The EU emissions trading scheme: an overview

Part II – Operation and impact  

Emissions prices hit new highs at the end of May 2005 with trading above €20/tCO₂e  following news of Italy ’s agreement with the European Commission to a 9% cut in its National Allocation Plan. Meanwhile UK gas prices for next winter also hit record levels above 60p/th, due to a variety of factors, including the impact of emissions trading. Following on from our article on the background and concepts of the EU emissions trading scheme in last month’s Mzine (click here to read it), this month’s article explores the operation of the trading market and the impact of emissions trading.

How trading works  

Emissions trading is not a new concept, with SO₂ and NOx schemes having operated in the US for a decade, and various other schemes in place since 2000. However, the EU emissions trading scheme is ground-breaking for a number of reasons, including its scale, covering over 12,000 sites across Europe accounting for 46% of EU CO₂ emissions; its international coverage, with 25 EU states involved and proposed linkages with schemes operated by non-EU members such as Norway and Russia; and its complexity, with 25 national registries and regulatory authorities to be established.  

The registries are a crucial part of the scheme as a whole. In order for emissions trading to work there must be an effective and reliable method of keeping track of the allowances issued, tracking title, and monitoring their eventual surrender for compliance purposes. Since emissions allowances can exist only in electronic form, this is done using a network of computer databases known as ‘registries’, that record emissions trading transactions, and track ownership of EU emissions allowances (EUAs). Under the EU ETS each Member State must establish a national registry. In a national registry, every site issued with EUAs will have its own ‘operator account’. Site operators can trade EUAs and use the registry to log transactions. After the end of each year, site operators must also log their actual emissions in the operator account and surrender EUAs to match this level of emissions by 30 April. As well as operator accounts, registries will offer ‘personal accounts’ which allow non-site operators to trade EUAs. National registries are designed to communicate with the central EU Community Independent Transaction Log (CITL) which checks transfers of allowances between national registries. Although registries are a vital part of the EU scheme, progress on their creation has been hampered by the late agreement on the EU regulations governing them in December 2004, only the month before the scheme was due to start. In the event only Denmark managed to activate its registry in time for the supposed allowance allocation deadline on 28 February 2005. At the time of writing at the end of May, only six national registries are operational ( Denmark , Finland , France , Germany , Netherlands , Sweden , and UK ), with the remaining 19 still awaited. Rather than develop their own registry system and software most states have chosen to use the UK ’s GRETA system (developed for the pilot UK emissions trading scheme which started in 2002) or France ’s Seringas, although Austria is developing its own system.  

With registries only now starting to emerge, almost all EUA trading so far has been forward trading, with contracts specifying notification of transfer in a national registry when they are in place. Forward trading has actually been happening since 2003, with the earliest trades including provisions for what would happen if the EU ETS was never implemented. Trading has concentrated on 2005 vintage EUAs, although, there have also been trades for 2006 and 2007 vintages. The first actual spot trade was reported between Shell and Danish generator Energi E2 on 7 February 2005, through the newly operational Danish registry. Forwards trading is carried out on the OTC market with contracts negotiated and agreed directly between buyers and sellers, either on the telephone, or through a broker or online trading platform. There are currently three standard OTC emissions contracts in use:  

• The IETA Emissions Trading Master Agreement – the International Emissions Trading Association designed this contract specifically for the EUA trading market. It is intended primarily for companies that need to trade for compliance purposes, and does not provide for the trading of other commodities.
• EFET Allowance Appendix to EFET Electricity Agreement – the European Federation of Energy Traders (EFET) has produced a widely used electricity trading master agreement. The Allowance Appendix now available for this contract is expected to be used primarily by power generators and other energy traders.
• ISDA EU Emissions Allowance supplement to ISDA Master Agreement – the International Swaps and Derivatives Association (ISDA) provides a master agreement that is widely used in a variety of cash and physically-settled assets. The ISDA emissions allowance supplement is expected to be particularly used by financial institutions and other traders operating across a range of commodity markets.

In addition to OTC forwards trading, there are a number of organised exchanges competing to provide contracts to the emissions trading market. These include EEX (of Germany ), Nord Pool (of Norway ), EXAA (of Austria ), SendeCO2 (of Spain ), and European Climate Exchange (operating with the IPE), Climex and Powernext Carbon based in the Netherlands . These exchanges offer a variety of spot, forward and futures contracts, but their key advantage is the ability to remove counterparty risk through the use of a central clearing function. This means that trading parties are not exposed if their counterparty goes out of business or in another ways fails to fulfil the contract. Trading so far is varied on the exchanges with ECX-IPE and Nord Pool generally the most active.  

Trading has been growing rapidly during 2005, with OTC volumes for last week reported by Heren at 4.5 million EUAs and exchange volumes around 1 million EUAs, as prices rose on tightening supply, due to the Italian Nap revision, and higher demand forecasts for 2005-2007. With a high reported of €20.30/tCO₂e last Thursday prices have trebled since the launch of the scheme in January 2005. One of the issues remains price tracking, with no widely accepted pricing index yet established. Currently there are four major indices reported: the Argus Emissions Index, which is a monthly cumulative index, and daily indices from EEX, the London Energy Brokers Association and Point Carbon’s Carbon Market Indicator. As the market develops it is expected that one or two indices will emerge as the main market indicators, possibly leading to floating contracts indexed to these indices, as is common in energy contracts.  

The impact of emissions trading  

Emissions trading is already having a wide-ranging impact on a number of areas. This section considers briefly the technical impact on accounting and risk management, before considering the wider impact on energy prices and corporate activities.  

Accounting  

One of the difficulties regarding the whole EU ETS project is the short timescale for implementation, as a result of which there remain a considerable number of areas of uncertainty despite the scheme already being operational. One of the large areas of uncertainty is accounting for emissions trading. The key questions cover what category of asset or grant EUAs should be considered to be, and the interaction between the timing of issuing and revocation of allowances. In period 1 of the scheme (2005-07) at least 95% of EUAs must be issued to companies free of charge. This gifts companies around January or February each year with a potentially large amount of assets (according to International Accounting Standard 38 emission allowances are defined as “intangible assets”). At the same time during the course of a year a company will general actual emissions, which are defined under IAS 37 as “contingent liabilities”, the fair value of which will fluctuate during the year, depending on market prices. Then, in April of the following year, the EUAs must be handed in, and in effect become valueless. This can lead to a serious mismatch between a company’s balance sheet and its profit and loss statement, leading to increased volatility in reported earnings. The free distribution of EUAs also may lead to them being classified as Government grants under IAS 20. Attempts have been made by the International Financial Reporting Interpretations Committee (IFRIC) to find a solution but their initial suggestion was vigorously debated by the IETA, and companies are still considering alternative solutions while the scheme is underway.  

Risk management  

The EU ETS raises many new areas of risk for companies. These include various business, regulatory, financial and legal risks associated with mandatory inclusion in a new and uncertain trading market. It also raises specific risks associated with the volume of emissions produced, and therefore the number of EUAs required by companies, and the price of those EUAs. Clearly the volume of emissions in any year will vary depending on a range of commercial and operational factors, including demand and production levels, competition within industry sectors, working patterns and industrial action, and efficiency of plant. Within the power generation sector, which will account for over 50% of EUAs allocated for 2005-07, relative emissions factors, efficiencies, fuel prices and energy demand will interact to drive the price of carbon and the volume of EUAs traded on the market. As power generators are expected to be the major traders in the developing market, the generation drivers are likely to be key determinants of EUA pricing. All other things being equal, carbon prices seem likely to float in a range between the marginal cost of coal and gas-fired generation. However, there are a series of complex interactions involved, in the context of an already high energy price complex, driven by record oil prices. In the UK gas prices for Winter 05/06 reached over 60p/th in May ’05, while electricity prices for the coming winter reached over £50/MWh. EUA demand for the winter is likely to be further boosted by NationalGridTransco’s Winter Outlook Consultation, published on 31^st May, which forecasts UK gas demand may only be satisfied this winter by changes to normal generating patterns, which would see more coal and oil-fired power generation running ahead of clean-burning, high efficiency combined cycle gas turbines. With emissions prices already at record levels, this is unlikely to be a bearish influence on the market. Further forward, a combination of the EU ETS and the EU Large Plant Directive, which will further limit activities or increase costs for some older coal-fired power stations, is likely to increase trends towards gas-fired generation right across Europe .  

The wider view  

The beginning of the EU ETS, and the coming into force of the Kyoto Protocol, have finally demonstrated that the future is carbon-constrained. Emissions trading in the EU provides clear financial incentives for companies to reduce their CO₂ emissions in EU countries, but it is also driving a wider global trend that sees emissions management as an essential business activity. There are signs that corporate culture is changing. A key trend has been the adoption of environmental criteria for financing by a number of major banks including, JP Morgan Chase, Bank of America, and Citigroup, following lobbying by Greenpeace. Meanwhile, despite the USA’s decision not to ratify the Kyoto Protocol, other pressures are emerging on US companies, including calls from institutional investors for companies to report on their climate change exposure, a cause that has been supported to some extent by the Securities and Exchange Commission. US industrial giant GE launched its Ecomagination programme last month, a strategy to invest €1.5bn/yr in cleaner technologies by 2010 and to bring environmental issues into the heart of its business-planning, while Ford has committed to improve emissions efficiency in its cars and production. Increasingly emissions reporting is being adopted by major players. Even ExxonMobil, regarded by many environmentalists as the chief sceptic of anthropogenic climate change, saw 28% of its shareholders vote in favour of a motion to report on its compliance with Kyoto targets in the countries it operates in where these targets apply. In Europe - where carbon constraints are the present, not the future, reality - emissions trading is already a key issue for some players, although the crunch may emerge next Spring, when the first year of emissions allowances are due to be handed over, and failure to comply will bring a fine of €40/tCO₂e plus a requirement to make up the shortfall in the following year. The ripples are, perhaps, only just beginning…