May 18, 2006 -- Datamonitor

 

With 21 of 25 member states having verified their 2005 emissions, Brussels has confirmed that the inaugural year of the European emissions trading scheme has a surplus of allowances. The emphasis on genuine carbon abatement must now shift to the second phase, however massive political and legal uncertainties still remain, as Datamonitor's Paul Stewart explains...

The European Commission (EC) has confirmed that the first year of the first phase of the EU's emissions trading scheme (ETS) currently has a 2.4% credit surplus. Of the four laggard states yet to submit their data, Poland and Luxembourg are widely anticipated to have excess allowances, negating the potential impact of a likely deficit of Italian carbon credits.

With national allocations already agreed for the period 2005 to 2007, the ability of all participating countries to bank surplus allowances for use in later years has raised the prospect that the initial phase of the world's first international 'cap and trade' emissions trading mechanism will end in surplus. Although some genuine emission savings have been made, an over allocation of allowances will not incentivize carbon-intensive industry to curb emissions.

The deadline for submission of second phase national allocation plans - for the period 2008-2012 - is the June 30, 2006. The EC needs to install more stringent allocations to not only get Europe's drive to meet its Kyoto targets back on track, but also restore confidence in the scheme. The accidental early release of sensitive market data has undermined confidence in the EU ETS, adding to already enormous volatility in the price of carbon, which in turn impacts the value of other energy commodities.

Need for uniformity

Short-term price volatility aside, the scheme faces longer-term political and legal challenges. The lack of a uniform national framework for emissions trading lies at the heart of the matter. European courts will decide this summer whether Germany, Europe's largest emitter, can keep its exclusive right to issue and withdraw additional allowances during the annual reporting process.

It remains unclear whether France and Poland will allow their affected industries to bank allowances between the first and second phases of the scheme. Ambiguities regarding the varying size and application of new entrant reserves (NERs) - set aside for new installations entering the scheme - are also an issue. News that five power generators are suing the EC over an additional 20 million allowances that were denied the UK during preliminary approval of its national allocation plan - or NAP - will only add to uncertainty. Whitehall may, however, view this as a potential bargain chip with which to push for the inclusion of new sectors, such as aviation, into the scheme.

Long term uncertainty

The difficult challenge of establishing a deliverable allocation plan for up to six years ahead, which must take full account of intangibles such as weather and economic development, and does not lead to competitive disadvantage, is only made more difficult by the specter of regulatory uncertainty and political horse-trading.

According to a recent Datamonitor survey of EU utility executive opinions, central and eastern European energy companies - natural sellers in the carbon market - believe the EC must give its full attention to a tighter second phase. By contrast, executives in the western Mediterranean were less bullish about this prospect, viewing this development as 'unlikely and irrelevant'. Further afield, however, all eyes are on Europe as the benchmark for pan-regional emissions trading, particularly in the US, where successful capping and trading of sulfur and nitrogen oxides was used as blueprint for the EU-ETS.

The aggressiveness of the EC's stance on second phase allocations and the ironing out of legislative uncertainties will be key. Ultimately, Brussels must get it right for the wider good of the Kyoto Protocol.

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