The challenges of auctioning pollution

The challenges of auctioning pollution (Source: Jan Smith)

Compared to earlier trading periods, Phase III of the EU ETS will see a marked reduction in the free allocation of emissions allowances to industrial installations, with a corresponding increase in auctioning levels. It is hoped that this shift will help redress the imbalance between the importance of the EU ETS in reducing emissions and the current sluggishness of the emissions market. To help achieve the environmental goal of the EU ETS, the auctioning process will have to be carefully designed and regulated so as to incentivize low-carbon development and encourage investment in the emissions market.

The problems of free allocation

Phase I of the EU ETS was characterized by high levels of free allocations of allowances to industrial operators.  The allocations were largely based on historical levels of emissions put forward by the operators themselves to EU Member States, who then distributed the allowances. The consequence was over-allocation of allowances as the cap (constituted of the total allocated allowances) in fact exceeded the actual emissions levels.

Phase II witnessed a tightening of the cap below Phase I levels. However, this did not avert over-allocation, which was significantly due to the decrease in production levels caused by the global economic crisis. Operators have thus found themselves holding substantial levels of freely allocated allowances which are surplus to their production needs.

The over-supply of allowances has significantly affected the emissions market, with prices plummeting since the start of Phase II; allowances are currently trading at around EUR 6/tonne. This does not bode well for the environmental effectiveness of the EU ETS, as it is much cheaper to buy allowances in the market than it is to invest in achieving emissions reductions.

The advent of auctioning 

It is hoped that the use of auctioning gradually from Phase II and much more extensively in Phase III will help stabilize the price of allowances at a sufficiently high level. The use of auctioning is also intended to remove the possibility of windfall profits, where operators can benefit from freely allocated allowances which are not needed to cover production.

Auctioning is intended to take over from free allocation as the principal method of distributing emissions allowances to operators. The expectation is that least 50% of allowances will be auctioned from 2013, compared to approximately 4% to date.

Designing and regulating an effective auctioning process

The auctioning process envisages a common platform operated by the European Commission and the Member States. In addition, individual Member States have the option of establishing national auctioning platforms. The UK, Germany and Poland have already expressed their intention to opt out of the centralized arrangement and conduct auctioning at national level.

Harmonization will therefore not be absolute, which may lead to divergences as between the centralized platform and the respective national approaches. There are concerns that diffusing the auctioning process may make it more difficult to provide the kind of strong price signal that the emissions market so urgently needs. It is also feared that the security issues which have arisen in the past with national emissions registries (previously noted by Climatico) may repeat themselves with national auctioning platforms.

From a market perspective, auctioning raises the question of the involvement of financial regulators. Access to and participation in the auctioning process, which is set to make up the larger part of the emissions market, will have to be adequately supervised so as to ensure transparency and thus aid accurate price formation and avoid market distortion. The UK Financial Services Authority (FSA) has recently published a consultation paper on the proposed extent of its involvement in regulating auctioning.

Towards a viable emissions market

Learning from past errors is vital if the auctioning process is to deliver the price formation and market stabilization results needed to uphold the environmental credentials of the EU ETS. Centralized price and security standards control is crucial in this respect. The European Commission also needs to take the lead in delimiting the scope of financial regulation of auctioning centrally at EU level, to the extent that the emissions market requires protection from information and price distortion.

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