David Hone

2011 turned out to be a busy year for the development of carbon pricing. Long the cornerstone of EU climate policy, the approach continues to find favour with governments focused on the issue of managing emissions, rather than those trying to manage the shape of the entire energy mix. Since the EU system was introduced in 2005, carbon pricing has appeared in Alberta and British Columbia in Canada, in the North Eastern US states and remains under consideration in South Korea. Several other governments have raised the possibility of a carbon pricing system of some sort.

At the outset of the year there appeared to be little prospect for much movement forward, with some worrying signs that a retreat was possible. Proposition 23 may have been defeated in California, but other legal challenges had surfaced and the new Australian government was not expected to raise an issue that had only a few months earlier led to the fall of the Prime Minister.

But by year end Australia had a carbon price mechanism in place, South Africa had announced its intention to implement a carbon tax, China was apparently moving forward with a variety of pricing mechanisms and California was finalizing the details of its cap-and-trade system. In addition the inclusion of aviation in the EU-ETS had withstood numerous legal challenges and looked likely to go ahead in 2012.

While this is a positive set of developments, it can’t counter the fact that there was a major step backward during the year as well. The price weakness in the EU-ETS at the end of the year and the related difficulties facing the Clean Development Mechanism (CDM) are worrying developments. Although COP 17 in Durban saw a lifeline of sorts thrown to the Kyoto Protocol (and therefore the CDM) and a key committee of the European Parliament voted in favour of a mechanism to bolster the ETS price, both these mechanisms remain in the balance.

2011 also saw a number of US States pull out of the Western Climate Initiative and New Jersey pull out of RGGI.

2012 could well be a pivotal year for a market-based approach to managing emissions.But with the prospect of new negotiations for an international agreement, the possibility of giving new life to carbon pricing is also with us.

As I have noted in recent posts, the EU Emissions Trading System is suffering a decline in fortune. The price has been relatively low since the onset of the financial crisis, driven in part by a decline in industrial activity linked to the recession, but also to continuous overlaying of policy by both Member States and the Commission. Examples of the latter include the UK price floor proposal and the draft Energy Efficiency Directive from the Commission.

The next cab out of the ETS rank looks to be the California cap-and-trade system. Recently Point Carbon reported that:

 “California carbon allowances (CCAs) for 2013 delivery were bid at $16.75/t this week [NB: About 2-3 weeks ago] on news that companies would not have to surrender allowances to cover their 2012 emissions, market participants said.”

California emissions in 2008 (the last full GHG inventory) were as follows:

The total is 427 million tonnes against an allowance allocation in 2020 of 334 million tonnes. At least on first inspection there appears to be the necessary scarcity to ensure a robust carbon price

But California also has multiple policy approaches which operate in the same space as the cap-and-trade system. For example, by 2020 California is required to supply 33% of its electricity from renewable sources. In the transport sector, the Low Carbon Fuel Standard requires a 10% reduction in the carbon footprint of transport fuels by 2020, achieved through electrification, changes in the well-to-tank emissions of the fuel (e.g. through lowering refinery emissions) and substitution of gasoline with alternatives such as ethanol.

Many scenarios could play out here and the level of nuclear power will be critical, but these two policies alone could see emissions drop to 360-370 MT by 2020, removing much of the scarcity driving the carbon market.

Since the election of Governor Brown there is already talk of an even higher renewable energy requirement and there are other existing policies as well (Renewable Portfolio Standard, various energy efficiency standards, CHP requirements, vehicle efficiency measures).  In addition, what is not factored in here is California’s share of the overall drop in US emissions since 2008 as a result of the recession. But on the upside, at least from a carbon market perspective, is the compression of the whole trading period by one year as a result of the delay in implementation.

A back of the envelope analysis today indicates that the California system probably won’t see an allowance surplus through to 2020, nevertheless much of the apparent scarcity is removed by multiple policies operating within the cap-and-trade space. This means that the carbon market becomes a shorter term compliance mechanism rather than a longer term investment driver. It functions only as a check on the other policies.

Rather, investment is driven by mandates and standards on the back of a specific, predetermined design outcome for California’s future energy system – almost certainly a higher cost solution for the energy consumer, but with the same environmental outcome as the cap-and-trade would deliver if left to function on its own.