Nov 04, 2008 -- Datamonitor

The European Environment Committee has backed plans to revise key clauses in the landmark climate and energy package just as the financial turmoil and the expected protracted economic slowdown place severe downward pressures on carbon credit demand and pricing.

Over the past few weeks, several EU Member States have sought revisions of the landmark climate and energy package in order to protect some of their key industries.

Eastern European countries - namely Bulgaria, Estonia, the Czech Republic, Hungary, Latvia, Lithuania, Romania, Slovakia and Poland - have been vocal critics of the proposed shift from the current free allocation system to the proposed pan-European auctioning mechanism, as fears that this policy would undermine their respective economies set in.

Prime ministers from most of these Eastern European countries had warned fellow EU Member States in Western Europe that they would only support the EU climate policy if their proposed changes were acknowledged. This involved lobbying major Member States - namely France, Germany and Spain - to force major revisions to the EU's plans for the third phase of the EU emissions trading scheme (EU ETS).

Poland, along with other neighboring Eastern European countries, had tabled several proposals aiming to ease its obligations under the EU ETS as well as in other sectors not covered by the scheme, claiming that the proposed changes did not respect the differences of the Member States' economic potential. This came on the back of claims that the vast majority of the EU-27's emission reductions had so far been achieved by less affluent Member States at a very high social and economic cost.

Both the EU parliament and Member States, via the EU council, now need to agree on the commission's package in order for it to become law.

Slowdown

In October, the seasonally adjusted Eurozone Purchasing Managers Index (PMI) for the manufacturing sector, seen as a leading indicator on the state of the economy, slipped significantly against September levels. There are now very strong signs that European manufacturing is on the decline, which could affect overall emissions and carbon prices. Indeed, a decrease in European manufacturing would mean lower emissions and a drop in demand for allowances from heavy industry. While such a downward revision in demand is unlikely to alter market fundamentals, it does imply less price support for carbon credits.

The slowdown in manufacturing was largely responsible for the price of European carbon declining to a new 18 month low in the last week of October as traders assimilated news of production cuts by big energy users. The credit crisis in global banking and market expectations of a recession in the US and Europe have hit stocks and energy commodities just as carbon continues to take its lead from front Brent crude futures, last trading at $61.75/bbl at the time of print, down 3.1% from its closing position on the Intercontinental Exchange on the October 30.

That same week, as expected, the sell-off was led largely by industrials concerned that demand for their products could slow or fall sharply in the midst of a severe downturn, with speculators also shorting their positions in anticipation of lower manufacturing output as continued fears about a global recession pressured prices.

Illogical resilience?

However, with so many uncertainties prevailing in the carbon and other financial marketplaces, carbon is increasingly irrational. Supply, demand and pricing could move in either direction as a result of a prolonged slowdown in economic growth. While banking of freely-allocated EU emission allowances (EUA) is believed to be the default trend among the major energy users today, wider supply and demand fundamentals could shift substantially as the downturn starts to bite.

Most companies started Phase II with long positions as they received the bulk of their carbon allowances for free. However, demand could shift skyward towards the back end of Phase II and the start of Phase III as compliance buyers enter the market to cover shortfalls. For now, companies are unsure of their likely industrial output in years to come, so they are showing little interest in looking beyond immediate compliance needs.

At the same time, it seems likely that, over Phases II and III, more electricity will be generated using coal as planned investments in new power plants are shelved. Similarly, a drop in funding for emission reduction projects in developing countries could lead to deflated supplies of UN-backed carbon credits, at a time when the certified emissions reduction price curve dips in and out of backwardation. A slowdown in financing may also result in older, less efficient and more polluting plants staying 'on-line' for longer, which in turn would imply a greater demand for carbon credits.

Also, it is ultimately unclear how the economic slowdown will affect the spread between gas and coal prices - very much the main driver of EUA prices - and whether the global recession would weaken demand for coal, with knock-on effects on the price of carbon.

Ultimately, it is worth remembering that electricity demand in mature economies is relatively resilient and is likely to remain so. A minimum element of price and demand stability can be expected in the medium term on the basis that the power sector accounts for the large majority of the carbon market.

One thing is certain: Europe will further undermine its already fragile credibility in international climate negotiations if it fails to pass its climate and energy package before the end of the year.

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