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Analysis of strategic growing market for emission allowances

Prices are rising and companies must increase their purchases. Trade in carbon dioxide emission allowances has become a key strategic issue for industry. SEB is therefore starting to offer carbon market research. Bjarne Schieldrop, Chief Analyst, Commodities, explains how the system works and how it is affected by the climate agenda.

“Previously companies received a large amount free and furthermore the price was below 5 euros per tonne for many years. Now they have to buy twice as many emission allowances and the price has quadrupled so this has become a market risk which suddenly has great significance,” he says.

Bjarne Schieldrop is an expert on the energy market and has followed the system for emission allowances ever since it was set up in the first test phase in 2005.

System to reduce carbon dioxide emissions

The background was the Kyoto Protocol from 1997 where nations committed to reducing carbon dioxide emissions. The EU decided to transfer some of these commitments to the private sector by introducing a “cap and trade” system for trading in emission allowances.

“The principle is simple. Assume that there are 1,000 emissions per year and that the target is to reduce this to 500 after five years. They issue 900 emission allowances in the first year and distribute them in the market through a mix of free allocation and auctions. Companies are entitled to either buy or sell emission allowances in the market. If the company can reduce emissions for a price which is lower than the market price, they can reduce emissions themselves and sell the emission allowances in the market. At the end of the year participants submit an account of their carbon dioxide emissions and the corresponding quantity of emission allowances. In the second year they issue 800 emission allowances, year three 700, and so on until the stated target is reached.”

Experiences during the test period

The EU’s Emission Trading System, EU ETS, was initially set up for a three-year test period between 2005 and 2007. It covered industries with major emissions such as cement, steel and aluminium plants and the power and heat generation sector. In total the system covered 40% of all emissions in Europe. The remaining 60%, which lies outside the system, consists of emissions from other companies, private individuals, cars, and so on.

“Politicians wanted to protect heavy industry from international competition and initially issued 100%, or even 110%, free allocation of emission allowances to these players to compensate for the stress caused by the new system. But from the outset energy companies such as oil and gas producers received an under-allocation of emission allowances.”

The system itself runs on an annual cycle. At the start of the year the total number of emission allowances to be issued is fixed. These are allocated free direct to companies or via auctions that are held at national level every 14days throughout the year.

Since allocation and the auctions take place at national level, this has often led to horse trading between countries with different conditions. Companies that are included in the system must by 30 March each year account for the quantity of emissions in the previous year. On 30 April they must then submit the corresponding amount of emission allowances.

“During the test phase allocation was generous and exceeded in total the actual level of emissions. But the industrial companies which had a surplus of emission allowances were reluctant to sell. They had received the emission allowances as a free gift, and it was politically sensitive to earn money by selling them. The effect was that for the first two years there were few emission allowances on the market and prices were high despite the system being over-allocated. In the final year of the test phase, 2007, the price of emission allowances collapsed however and gradually fell to zero.”

Reformed after the financial crisis

In 2008, when the Kyoto Protocol came into force, the test phase ended, and the system went into live production. The system was cleared and started again from the beginning. Free allocation to industry remained high while the power sector was under-allocated. Now trade in emission allowances began to pick up.

“But then came the financial crisis of 2008–2009 and industry slowed down. Emissions naturally fell sharply and prices on the carbon dioxide market collapsed down to 3-4 euros per tonne. The system was not flexible enough to handle a financial crisis,” says Bjarne Schieldrop.

This was followed by several years when Europe’s politicians were busy coping with the financial crisis and national debt crises. But after 2015 the politicians started to focus on how the system should be modified and introduce mechanisms to handle crises of this type.

Europe emits a total of 4–5 billion tonnes of carbon dioxide annually. Of this the trading system today accounts for 1.6–1.7 billion tonnes. Previously it was up at around 2.2 billion tonnes. The first step in reforming the system was to remove the surplus of just over 2 billion tonnes, more than a year’s consumption, which had accumulated during the recession following the financial crisis.

In 2019 the Market Stability Reserve was introduced which means that when the surplus exceeds a given level, 24% of the surplus is taken off the market and placed in a reserve. In the event that this reserve exceeds a year’s consumption, the emission allowances are permanently removed from the market.

“Now, after a lot of trial and error, there is a system that is more stable and better able to handle crises and variations. This could be seen during the corona crisis. Initially the price of emission allowances fell sharply due to reductions in carbon dioxide emissions. But, since there is now a mechanism that regulates the surplus, the market quickly recovered and the price stabilised.”

Dramatic changes since last year

So where do we stand today?

Yes, according to Bjarne Schieldrop there have been dramatic changes during the past year.

“Even if there is now a framework with rigid rules, you have to remember that this is a 100% politically constructed system. You need to fundamentally analyse the market, but also purely politically. The politicians can always go in and change the market framework.”

So back to June 2020. The situation then was that Europe in the Green Deal 2019 had assumed the yellow jersey with a target of zero emissions by 2050. On the other hand, it was more uncertain how China, which has the highest carbon dioxide emissions in the world, and the USA under Donald Trump would react. This created political uncertainty around how hard Europe would push its climate agenda,

“Then it was autumn and the first thing that happened was that China declared that they would reach zero emissions by 2060. Then the EU announced a sharply increased milestone on the way to zero emissions. Now emissions were to be reduced, not by 40% but by 50% by 2030 compared with the base year 1990. We should build new factories and change our lifestyle in nine years. That’s pretty radical.”

The change of scene was completed when Donald Trump lost the election and the new Biden administration declared that the USA would reach zero emissions by 2050 and that the entire energy sector should reach zero emissions by 2035.

“Where we are right now means that all three major political and economic power centres are heading in the same direction. There is no longer anything to hold back Europe. So, we can assume that they will also put political force behind the emission targets.”

Key decisions this summer

The price of emission allowances, which has hovered around 5 euros per tonne for many years, has in the past year risen fast and is at the time of writing EUR 38.40. Also, the trading system means that participants get fewer emission allowances free and need to purchase an increasing number on the market.

In summer 2021, Europe must make a number of key decisions if it is to have a reasonable chance of reaching the target of zero emissions by 2050. This will affect trade in emission allowances and one issue is how the load should be shared between the sectors that are part of the trading system and the rest of the market.

“If they choose to place a major part of the load on the trading sector, there will be a high visible price for carbon dioxide. If they place a major part on sectors outside the trading system, there will be a high invisible price for carbon dioxide. Because all regulation has a price. For example, if you want to reduce car traffic you do it typically with subsidies for electric cars or with taxes. Both options cost and both have a carbon dioxide price, but one is visible and the other is invisible.”

This dynamic is central to analysing development. It is a difficult market to analyse since it must be analysed from political, economic, scientific and social viewpoints in Bjarne Schieldrop’s opinion.

What is the real cost of emitting carbon dioxide?

“What is really the right price for emitting carbon dioxide? What effects does it have on the environment and society? According to economic theory there should be a tax on emissions corresponding to the costs they cause. The principle for this is simple, but the calculation is difficult. What is the negative effect in 2100 and how do you discount this back to today? Here there is considerable uncertainty depending on what discount rate is used in the calculation.

“The calculations have fluctuated widely in recent years from a price of 1 euro per tonne to 200 per tonne. But recently a consensus has been reached that the correct social cost for carbon dioxide which covers the damage occurring now and in the future should be between 40 and 80 euros per tonne with an increase of 5% per year.”

This discussion will also affect the price on the market for emission allowances.

“The literature about what should be the morally correct price for carbon dioxide emissions influences the EU politicians when they decide on the way forward to 2050. You cannot be the world’s green leader and at the same time have a marketplace with a visible carbon dioxide price that is way below this. It would be an embarrassment. My assessment is that the price per tonne should be from 45 euros and upwards.”

Trading in emission allowances has become and will increasingly be a central economic issue for industrial companies. It has also become a central part of the bank’s commodity trading. This is because emission allowances differ from other commodities since they are something that is used by all industrial companies in the system.