The truth about second phase ETS

Read in a Montel report on the commodity markets this week:

“The downward correction for carbon still makes sense,” said an analyst at a large European utility, as oil prices were trading above USD 72/bbl. “Phase two of the EU ETS [EU emissions trading scheme] is oversupplied and the only bullish straw is banking to phase three. But this phase is highly uncertain; the CO2 price will largely depend on what comes from the negotiation in Copenhagen [in December]. So EUA banking is in fact speculation on the outcome of political negotiation,” he added.

It looks like participants in the carbon market are starting to realize that we might be facing over-supply again. Indeed, the possibility of holding on to your rights and using them in the post 2012 period (banking) will avoid that the price drops back to 0 euro per tonne levels like we saw for first phase rights. When the price hits a certain bottom, people will no longer bother to sell their rights and hold on to them. But that we have to consider over-supply again is remarkable. At the beginning of July 2008, phase II emission rights prices hit their highest level so far above 30 euro per tonne. Market participants at that point were mostly convinced that a real shortage of emission rights would occur as allocations had be far lower than real emissions. We have always been doubtful about this, as many analysts underestimated:

– The effect of falling energy demand. Most of them considered that the emission of carbon dioxide would just continue to grow like it had always done.
– The influx of emission rights from CDM projects (up to 10% – so-called CER’s).

Of course, the economic downturn is what will probably cause total emissions to drop below the total amount of emission rights that has been awarded. But I think that industry’s efforts to lower energy consumption and the CER-situation are also contributing to the excess of emission rights and that this has been underestimated all along.

Three and a half years are still to go, and we will only now for sure whether phase II was over-supplied or not by the end of 2012. If it would indeed be true that this phase has again been over-allocated, some serious questions arise:

1. Is it possible to have an effective allocation policy in an EU context?
2. For five years, the emission rights price will not help in pushing industries to decrease their carbon dioxide emissions. How will this affect the overall carbon dioxide emission reduction of the EU?
3. Does it make any sense to continue with emission rights trading if it isn’t contributing to reducing emissions?
4. Can the EU continue to act as ‘best of the class’ in international climate change negotiations?
5. What lessons should be drawn from this by other countries that are considering an emission trading scheme such as the US?

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