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(Gerard Wynn is a Reuters market analyst. The views expressed are his own.)
By Gerard Wynn
LONDON, Oct 5 (Reuters) - European carbon permits, shorn of fundamental drivers, have become a bet on recession and the psychology of players including distressed polluters and European Commission officials.
Prices have gradually neared levels seen in the 2009 recession and are down nearly 30 percent year-to-date, under-performing almost all commodities.
The European Union's cap and trade scheme forces nearly 13,000 European factories and power plants to submit an emissions permit, or EU allowance (EUA), for each tonne of carbon dioxide (CO2) they emit.
Alternatively, they can top up by buying carbon offsets called certified emissions reductions (CERs) from low-carbon projects in developing countries.
To work properly, the scheme should be collectively short of EUAs to drive emissions cuts, but in fact that cornerstone requirement was met just once since its launch in 2005 after a financial crisis curbed industrial output and pollution.
The EU does have tools to limit EUA supply, but one wonders if it has the courage to use them, given its concern not to be seen intervening in its flagship carbon market, and the risk of over-compensating and driving up industry costs.
The EU emissions trading scheme (ETS) has demonstrated that the knack of achieving a small EUA short -- not too short to cripple industry nor long rendering the scheme useless -- is a difficult balancing act.
It may represent a critical flaw in carbon markets over a technically simpler but politically unpalatable carbon tax.
The Commission this year published two documents, a "2050 Roadmap" and Energy Efficiency Directive which both explicitly allowed the removal, or "set-aside", of excess EUAs from its emissions trading scheme (ETS) if EU efficiency goals were met.
A Commission spokesman reiterated the option by email late on Tuesday: "The Commission considers that setting aside a corresponding number of allowances in the third period may be needed," he said, referring to the third ETS trading period from 2013-2020.
Some EU member states support proceeding with set-aside, according to documents seen ahead of a meeting next week of environment ministers .
Fully wiping out a combined CER and EUA surplus could triple carbon prices, forcing power generators to cut emissions by switching from high-carbon coal to gas-fired power.
Present coal and gas prices imply an EUA fuel switch price of 25-30 euros, compared with prices now of 10 euros CFI2Zc1 and a previous recession low of 8.1 euros.
At present the available supply of CERs is probably enough to make up the EUA shortfall through 2020, analysts say, meaning they instead set the marginal cost of emission reduction. CERs are currently trading at about 7.5 euros CEREZc1.
EUA prices in the short-term follow the selling behaviour of industrial companies which hold most of the present surplus, and recent price falls suggest distressed polluters may be cashing up.
Long-term prices depend on the persistence of the EUA/ CER surplus through 2020 and beyond, as polluters can in theory use these through a fourth trading period which ends in 2028.
Analysts calculate the EUA/ CER excess through 2020 at roughly plus or minus 500 million tonnes.
European Commission officials could cancel that by full use of set-aside, removing up to 800 million EUAs as proposed in one early draft, sending prices back up to their fuel switch value.
In addition, the Commission could postpone the forward sale of 300 million EUAs, ear-marked for 2011-2012 to raise money for clean energy projects.
That sale process run by the European Investment Bank was conditional on not influencing carbon prices, now fragile, and it makes less sense to auction an under-priced asset.
However, both such measures would spook the market, raise existential questions about what the ETS is for and in particular whether regulators have a secret target price in mind.
The ultimate game-changing intervention would be for EU states to introduce a carbon price floor, but that would start the shift towards a carbon tax and represent a major climbdown on a key EU project. (Editing by Keiron Henderson)