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Carbon Emission Trading: A New Financial Market

Carbon Emission Trading: A New Financial Market. Spring Meeting 2007 Oïkos International “Sustainable Development: What role to play for finance”. Laurent Viguier INV – Buy-side Equity Research April 19, 2007. Timetable. Climate Change: Scientific Evidences and Economic Impacts

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Carbon Emission Trading: A New Financial Market

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  1. Carbon Emission Trading:A New Financial Market Spring Meeting 2007 Oïkos International “Sustainable Development: What role to play for finance” Laurent Viguier INV – Buy-side Equity ResearchApril 19, 2007

  2. Timetable • Climate Change: Scientific Evidences and Economic Impacts • The Kyoto protocol: Architecture and Commitments • Why Should We Trade Emissions? • CO2 Trading in Practice: The EU ETS • Conclusion

  3. 1. Climate Change: Scientific Evidences and Economic Impacts

  4. Evidence from Direct Observation of Climate Change • The total temperature increase from 1850 – 1899 to 2001 – 2005 is 0.76°C. • Global average sea level rose at an average rate of 1.8 mm per year over 1961 to 2003. • Mountain glaciers and snow cover have declined on average in both hemispheres. Source: IPCC WGI Fourth Assessment Report, 2007

  5. Projections of Future Changes in Climate • For the next two decades a warming of about 0.2°C per decade is projected for a large set of emission scenarios • For the low scenario (B1) surface warming for the end of the 21st century is 1.8°C • For the high scenario (A1FI), the best estimate is 4.0°C Source: IPCC WGI Fourth Assessment Report, 2007

  6. The Impacts of Climate Change on GDP Growth • Economic models agree that the effects of warming above 2 - 3°C would reduce global welfare • Models also agree that poor countries will suffer the highest costs Source: Smith et al., 2006

  7. Costs of Stabilizing Greenhouse Gases Concentrations • The GDP costs of stabilizing GHG concentrations are expected to be high • For 2025, costs range from 0 to 3.5% of GDP Source: Barker, 2006 Source: EMF21, 2006

  8. Flexibility is necessary • Uncertainty and irreversibility  Temporal flexibility • Cost divergence across sectors and regions  Spatial flexibility • Emission Trading contributes to: • Spatial flexibility: trading of permits across regions • Temporal flexibility: i.e. banking and borrowing of permits

  9. 2. The Kyoto Protocol: Architecture and Commitments

  10. Basics of the Kyoto Protocol After Russia’s ratification, the Kyoto Protocol became a legally binding agreement in February 2005, committing signatories to greenhouse gas (GHG) emission limits The Kyoto Protocol: • Targets emissions of the six main GHGs: • carbon dioxide (CO2), methane (CH4), nitrous oxide (NOx), hydrofluorocarbons, (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6) • Represents 55% of developed countries’ GHG emissions of 1990 levels • Does not include the United States or Australia Commitments of Phase I of Kyoto Protocol (2008-2012): • EU Average -8% (with Germany and Denmark -21%, Portugal +27%) • Japan -6% • Annex I countries (most developed countries) average -5.2% Emissions Reduction Targets are relative to 1990 (base year)

  11. Members of the Kyoto Protocol Annex B Countries with Commitments Non-Annex B Countries = No Commitments

  12. Reaching the Kyoto Targets: The 3 Flexible Mechanisms Annex 1 parties must establish domestic policies and measures to cut GHG emissions (‘Green policies’) and establish national agencies to monitor and report emissions Countries can meet their emissions targets using the three Flexible Mechanisms: 1. Emission Trading- Annex I countries can buy and sell emission rights • The EU Trade Allowance (EUA) represents 1 tonne of CO2 2. Clean Development Mechanism (CDM)- Annex 1 Parties implementing emission reducing projects in non-Annex 1 countries (i.e. developing countries). • The Carbon Credits are called: CERs = Certified Emission Reductions 3. Joint Implementation (JI)- Annex 1 Parties undertaking net greenhouse-gas emission reducing projects in other Annex 1 countries (often emerging economies). • For the current EU-ETS Phase I until 2007, only CDMs are permitted. • The Carbon Credits are called: ERUs = Emission Reduction Units

  13. The Kyoto Mechanisms Emissions Trading (EU ETS) Annex B Country (industry) Annex B Country (transport, etc) Joint Implementation (JI) Exchange of CO2 quotas Clean Development mechanism (CDM) Clean Development mechanism (CDM) Non-Annex B country (All sectors) Annex B Country (industry)

  14. 3. Why Should We Trade Emissions?

  15. Tradable Emission Permits (QET) • John Dales (1968) • Maths by David Montgomery (1972) • First experiments in the USA since 1974 (SO2 from electric utilities) • Main argument for TEP: Minimize the economic cost while reaching the global environmental target

  16. The Problem of Allocating Abatement Assumptions: • Two emitters • Damages are additives: DT = D1+D2 (ex: CO2) • Marginal costs of reductions differ among emitters (i.e. technology, resources, etc) • Global reduction target is 50% • How to allocate the effort? 50% each?

  17. P150 Polluter 1 (High MACs) Dollars Polluter 1 MAC1 Abatement Δ10 Δ150 50% reduction  Marginal abatement cost is P150  TOTAL abatement cost for polluter 1 is the pink triangle

  18. P250 Polluter 2 (Low MACs) Dollars Polluter 2 MAC1 MAC2 Abatement Δ20 Δ250 50% reduction  Marginal abatement cost id P250  Total abatement cost for polluter 2 is the pink triangle

  19. Inefficient Allocation Dollars MAC1 MAC2 P150 P250 Abatement Δ20 Δ250 P150 >P250  Global cost of the total reduction is not minimized

  20. MAC1 Gains of the buyer Volume of traded quotas = ΔA* - ΔA1 MAC2 Gains of the seller P* ΔA1 ΔA* Equilibrium in the Emission Market Francs Abatement A1 Abatement A2 ΔA2 At the equilibrium, Supply = Demand and the price is P* Every polluter gains from the exchange of quotas!!

  21. Efficient Allocation under different instruments • Tax: Uniform tax rate applied to all emitters  optimal reductions • Standard: Optimal targets that equalize MACs among polluters • Information problem + equity issues • Emission trading: Whatever the initial allocation, the MACs are equalized through the market and the optimal solution is obtained

  22. Example of MACs for CO2 in Japan, Europe and USA Source: Viguier et al., 2001.

  23. 4. CO2 Trading in Practice: The EU ETS

  24. Phase I runs from 2005-2007 Only CO2 emissions from large emitters: Power stations Boilers > 20MW thermal input Oil refineries and Coke ovens Iron and steel plants > 2.5 t/hr Glass factories > 20t/d Ceramic, bricks and porcelain factories Cement factories > 500 t/d Wood pulping and paper manufacturing > 20t/d 2.2 bn allowances allocated annually. Phase II will run from 2008-2012 Other industries that might beaffected: The transport sector, especially Aviation The petrochemical industry Aluminium smelting Waste disposal Agriculture EU-ETS Phase II corresponds to the Kyoto Protocol Implementation Phase European Emissions Trading Scheme (EU ETS) From January 1, 2005, the EU has operated an emissions trading system:

  25. Carbon Market Dynamics

  26. CO2 Quotas Traded since January 2005(cumulative, MtCO2)

  27. CO2 Price in the EU Market First emission inventories  no shortage! Two different markets: No banking

  28. Coal price Gas price Why the spot price collapsed? • Structural reasons: • In May 2006, the market understood the phase to be long (initial allocation was too generous) • No banking  prices will necessary end up at a very low price at Dec. 07 • Short term trends: • Climatic conditions (hot winter) • Energy market: coal/gas spread

  29. Kyoto did not collapse after US withdrawal • The EU successfully implemented the first international ETS: • Improvement are required tor reduce uncertainty and volatility in the EU ETS: i.e. NAPs, reserves for new entrants, banking, etc • CO2 commodity  “Business-As-Usual” for the financial market 5. Concluding Remarks

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