(The author is a Reuters market analyst. The views expressed
are his own.)
By Gerard Wynn
LONDON, March 12 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
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.
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
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.
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
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.
Chart 1: (page 6) goo.gl/XA7Ou
Chart 2: link.reuters.com/hed66t
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
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)