COLUMN-What is the underlying value of EU carbon?: Wynn

Tue Mar 12, 2013 9:02am EDT

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(The author is a Reuters market analyst. The views expressed are his own.)

By Gerard Wynn

LONDON, March 12 (Reuters) - The uncertainty over prospects for the European Union emissions trading scheme is so great that it justifies current low carbon permit prices - which may even be a little high by one method of estimating underlying value.

The scheme faces a range of possible outcomes in this decade. These range from a cancellation of up to 1,900 million or so surplus EU allowances (EUAs) following on from reforms now being planned and which would greatly boost confidence, to total scrapping of the market, which is unlikely.

The associated near-term price outcomes range from zero to about 10 euros per EUA, each equivalent to a tonne of carbon dioxide.

Today's carbon price of just under 4 euros is around half last year's levels.

The prices of EUAs, which are central to EU climate policy, have plunged as recession and slowing industrial production led to a surplus of allowances. Prices are too low to drive investments in clean energy to help cut greenhouse gases.

One method for calculating the underlying value of EUAs is to discount the estimated future fuel switch price when the market is next in short supply of permits.

At present allowances are so cheap they do little to shape choices of fuel. When the market is short, electricity generators can meet their obligations either by cutting their emissions, for example by switching from coal to burning cleaner gas, or else by buying allowances.

Discounting the estimated future fuel switch price is a theoretical way of estimating present value, which for any given scenario requires assumptions about future demand, market reform and fuel prices.

It will differ from actual present prices which are determined by daily supply and demand and news flow.

Daily supply and demand are set by utility hedging of future power sales, the weather and the willingness of industrial companies at any given moment to sell their huge surpluses.

However, a discounted fuel switch price analysis is useful to illustrate assumptions around underlying value and the risk of tying up capital in this market.

NEXT SHORT?

Given the vast uncertainties that still surround EU reform of the carbon market up to 2020, it is unsurprising that few analysts have so far estimated the carbon market demand-supply balance beyond then.

The European Commission last November estimated a cumulative surplus of more than 2 billion tonnes of EUAs by the end of the decade. (Chart 1)

Thomson Reuters Point Carbon estimates a cumulative surplus of 2.4 billion tonnes in 2020, including the aviation sector and use of international credits traded under Kyoto Protocol schemes.

Point Carbon analysts estimate that the biggest annual surplus was in 2012, but shrinking surpluses would persist annually through 2020, after including the use of international credits, adding further to the massive cumulative overhang. (Chart 2)

Looking beyond 2020, under one set of assumptions without any reform of the carbon market, the cumulative EUA surplus would persist until 2034.

Those assumptions are, after 2020: emissions falling by 0.5 percent annually and the total allowed cap including aviation falling by 1.2 percent per year (each continuing Point Carbon's expected trends for the second half of this decade); and no use of international credits.

The EU is unlikely to let the market limp along unassisted for another two decades, however.

Under the most ambitious imaginable short-term fix, EU member states could agree to cancel permanently some 1.9 billion EUAs during the present trading phase of the scheme.

Using the same assumptions as above and subtracting the cancelled allowances, the market would then become short in 2025.

Alternative, post-2020 reforms could include much steeper annual reductions in the carbon cap from 2025, as allowed under the existing emissions trading law; a carbon price floor; or an ambitious 2030 EU-wide emissions cap.

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Chart 1: (page 6) goo.gl/XA7Ou

Chart 2: link.reuters.com/hed66t

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DISCOUNTED PRICE

Under the drift scenario of no reform, the market could clear the surplus in 2034 at a real (in 2013 money) fuel switch price from coal to gas of 60 euros per EUA compared with about 45 euros now, assuming a widening of prices between the two fuels.

In that event, the underlying value of EUAs today is 2 euros, applying a cost of capital of 15 percent.

Such a valuation is nonsense, given no-one would pay attention to or invest in a market that was set to be in limbo for so long, and present prices should fall closer to zero in the absence of meaningful reform.

Under an ambitious reform scenario, if the market cleared in 2025 with a fuel switch price of 50 euros, then EUAs would now be worth 7.1 euros, applying the same cost of capital.

It appears that the market is presently applying a higher risk premium against such an outcome, where investors would require returns of 19 percent annually to generate today's carbon price of just under 4 euros.

There are many critical assumptions involved in such analysis, not least the future fuel switch price (and implied future coal and gas prices), and a linear annual reduction in emissions after 2020 at the same rate as estimated by Point Carbon for the five preceding years.

It suggests that carbon is presently trading in the right ball park, in between the extreme outcomes of no market reform and radical change, with an implied risk premium on the latter which arguably should be even larger given it is a long way off. (Reporting by Gerard Wynn; Editing by Anthony Barker)

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