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An Introduction to Carbon Markets Financial Markets Group London School of Economics 15 May 2008

An Introduction to Carbon Markets Financial Markets Group London School of Economics 15 May 2008. Sam Fankhauser IDEAcarbon. Overview. Why markets? The efficiency of markets Permits vs. taxes Carbon markets EU Emissions Trading System The Kyoto mechanisms Voluntary markets

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An Introduction to Carbon Markets Financial Markets Group London School of Economics 15 May 2008

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  1. An Introduction to Carbon MarketsFinancial Markets GroupLondon School of Economics15 May 2008 Sam Fankhauser IDEAcarbon

  2. Overview • Why markets? • The efficiency of markets • Permits vs. taxes • Carbon markets • EU Emissions Trading System • The Kyoto mechanisms • Voluntary markets • The future of carbon markets • Creating a market • Policy environment: the global deal

  3. The need for emission cuts From the Stern Review

  4. Sharing the abatement burden 6.00 United States 5.00 Can-Aus-NZ 4.00 Russia Japan Developing country (non-Annex I) countries W.Europe Emissions (Tonnes of Carbon Per Capita) 3.00 EITs South Africa 2.00 MiddleEast Latin America 1.00 China OtherAsia Other India Africa - 0 1000 2000 3000 4000 5000 6000 Population (Million)

  5. The benefits of emissions trading • Effectiveness • Track record in reducing emissions • Efficiency • emission reduction at lower costs • Integration • Finance and technology flow to emerging markets Cost of meeting Kyoto targets for the USA, 2010 US$ billion Source: Manne and Richels (1998)

  6. Taxes vs permits • Economic efficiency argument • Taxes: certain cost, uncertain quantity • Permits: uncertain cost, certain quantity • Optimal choice depends on the slope of marginal abatement, damage cost curves (Weitzman)

  7. Taxes vs permits MAC Steep MB curve Flat MB curve MB MAC Marg. Abatement Cost Marg. Abatement Cost MB target target

  8. Taxes vs permits MAC Choose permits Choose tax MB MAC Marg. Abatement Cost Marg. Abatement Cost MB target target

  9. Taxes vs permits • Political economy arguments are more conclusive • International carbon tax agreement difficult to achieve • Domestically, industry prefers (grandfathered) permits

  10. Grandfathering – a source of profit

  11. Overview • Why markets? • The efficiency of markets • Permits vs. taxes • Carbon markets • EU Emissions Trading System • The Kyoto mechanisms • Voluntary markets • The future of carbon markets • Creating a market • Policy environment: the global deal

  12. More than one carbon market • Allowance market (cap-and-trade) • EUA EU Emissions Trading System • AAU Kyoto International Emissions Trading • Kyoto mechanisms (baseline-and-trade) • CER Clean Development Mechanism • ERU Joint Implementation • Voluntary market • CFI Chicago Climate Exchange • VER Voluntary carbon offsets

  13. …dominated by the EU ETS Source: World Bank

  14. Heterogeneous prices Source: Reuters Interactive

  15. The Kyoto Mechanisms • Clean Development Mechanism • Annex I firm/country financing emission reductions in a non-Annex I country • Joint Implementation • Same as CDM but between entities in Annex I countries • International emissions trading • Trade of AAUs between Annex I parties • Green Investment Schemes

  16. A closer look at the CDM Technologies Sellers Source: World Bank

  17. A growing pipeline Source: IDEAcarbon / ECON Global Carbon Report

  18. Accounting for project risks

  19. Kyoto supply

  20. CER Supply

  21. Compliance Demand

  22. Clearing the market Inventory is larger than potential demand • Serve public sector demand first • Less price elastic • Price differentiation allows to charge more • Serve private sector demand • Price elastic, demand determined by in-house abatement options • Downward pressure on prices • Bank supplies into post-2012 period • Regulatory uncertainty means sale at a discount

  23. The 2008-12 market

  24. Question mark: AAUs Source: World Bank

  25. EU Emissions Trading Scheme • 11,000 installations in 27 EU countries • Energy, refining, minerals, metals, pulp&paper • Annual compliance requirement • Targets set in National Allocation Plans • Mostly grandfathering, some auctioning • Possibility to import Kyoto carbon • At least three trading phases • Phase I 2005-07 • Phase II 2008-12 • Phase III 2013-20

  26. Price volatility … a sign of insufficient market information Source: IDEAcarbon / ECON Global Carbon Report

  27. Collapse of phase I price Source: IDEAcarbon / ECON Global Carbon Report

  28. Price drivers in the EU ETS • National Allocation Plan • Both phase II and phase III through banking • Ratio of coal to gas price • Determines fuel switching • Marginal abatement cost elsewhere • Weather • Cooling / heating demand • Hydro availability • Output / GDP • Process emissions in industry • Electricity demand

  29. Prospects for Phase II

  30. Chicago Climate Exchange • Self-described as “world’s first and North America’s only voluntary, legally binding, rules-based GHG reduction and trading system” • Established in 2000 with currently 312 (voluntary) members • power, automotive, chemical industry; banks, universities, municipalities; project developers, offset aggregators, NGOs • Six gases, both allowance-based and offset credits • In 2006 about 10.3 MtCO2e were transacted, worth US$91m; as of July 2007 26.3 MtCO2e had been traded on the exchange

  31. Overview • Why markets? • The efficiency of markets • Permits vs. taxes • Carbon markets • EU Emissions Trading System • The Kyoto mechanisms • Voluntary markets • The future of carbon markets • Creating a market • Policy environment: the global deal

  32. Growing European market Source: IDEAcarbon, ECX

  33. North America • US state-level • Regional Greenhouse Gas Initiative (RGGI) • Western US Initiative • California AB 32 • US federal level • Lieberman-Warner Climate Security Act • Before the Senate in H1 2008 • Other bills in both House and Senate • Canada • Intensity targets for large emitters

  34. Asia - Pacific • New Zealand (NZ ETS) • Starts trading in summer 2008 with forestry • Covering all emissions by 2013 (industrial processes by 2010) • Australia (AETS) • Starts trading in 2011 • Covering >70% of emissions (ex. Agriculture, forestry, fugitive emissions) • Japan • Focus on voluntary schemes (JVETS)

  35. Open issues • Permit allocation • Auctioning, grandfathering, benchmarking • Scope • Difficult sectors like agriculture, transport • Upstream vs. downstream • Safety valves against price spikes • Carbon leakage and competitiveness • Linking with other schemes • CDM imports • Linking with other schemes (e.g. NZ – Aus)

  36. Long-term: Markets in 2020 • Carbon markets in practically all OECD countries • Regional schemes linked by an extended, enhanced CDM • Underlying assets: 7.5 billion allowances, worth 200 billion? • Of which > 4 billion in a US federal scheme? • Trading volume: 8 – 13 billion tCO2 • What is the global deal?

  37. The “global deal” • Long-term target: a 50% cut by 2050 • For a 450 - 500 ppm stabilisation target • Consistent with G8, EU rhetoric • Equitable burden-sharing • Up to 80% cut in developed countries • Developing countries get help on technology, carbon finance • The next 6 months are crucial • Target: agreement by 2009, ratified in 2012 • Next step: G8 Japan (summer); COP (Poznan)

  38. Contact Details sfankhauser@ideacarbon.com Tel +44 20 7664 0205 www.ideacarbon.com

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