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.

EUAA trading should not be grounded (Source: David McKelvey)

Trading in the latest type of carbon credit, EU aviation allowances (EUAAs), has begun despite remaining doubts as to the viability of the new market, which have been exacerbated by diplomatic turmoil. The requirement that all airlines, including non-EU operators, comply with the EU ETS has provoked resistance from a number of key countries. It has also raised questions as to the regulatory wisdom of creating a market in emissions allowances where liquidity and price levels remain challenging to maintain.

Regulating aviation under the EU ETS

Under the EU ETS, all airlines flying from and to airports situated in the EU will be obliged to surrender allowances corresponding to their levels of flight emissions. Crucially, this obligation extends to non-EU airlines. The move to include aviation in the EU ETS brings the sector in line with the others covered by this environmental regulatory regime, such as energy and metal production industries. The inclusion of aviation in the EU ETS will require airlines to buy and sell emissions allowances in the market in order to ensure that they hold them in sufficient numbers for the purposes of surrender.

Political opposition

The UNFCCC and the International Civil Aviation Organisation (ICAO) have long supported the regulation of aviation emissions through trading, but no global agreement has yet been reached in this respect. The EU’s decision to unilaterally regulate this sector under the EU ETS represents the first practical expression of a focused effort to accelerate the creation of a global mechanism to reduce aviation emissions.

The brave step taken by the EU has not been without controversy. Notable jurisdictions such as the US, China and India have been particularly vociferous in opposing the extension of the EU ETS to their airlines. In particular, the US brought legal action arguing that the extension contravened a number of international agreements, namely the Chicago Convention, the Open Skies Agreement and the Kyoto Protocol. The European Court of Justice (ECJ) held that the EU’s move complied with the relevant agreements and did not infringe the sovereignty of the affected states. However, the judgment did not mark the end of the dispute, since US airlines continue to oppose the trading scheme.

A new market in allowances

The first exchange trade in EUAAs took place on 27 February 2012, and was carried out by Vertis Environmental Finance, a specialised environmental commodities broker, on the ICE exchange. It is early days yet, but other firms’ interest in EUAA trading will be indicative of the levels of liquidity that can be expected in this fledgling market. ICE Futures Europe has expressed its confidence in the EUAA market by launching a form of futures contract with allowances as the underlying product. Interest has also been expressed by other trading platforms, notably the European Energy Exchange (EEX) and BlueNext.

However, uncertainty as to the degree of participation in the scheme by non-EU airlines renders it harder for financial entities to ascertain the value of becoming involved in the EUAA market. China, for instance, has announced that its airlines are banned from complying with the EU ETS. It is unclear what practical steps the EU could take in international law in order to achieve compliance; the problems of monitoring and enforcement have been highlighted in an earlier Climatico post. This situation is markedly different from the beginnings of the EU ETS and its application to EU industrial operators, which was not faced with such serious jurisdictional challenges.

Saving EUAA trading

Active participation in the market is absolutely crucial to the success of the EU ETS to reduce emissions in the aviation sector. Low levels of liquidity would equal low EUAA prices and therefore little incentive for operators to reduce their emissions as opposed to simply continuing to purchase allowances in the market.

International opposition to the application of the scheme to non-EU airlines could potentially be very damaging. Such refusal to participate could drive away financial traders and substantially shrink the market in EUAAs while it is still in its incipient phase. Until the EU can achieve some degree of international cooperation, or at least a diminution in opposition, it is difficult to see how its environmental regulation can be enforced against unwilling parties.

Industrial gas credits – banned from the EU ETS (Source: Isaac Mao)

In the aftermath of the Durban conference analysts have been turning their attention to the continued role of Kyoto Protocol emissions credits in the EU ETS. To date this trading mechanism has provided the biggest market for Kyoto credits, but the position is set to change drastically from 2013 onwards due to significant restrictions on the type and number of permissible credits. It is hoped that this move will address some of the credibility issues that have been plaguing the EU ETS (notably the use of environmentally dubious credits). Moreover, EU emissions allowances (EUAs) will become firmly established as the tradable instrument of choice in the market.

The impact of Kyoto credits on the EU ETS

In addition to EUAs, regulated installations can use credits from two kinds of Kyoto mechanisms, namely Clean Development Mechanism (CDM) and Joint Implementation (JI) projects to fulfil their EU ETS obligations. Each EU Member State currently sets its own limits on the use of CDM and JI credits. Phase III of the EU ETS will see the introduction of a general cap on Kyoto credits of 50% of total, EU-wide emissions reductions.

The linkage between Kyoto mechanisms and the EU ETS has provided these credits with market value. In particular, the price of Certified Emission Reductions (CERs) resulting from CDM projects has to date closely followed that of EUAs, as the former type of credit has been extensively traded by EU ETS regulated entities.

Environmental credentials of Kyoto credits

The usability of Kyoto credits in the EU ETS has been progressively reduced over the years so as to address concerns regarding the effectiveness of the credit-generating projects in combating climate change.

A notable example of credits which will be banned from the EU ETS in Phase III (from 2013) are those generated from the destruction of HFC-23, a by-product of a highly noxious refrigerant which is itself a potent greenhouse gas. HFC-23 crediting has been particularly popular in India and China. It has been strongly criticised by environmental organisations on the basis that the additional HFC-23 may arguably not have been produced at all were it not translatable into Kyoto credits.

Cutting the Kyoto mechanisms short

Phase III of the EU ETS is set to entail considerable quantitative and qualitative restrictions on the applicability of Kyoto credits. These developments reflect the recently amended wording of the EU ETS Directive, which provides that credits must “represent real, verifiable, additional and permanent emission reductions and have clear sustainable development benefits and no significant negative environmental or social impacts”.

From the qualitative perspective, the current ban on the use of credits from nuclear energy or land use, land use change and forestry (LULUCF) activities will continue beyond 2013 alongside the new ban on industrial gas (HFC-23 and N₂O) credits.

On the quantitative front, credits from CDM projects registered after 2012 can only be used in the EU ETS if they originate from a defined list of Least Developed Countries (LDCs), which does not include large emerging economies such as India and China. The exclusion of such countries is intended to motivate them to reduce emissions in ways other than the generation of CERs and thus step up their regulatory approaches to mitigating the effects of climate change.

Where does this leave international emissions credits?

As the demand for CDM and JI credits for use in the EU ETS will inevitably drop from 2013, the continued relevance of these mechanisms will depend on the level of interest that they can generate in other emissions trading schemes, such as the incipient Australian or New Zealand systems. The EU Commission has arguably taken the correct approach in placing clear limits on the usability of Kyoto credits, which has been made dependent on their environmental quality and provenance. In the short term at least it is envisaged that the market in EUAs will emerge as dominant, as it is unlikely that national trading schemes will be able to absorb levels of Kyoto credits on the same scale as the EU ETS.

By Climatico Contributor: Sabina Manea

Although much work remains to be done, Durban has ended on a hopeful note (Source: IISD)

The outcome of the UN conference in Durban has been more positive than initially indicated by the complexity of the negotiations. It is particularly laudable that a second commitment period of the Kyoto Protocol has been secured. This result translates into a continued existence of the international emissions trading mechanism.

Despite detailed discussions on the matter, the parties have postponed reaching a firm conclusion on the continued surplus of AAUs in the market and their carry-over into the second commitment period. Although not addressed centrally at Durban, the future linkage of national and regional emissions schemes has emerged as a clear goal of parties such as the EU, Australia and New Zealand.

Carry-over of the AAU surplus

As the Kyoto Protocol is set to continue beyond its current end date of 2012 until 2017 or 2020, AAU trading remains in force as a market-based mechanism of climate change mitigation under the Protocol.

Discussions over how to address the surplus and carry-over of AAUs into a second commitment phase took place throughout the Durban conference. Responsibility for the deliberations was assigned to the AWG-KP spin-off group on numbers. Parties in the group presented a number of possible options, of which limiting the carry-over of surplus AAUs was the subject of particular focus. The final outcome of the discussions signalled a firmer resolution to select the most appropriate avenue for the treatment of the AAU surplus. The CMP instructed the AWG-KP to assess the implication of the AAU carry-over on the desired scale of emissions reductions in the second commitment phase, to be completed by AWG-KP 17.

A promising outlook for linkage between emissions trading schemes

The issue of linkage between national and regional emissions trading schemes was not addressed during the official Durban negotiations. However, encouraging signs emerged in parallel with the conference as to the willingness of countries to work together towards creating more connectivity.

Several parties have already taken the initiative and have begun negotiating to link their emissions trading schemes. Australia plans to go ahead with its trading scheme, which is due to start in 2015, and there are plans in the pipeline to link it with the EU ETS as well as with New Zealand’s mechanism.

The future of emissions trading post-Durban

It is of paramount importance that the AWG-KP follows up on the task entrusted to it by the CMP in order to reach a conclusion on the most appropriate solution to the carry-over issue. The success of the second commitment phase in combating climate change is closely connected to the treatment of the AAU surplus. If emissions trading is to remain a viable means of environmental regulation under the Protocol, it is essential to maintain the functionality of the AAU market so that it can help achieve the necessary levels of emissions reductions.

Harnessing the AAU market at the centralised, international level can be usefully supplemented by closer cooperation and linkage between national and regional emissions trading schemes. Given the continued popularity of this market-based mechanism with regulated entities, especially as exemplified by the EU ETS, emissions trading is likely to take precedence over other more prescriptive solutions (such as taxes) for the foreseeable future.

By Climatico Contributor: Sabina Manea

Dais during the COP17 opening plenary (Source: IISD)

A week into the Durban conference, progress on the continued workability of the Kyoto Protocol emissions trading mechanism is slow. A number of parties to the negotiations have acknowledged that action needs to be taken to tackle the surplus of Assigned Amount Units (AAUs) in the international emissions market. The details of the action remain undecided, despite some proposals being put forward in various discussion groups. If a second commitment period is to go ahead, agreement on the carry-over of AAUs will have to be reached in order to give certainty to the market.

As to the issue of linkage, a centralised decision now appears unlikely, and separate negotiations have started to take place between different blocs as to ways of connecting national and regional emissions trading schemes.

Carry-over of AAUs and the emissions market

As previously reported by Climatico, emissions trading is a key pillar of the Kyoto Protocol, and is aimed at reducing greenhouse gas emissions by way of a participatory market mechanism. The viability of the emissions market is therefore vital to the smooth functioning of this system. The principal threats to the continuing functionality of the emissions market are the AAU surplus (caused by oversupply) and uncertainty over whether there will be a gap between commitment periods.

The Ad-hoc Working Group for the Kyoto Protocol (AWG-KP) has so far been the forum of choice in addressing the issue of the AAU surplus and the workings of the emissions market. The Least Developed Countries (LDC) bloc and the Alliance of Small Island States (AOSIS) were particularly vocal in expressing their desire to see a plan emerge for a credible second commitment period, which would necessarily involve the elimination of the loophole that is the AAU surplus. These blocs were joined by Australia and the EU, which is understandable given the former’s intention to have a national emissions trading scheme from 2015 and the latter’s already existing EU Emissions Trading System (EU ETS).

The proposed adjustments to the emissions market are of relevance only if the Kyoto Protocol continues into a second commitment period. This is in itself an issue currently debated in Durban, with different factions being formed over the contents of an extension of the Protocol beyond 2012. But if the Kyoto Protocol is to survive Durban, the problem of the surplus AAUs must be addressed if emissions trading is to remain an effective part of the UN climate change mitigation framework.

Linkage between national and regional emissions schemes

With several national and regional emissions trading schemes either up and running (the EU ETS) or in the pipeline (Australia), another key issue that the Durban conference needs to address is that of linkage between them. This has not formed the subject of direct discussion in the official negotiating sessions at Durban. However, Australia has announced that it intends to start work on linking its fledgling trading scheme to those in New Zealand and the EU.

This is an important step in improving market integration, and may well prove a viable alternative to the Kyoto emissions trading mechanism should parties fail to agree on or delay the second commitment period. It is somewhat disappointing that the driving force behind a system of linkages between schemes has not originated from the Durban negotiations themselves. However, given that parties are finding it challenging to agree on more pressing issues such as the continuity of the Kyoto Protocol, it is not altogether surprising that linkage is not at the top of the agenda. It seems that individual blocs or countries have been left to enter into their own bilateral or multilateral negotiations on this matter if they view emissions trading as a valuable regulatory tool of climate change mitigation.

Hopes for the second week of negotiations

Indications that many negotiating parties are keen to reach an agreement over the treatment of the AAU surplus are encouraging. It is hoped that this willingness to engage in discussions will materialise into a concrete solution by the end of the conference, and particularly one which can uphold the viability of the emissions market. The AWG-KP has already presented a number of possible avenues of action, ranging from no restrictions on the carry-over of AAUs to different options on limits. It is necessary that a sufficiently small amount can be carried over into the second commitment period, so that the environmental goal of emissions reductions is not compromised.

On the issue of linkage, it remains to be seen which other countries or blocs (if any) express a desire to work together to achieve a closer interconnection between their respective mechanisms, as centralised action in this respect appears overly complex to orchestrate.

Emissions trading is set for a key role in UN negotiations (Source: UN Climate Change)

By Climatico Contributor: Sabina Manea

With the United Nations Climate Change Conference due to start on 28 November, emissions trading is a key topic due for discussion in Durban. As one of the three Kyoto market-based mechanisms seeking to reduce greenhouse gas emissions, emissions trading has emerged as a crucial weapon in the arsenal of climate change mitigation at the international level. It needs to be decided whether the tradable units (called assigned amount units, or AAUs) remain valid beyond 2012, or whether the surplus of AAUs currently in existence should be reduced in line with emissions reductions targets. An investigation is also necessary into possible solutions to link the various existing and emerging national and regional trading schemes.

Continued validity of AAUs and linkage

The first commitment period of the Kyoto Protocol runs from 2008 until the end of 2012. Carrying over an unlimited amount of unused AAUs into a second commitment period is permitted under the current formulation of the Kyoto Protocol. However, there is a considerable surplus of AAUs, principally due to over-allocation to former Eastern bloc countries, whose industries shrank significantly in the 1990s. In order to pursue the targets of emissions reductions set by the Kyoto Protocol it is necessary to establish whether the surplus could be cancelled or otherwise retired from the market.

The number of national and regional emissions trading schemes is on the increase. The European Union Emissions Trading System (EU ETS) is the largest mandatory scheme currently in existence. California and Australia have announced plans to implement emissions trading in their respective jurisdictions. China and South Korea have also publicised their intention to run such schemes in the future. The possibility of establishing a means of linking these different schemes to one another would help establish a truly worldwide emissions market.

Reconciling conflicting interests

Countries holding surplus AAUs understandably wish to bank them into a second Kyoto commitment period. EU Member States could use these AAUs to help their industrial installations comply with the EU ETS (as AAUs are equivalent to EU emissions allowances). Unused AAUs can also be sold in the market to make substantial windfall profits.

Other countries are taking a more restrictive approach. Denmark is lobbying for AAUs not to be bankable, in line with continuing emissions reductions. As a compromise, South Africa, the host country for the UN conference, has suggested a compromise consisting of a limited 1% carry-over of spare AAUs.

AAU allocations and emissions reduction targets

The Kyoto Protocol sets caps for countries with emissions reduction commitments (Annex B Parties). These caps consist of AAUs, which are allocated to each country on the basis of historical levels of emissions. If a country requires more AAUs than provided in its initial allocation, it can buy additional ones in the market from other countries who hold excess AAUs, and vice versa.

The surpluses of AAUs held by some countries call into question the validity of their emissions reductions, which have been achieved incidentally due to economic decline, rather than actively through the development of greener technologies.

Emissions trading as an effective pillar of climate change mitigation

A firm decision on the treatment of the AAU surplus is overdue; the issue of unlimited banking was noted, but not amended at the Cancún conference in 2010. Ideally the conference in Durban would provide a clear statement regarding the extent to which AAUs are bankable into the following commitment period, as well as a plan for addressing the problem of the surplus. The international emissions market would also greatly benefit from a proposal for a system of linkage between national and regional emissions trading schemes. A variety of opinions has already surfaced on how this would work, ranging from a centralised mechanism to a decentralised network of trading links.

Tying the loose ends of the Kyoto emissions trading mechanism is vital for its continued success in the fight against climate change. The validity and internal workings of this mechanism beyond 2012 are areas which would particularly benefit from direct attention by the negotiating parties at Durban. A further step in the direction of improving interconnectivity with other emissions trading schemes would provide additional support. These important issues will therefore form the focus of coverage as the conference progresses.  

Disputed land (Source: Achmad Rabin Taim)

Clean Development Mechanism (CDM) credits have been receiving plenty of bad press, with the latest being reports of human rights abuses committed in Honduras over the ownership of credit-producing land. This is particularly serious as the CDM has been set up to feed into the EU ETS, which means that CDM credits find their way into the EU emissions market. Trading in credits whose origin is both legally questionable and ethically suspect does not bode well for the environmental integrity of the EU ETS.

The CDM

EU ETS regulated installations are allowed to use a set proportion of emissions reduction credits generated from CDM projects in developing countries. This is permitted as a way of linking the Kyoto Protocol mechanisms to the EU ETS. In exchange for one CDM credit a Member State has to issue and surrender one emissions allowance and then cancel the credit, which cannot itself be traded within the EU ETS. There are legislative limits on the levels of CDM credits that can be swapped for allowances.

Earning credits in this manner has proved a popular way of fulfilling EU ETS obligations due to the proliferation of CDM projects across the developing world. There are currently over 3,000 CDM projects registered with the UN.

Who owns the land?

CDM projects involve land which is owned by UN approved entities that are in charge of generating the credits. This is the case in Honduras, where the projects under fire have entailed the production of palm oil. Local farmers are protesting against the palm oil plantations and claim that they have been wrongfully evicted from their land so that the CDM projects can go ahead. There are widespread reports of worrying levels of violence against those who are trying to recover their land.

This dire situation highlights one of the key problems with the CDM. How can the ownership of the CDM credits be secure when the ownership of the credit-generating land itself has been thrown into doubt? Many of the developing countries which host these types of projects lack an adequate land registration system whereby ownership can be adequately recorded and subsequently protected. This leads to situations like the present one in Honduras, where land disputes between parties with competing claims can degenerate into something much more sinister.

Banning the “bad” CDM credits?

The CDM has brought the inadequacy of land ownership protection present in these developing legal systems into the EU’s own back yard. Not only does this render the ownership of the credits themselves disputed, but it also brings with it the allegation that the system is being built on unethical practices. While the EU is in no way responsible for these unfortunate events, the controversy is stretching to the EU ETS due to the reliance of regulated installations on CDM credits to earn emissions allowances.

There are demands from within the EU to ban those CDM credits which have been tainted by human rights abuse allegations. It is rightly perceived that the EU ETS cannot be associated with grave breaches of this nature. This kind of ban on suspect credits has happened before with Chinese CDM projects which were said to lack any environmental integrity. The projects in question involved producing a noxious gas (HCFC-22) simply to burn its equally noxious output (HFC-23) and thereby earn credits.

Increased vigilance is needed

The controversy that surrounds the CDM is not fading away very easily. This is because the UN’s monitoring powers in respect of projects which are spread worldwide are not sufficiently strong to prevent the system from being abused. The EU ETS is suffering the consequences, which may well add to the volatility of the emissions market. The EU needs to be especially vigilant. Having to ban a new type of offending credit on a regular basis is cumbersome, but the more sweeping alternative of seriously questioning the CDM has not been seriously put on the table so far.

Emerging patchwork of supply important for REDD (source: Ken Bosma)

Last month, the second edition of State of the Forest Carbon Markets,was released. All in all, the report painted a positive picture for the forest carbon markets: the volumes, transaction value and average prices in 2010 were all up on the previous year at, respectively, 30.1MtCO₂e, $178 million and $5.50/tCO₂e.

Notably, REDD based transactions dominated the total volume contracted in the primary market – 67% of the 29MtCO₂e primary market, due to the methodologies developed for the voluntary market – whilst afforestation/reforestation projects declined in transactions across every primary and secondary market.

Moving away from multilateralism

Latin America contracted more than half of all projects in 2010, with the EU as the largest source of demand. Of interest, however, is the increase in localised demand: outside of Europe, most of the demand for a region’s credits was from within that region. In North America, for example, demand nearly equalled supply from the region.

This to be expected, if considered in the context of the wider move towards a patchwork approach to climate policy. The patchwork approach is the increasing preference to enact a patchwork of policies to tackle climate change on a sub-national, national and regional level. These efforts are, arguably, being prioritised over the global, multilateral efforts to address climate change by many countries. It seems that forest carbon is no exception; indeed this approach is becoming increasingly important for REDD.

A patchwork of supply

The report finishes by projecting a growth in supply to 373.1Mt over the period 2011-15, of which REDD projects will supply 335.3Mt, stating that the emerging picture is “fundamentally about a small—but growing—cadre of forward-looking buyers and investors making big bets on the future of the forest carbon markets.”

This is true; the bets are certainly “big”. However, with many countries moving towards a patchwork approach to climate policy, the international compliance market-mechanisms look increasingly unlikely to create significant demand – and in turn supply – for REDD, any time soon. In the Panama climate talks, for example, the focus of discussion still appeared to be on the how market-based mechanisms for REDD are to be included, if at all; demonstrating the absence of globally coordinated efforts to source REDD finance and the gap in financial mechanisms.

It’s possible, then, that “bets” are being made on the growth in REDD supply coming almost entirely from the voluntary markets and a patchwork of non-UNFCCC led unilateral or bilateral compliance mechanisms. The voluntary market is already seeing some significant movement in this area, as the report above demonstrates. In the case of unilateral or bilateral compliance mechanisms, however, the growth is more difficult to envision, precisely because it is a patchwork of mechanisms providing supply, but also because their existence is dependent on the need to offset emissions, i.e. the presence of an emissions cap.

The Governors’ Climate and Forests Taskforce (GCF) is attempting to create such a mechanism. The purpose of the GCF is to create compliance grade REDD credits, such that the entity complying with a cap will buy those emissions reductions in the future. This type of mechanism, whereby the sub-national or national entity that intends to cap emissions helps create methodologies for REDD project types, will become increasingly important for REDD over the coming years. This is because the GCF should, hopefully, demonstrate how REDD can work for projects in the compliance markets, but most importantly, it does so in the context of the emerging patchwork approach.

From the perspective of international climate policy, it may look ungainly, and be more difficult to quantify the emissions reductions on a global scale, but if national and sub-national entities with emissions caps and offsetting rules begin to create similar bilateral mechanisms to that being attempted by the GCF, the REDD market will develop far beyond that offered by voluntary markets alone, bridge some of the finance/supply gap left by the absence of a multilateral mechanism, and do so in the context of the bottom-up, patchwork growth in the REDD space.

Easier to lose than land (Source: Salisbury Area Plaques)

In anticipation of the centralised European registry for the EU ETS the Commission has turned its attention to the legal issues surrounding the traceability of stolen emissions allowances. The approach taken is deferential to the national laws of individual Member States rather than providing a harmonised EU-wide rule. However, the Commission’s proposals have done little to address the risks faced by market participants if found to be unwittingly holding stolen allowances. This is not particularly helpful for the overall health of the emissions market.

Identification and recording of emissions allowances

Much like a land registration system, each emissions allowance within the EU ETS is currently identified by a unique serial number (called a unique unit identification code in the EU ETS registry regulation) and is recorded in one of the national Member State registers, depending on which Member State it has been allocated to. The Community Independent Transaction Log (CITL) supervises and verifies all transfers of allowances between national registries to ensure that they comply with the EU ETS rules.

Phase III of the EU ETS (commencing in 2013) will see a centralisation of the registry system, with all emissions transactions being carried out through a single EU registry, the European Union Transaction Log (EUTL). The central registry will be operated by the European Commission and will replace the individual Member State registries.

Theft of emissions allowances

Since the start of 2011 the emissions market has witnessed several incidents of allowances being stolen from national registries. Eastern European Member States in particular were affected, with millions of euros’ worth of allowances being lost when fraudsters broke into the electronic registry systems. This brought the emissions spot market to a halt in January 2011.

A substantial number of these allowances have not been recovered to this day. This is in spite of each allowance having a serial number, which in theory at least should make its movement through the accounts in the registries easily traceable. However, the approach of the Commission has been to leave the recovery of stolen allowances to the legal systems of individual Member States, without attempting to draft any generally applicable rules in this respect.

Where have all the serial numbers gone?

That derogating to individual Member States represents official policy in this area has been confirmed recently by the Commission’s intention to amend the EU ETS registry regulation to make serial numbers confidential. This means that any stolen allowances will no longer be capable of identification; the responsibility for holding them rests with their owner at any particular time.

The Commission’s proposal is that unknowing purchasers of stolen allowances should be allowed to keep them, while the interpretation of “purchaser in good faith” should be left to the national laws of each Member State. However, Member States have different rules regarding the tracing of stolen property. Emissions market participants would be left uncertain as to what they are holding in their registry accounts. They would no longer be able to identify which allowances are stolen, and would also be potentially liable to losing them if the law of a particular Member State stipulated that the allowances should be returned to their original owner.

Effects on the market

This level of uncertainty does not bode well for the emissions market and could seriously undermine the viability of the EU ETS. There have already been objections to the Commission’s proposal not to publish serial numbers. Coupled with this are the recent closures by some financial institutions of their emissions trading desks, amid fears that the market is too unstable to merit involvement. While the Commission’s attempts to address the security issues in the EU ETS are in themselves commendable, the approach has not so far elicited the desired response from the market.

Who will regulate? (Source: Sébastien Bertrand)

The EU ETS remains high on the UK Parliament agenda following a recent submission by Barclays Capital calling for an independent and separate regulator for the regime. The submission provides a much needed focus on some of the key peculiarities of the EU ETS which have been known to cause tension in the emissions market. In particular, the wide ambit of the EU ETS, open as it is to anyone who wishes to trade in emissions allowances (EUAs), is a potential cause for concern due to the inherent risks of market manipulation.

Who regulates?

The body currently in charge of managing the EU ETS is the European Commission, specifically the Directorate-General for Climate Action (DG CLIMA). Besides being responsible for developing and implementing climate change policy at the EU and international levels, DG CLIMA has the added task of supervising the workings of the EU emissions market.

What is somewhat surprising is the lack of express involvement of another Commission department that would logically have the requisite expertise in this area, namely DG Internal Market. After all, the bulk of the emissions market is made up not of spot trading, but rather of derivatives (specifically forwards) trading based on the EUAs as underlying assets, as this helps participants hedge against possible price volatility. The flexibility and openness of the emissions market has attracted large swathes of financial entities that trade in EUAs and EUA-based instruments for speculatory reasons rather than for compliance with the EU ETS.

The EU ETS – beyond environmental protection

The creation of such extensive emissions trading has taken the EU ETS from the purely environmental and regulatory sphere which it was initially intended to inhabit and placed it firmly in the realm of the financial markets. However, unlike other financial markets, the emissions market is not fully regulated as it is open to entities which are neither under EU ETS compliance obligations nor regulated as financial firms, notably under the Markets in Financial Instruments Directive (MiFID).

The risk of the Commission losing its grip over emissions trading has materialised on a number of occasions, with instances of VAT fraud and theft of EUAs from Member States’ national registries crippling the market. This is particularly damaging to investor confidence as it seriously undermines the credibility of emissions trading.

A sui generis regime?

This level of trouble has not been seen on any other commodities markets, and may suggest that emissions trading is in a class of its own and may require special treatment. The Barclays Capital submission suggests that participation in the market should be restricted to EU ETS and MiFID regulated firms, and that a separate regulator should be appointed that is independent of policymaking bodies. The latter measure would ensure that no public policy-based intervention would occur in respect of emissions prices. This point is particularly interesting given recent UK proposals to introduce a carbon price floor (see earlier Climatico post).

A special regulator in charge of the EU ETS would dilute DG CLIMA’s control over emissions trading as a tool of environmental protection as this goal would presumably have to be balanced against the merits of developing and maintaining a viable market in emissions in its own right. This may be a healthy outcome as it could enable the new regulator to harness the expertise of the EU financial regulation regime while bearing in mind that the EU ETS is a creature of public policy, and as such should pursue the environmental goal of emissions reductions. Whether the EU Commission has the resources or willingness to fashion this hybrid regulatory regime is of course another question.