008-2012 period, traded at an average €16.50 during our seven months of records in 2007. This indicates a real backwardation in the sCER market, as the spread between the Dec 08 and the Kyoto strip is much less than the cost of carry. Indeed, the backwardation was absolute throughout most of August, as the Dec 08 sCER was valued above the Kyoto strip. The most general explanation for this phenomenon is concerns for a CER supply crunch in 2008 and 2009, and good supply in later years.

2.2.2 Does the EU ETS work? The launch of the EC’s proposal for a climateenergy package clearly showed that in the future more emission reductions will take place in the EU, particularly if a “satisfactory” international agreement is reached following the Kyoto Protocol. This begs the following questions: are companies

10

ready for this and do we see any signs of internal abatement due to EU ETS? A series of questions that Point Carbon has been asking annually since 2006 could prove instructive. Respondents are asked to choose one alternative on a scale from 1 (“completely disagree”) to 5 (“completely agree”). We count options 4 and 5 as agreement, options 1 and 2 as disagreement, and the middle option 3 as neither agreement nor disagreement — see Figure 2.9.

Respondents: EU ETS significant more mature now than one year ago The results are almost the same in 2008 as in 2006 and 2007. The only exception is the statement “EU ETS is a mature market”, which has gained a somewhat higher score this year (although it is still fairly low). The answers to the question on emissions reductions have not changed markedly in the last three years. Obviously, in the case of the statement “EU ETS facilitates emissions reductions”, the question is where – within the EU or in CDM/JI countries. This

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Figure 2.10 Sector emissions-to-cap (E-t-C) in 2006 compared to 2005 E-t-C calculated using verified emission data and aggregate installation-level caps in each sector. Positive numbers signify greater emissions than allowance allocation. 

 

  



 



 



 



 

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 











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

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













Figure 2.11: Changes in EU ETS emissions at country level, 2005-2006 Top five increases and decreases in absolute terms. 

   

 

  

 





 













 





11

  

  



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

Point Carbon

Carbon 2008

year we made the question more specific, asking whether “EU ETS facilitates emissions reductions in the EU”. The answers were rather similar to 2006 and 2007, with more than 50 percent of the respondents agreeing with this statement. But can these emission reductions also be seen from the verified data from 2006?

What do the verification data tell us? The verified 2006 emissions increased to 2 028, up 22 Mt (1.1 percent) from 2005. At the sector level, 2006 saw the same picture as in 2005: a short power sector and long industry sectors. The higher emissions can be explained mainly by production growth, but fuel prices and weather also contributed. Lower hydro production meant higher emissions in the Nordic region, but the opposite situation in Iberia.

20 percent of respondents use trading as primary compliance strategy Figure 2.10 compares 2005-2006 emissions aggregated by sector for EU-23. Of the 22 Mt emissions growth from 2005 to 2006, 12 Mt were accounted for by the sector comprising public electricity and heat production (power and heat),

whereas an additional 10 Mt were emitted by the industry sectors. The metal and cement/lime/glass sectors emitted 7.5 Mt and 6 Mt more in 2006, respectively. Installations in the oil and gas sector emitted 1.5 Mt less, “others” emitted 1.4 Mt less and the pulp and paper sector emitted just 50 kt more in 2006 than in 2005. Despite the higher emissions, there was still a comfortable surplus of allowances in 2006.

Verified emissions increased 1.1 percent from 2005 to 2006 Most countries that had surpluses in 2005 also had surpluses in 2006, with Denmark as a notable exception. Figure 2.11 shows the countries with the greatest changes in emissions from 2005 to 2006. More than half of the countries included in the first phase — 13 in total — saw small changes that fell between a reduction of 2 Mt and an increase of 3 Mt. The increased emissions in Finland and Denmark in particular, were due to low hydro levels in the Nordic region in the first three quarters of the year, and consequently lower hydroelectric production. In the UK, coal consumption for power generation

Figure 2.12: Compliance strategies in the EU ETS N=451. Companies with emissions covered by the EU ETS. Reducing our own emissions (internal abatement) Trading

Developing CDM/JI projects A combination of the above

Other

0%

10%

20%

30%

40%

50%

Source: Point Carbon

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11 March 2008

was 11 percent higher in 2006 than in 2005, growing from 33 to 37 percent of total electricity production. Conversely, gas-fired generation, which produces less than half the amount of emissions than coal, was down by 8 percent. Fuel price changes alone would explain only a small part of the increase in emissions. NBP gas prices for spot delivery went up four percent from an average 40.27 pence per therm in 2005 to 41.94 pence per therm in 2006. At the same time, API2 coal for spot delivery in Europe was up five percent from US$ 60.72 on average in 2005, to US$ 63.77. These changes are more or less in line with inflation.

Fundamentals can to a large extent explain the increase in 2006 emissions Unlike in 2005, when gas-fired generation in the UK was slightly more profitable than coal-fired generation during the entire summer season, coal was consistently in the money against gas throughout 2006 in the UK. Coal-fired generation was helped in part by a reduction in the average summer carbon price (Q2 and Q3) from €21.04 in 2005 to €17.91 the following year. Given the relatively small changes in fuel prices, the lower carbon prices are likely to have played a substantial part in this role reversal.

On the surplus side, improved hydrology in Iberia and France, combined with a mild winter as well as a temperate summer in continental Europe, account for the falling emissions in Portugal, Spain and France. Spain in particular saw hydroelectric generation increase by 32 percent and combined cycle gas-fired generation go up by 30 percent, while coal-fired fell by 15 percent.

Do we see any signes of internal abatement? So far, we have seen the role of fundamentals — fuel prices, demand and weather — in influencing emission levels in 2006. However, emissions are also a function of company behaviour, notably of efforts to reduce emissions. Such efforts need to be ramped up in Phase 2 and Phase 3 of the scheme to achieve tougher overall reduction targets. How will this be done? How much of this has already begun in Phase 1? What did companies do to comply in 2007? Generally speaking, compliance will be a result of internal abatement, trading, offsets development and changes in production patterns. In Figure 2.12 we display the responses to our question asking for a company’s main compliance strategy. Aside from

Figure 2.13: Has the EU ETS caused your company to reduce its own emissions? N=420 (2008) and 447 (2007). Companies covered by EU ETS (2008) or CO2 regulation in general (2007) 50% 2007 40%

2008

30%

20%

10%

0% The EU ETS has not The EU ETS has The EU ETS has Don't know (2008) / caused any emission caused reductions to already caused not relevant (2007) reductions in our be planned but not yet emission reductions in company started my company Source: Point Carbon

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Carbon 2008

Figure 2.14: The EU ETS and current investments at company level “Has the price of carbon influenced the degree of new investments in your company?” N=385/312. Companies covered by EU ETS (2008) or CO2 regulation in general (2007)

Yes

To some extent

No

0%

10%

20%

30%

40%

2008

Source: Point Carbon

50%

2007

the combination and “other” strategies, the most frequent is internal abatement. We will return to this strategy below.

introduced some measures to reduce emissions (Table 2.1). These measures were found particularly in the form of fuel switching or energy efficiency.

Abatement

We also asked about abatement in our 2007 and 2008 carbon market surveys. The results of these surveys are given in Figure 2.13. Compared to last year’s survey, there is very little change in the share of companies that report reducing or planning to reduce emissions because of the EU ETS. Last year,

The verified emissions do not show indications of large-scale abatement in the EU ETS. Emissions are up in all sectors except for oil and gas. Nevertheless, 71 percent of the companies represented in a Point Carbon survey conducted in April 2007 had already

Table 2.1: Reported reduction activities by sector in the EU ETS Reported emission reduction efforts by sector, weighted by 2005 emissions. The percentages indicate the share of companies that have done something to reduce emissions in 2006, not the level of such reductions. Total volume represents the 2005 emissions of respondents’ installations.

Sector Power&heat

14

Energy saving

Fuel switch

Process

Output red.

31%

34%

23%

12%

Metals

19%

2%

54%

25%

Oil/gas

42%

10%

5%

42%

Cement/lime/glass

22%

37%

35%

5%

Pulp/paper

47%

21%

14%

17%

Other

38%

19%

13%

30%

Total

31%

27%

25%

17%

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11 March 2008

Figure 2.15: The role of long-term carbon prices at industry level “Has the price of carbon influenced the degree of new investments in your company?” N=385/312. Companies covered by EU ETS (2008) or CO2 regulation in general (2007)

Decisive factor

Influencing calculation, but not decisive

No importance

0%

10%

20%

30%

40% 2007

Source: Point Carbon

50%

60%

2008

Figure 2.16: You can run… “Has your company considered moving production outside the EU ETS area because of carbon costs?” N=380. Companies covered by the EU ETS.

No

Yes, are considering moving production

Yes, have planned to move production

Yes, have already moved production

0%

20%

40%

60%

80%

100%

Source: Point Carbon

15

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Carbon 2008

65 percent of companies said they had done so; this year the figure is 62 percent. Taken together, our surveys in January and April 2007 and January-February 2008 indicate that at least two-thirds of EU ETS companies are involved in or are planning emission reductions of some kind. The larger question, of course, is how much these will deliver.

Production improvements and investments To gauge the impact of the carbon price on company behaviour, we asked three questions in Carbon Market Survey 2008 relating to: 1. the current effect of the carbon price on the respondent’s company’s investment;

2. the long-term effect on investments in the respondent’s industry; and

unchanged from last year. Again, only companies with obligations under the EU ETS are included in the sample. When it comes to moving production, 83 percent of our respondents’ companies had not considered doing so (Figure 2.16). However, the sample here includes all EU ETS compliance companies, including power companies that cannot move easily. Consequently, the number for industrials could be higher than the 17 percent that have, plan or are considering moving production outside the EU ETS area.

73 percent consider cost of carbon in investment decisions

In the companies of individual respondents, the carbon price is relevant to the investment decisions of 73 percent of the EU ETS companies, unchanged from 2007 (Figure 2.14). Here we asked whether the price of carbon has influenced the degree of new investments.

Aside from internal abatement, trading and changes to production location or volumes, a compliance strategy mentioned by a small proportion in Figure 2.12 is the development of CDM and JI projects. This is a strategy that is typically pursued by large power companies among those with EU ETS compliance obligations. Just as importantly, dedicated project developers provide the carbon market with credits at a lower cost than EUAs.

In a similar vein, only six percent of our 385 respondents said that the long-term carbon price (to 2020) had no impact on new investment in their industry (Figure 2.15). This is also virtually

How has the project market fared in our survey? What is the view of the CDM and JI today, and their prospects for the future? This will be the topic of the next section.

3. relocation as a possible effect of a carbon price.

Figure 2.17: Who are they and what do they want? The relative share of categories of CDM buyers (left) and project types (right) in 2007

Waste 10%

Fund 18%

Government 4%

Energy efficiency 20%

Fuel switching 1%

Renewable energy 29%

Fugitive emissions 10%

Source: Point Carbon

Private 78%

Unknown/other 7% LULUCF 1%

16

HFC-23 14% N2O 8%

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11 March 2008

2.3 CDM Activity within Kyoto’s flexible mechanisms — specifically the CDM — grew significantly in 2007, to 947 Mt and €12bn. Given that sCER prices are much higher than in the primary market (€16 vs. €10 in our calculations), the increased sCER volume has significantly boosted the total value of the CDM market segment in 2007.

2.3.1 Primary CDM market Some of the increased activity in the CDM market is due to a tripling of issuance rates compared to 2006, with 76.6 m CERs having been issued in 2007. Although 2007 saw a significant increase in inflow of new CDM projects, especially within renewables, there is still a squeeze in terms of expected issuance for the first two years of the Kyoto commitment period (2008-2009).

Significant increase in inflow of new CDM projects in 2007 In early spring, the primary CER market prices for immature projects sprung to about €9-11, but since then the price has been stable, perhaps increasing slightly. The price movement was probably due to a sustained demand for primary CERs. In general, prices in the primary CER market still depend

on project stage, project type and counterparty. Registered projects fetched around €12, while issued CER attracted prices between €14 and €17. Moreover, hydro projects traded at a slight discount due to uncertainty over to what extent CERs from large hydro projects will be usable in EU ETS. Wind projects, on the other hand, fetched a slight premium due to a good and stable performance combined with a high score on sustainability.

Still a squeeze of expected CER issuance in 2008 and 2009 Gold Standard CERs traded at a premium of about €1-2 per tonne. One reason for this was healthy demand combined with low supply, since only four CDM projects have qualified under the standard so far. Supply grew healthily over the year. The UNFCCC`s pipeline of projects surpassed 2 800 projects in 2007, compared to approximately 1 500 a year earlier. However, two notable features were the constant decline in size of projects and the increased influx of small-scale renewable energy projects. Renewable energy was the largest transacted project category in 2007, accounting for 29 percent of total confirmed transaction volume. Furthermore, energy efficiency almost tripled its market share to 20 percent.

Figure 2.18: China in your hand The relative share of CDM country sellers (left) and buyers (right) in 2007

Uzbekistan 2% Mexico 4% India 5%

Chile 2%

Other 7% Austria 3%

Germany 7% United Kingdom 46%

Brazil 8%

Indonesia 10%

Source: Point Carbon

17

Other 10%

France 8%

China 62% Luxembourg 11% Japan 15%

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Carbon 2008

The losers were projects reducing industrial gas emissions. HFC-23 and N2O destruction projects fell from a combined 54 percent of 2006 volume to only 22 percent in 2007. This development should be taken to heart by those who have previously criticised the CDM for channelling money into lowcost industrial gas projects rather than renewables. There was a lot of talk about the market facing a significant bottleneck due to the EB process when several developers blamed the down-writing of their portfolios on the rigorous approval process. There may be some truth to this, but it is certainly not the only factor. Low performance rates for certain project types combined with general project delays have also contributed to the slow issuance rate.

HFC-23 and N2O projects were considerably fewer in 2007 than in 2006 That being said, without reform of the approval process, the market could see yet another year with a low issuance volume. The year did, however, end on a promising note, with a deal in Bali for a thorough review of the CDM process. Private buyers solidify their dominance, with 78 percent of confirmed CDM transaction volume in 2007 — see Figure 2.17. This is up from 58 percent in 2006. These buyers eat into the shares of carbon funds and governments alike,

both of which have seen their relative market share cut in half. On the supply side, China is still bigger than all the rest, although it has inched down from 70 percent in 2006 to 62 percent of transaction volume last year — see Figure 2.18. Brazil’s volume is somewhat up on our last update, whereas India’s volume is down. Interesting newcomers in this league of top seller countries are Indonesia and Mexico.

China still by far the largest CDM selling country The UK reigns supreme among buyer countries, which indicates that a sizeable share of buyers in 2007 were financial institutions rather than compliance buyers. Luxembourg’s 11 percent supports this inference. Japan is second on the list at 15 percent — up from a surprisingly low 3 percent last year — suggesting continued compliance buying by the country’s government, power sector and heavy industry.

2.3.2 Secondary CDM market The gold rush for primary CERs continued throughout the year as numerous new participants entered the market and started competing for market share.

Figure 2.19: Evaluations of the CDM market, 2006-2008 Share of respondents agreeing with given statements. Note: 2007 and 2006 surveys ask about the CDM/JI market as a whole. N= 3176/2016/777. The CDM market facilitates emissions reductions The CDM market is the most cost-efficient way to reduce emissions

The CDM market is a success 2008 2007

The CDM market is mature

2006

0%

20%

40%

60%

Source: Point Carbon

18

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11 March 2008

But unsurprisingly it was the sCER market that attracted most attention. Secondary CER trading was established as a significant market segment of its own in the course of 2007, albeit one still lacking the liquidity of the EUA market. The sCER market has changed almost beyond recognition over the past year, with an estimated total traded volume of 350 Mt compared to 40 Mt in 2006. The Dec 08 sCER contract began the year at €14 but fell throughout the winter months with a declining EUA-price to an all-time low €10.70 in February. By the end of May the price had recovered, peaking at €17.45.

sCERs traded 350 Mt in 2007, up from 40 Mt in 2006 Looking at the EUA-sCER spread, sCERs were trading at 90 percent of the EUA price in the early months of 2007. Back then, many assumed that the two prices would converge. However, recent volatility in the EUA market saw only moderate reaction in the price of issued CERs in the secondary market. On 31 December, Dec 08 sCERs were worth 76 percent of the EUA price (around €17.13) while the 08-12 strip spread was at 73 percent of the EUA price. The market also saw the first CERs traded on an exchange, when Nord Pool launched a CER contract in June. Last year saw some major milestones in the CDM market. The moment we all had been waiting for finally arrived when the international transaction log (ITL) went online and linked the Japanese national registry with the CDM registry. Immediately following this, the first CER spot trade took place. The event removed some of the uncertainty in the CDM market, as the lack of a delivery path had been one reason cited for the CER price discount compared to EUA prices. The CDM Executive Board (EB) made some important decisions last year, the most notable of which was the decision in June to finally approve the guidelines and procedures for Programmes of Activities (PoAs), and their surprising decision in September to approve the “supercritical coal methodology” for using less GHG intensive technologies for energy production based on fossil fuels. Both decisions sent positive supply signals to the market. On the other hand, the EB’s lack of agreement on several proposed biofuel methodologies constituted signals in the opposite direction.

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Moreover, the UNFCCC secretariat received greater resources and took on more people to help the EB in 2007. This gave the EB more time and capacity to scrutinise projects and the request for review at both registration and issuance stage increased significantly, with a total of 100 projects put on review throughout the year, compared to 23 in 2006. Also, the additionality criteria have been interpreted more strictly by the EB than in previous years. Throughout the year, a total of 43 projects were rejected. How well does the CDM market work? For the third time, we asked our respondents to provide a general evaluation of the project market — this year with specific questions about the CDM (and JI). The results show continuity above all. Respondents see some more maturity in the CDM market, but the level is still low, with only 12 percent agreeing (Figure 2.19). Half the sample still disagrees with the notion that the CDM market is mature.

2.4 JI During 2007, 16 Emission Reduction Purchase Agreements (ERPAs) with a total volume of 12.7 Mt were confirmed by market players. The ERUs for these contracts are generated by projects represented by renewables, nitrous oxide, biomass, energy efficiency and fugitive emissions types. It is notable that the N2O projects account for one-third of total volume, followed by renewables and landfill projects (19 and 13 percent respectively). Early-stage negotiations have been reported by market players in energy efficiency and landfill gas projects. On average, ERU price ranges have increased compared to the previous year, with the price range across contracts becoming narrower. While cited ERU prices for standard off-take contracts varied from €6 to €10 depending on project risk, sellers’ expectations for the ERU price were higher due to the significant increase of CER prices throughout the past year.

N2O projects account for 1/3 of total JI volume in 2007 In 2007, the numbers and volumes of projects submitted to the JI supervisory committee (JISC) for verification were boosted. Overall, 84 projects with a total volume of 117m ERUs were submitted to the JI Supervisory Committee (JISC) for public comment during 2007, taking the pipeline to a total

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Carbon 2008

Figure 2.20: A question of implementation? Evaluation of JI in 2008. Share of respondents agreeing with given statements. N=2965 The JI market is more mature now than one year ago The JI market facilitates emissions reductions The JI market is the most cost-efficient way to reduce emissions The JI market is a success

The JI market is mature 0%

10%

20%

30%

40%

Source: Point Carbon

of 107 projects that are capable of generating up to 34.5m ERUs annually during 2008 – 2012. The projects submitted to the JISC in 2007 are mainly hosted by Russia and Ukraine, representing 42 and 39 percent of total volume, respectively. The Russian pipeline of 42 projects clearly shows the prevalence of natural gas pipeline leakage abatement projects. Taking into account the methodological ambiguities for the measurement of gas leakage emission reduction, potential buyers have to consider the risk of non-approval under Track 2 for a large share of the existing Russian JI pipeline.

Russia and Ukraine still dominating the JI market Gas leakage abatement projects account for almost 34 percent of JI volume in Russia, while nitric acid, landfill and fuel switching projects add up to 40 percent. The Ukrainian pipeline of 16 projects is represented mainly by the large-scale coalmine methane and energy efficiency projects. The Lithuanian and Polish project pipelines with shares of seven and six percent, respectively, are made up mainly by large N2O projects. While the JISC formally started Track 2 in 2007, only one project reached the stage of final determination (corresponding to registration under the CDM). The second project submitted for final determination was refused for review on additionality grounds. The JI potential in the new EU member states was seriously limited by the EU ETS double-counting rules, which leaves room basically only for nonCO2 projects, e.g. N2O and landfill methane.

20

Moreover, the Phase 2 allocation cuts have led to strong opposition and subsequent lawsuits by the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Romania. Bulgaria may also join the case. While the allocation cuts will lead to reductions in JI reserves and set-asides, the most important consequence is that the JI potential in these countries is likely to weaken. As a result, the main JI host countries remain the non-EU members Russia and Ukraine. However, due to the formation of a new Ukrainian government in mid-December, governmental structures such as the National Environmental Investment Agency might see some changes. This could significantly impact JI and GIS development in Ukraine. Respondents to our Carbon Market Survey 2008 think the JI market neither is a success (12 percent) nor mature (6 percent), but one-third of respondents considers the market more mature now than last year (Figure 2.20).

2.5 Voluntary markets How big was the voluntary carbon market in 2007? This market includes the generation and transaction of carbon credits in non-compliance markets. The generation of non-compliance credits — which we will refer to as voluntary offset credit supply — comprises the reduction of GHG emissions for the purpose of selling them to voluntary end users and not to compliance buyers.

2.5.1 Conceptualising the voluntary market The voluntary market reflects the sum of all transactions of carbon credits and allowances, where the final purpose of cancelling or retiring the carbon credit is not to comply with legislation or to fulfil agreements between companies and governments. This definition includes individual and corporate purchases of carbon credits for the purposes of “carbon neutrality” or offsetting particular GHGemitting activities, such as air travel and industrial processes. This also covers activities on voluntary exchanges such as the Chicago Climate Exchange (CCX). The definition of the voluntary carbon market, as seen from a transaction point of view, is illustrated in Figure 2.21. The compliance market consists of companies and governments that by law must surrender emission allowances or credits. The types of credits and allowances that compliance buyers

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Figure 2.21: Much that separates, a little in common? The range of carbon credits available for purchase by voluntary market participants. Note that carbon credits originally generated for compliance purposes could also end up in the voluntary market. NGAC = New South Wales Greenhouse Gas Abatement Certificates.

    



 



   





may use is more constrained than in the voluntary market, which is largely unregulated. The voluntary market, on the other hand, permits the use of credits such as verified emission reductions (VERs), nonverified emission reductions (ERs) and prospective emission reductions (PERs), as well as CERs, ERUs, EUAs and other credits and allowances generated for the compliance market.

Total voluntary volume in 2007 estimated to 75 Mt Our definition excludes trades between project developers and financial institutions, where the final purpose of trading is to supply compliance carbon credits to compliance buyers. It also excludes trades intended to fulfil agreements between the Japanese government and major companies to reduce their GHG emission intensity, even though these are termed “voluntary.” This is because these agreements represent industry-wide commitments intended as a strong alternative to binding targets in reaching Japan’s Kyoto goals, with a view to making legislation unnecessary.

2.5.2 Volumes and values Combining data from brokers and voluntary offset credit providers in the US and Europe, as well as

21

from the voluntary Chicago Climate Exchange (CCX), we find that the voluntary market traded around 55 Mt CO2e in the first three quarters of 2007. The total 2007 volume was an estimated 75 Mt compared to less than 20 Mt in 2006. Our market size assessment indicates strong growth in the voluntary carbon market. Furthermore, in our survey, 45 percent thought that the voluntary market had grown more mature over the past year (see figure 2.22). On the negative side, only ten percent thought of the voluntary market as transparent. A majority of the transaction volume takes place in the US, where more than 30 Mt have traded this year to date, or about 60 percent of the total. The CCX accounts for half this volume, with the remainder made up by the corporate voluntary market and the consumer retail market. Carbon credit prices in the US vary between $2/tonne and $15/tonne, depending on project type.

Prices range from $2/tonne to $15/ tonne for voluntary project credits 2007 was the year in which North American market players announced ambitious carbon strategies, from calculating footprints to developing internal abatement opportunities, or buying, building or

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Figure 2.22: Voluntary carbon: Prospect or peril? Share of respondents agreeing with given statements. N=2998

The voluntary carbon market is more mature now than one year ago

The voluntary carbon market poses a risk for the reputation of the compliance markets

The voluntary carbon market fosters innovation in emission reduction methods

The voluntary carbon market produces real emissions reductions

The voluntary carbon market is transparent

0%

10%

20%

30%

40%

50%

Source: Point Carbon

partnering in developing offset projects. Estimated transactions involving new projects quadrupled in 2007. Subsequently, a fourfold increase is expected for offset credits registered in 2008, while the number of projects from new contractual agreements could slow down or even decline. Outside the US, the voluntary market is strongly influenced by the Kyoto market, with CDM and JI project developers supplying VERs to voluntary buyers. Some offset credit providers also offer CERs for non-compliance purposes. We estimate that voluntary CER transactions will total only 1-3 Mt in 2007, which means that there will be no effect on CER prices. On the other hand, if transparency and standards in the voluntary market do not improve over time, CER demand from voluntary buyers could increase significantly in the coming years.

2.5.3 Supply To satisfy demand, developers are now scrambling to create new projects that meet standards complementing or supplementing the CCX Carbon Financial Instrument. Credits may not be available yet, but the quality of the pipeline, in terms of expected certification through the Voluntary Carbon Standard, Gold Standard, CCB standard, etc, is responding to market demand for offsets from specific project types linked to established standards and methodologies.

22

The voluntary US supply pipeline totals 140 Mt, counting all projects for which we have data. Waste methane and energy efficiency projects dominate the US pipeline in volume terms. Looking at Kyoto projects, potential VER supply from CDM projects has a current maximum volume of 100 Mt to the end of 2007. Voluntary markets have an impact on compliance markets not only by trading the same or similar credits, but also by providing models for emerging compliance markets. In particular, the current pipeline of US voluntary offset supply will influence the volume, type and quality of offsets available to the 10-state RGGI. Current offset providers to the voluntary US market also have a voice in the development of a future US cap-and-trade scheme. We may, for example, see a greater emphasis placed on agricultural projects and carbon capture and storage (CCS) in the US than is currently the case in the CDM or EU ETS. Finally, the quality of voluntary offset credits worldwide will influence public opinion and the reputation not just of the voluntary market, but of emission trading in general. Forty percent of those taking our 2008 survey share this concern, as indicated in figure 2.18. Conversely, 28 percent think there is no significant reputational risk.

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11 March 2008

3. Carbon markets towards 2012 The first Kyoto commitment period, which ends on 31 December 2012, is set to be dominated by the EU ETS and CDM on the market side. The interlinked EU ETS and CDM markets will see the greatest cumulative volume and value, as they are consolidating and getting more sophisticated. In addition, the next five years will see the JI market deliver its first credits and possibly an emerging market in national Kyoto allowances or AAUs. Beyond Kyoto, the ten-state RGGI has already produced the first US compliance trade, and more is expected.

3.1 Expectations for global 2008 volumes and trends The total traded volume in global carbon markets in 2007 was 2.7 Gt, valued at just over €40 bn. We expect this to grow to 4.2 billion tonnes CO2e in 2008, up 56 percent from 2007 – see Figure 3.1. The EU ETS maintains its position as the largest market. Traded volume in the EU ETS is expected to be 2.6 Gt in 2008. At current prices, this would be equivalent to €63bn (US$ 92bn). We expect that the general trend of increasing traded volumes will continue as the global market

becomes more mature and sophisticated. An increase in contract types, more players and markets and greater competition between market players (such as exchanges and brokers) will together generate momentum for higher volumes. As a consequence, liquidity providers will be attracted to this market. On the other hand, turbulence in global financial markets may contribute to less vigorous growth in transacted volumes.

Carbon market expected to grow 56 percent in 2008 We expect that the 2008 carbon market will differ from 2007 in several ways. First, the EU ETS Phase 2 is considerably tighter than Phase 1. Moreover, the start of short-term prompt trading for Phase 2, where only forward trading was seen previously, is expected to contribute to increased traded volumes. Second, the EU climate and energy package, launched on 23 January this year, has sent a potentially bearish long-term signal to the project markets by placing uncertainty on the future of the Clean Development Mechanism (CDM). More immediately, the reduced average credit limits on CER/ERU and the tight Phase 3 are expected to dampen EUA-sCER swaps.

Figure 3.1: Stairway to the first Kyoto period, take 2 Reported and estimated contracts 2005-07; forecast for 2008, Gt CO2e

5 Other

Annual volume (Gt)

4

JI 56%

CDM total 3

EU ETS total

64% 2

104% 1

0 2005 Source: Point Carbon

23

2006

2007

2008 (forecast)

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Carbon 2008

Figure 3.2: Long on shorts. EU ETS company allowances and credit limits compared to expected emissions in Phase 2. N=433. Companies covered by EU ETS. Allocation is sufficient for compliance. We will have surplus EUAs to sell. Allocation is sufficient for compliance. We have no surplus EUAs. Allocation + some of the credit limit needed for compliance. Allocation + full credit limit needed for compliance. Allocation + full credit limit needed. We also need to buy EUAs. Allocation + full credit limit needed. We also need to buy EUAs. We will have surplus CERs to sell/swap. Don't know

0%

10%

20%

30%

Source: Point Carbon

Third, new policies in key countries such as the US and Australia imply that we will see trading in new markets. This will be accelerated by the ongoing negotiations under the Bali action plan.

3.2 EUA market In the EU ETS, which covers about 2.1bn tonnes CO2e annually of underlying assets, new financial instruments are developing and their use is spreading. What are the main developments in the EU ETS market from a trading perspective? What effects does the EU ETS have on company behaviour when it comes to abatement, investment, production and other ways of managing emissions? And beyond current bid/offer spreads, what prices do compliance and financial players foresee for the period?

3.2.1 EU ETS in 2008 The 2007 volume in the OTC market and on the exchanges corresponds to almost five times the annual Phase 2 shortage of about 300 Mt in the power and heat sector. This gap needs to be filled every year. We estimate that in 2008 this volume will increase to about seven times the power and heat gap.

24

There are several reasons why we expect this growth. First, the tightness of the Phase 2 cap is expected to increase the traded volume compared to 2007, simply because more players are short of allowances. Industrials that were long in Phase 1 are in general balanced or slightly in Phase 2, while power and heat installations that were short in Phase 2 have now become even shorter.

EU ETS to trade seven times power and heat shortage in 2008 Figure 3.2 displays the shortness of companies covered by the EU ETS, as reported in our 2008 survey. Only 15 percent of the respondents expect to be long in Phase 2, that is, to have an allocation that is sufficient for compliance and surplus EUAs to sell. About one-third – expected to be in the power sector – will need their full allocation, credit limit and extra EUAs. Shortness will mean more trading since fewer can ignore the EU ETS. As a consequence, Phase 2 volume will go up compared to Phase 1. Second, a tighter cap gives higher volatility because prices become more sensitive to changes in fundamentals. This will be attractive to financial players as well as compliance traders, consequently increasing the traded volume. As seen in Figure 3.3,

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11 March 2008

Figure 3.3: Gearing up for a volatile 2008? EUA volatility and moving-average daily volume (OTC and exchanges) in 2007 and 2008 to date. 10

70%

9

60% 50%

7 6

40%

5 30%

4 3

Volatility

Daily EUA volume (Mt).

8

20%

2 10%

1

30-day MA volume

19/2/08

25/1/08

2/1/08

5/12/07

12/11/07

25/9/07

18/10/07

31/8/07

8/8/07

16/7/07

21/6/07

29/5/07

3/5/07

10/4/07

14/3/07

19/2/07

25/1/07

0% 2/1/07

0

EUA 40-day volatility

Source: Point Carbon's Carbon Market Trader

Figure 3.4: Rapid growth in options Options volume (notional) on the ECX, January 2007 - January 2008. The volume includes options traded on the exchange and options traded elsewhere but cleared on the exchange.

Notional options volume in EUA million

50 45 40 35 30 25 20 15 10 5 Jan-08

Dec-07

Nov-07

Oct-07

Sep-07

Aug-07

Jul-07

Jun-07

May-07

Apr-07

Mar-07

Feb-07

Jan-07

0

Source: ECX

25

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Carbon 2008

wind, precipitation and power outages will have an immediate impact on EUA prices.

Figure 3.5: Options in the EUA and CER markets “Have you bought/sold or will you buy/sell EUA or CER options?” N=1,254. Respondents in the EUA/CER market.

Yes, have bought/sold options

Fourth, Phase 2 will involve significantly more auctions than Phase 1, which will contribute directly to increased transaction volume.

Options trading expected to grow significantly in 2008

Yes, will buy/sell options

Have not/will not buy/sell options

0%

10%

20%

30%

40%

50%

Source: Point Carbon

the 30-day moving average on daily volume in 2007 remained quite stable despite lower volatility in the second half of 2007, while it has increased in 2008 so far, along with higher volatility. Third, the fact that Phase 2 has now begun implies that there will be compliance buying on the prompt, and fundamentals such as fuel prices and weather will contribute to increased volatility. This, in turn, will lead to higher volumes. Factors such as temperature,

Finally, option trading has increased rapidly in the EUA market in the last few months, especially in January 2008 – see Figure 3.4. The EUA options market took off in 2007, with the ECX reporting a notional volume of 58m EUA options (see Figure 3.3). This growth continued into January 2008, which saw 45m EUA options traded on the exchange. Our survey results reflect the penetration of options in the carbon market. Figure 3.5 demonstrates how 55 percent of our respondents in the EU ETS and CDM markets have either entered or plan to enter the options market. CER project developers and aggregators are the most active in the options market – almost two-thirds of this group state that they have traded options or plan to do so. In the EU ETS, this was the case for around half of the respondents.

Figure 3.6: The final cut Comparable caps in Phase 1 and Phase 2. Includes EU27 and Norway 2,500

2,300

Mt/year

2,100

1,900

1,700

1,500 Phase 1 cap

Phase 2 Submitted

EC Cuts

Final phase 2 cap

BAU Emissions

Source: Point Carbon

26

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11 March 2008

Financials or companies with an EUA allocation may either hedge their EUA positions directly through options, or as part of structured EUA-sCER swap deals. Options are attractive for liquidity providers, as they do not require the provider to take a position in the underlying commodity.

3.2.2 Towards 2012 – and beyond

Option trading is expected to increase as volatility grows, and the hedging and re-hedging of options also produces significant trading volume of EUA forwards.

The initial shortage in the 2008-2012 period creates a demand for real emission reductions, either at home or in non-Annex 1 countries.

Despite the growth momentum in the EU ETS, there are also factors pulling against the volume. For instance, industrials are likely to reduce their EUAsCER swap trades due to the stricter credit limit proposed by the EC. Viewed in isolation, this will reduce the transacted volume. On the other hand, less swap trading could mean a higher EUA price, as fewer credits will be available in the market. This could cause growth in volume that outweighs the relative decline in EUA-sCER swaps. Our 2008 forecast for the EU ETS is comparable to the underlying assets, i.e. the total 2008 allocation. In comparison, the turnover in mature markets, such as the Nordic power market and the oil market, is 6700 percent. In this context the carbon market is still a young market with a considerable upside.

In its rulings on Phase 2 national allocation plans, which took place from November 2006 to October 2007, the EC was unquestionably tough. As a consequence, the caps in 2008-2012 are much tighter than in Phase 1.

The overall cap for Phase 2 for EU-28 (EU-27+Norway) is currently at 2 103.5 Mt/year. In total, the EC has cut the allocation by 245 Mt/year – or 10.4 percent – compared to the allocation suggested in the NAPs (see Figure 3.7). The largest cuts in volume terms have been requested in Poland (76 Mt), Germany (29 Mt) and Bulgaria (25 Mt). The largest cuts in relative terms have been requested in countries located in Eastern Europe, with the three Baltic States (about half) and Bulgaria (37 percent) at the top of the list. The credit limits, defined as the maximum CDM/JI volumes that can be used for compliance purposes in Phase 2, were set quite generously, as every country was guaranteed a minimum 10 percent. Table 3.1 shows the suggested caps by member

Figure 3.7: Willingness to buy/sell EUAs at various prices N=311. Companies with emissions covered by the EU ETS. 100%

Share of respondents

80%

60% would buy at max would sell at min

40%

20%

> 100

50-100

35-50

30-35

25-30

20-25

15-20

10-15

0-10

0%

€/tonne Source: Point Carbon

27

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Carbon 2008

Table 1: The decided and undecided ones.. The table shows the status for the Member States on whose NAPs the European Commission has made a decision and for those countries where the EC has not yet made a decision. All in Mt/year.

COUNTRY

NAP

EC decision

Reduction [Mt/%]

Credit limit

AUT

32.8

30.7

2.1 (6 %)

10.0 %

BEL

63.3

58.5

4.8 (8%)

8.4 %

BGR

67.6

42.3

25.3 (37%)

12.6 %

CYP

7.1

5.5

1.6 (23%)

10.0 %

CZE

101.9

86.8

15.1 (15 %)

10.0 %

DEU

482.0

453.1

28.9 (6%)

22.0 %

DNK

24.5

24.5

0.0 (o%)

17.0 %

ESP

152.7

152.3

0.4 (0.3%)

20.0 %

EST

24.6

12.7

11.7 (48%)

0.0 %

FIN

39.6

37.6

2.0 (5%)

10.0 %

FRA

132.8

132.8

0.0 (0%)

13.5 %

GBR

246.2

246.2

0.0 (0%)

8.0 %

GRC

75.5

69.1

6.4 (8%)

9.0 %

HUN

30.7

26.9

3.8 (12%)

10.0 %

IRL

22.6

22.3

0.3 (1.3%)

10.0 %

ITA

215.2

201.6

13.6 (6%)

15.0 %

LTU

16.6

8.8

7.8 (47%)

20.0 %

LUX

4.0

2.5

1.5 (38%)

10.0 %

LVA

7.7

3.4

4.3 (56%)

10.0 %

MAL

3.0

2.1

0.9 (30%)

-

NLD

90.4

85.8

4.6 (5%)

10.0 %

NOR

15

15

0.0 (0%)

20.0 %

POL

284.6

208.5

76.1 (27%)

10.0 %

PRT

35.9

34.8

1.1 (3%)

10.0 %

ROM

97.6

75.9

21.7 (22%)

10.0 %

SVK

41.3

32.6

8.7 (21%)

7.0 %

SVN

8.3

8.3

0.0 (0%)

15.8 %

SWE

25.2

22.8

2.4 (10 %)

10.0 %

2348.4

2103.4

245 (10.4 %)

n.a.

TOTAL (EU28)

28

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11 March 2008

Figures 3.8-3.11: Should I buy, sell, bank or reduce emissions? N=311. Companies with emissions covered by the EU ETS. 35%

35%

I/we would buy EUAs today at a maximum price of ...

30%

30%

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0% €0-10

35%

I/we would sell EUAs today at a minimum price of ...

€10-15

€15-20

€20-25

€25-30

€30-35

€35-50 €50-100

above €100

€0-10 35%

I/we would bank any surplus EUAs into Phase 3 rather than sell them, at prices below ...

30%

30%

25%

25%

20%

20%

15%

15%

10%

€10-15

€15-20

€20-25

€25-30

€30-35

€35-50 €50-100

above €100

We would seek to reduce our own emissions and start to sell EUAs if the EUA price were to stay above ...

10%

5%

5% 0% €0-10

€10-15

€15-20

€20-25

€25-30

€30-35

€35-50 €50-100

above €100

0% €0-10

€10-15

€15-20

€20-25

€25-30

€30-35

€35-50 €50-100

Source: Point Carbon

state, the EC decision and the credit limit as originally set before the launch of the EC proposal on 23 January this year. It is generally accepted that the EC did a good job in setting the caps, but was more generous in setting the credit limit. Consequently, Phase 2 could in theory produce no emissions reductions in Europe, just credit imports from CDM and JI countries.

Supply-demand curve in survey around current EUA 08 level The Commission corrected this through the EU ETS review – and the Phase 3 proposal – in January this year. The fundamental balance of the EU ETS in Phase 2 is now merged with that of Phase 3 (2013-2020). This is because EUAs can be banked without limits from one year to the next. Higher Phase 3 prices should thus also translate into higher Phase 2 prices. All the proposals in the EC energy and climate package are to some extent related to the overall EU climate and energy targets, i.e. a 20 percent reduction in GHG emissions, a 20 percent share of renewables in final energy consumption and a 20

29

above €100

percent increase in energy efficiency. All targets would be achieved by 2020. The commission’s climate and energy package comprises a number of elements: 1. amendments to the EU ETS;

2. a proposed burden-sharing among EU countries for emissions not covered by the EU ETS; 3. promotion of renewable energy in the EU, including national targets; 4. promotion of carbon capture and storage; 5. improvement in energy efficiency; and 6. changes to state aid rules to facilitate emission reductions (already adopted). Under the EC proposal, the future allocation in the EU ETS would be reduced by 1.74 percent per year compared to the allocation in the “mid-point” of Phase 2 (2010). This gives a maximum amount of allowances to be issued in 2020 of 1 720 Mt. On average, the annual allocation in Phase 3 will be 1 846 Mt. Compared to the reported 2005 emissions, the average Phase 3 allocation implies a 14 percent reduction, while the annual allocation in 2020 is equivalent to a 21 percent cut from the 2005 level. The Commission has not yet concluded on distribution of allowances at the sector and installation levels. At

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this stage, the Commission states that no installation will receive a free allocation in 2013 that is higher than its average emissions in the 2005-2007 period. On auctioning, however, the rules are pretty clear. For the power sector, refineries and carbon capture and storage plants, all allowances would be auctioned from 2013. Installations in other sectors (including aviation and refineries) will receive 80 percent of the allowances for free in 2013 decreasing to zero in 2020.

In the event of a “satisfactory” international agreement, the EU might increase the overall reduction target from 20 percent to up to 30 percent. The additional reductions required by a 30 percent target would be split between the EU ETS and the non-trading sectors. The EU ETS would take on an additional reduction corresponding to its relative reduction effort in the 20 percent scenario. If the EU should aim for a 30 percent reduction target, the cap in 2020 would be set just below 1 400 Mt, while the average allocation in Phase 3 would be set at about 1 630 Mt/year. Not surprisingly, a “satisfactory” international agreement would thus imply a significantly tighter allocation in the EU ETS.

Phase 3 considerably tighter in a 30 percent reduction scenario Under current EU legislation, the overall credit limit for the 2008-2012 period is set at around 1 400 Mt (about 280 Mt/year). However, unless a “satisfactory” global climate deal is reached and the EU commits to an overall reduction target beyond 20 percent, the Phase 2 credit limit would effectively be extended to also cover Phase 3.

How does the EC define what is satisfactory? At the same time, a 30 percent reduction target will also lead to increased use of CERs/ERUs in Phase 3. Half of the additional effort could be covered by import of credits, under the proposal.

This implies that the 1 400 Mt limit now in place for Phase 2 would apply for the period 2008-2020, giving an average import potential of just above 100 Mt per year. This corresponds to a credit limit of nearly 6 percent for the 2008-2020 period for the installations included in the scheme in Phase 2.

Until now, Phase 2 and Phase 3 have been linked through the possibility of banking allowances into Phase 3. However, by extending the Phase 2 credit limit to 2020, the Commission has effectively merged Phases 2 and 3 of the scheme. Thus, the EC

Figure 3.12: To sell or not to sell – the spread Spread demanded for selling the EUA-CER swap. N=187. EU ETS compliance companies with surplus CER/ERU limit only. 40%

Before 23 Jan

From 23 Jan

Trading range

Responses

30%

20%

10%

0% € 0-2 Source: Point Carbon

30

€ 2-4

€ 4-6

€ 6-8

€ 8-10

€ 10 +

Don't know

Would never sell

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11 March 2008

Figure 3.13: Expectations for EUA prices: 2010 and 2020 N=3262 (2008) and 1893 (2007)

40% 35% 30%

2007 responses 2008 responses

40%

Price in 2010

35%

Mean 2007: €18 Mean 2008: €24

30%

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

2007 responses 2008 responses

Price in 2020

Mean 2007: €25 Mean 2008: €35

0% < €5

€5 - €10

€10 - €15 €15 - €20 €20 - €25 €25 - €35 €35 - €50

> €50

< €5

€5 - €10

€10 - €15 €15 - €20 €20 - €25 €25 - €35 €35 - €50

> €50

Source: Point Carbon

proposal will have a significant impact on the market balance in the 2008-2012 period.

3.2.3 Prices in the EU ETS

17 percent said they would not pay more than €10 for an EUA. Conversely, 21 percent said they were willing to sell below the €20-25 level, while three percent would not sell EUAs below €100.

The current price of an EUA for delivery in December 2008 is around €21. While the market sets the prices at which EUAs and CERs are traded, compliance buyers and sellers have natural positions that make it rational to also buy and sell at prices other than the prevailing market price. For example, an industrial company may initiate reductions at a certain threshold price and sell surplus EUAs, or start an emission intensive production process and buy EUAs if the price falls below a certain level.

We can also look at the question of price in another way, by asking how many of our respondents would buy, sell, bank and/or reduce own emissions at various carbon prices. Figures 3.8-3.11 display the answers.

In the following, we use our survey to try to gauge these underlying factors that would determine supply and demand under other conditions than the present market. In other words, we have tried to estimate a simple marginal abatement cost (MAC) curve.

As we see from Figure 3.11, around 75 percent of respondents would require carbon prices above €20-25 to start reducing their own emissions in Phase 2 and selling their excess EUAs. A majority would bank their excess EUAs even at prices below €20-25. Finally, as also indicated in the previous chart, the minimum price for selling appears to be about €25 for roughly half the sample, whereas the €15-20 is the median buying range.

EUA price in 2020 expected at €35/ tonne, €10 up from last year Figure 3.7 shows the number of respondents willing to sell or buy EUAs at various prices. Not surprisingly, the two cumulative curves cross at around €20-25, the price level during the survey period. About 30 percent of respondents (although not necessarily the same individuals) chose this level for the maximum buy/minimum sell amount. Only 13 percent would buy above this level, while

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Three percent of respondents would not sell EUAs below €100/tonne

Among financial institutions, more than 40 percent of the respondents reported that they would buy or sell EUAs in the €20-25 range. More than threequarters were found in the ranges from €15 to €30. The difference from the compliance players is the focus on the current price, as financials have no natural exposure. There were 175 responses in this category.

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Figure 3.14: Reported marginal abatement costs (MAC) in the EU ETS N=412. Companies with emissions covered by the EU ETS. 70% 60% 50% 40% 30% 20% 10% 0% € 0-10

€ 10-15

€ 15-20

€ 20-25

€ 25-30

€ 35-50 € 50-100 above € 100

don't know

Source: Point Carbon

Roughly speaking, in the compliance category, the median respondent would sell an EUA at €25 or above, but would bank it to Phase 3 at prices below €20, rather than sell it.

EUA-CER swaps In the course of 2007, it became clear that the EUA price would be strongly linked to the CDM market, and notably to the market in sCERs. The sCER market comprises transactions taking place after the initial ERPA, and the CERs that are traded may come from any project. EUA-sCER spreads for December 08 delivery have moved within a range from €2.41 to €7.98 since last May. However, in 2008 so far, the range has been confined to €4.28 - €6.18. Is there a greater potential for EUA-CER swaps if the price increases? Or is the current price level sufficient to lure the industrial companies with surplus credit limits to do the swap? In short, how much do our respondents demand to sell an EUA and receive a guaranteed-delivery CER in return?

EUA-sCER swap deals at €4.28€6.18/t so far in 2008 To probe the swap market, we asked the following question to all EU ETS companies that did not say they needed their full credit limit for compliance:

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“What premium (spread) would you demand to give up an EUA and receive an issued CER in 2008?” Figure 3.12 demonstrates the responses. The average swap price was €6.33/tonne.

Respondents’ average swap price is €6.33/tonne Our survey straddled the 23 January release of the EU climate and energy package, which allows us to check if there was any effect of the news of a potentially tighter credit limit for the average 2008-2020 period. What we see is that the share of respondents who did not know at what price to sell increased from 29 to 37 percent. Other changes were more ambiguous. There may thus have been a small effect of the publication of the EU package, but besides the increase in potential spread sellers that “don’t know” their preferred price, we cannot conclude with certainty that this has affected our survey respondents directly.

Long-term prices To get a general sense of where respondents think the EUA price will go in the medium term, we asked all our respondents to give their best guess of the level of the EUA price in 2010 and 2020. The results are given in Figure 3.13. The trend from last year is an increase in expected prices by about €5-10 for both

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Figure 3.15: Expectations for CER volume by end of 2012 N=3149/1750 (“Don’t know”/”No opinion” excluded from total). Note that the 2007 number includes both CER and ERU volume. 35% 30%

Mean 2008: 2.4 Gt

2008

Mean 2007: 1.9 Gt

2007

25% 20% 15% 10% 5% 0% <1.5 Gt

1.5 - 2 Gt

2 - 2.5 Gt

2.5 - 3 Gt

3 - 3.5 Gt

> 3.5 Gt

Source: Point Carbon

2010 and 2020. Specifically, the median response for the 2010 price went up from the €15-20 range in 2007 to €20-25 in 2008, increasing the average price from €18/tonne to €24/tonne. Likewise, the median expectation for the 2020 price was €20-25 in 2007, rising to €25-35 in 2008, and the average price from €25/tonne to €35/tonne. In our survey, we defined the marginal abatement cost as how much it would cost the company to reduce emissions by the last 1 tonne CO2 to be in compliance. An ordered set of MACs for all covered entities – a MAC curve – should in principle give the fundamental EUA price as a function of the cap.

Expected CER volume by end of 2012 up 0.5 Gt since last year However, this MAC is difficult to estimate. When asking survey participants in the EU ETS to report their MAC, more than half could not or would not do so. The result is given in Figure 3.14. Among those that did report a price range, the most frequent response category is €20-25, i.e. the price at the time of the survey. However, an average price of approximately €40 means that there is a greater upside than downside. This average, for what it is worth, is higher than the cost displayed in Figure 3.11.

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3.3 CDM market in the Kyoto period The CDM market consists of the primary, secondary, and options markets. The primary CER market involves the first buying and selling of the emission reductions from specific CDM projects, whereby trades are conducted through ERPAs. In contrast, the sCER market involves trades in CERs that have already been traded once through primary transactions. There is also a small but growing market in CER options, and a budding post-2012 CER market.

3.3.1 Primary CDM Based on Point Carbon’s transaction database, project database, and current estimate of inflow of new projects in 2008, we project that primary CDM transactions in 2007 will decrease to near the 2006 primary CDM transaction volume. The main reasons for the expected reverse development are: 1. reduced demand from EU ETS due to the new credit limit;

2. no more inflow of large HFC and N2O adipic projects in China; and 3. many installations in the EU ETS are closer to completing their acquisition of credits for compliance purposes Demand conditions may change significantly if the

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EC’s proposal remains unchanged. Specifically, if there is no “satisfactory” post-2012 deal, the average credit limit for 2008-2012 is set to decline from 280 Mt/year to 107 Mt/year. This level would remain until 2020. This potentially bearish long-term demand signal is considered to have some, if still limited, effect on the inflow of new projects in 2008, given that developing a CDM project takes years. Most of the reduced inflow will be felt only at the end of the 2008-2012 period.

Respondents find CER demand after 2012 very likely The major EU ETS review effect, however, is expected to be seen on the widening of the bid-offer spread on primary CERs. Buyers may be willing to pay less due to a potential over-supply of credits, while sellers prefer to sit on the fence, accumulating credits and waiting for higher prices. This is expected to lead to lower transacted volumes in 2008. The last big CDM projects involving industrial gases (HFC and N2O from adipic acid production) entered the pipeline and were transacted in 2007, exhausting this source of CERs with low marginal abatement costs. In their absence, renewable energy projects in hydro and wind have come to the rescue, most notably in China.

Although we expect China to remain the dominating CDM host country in 2008 (see Figure 2.18), we may start to see increased activity in countries perceived to be in line for mandatory caps. For instance, countries such as South Korea, Mexico and Argentina may be able to convert CDM into JI projects and thus sell credits into U.S. and EU carbon markets in the post-2012 period more easily, making these more attractive for investors. As explained in “American Climate Policy: A Tale of Two Bills” (CMA 12 February 2008), the Lieberman-Warner bill suggests allowing some ERUs, but not CERs, for compliance. As the Kyoto period is finally here and 2012 is approaching, compliance players, mainly in the private sector, may already have contracted a considerable amount of the volume of credits required to meet their Kyoto targets. Demand from compliance buyers is therefore expected to be somewhat reduced compared to previous years. On the other hand, more than 1 500 Mt were traded in the primary CDM market in 2005-2007, and according to Point Carbon supply estimates, there are still more than 1 000 Mt of existing projects to be contracted. A major question regarding the CDM is what volume of emission reductions from developing countries, in the form of issued CERs, will be produced by the end of the first Kyoto commitment period. To this

Figure 3.16: CER demand after 2012 N=3153/1851. Note that the 2007 number is based on a question including both CER and ERU demand.

Very likely

Likely

Not sure

Unlikely

Very unlikely

0% Source: Point Carbon

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10%

20%

30% 2007

40%

50%

2008

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Figure 3.17: Profit from borrowing? Question: “Does your company allow for borrowing from the company’s 2009 allocation to use for compliance in 2008? N=414. Companies covered by the EU ETS.

Yes, may borrow without any limit

Yes, may borrow up to a certain limit

No

0%

5%

10%

15%

20%

25%

30%

Source: Point Carbon

question, the most frequent response was that 2.53.0 Gt of reductions would produce issued CERs by the end of 2012, see Figure 3.15. While we did not ask exactly the same question last year, the most comparable result from the 2007 survey indicated an expectation of 1.5-2.0 Gt from CDM and JI together. Thus, supply expectations appear somewhat higher than last year.

CER issuance level decides traded volumes of sCER How secure is the future of the CDM? We asked our respondents – this year and last year – to assess the likelihood that there would be demand for CERs and ERUs post-2012. The answer for the CDM is unchanged or slightly better than last year. Figure 3.16 shows that 80 percent consider it likely or very likely that there will be CER demand after the first commitment period of the Kyoto Protocol.

3.3.2 Secondary CER market 2007 saw strong activity in the EUA-sCER swap market. While some expected the spread to converge on zero, the swaps have shown their own price dynamics. Regardless, the EUA and sCER markets have been closely linked in the course of

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2007, meaning that neither one can be understood without understanding the other. We assume that three fundamental factors will influence 2008 volume: 1. We expect issuance to almost double from 2007 to 2008, leading to a greater number of sCERs in the market.

2. Spot trading of CERs will then become more commonplace, thus making trading easier for parties without the credit lines to engage in forward trading. This may also move part of the sCER volume from bilateral to OTC trading and the exchanges. 3. We may see a reduction in swap volume as industrials become more wary of taking on CERs in return for EUAs. We expect the sCER volume to increase proportionally to issuance; with other positive and negative effects cancelling each other out.

Prices As shown in the previous chapter, the sCER market is backwardated in part due to an expected CER supply crunch in the early years of Phase 2, and/or good supply further out in the period. Ample CER supply expected further out on the curve contributes to this effect. One way to reduce this backwardation

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would be for compliance companies to borrow from next year’s allocation for current year compliance. A company could do this, for example, by using some of next year’s allowances for this year’s compliance, and then save some of its credit limit for later years, when sCERs are cheaper. The design of the EU ETS permits companies to do this, since the Directive stipulates that EUAs for each year should be issued every 28 February, whereas EUAs for last year’s compliance do not have to be handed in until April. Yet will companies allow themselves to take this opportunity, given internal risk management regulations? Our data show that a surprising number actually will. As Figure 3.18 shows, more than 40 percent of the respondents – all from companies covered by the EU ETS – reported that they could borrow at least some of next year’s allocation. There thus seems to be room for reducing the backwardation in the sCER market if some of this potential is utilised.

CER options CER options were traded in 2007, but market participants predict a higher volume this year. One problem with CER options stems from the manner in which they are issued; financials should be able to hedge them in the market. Since the sCER market is not particularly liquid, it is quite difficult to trade options. However, once more countries attain Kyoto

eligibility and the ITL-CITL link is up and running, it will be possible to trade CERs much more smoothly. Consequently, the options volume in 2008 will, to a large extent, depend on the timing of registry linking and eligibility.

CER option trading expected to increase significantly in 2008 There is also some evidence that market participants are looking further ahead in their trading strategies, some even to beyond 2012. CER forwards for delivery post-2012 have been traded by 8 percent of companies with obligations under the EU ETS, as shown in Figure 3.19. CER options for after 2012 are used by half that number, while post-2012 EUA instruments are less frequently used.

3.4 JI – existing market, deliveries now? The market created by the JI mechanism has been active for years, but no ERUs have so far been issued. Most of the JI projects submitted to the JISC in 2007 appear to be in the final stages of ERPA negotiations. The process is being spurred on by the fact that the crediting period (2008-2012) has already started and project participants want faster negotiation processes. The pace is slow in Russia,

Figure 3.18: Soaring sCER Comparison of changes in the EUA and primary/secondary CER market segments, 2005-07 and forecast for 2008 3

EUA total Primary CER

Annual volume (Gt)

Secondary CER 2

1

0 2005

2006

2007

2008 (forecast)

Source: Point Carbon

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however, despite recent improvements. At the same time, the rules for JI in new EU ETS member states are increasingly restrictive, potentially reducing supply.

would be delivered from Russia. As may have been expected, almost half of the sample did not state any opinion on this question, either replying “don’t know” or simply recording no answer.

It is possible that the contracted volume in 2008 could be boosted by some positive changes in Russian procedures and by progress towards eligibility status in Ukraine (expected in April this year). We expect 250 Mt will be issued from Russia over the next five years. Thus far, there are only 11 Mt contracted with Russian companies. This means that we should expect large bundle contracts to be reported in the market. A similar situation has also emerged in Ukraine.

Among the substantive replies, the most frequent and median (middle) response was the year 2010 (Figure 3.20). One-third of the respondents (not counting the “don’t know” responses) chose this option. That being said, 17 percent thought that Russia would not deliver any ERUs during 20082012. (On the other hand, our sample included 18 respondents located in Russia; of these, fifteen thought that ERUs would be delivered no later than 2009.)

First AAU trade expected in 2008, likely to involve Ukraine

3.5 AAU – large potential, limited supply?

What the JI market is waiting for now, of course, is delivery of ERUs. Unlike the CDM market, where credits (CERs) have been issued since 2005, ERUs cannot be created or transferred until the host country has gained eligibility under the Kyoto Protocol’s Article 17, and in any event not until the beginning of 2008. A major question is whether, when and how many ERUs will come from Russia. We asked all our respondents when they thought the first ERU

The Kyoto Protocol permits countries with commitments – written into the Protocol’s Annex B – to buy and sell parts of their permitted emission volumes, or assigned amounts (AA), as assigned amount units (AAUs). The market is potentially very large – in the order of several billion tonnes CO2e – but no known trades have yet taken place. Nonetheless, with the first Kyoto commitment period now underway, and Annex B countries gaining eligibility for international emission trading, it is becoming increasingly likely that an AAU trade will take place.

Figure 3.19: Post-2012 EUA and CER market activity N=419. Companies with emissions covered by the EU ETS.

Yes, CER forwards

Yes, CER options

Yes, EUA forwards

Yes, EUA options

No

Don't know

0%

10%

20%

30%

40%

50%

60%

70%

80%

Source: Point Carbon

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Figure 3.20: When will the first ERU be delivered from Russia? N=3041 (“Don’t know”/”No opinion” excluded from total in the chart).

35% 30% 25% 20% 15% 10% 5% 0% 2008

2009

2010

2011

2012

Source: Point Carbon

Not in the 2008-12 period

Figure 3.21: An AAU trade in 2008? N=3027

Yes

No

Don't know

0%

5%

10%

15%

20%

25%

30%

35%

40%

Source: Point Carbon

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Countries often mentioned as potential AAU sellers are Latvia, Hungary and Ukraine. In February, Ukraine’s National Environment Investment Agency revealed plans to carry out a pilot AAU transaction, of a size 10-20 Mt, by April or May. The country has developed a green investment scheme (GIS) under which it will earmark revenues from AAU sales for investments in projects that will contribute to further emission reductions. We asked whether survey respondents thought they would see an AAU trade in 2008, and further how much the volume would be from the main potential seller countries – Russia and Ukraine. The results are displayed in Figure 3.21 and 3.22. If AAU trading takes place, how much will we see? Here, the most favoured reply was 500 Mt – 1 Gt. Furthermore, two-thirds of the substantive responses are seen in the “less than 500 Mt” and “500 Mt-1 Gt” categories. A rough weighted mean came out at just under 1 Gt. This number is well below the total AAU supply potential, and the potential upside is thus substantial. In this chapter, we have discussed the Kyoto markets, some of which have already reached fairly advanced stages and almost maturity, according to our survey. On the other side, potential markets such as that concerning AAUs may come into existence through trades and deliveries this year or next.

3.6 Regional Greenhouse Gas Initiative (RGGI) The RGGI, the United States’ first foray into cap-andtrade programmes for GHGs, will begin in 2009. The RGGI system will cap CO2 emissions from power plants throughout the region. The first compliance period of the ten-state scheme begins on 1 January 2009. However, most states are expected to start auctioning allowances this year. From 2009 to 2014, the overall emissions cap is set at 188 million short tons (m s/t). This is approximately 8 million s/t above 2000-2002 historical emissions. RGGI authorities have set the budget high enough to allow room for economic growth, but did they set it too high? The answer could mirror the single most important lesson from the first phase of the European Union Emissions Trading Scheme (EU ETS): Do not over-allocate allowances. While official RGGI numbers were last published for the year 2004, we have used US EPA and DOE data to estimate emissions for 2005 and 2006. 2005 will be remembered as a year with a hot summer and high electricity usage. Estimated emissions were around 185 m s/t, close to the RGGI cap of 188 m s/t. However, between 2005 and 2006, the use of petroleum fuels for electricity generation dropped dramatically. This drop in oil-fired generation is

Figure 3.22: From Russia and Ukraine with AAUs? N=3 027 (“Don’t know” excluded from total in the chart).

35%

30%

25%

20%

15%

10%

5%

0% None

Less than 500 Mt

500 Mt - 1 Gt

1 - 2 Gt

2 - 3 Gt

More than 3 Gt

Source: Point Carbon

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compensated by an increase in gas-fired and nonemitting generation sources.

required to auction their allowances before the end of the year.

This led to an equally dramatic drop in emissions of 21 m s/t between 2005 and 2006, leaving the scheme long by 13 percent. As displayed in Figure 3.23, emissions are estimated to be 185 m s/t in 2005 and 164 m s/t in 2006. The hashed area in the figure illustrates the gap between historical emissions and the 2009-2014 cap level. Emissions had been remarkably stable between 2000 and 2004, before climbing slightly in 2005 and dropping dramatically in 2006.

In addition, we expect a “secondary” market to emerge, in which allowances are traded between compliance buyers, financials, and others, after the auctions.

RGGI expected to be long the first years of operation While fuel-switching, driven by the relative price of petroleum based fuels and natural gas, played a significant role in this steep fall, two other factors help explain the emissions drop: weather-driven electricity demand and environmental programmes covering other air pollutants. Traded RGGI volume will be the sum of auctioned volume and spot or forward trades in the secondary market. The auctioned volume is set to be by far the largest, as most states have pledged full or close to full auctioning. The greatest source of uncertainty is not knowing how many states will be able to complete the legislative and administrative work

Finally, in 2008 we expect some pre-compliance activity in anticipation of mandatory federal schemes in the US, Australia and possibly Canada. A pre-compliance transaction is one in which a future participant in a planned mandatory ETS buys credits with the expressed purpose of using them for compliance. Examples of pre-compliance buying were seen in the US in the mid-1990s in anticipation of Kyoto trading. One argument for pre-compliance trading in the US in 2008 is the fact that NYMEX will start offering carbon trading on 17 March this year. Being the world’s largest physical commodities futures and options exchange, the traded volumes of the contracts offered (e.g. EUAs, CERs, voluntary carbon emission reductions) have the potential to attract both compliance and financial actors. Establishing a clear line between voluntary and precompliance transactions is methodologically difficult, as our definition is based on the motivations of the buyer. Some voluntary carbon buyers also mention pre-compliance positioning as one of several reasons for entering the carbon market.

Figure 3.23: Mind the gap State by state RGGI historical emissions for 2000-2006, in million short tons. The hashed area represents the difference between the RGGI cap and the sum of statewide emissions SPREAD BETWEEN CAP AND TOTAL EMISSIONS

Million short tons of CO2

200

cap-total MD RI MA VT NY NJ NH ME DE CT

150

100

50

0 2000

2001

2002

2003

2004

2005

2006

Source: Point Carbon

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4. The carbon markets beyond 2012 The first Kyoto period ends in 2012 and it is still not clear whether a new international climate agreement will be reached or not. What seems evident, however, is that the momentum in regional carbon markets is reasonably strong and that they will continue to operate independently of a new international agreement beyond 2012. The EU ETS Phase 3, which will run from 2013-2020, is an example of this. The market is now also paying particular attention to developments in the US. Recent advances made by federal emission trading bills will encourage developments such as US-EU carbon market linkage in the not too distant future.

4.1 Towards a new global climate agreement 4.1.1 The Bali Mandate The December 2007 COP/MOP meeting in Bali was the last realistic chance to kick start the negotiations necessary for a new ratified agreement to be in place at the beginning of 2013. Despite not being reached until the last minute (on 15 December), the Bali mandate was agreed on by all participants and thus creates strong momentum — and commitment — for continuous negotiations towards a final post2012 agreement. It is hoped that the agreement will be signed at the UNFCCC Conference of Parties (COP) in Copenhagen in 2009. The main outcome of the Bali meeting was an agreement on a mandate that commits all the members of the UNFCCC to engage in a process to produce a comprehensive climate deal over the next two years. Specifically, the Bali mandate consists of a decision in the Convention, or “dialogue” track, and two decisions under the Kyoto track. The mandate contains no quantified emission reduction goals. This, however, is not necessarily a weakness, as the important point is for all parties to meet at the negotiation table, not to agree on targets in the mandate. That being said, the mandate acknowledges the scientific findings of the IPPC, and states that “deep cuts in global emissions will be required”.

4.1.2 The Bali positions The Bali negotiations were tough. The main areas of contention were whether quantified emission reduction targets should be included; to what extent

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developing countries should take on commitments; whether they should have obligations to monitor and report the effects of national climate policies; and whether and how the mandate should make reference to the IPCC scientific findings. The principal disagreeing parties were the US, Canada, Australia and Japan on one side, and the EU and developing countries on the other. A line of conflict was also drawn between developing and developed countries.

Bali: Agreed to negotiate towards 2009 signing All parties, including the US, maintained their desire to produce a mandate, both before and during the conference. However, the US resisted any reference to quantified emission reductions, saying it did not want to “prejudge” the conclusions of negotiations. The US was also generally negative towards financing and technology transfer provisions. Japan supported the US in not wanting to quantify emission reductions for Kyoto Annex B countries, except in a context where all major emitters would take on comprehensive emission reductions or limitations. The EU was strongly in favour of a 25-40 percent emission reduction range for all developed countries by 2020, pointing to the recommendations by the IPCC that global emissions have to peak in the next 10-15 years and that developed countries need to adopt this 2020 target in order to reach this goal. The EU also sided with the developing countries and demanded a clear distinction between what should be required of Annex 1 countries and non-Annex 1 countries. The Group of 77 (G-77) and China — a diverse developing country bloc consisting of 130 members — insisted on maintaining a clear division between Annex 1 and non-Annex 1 countries in the reference to commitments and actions. They also wanted support in the form of adaptation, technology transfer, capacity building, general financial assistance and action on avoided deforestation. Developed countries had trouble seeing exactly how such actions (notably technology transfer) could be implemented in a meaningful way. Several developing countries, including China and South Africa, were strongly in favour of a new deal and offered to reduce the growth of their own emissions, provided that Annex 1 countries make a commitment to emission reductions.

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4.1.3 The forthcoming negotiations The forthcoming negotiations will follow two parallel tracks. The Convention track will be the principal one, as the US has not ratified the Kyoto Protocol. The Kyoto track is a “back-up” solution and also constitutes a solid foundation for the content of the new agreement. The Convention track produced the “Bali action plan” (BAP). The Kyoto track produced a decision in the Ad-hoc Working Group on New Commitments for Annex 1 Parties (AWG), as well as a decision to conduct a second review of the Kyoto protocol under its Article 9. Of the two tracks, the Convention track will be the most important because it involves the US, whereas the Kyoto track will continue in order to reassure developing countries, as well as for legal reasons. The Kyoto track also constitutes a significant foundation and starting point for a new protocol to be negotiated towards and during the COP in Copenhagen in 2009. Under the Bali action plan, a formal negotiation committee will be set up for the Convention track. It will be called the Ad-hoc Working Group on Longterm Cooperative Action under the Convention. Note that this AWG is separate from the existing AWG for new commitments under the Kyoto track. This new working group has been tasked with presenting its work for adoption by the COP in Copenhagen in 2009. It asked for initial submissions to its work

Will a global post-2012 climate agreement to be reached before 2012. [N=3060] Not sure

No

Yes

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A key question in the negotiations is whether developing countries will take on commitments in a new agreement. As it stands now, the distinction between developing and developed countries remains, and the forthcoming negotiations will consider mitigation “actions” by all countries and mitigation “commitments” by developed countries. Developing countries secured strong promises from developed countries on adaptation, technology transfer, capacity building and tropical deforestation and degradation.

4.1.4 Towards an agreement? Will negotiators be successful over the next two years and produce a global climate regime for the post-2012 period? In our survey, 71 percent think agreement will be reached (Figure 4.1). This is exactly the same response as last year. While the positive answers were relatively evenly distributed, Japan and Germany were the most optimistic of the major countries, each with more than 80 percent expecting a positive outcome. Respondents from India, China and the US also scored well above average, with 7578 percent giving positive answers.

71 percent think international agreement reached by 2012

Figure 4.1: Copenhagen, here we come

Source: Point Carbon

programme by 22 February 2008 and will hold its first meeting in March or April 2008. The mandate has therefore created a momentum for continuous negotiations in the run up to Copenhagen.

What if the US in the end decides not to “join the consensus,” even though it went along with the international community in Bali. In fact, even if the US were somehow not part of it, our respondents think that a post-2012 agreement would still be reached. Figure 4.2 shows the aggregate result. Such an outcome might be a continuation of negotiations of new caps for Annex B countries under the ad-hoc working group set up for this purpose. But given the increasingly hard-nosed positions of several developed countries in this group —including the EU — it is not clear how this could succeed. It is particularly instructive to see that only 58 percent of Japanese respondents answered “Yes” to this particular question. Given that our survey shows an expectation of a post-2012 deal, which of the countries will take on “commitments”? Although a rather ambiguous

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word, we anticipate “commitments” will be something akin to emission targets or Kyoto caps. Figure 4.3 shows the opinions of our survey participants.

Figure 4.2: Could it happen without the US? Question: “Will there be a post-2012 agreement, regardless of whether the US participates?” N=3036.

These results illustrate interesting points in a number of groups: • Europe, Japan and Australia: More than 80 percent think that these countries will participate with commitments. Kyoto latecomer Australia is just ahead of Canada. Could this be due to the Rudd effect, given the new prime minister’s emphasis on climate policy?

Yes, a post2012 agreement will be reached regardless

• The highlights of the next group are the US and Russia. Just over half of our sample thinks that these two giants will participate with commitments. In the Carbon Market Survey last year, more than 60 percent of the respondents thought that the US would participate in a post-2012 agreement with commitments, compared to around 50 percent this year. This is a rather interesting result, as developments in US climate policy have been substantial in the past year, both at federal and state levels.

No, a post2012 agreement requires US participation

0%

20%

40%

60%

80%

Source: Point Carbon

Figure 4.3: Who will participate with commitments? Likely participants in a post-2012 scheme. N=3013/1910

Europe Japan Australia Canada New Zealand Russia USA Ukraine South-Korea Some developing countries China India

2008 2007

Mexico Sectors in developing countries 0%

20%

40%

60%

80%

100%

Source: Point Carbon

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• Despite the fact that Canada has significant difficulties in meeting its Kyoto target, the survey respondents are confident of Canada’s participation in a new global climate agreement. Nearly 75 percent think Canada will join, just slightly less than in the Carbon Market Survey last year. • Finally, there are the rapidly industrialising countries: China and India, at 35 percent. Although not mentioned as an alternative, numerous respondents mentioned Brazil as another likely candidate. • It is also worth noting that South Korea seems a likely candidate for post-2012 agreement, gaining a positive response from 45 percent of our respondents. This now-industrialised country illustrates the problems of continuing a strong bifurcation between developing and developed countries, as laid down in 1992 when the UNFCCC Annex 1 was written.

4.2 Carbon markets in North America As described in Chapter 3.6, the RGGI will start in 2009, but the first auctions will in fact be held before this, in 2008. Besides RGGI, there are a number of initiatives in North America, both at federal and state level, that may be implemented in a few years. In Canada, both the federal government and the provinces have launched climate plans and strategies, with the provinces being the most proactive. As uncertainty is still significant when it comes to Canadian climate policy in general, we will leave that for now and instead concentrate our discussions on its great neighbour to the south.

4.2.1 US State initiatives Regional initiatives are at the forefront of climate policy in North America. In February 2007, the Western Climate Initiative (WCI) emerged as a regional, coordinated attempt to address climate change by reducing GHG emissions in the western part of North America. In August 2007, six Western states (Arizona, California, New Mexico, Oregon, Washington and Utah) and two Canadian provinces (British Columbia and Manitoba) announced a joint target of 15 per cent below 2005 GHG emission levels by 2020, and are currently developing an emission trading system whose design will be made public in August 2008. The WCI target was not the result of a negotiation process but a compilation of state targets into an aggregate reduction target.

44

In November 2007, six Midwestern US states and the Canadian province of Manitoba signed the Midwestern Greenhouse Gas Accord, aiming at reducing their regional GHG emissions by 60 to 80 per cent of current levels by 2050, through a cap-and-trade system. The six participating states (Wisconsin, Minnesota, Illinois, Iowa, Michigan and Kansas), three observer states (Ohio, Indiana and South Dakota) and Canadian province Manitoba intend to have targets for reducing emissions from all six GHGs in place by November 2008. Within one year, they will also finalise a multi-sector cap-and-trade programme and create a model rule for implementing the carbon market in state laws. The accord states that a cap-and-trade programme should start within 30 months of the document being signed.

4.2.2 Federal level Pre-compliance trading in the US in 2008 is expected simply because it appears increasingly likely that the US will enact federal cap-and-trade legislation to manage the nation’s GHG emissions. The US Senate’s Lieberman – Warner Climate Security Act (CSA), introduced in October 2007, is expected to be the basis for a future federal US emission trading scheme (US ETS). As the CSA progressed through the legislative process, a revised version of the original bill was developed. The initial bill places most of the regulatory burden on the actual emitters. The newer version shifts more of this burden upstream to fossil fuel producers, processors and importers.

A US ETS could be the largest carbon trading scheme in the world The cap in the original version of the bill is set at 5.2 bn tonnes CO2e in 2012. The cap decreases by 96 Mt CO2e annually until 2050 when the cap is 1.56 bn tonnes CO2e, a 70 percent decrease from 2005 levels. The CSA covers emissions from 73 percent of the US economy; from the power, industrial and transportation sectors. Eighteen percent of the allowances would be auctioned in 2012. This percentage increases on an annual basis to 70.5 in 2036, and then remains unchanged until the end of the programme in 2050. Installations in electric power and industrial sectors are initially grandfathered 20 percent each, but this allocation percentage decreases linearly to zero by 2036. The transportation sector, having emissions of

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11 March 2008

just above 2 bn tonnes CO2e in 2012, is not allocated any allowances over the period. The original CSA proposal would begin with an estimated difference between business-as-usual and cap (‘EBAU-t-C’) of 420 million allowances (8 percent of cap).

L-W bill permits 30 percent offset, half from abroad To ensure a cost-effective trading scheme, regulated facilities would be permitted to cover up to 30 percent, or 1.56 bn tonnes CO2 in 2012, of their compliance obligation, with offsets: 15 percent from domestic sources and 15 percent from international emissions allowances or credits purchased from a foreign emissions trading market, amounting to 750 Mt international credit import in 2012. In the revised approach, the cap is set at 5.7 bn tonnes CO2e in 2012, which is roughly equivalent to the 2005 emissions from the covered facilities. Given the BAU emissions projections and the emissions cap specified in the revised CSA bill, the regulatory scheme would begin with an estimated 582 Mt allowance shortage in 2012 (420 Mt in the original). To meet this shortage, domestic offsets are the cheapest, but supply is likely to be limited. The coal to gas switching price is approximately $50 - 60/ tonne on average, assuming current fuel prices and

typical plant characteristics. Beyond fuel switching, carbon capture and storage technologies kick in at a carbon cost of between $25 to 100/tonne CO2e. The relative US fuel prices and the domestic offset supply will be significant factors influencing US ETS demand for international allowances, primarily EUAs and ERUs. As CERs are not accepted in a US ETS, this will to a certain extent provide an incentive for the US to contribute to a new international post-2012 agreement in order to have international cap-andtrade programmes to generate foreign allowances for compliance in the US. The market created by the proposed CSA would be the largest cap-and-trade emissions trading system in the world. It would dwarf the size of the EU ETS with a cap of 5.2-5.7 Gt against the EU’s 2.1 Gt.

Will a US ETS put pressure on EU ETS? To gauge expectations for GHG emissions trading in the US, we asked the following question to all our survey recipients: “Do you think the US will introduce a federal mandatory cap-and-trade scheme for greenhouse gases before 2015?” As Figure 4.4 shows, over 70 percent of the respondents think that one will be introduced, while only 15 percent think it will not. Of course, this result is subject to potentially strong bias, given that the survey is mainly taken by people who have strong interests in GHG emissions trading. Nevertheless, these same people think that the future US ETS will not be particularly strict. As Figure 4.5 shows, only one-tenth of the respondents expect a US ETS stricter than the EU ETS Phase 2, despite the strong ambitions of the Lieberman-Warner bill. There is little difference if we look separately at the 256 answers to this question from respondents located in the US itself (in total, the survey had 292 US respondents).

Figure 4.4: US ETS by 2015? N=3004

Don't know

No

Only ten percent expect US ETS to be tighter than EU ETS Phase 2 Yes

Source: Point Carbon

45

The result in Figure 4.5 is somewhat surprising. As we have outlined above, the CSA is stricter than the EU ETS Phase 2 in terms of reductions, coverage and degree of auctioning. It would be more interesting to liken it to EU ETS Phase 3. One explanation for

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Carbon 2008

Figure 4.5: How strict will the reduction requirements be in a US GHG? Comparison with the EU ETS Phase 2. N=2117. Only respondents expecting a US ETS by 2015.

Less strict than the EU ETS

About as strict as the EU ETS

Stricter than the EU ETS

No opinion

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Source: Point Carbon

this result might be that a future US ETS is seen not in terms of any specific proposal currently available, but rather in light of a recent history of US climate inaction. Developments over the next year, with a presidential election and negotiations under the Bali mandate, should give us a better idea of what to expect from a federal US scheme.

4.3 Other upcoming markets Following the example of the EU ETS, a number of other initiatives for regional emissions trading schemes are emerging. These are still at the idea and planning stage, but might very well be operational within a few years.

4.3.1 Japan Domestic emissions trading is still very controversial in Japan. Whereas the opposition Democratic Party of Japan has proposed a domestic ETS, industry, power producers and the governing Liberal Democratic Party appear to be staunchly opposed. It is thus unclear when a Japanese mandatory ETS will be established, if ever. To assess expectations for a domestic ETS in Japan, we asked the following question: “Will Japan introduce a mandatory cap-and-trade scheme to

46

reduce emissions from the electricity and industry sectors?” Our results show that only 34 percent expect the introduction of mandatory GHG emissions trading in the 2008-2012 period (Figure 4.6). Note that Japanese respondents are more pessimistic about a domestic ETS than the respondents as a whole, with 28 percent saying that it will never happen.

4.3.2 New Zealand and Australia In September 2007, the New Zealand Government announced the world’s first cap-and-trade scheme to cover all six GHGs covered by the Kyoto protocol. Forestry will be covered from 2008; liquid fossil fuels from 2009; stationary energy sources, such as power plants and industrial installations, from 2010; and agriculture, which is responsible for 50 percent of the country’s emissions, will be covered from 2013.

New Zealand and Australia planning for emissions trading While the government will allocate freely to the forestry sector, unlike the EU carbon scheme, the electricity sector will receive no allowances

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11 March 2008

Figure 4.6: Domestic ETS in Japan? Don’t hold your breath... Will Japan introduce a mandatory cap-and-trade scheme to reduce emissions from the electricity and industry sectors? N=3005. Responses from Japan: 65.

Yes, after 2012

Yes, during the 20082012 period

Japanese responses

No

Total responses

0%

10%

20%

30%

40%

50%

60%

Source: Point Carbon

according to the plan. This is because the sector can pass all of its costs on to the end consumer. Moreover, industry will be allocated carbon credits equal to 90 percent of their 2005 emissions.

has been the key player in the global carbon market thus far, with the EU ETS as the main driver for emission reductions, both at home and in developing countries.

In addition to these, we may expect that current CDM countries like South Korea and Mexico, which are likely to take on commitments in a new post2012 agreement, will also begin to develop regional emissions trading schemes.

The release of the EC’s new proposal for a comprehensive climate-energy package in January this year, confirmed Europe’s intention to combat climate change, with or without similar contributions from other countries. These new proposals, if adopted, will effectively extend the current EU ETS trading period up to 2020.

Details on the design of an Australian emission trading scheme have not yet been settled. The aim is to launch the plan by the end of 2008. So far, however, it seems that the schemes will start in 2010 with the intention of having a wide coverage, indicatively more than 70 percent of Australia’s GHG emissions. It is also likely that the scheme will allow international offsets, preferably from the Kyoto project markets. Linking to the New Zealand trading scheme has also been discussed.

4.4 Towards a global market? Although we have just entered the first Kyoto period, this report clearly shows that we must pay very close attention to what will happen when this period comes to an end in December 2012. There are three principal reasons for this. First, Europe

47

Post-2012 issues crucial for current emissions trading schemes Second, climate policy gained considerable momentum in the US in 2007, and initiatives at both state and federal levels mean that the country is now moving closer to implementation of emission trading schemes. RGGI will start on 1 January 2009 (and in fact, some early auctions are planned in 2008), while initiatives in the West and Mid-West will take a few more years to materialise. Most importantly, however, is the LiebermanWarner Bill now going though the Senate. This bill

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Carbon 2008

Figure 4.7: What will be the cost of carbon in 2020? Currency of choice. N=2591 (2157 respones in EUR; 967 in USD) 45% Price in € (average = 38)

40% Price in $ (average = 46)

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

10-20

20-30

30-50

50-100

above 100

Source: Point Carbon

is expected to become the foundation for a federal emissions trading scheme in the US and may be implemented as early as 2012. These US plans are, like the EU ETS, taking shape independently of the negotiations for a new international agreement on climate change. However, all US initiatives so far include provisions for employing international credits for compliance purposes (primarily EUAs and Kyoto credits). This indicates that there will be a close bond between upcoming regional emissions trading schemes and existing schemes, primarily the EU ETS. The carbon market is still, and will remain, a politically driven market, as supply and demand for credits are determined to a significant degree by political decisions. Finally, the importance of post-2012 issues is also connected to the ongoing negotiations for a new international climate agreement which will replace – or modify - the existing Kyoto Protocol. In particular, this involves discussion on how and to what extent large-emitting developing countries such as China and India will be involved in a new international agreement. The key question is: Will these countries take on commitments in a new international agreement? The results from our survey clearly demonstrate that a new international agreement

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is expected, but only a minority believes that China and India will take on commitments post-2012. Given the development of an increasingly interlinked global carbon market, we asked our survey recipients the following question: “Will there be a global reference price for CO2 emissions in the year 2020? The existence of such a price (regardless of its level) would be a reliable indicator of policy success.

Will China and India take on commitments post-2012? Seventy-three percent of our sample think that there will be a global reference carbon price in 2020 (see Figure 4.7). This result fits well with our general findings in this chapter (ca. 70 percent optimistic survey sample). We then asked our survey recipients what this global carbon price was likely to be. The most frequently chosen reply, and the median, was 30-50 Euros or US dollars. Interestingly, the global carbon prices for 2020 given in this question are much higher than the average prediction for the 2020 EUA price shown in the previous chapter. Could this be because a global market is expected to accommodate a higher price?

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Carbon Glossary

A AA and AAU, see Assigned Amount and Assigned Amount Units. Additionality Under the Kyoto Protocol, certificates from JI and the CDM (see explanations below) will be awarded only to project-based activities where emissions reductions are “additional to those that otherwise would occur”. The issue has to be elaborated further by the Parties to the Kyoto Protocol, and on the basis of practical experiences. Annex B Countries Annex B countries are the 39 emissions-capped countries listed in Annex B of the Kyoto Protocol. Annex I Countries Annex I countries are the 36 countries and economies in transition listed in Annex I of the UNFCCC. Belarus and Turkey are listed in Annex I but not Annex B; and Croatia, Liechtenstein, Monaco and Slovenia are listed in Annex B but not Annex I. In practice, however, Annex I of the UNFCCC and Annex B of the Kyoto Protocol are often used interchangeably. Annex II Countries Annex II of the UNFCCC includes all original OECD member countries plus the European Union. Assigned Amount (AA) and Assigned Amount Units (AAUs) The assigned amount is the total amount of greenhouse gas that each Annex B country is allowed to emit during the first commitment period (see explanation below) of the Kyoto Protocol. An Assigned Amount Unit (AAU) is a tradable unit of 1 tCO2e.

B Backwardation A market condition in which a futures price is lower in the distant delivery months than in the near delivery months. The opposite of contango (see below). Baseline and Baseline Scenario The baseline represents forecasted emissions under a business-as-usual (BAU) scenario, often referred to as the ‘baseline scenario’ i.e. expected emissions if the emission reduction activities were not implemented. BAU, see Business As Usual Scenario. Bear Someone who thinks market prices will decline. Bull

Someone who thinks market prices will rise. Business As Usual Scenario (BAU) A business as usual scenario is a policy neutral reference case of future emissions, i.e. projections of future emission levels in the absence of changes in current policies, economics and technology.

C Cap and Trade A Cap and Trade system is an emissions trading system, where total emissions are limited or ‘capped’. The Kyoto Protocol is a cap and trade system in the sense that emissions from Annex B countries are capped and that excess permits might be traded. However, normally cap and trade systems will not include mechanisms such as the CDM, which will allow for more permits to enter the system, i.e. beyond the cap. Carbon Dioxide Equivalent (CO2e) This is a measurement unit used to indicate the global warming potential (GWP) of greenhouse gases. Carbon dioxide is the reference gas against which other greenhouse gases are measured. CDM, see Clean Development Mechanism. CDM EB, see Clean Development Mechanism Executive Board. CERs, see Certified Emission Reductions. Certification The certification process is the phase of a CDM or JI project when permits are issued on the basis of calculated emissions reductions and verification, possibly by a third party. Certified Emission Reductions (CERs) CERs are permits generated through the CDM. Clean Development Mechanism (CDM) The CDM is a mechanism for project-based emission reduction activities in developing countries. Certificates will be generated through the CDM from projects that lead to certifiable emissions reductions that would otherwise not occur. Clean Development Mechanism (CDM) Executive Board (EB) The CDM EB is accountable to the Conference of the Parties to the Kyoto Protocol (see below). It registers validated project activities as CDM projects. Commitment Period The five-year Kyoto Protocol Commitment Period is scheduled to run from calendar year 2008 to calendar

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Carbon Glossary

year-end 2012. Contango A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. The opposite of backwardation. COP, see Conference of the Parties. Conference of Parties (COP) The COP is the supreme body of the United Nations Framework Convention on Climate Change (UNFCCC). The last conference (COP-11/MOP1) was held in Montreal, Canada in November/December 2005. Countries with Economies in Transition (EIT) Countries that are in the transition from a planned economy to a market-based economy, i.e. the Central and East European countries, Russia, and the former republics of the Soviet Union.

E EIT, see Countries with Economies in Transition. Emission Reduction Unit (ERU) Permits achieved through a Joint Implementation project. Emissions to Cap (E-t-C): Emissions-to-cap (E-t-C) is calculated by subtracting the seasonally adjusted cap from emissions (actual or forecasted). This metric gives an indication of whether the market (for a specific period) is producing more or less than the seasonally adjusted cap for that same period. More specifically, if not taking CERs into account, a positive (negative) E-C means that the market is fundamentally short (long), suggesting a buy (sell) signal. Emissions Trading Emissions Trading allows for transfer of allowances or credits across international borders. However, it is a general term often used for the three Kyoto mechanisms: JI, CDM and emissions trading. ERU, see Emission Reduction Unit. EU ETS, European Union Emissions Trading System.

F Financial additionality CDM projects have to be financially additional, which means that the projects that Annex I countries support within the framework of the CDM should

not be financed by official development aid, but that additional funding is to be made available for such projects.

G Grandfathering Method for allocation of emissions, where permits are allocated, usually free of charge, to emitters and firms on the basis of historical emissions. Greenhouse gases (GHGs) Greenhouse gases (GHGs) are trace gases that control energy flows in the Earth’s atmosphere by absorbing infra-red radiation. Some GHGs occur naturally in the atmosphere, while others result from human activities. There are six GHGs covered under the Kyoto Protocol - carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6). CO2 is the most important GHG released by human activities.

H Host Country A host country is the country where a JI or CDM project is physically located. Hot Air Excess permits that have occurred due to economic collapse or declined production for reasons not directly related to intentional efforts to curb emissions.

J JI, see Joint Implementation. Joint Implementation (JI) Joint Implementation is a mechanism for transfer of emissions permits from one Annex B country to another. JI generates ERUs on the basis of emission reduction projects leading to quantifiable emissions reductions.

K Kyoto Protocol The Kyoto Protocol originated at COP-3 to the UNFCCC in Kyoto, Japan, December 1997. It specifies emission obligations for the Annex B countries and

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Carbon Glossary

defines the three so-called Kyoto mechanisms: JI, CDM and emissions trading. It entered into force on 16 February 2006

M MAC, see Marginal Abatement Cost. Marginal Abatement Cost (MAC) The marginal abatement cost is the cost of reducing emissions with one additional unit. Aggregated marginal costs over a number of projects or activities define the marginal abatement cost curve. Memorandum of Understanding (MoU) A MoU is an agreement between two parties that aims to formally recognise a joint desire to ultimately conclude an agreement or to achieve goals jointly. It may or may not have legal backing of sanction, depending upon how it is constructed. MoUs are often used as a basis for CDM/JI projects.

N National Authorities and Designated National Authorities The national authority is the official body representing the Government which takes part in the arrangement of CDM/JI projects. For JI host countries, the national authority approves the projects and issues the emission reduction units. For CDM host countries, the designated national authority issues a nonobjection letter necessary for the project approval. Non-Annex I countries Annex I is an Annex in the UNFCCC listing those countries that are signatories to the Convention and committed to emission reductions. The Non-Annex I countries are developing countries, and they have no emission reduction targets.

S Supplementarity A requirement in the Kyoto Protocol stating that emissions trading should be a supplement to domestic action. It reflects the request of the European Union to limit the use of the Kyoto Protocol flexibility mechanisms. It is still not determined how supplementarity should be interpreted.

U United Nations Framework Convention on Climate Change (UNFCCC) The UNFCCC was established 1992 at the Rio Earth Summit. It is the overall framework guiding the international climate negotiations. Its main objective is “stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic (man-made) interference with the climate system”.

V Verification In order for AIJ, CDM and JI projects to have a formalised validation of an emission reduction stream, a recognised independent third party must confirm that claimed emissions reduction activity has occurred.

P Permit Permits are often used for denoting the tradable units under the Kyoto Protocol, i.e. AAUs, ERU or CERs. Project Design Document (PDD) Document completed by project developers in order to register their project under the CDM.

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