World Bank State and Trends of the Carbon Market 2010: an alternative view

The 2010 edition of the World Bank's annual State and Trends of the Carbon Market just came out. It's a useful (if obscure at times) source of info, if you filter through the obvious biases. Here's an attempt to do just that:

* The WB carbon market watchers are worried about the future of the UN's Clean Development Mechanism: demand for CDM credits fell, the development of new projects ground to a near halt, financiers were shipping out of CDM, and the future of demand for CDM offsets after 2012 is unclear.

* "The European Union Emissions Trading System (EU ETS) remained the engine of the carbon market. A total of US$119 billion (€89 billion) worth of allowances and derivatives changed hands." The increased volume of trade in the EU ETS is explained by (I) VAT manipulation, some of which was fraudulent; (ii) a fire sale of surplus permits to raise short term cash, (iii) an increase in speculation

* On "volume of trade" there's actually a massive fudge in the WB's way of dealing with the VAT loopholes - in particular, the purchases of EURs as a way to "legitimately" generate short term financial gain (as opposed to the illegal, carousel fraud stuff). The WB notes a 450% increase in "spot market trades" in early 2009, which is closely related to this (although partly also explained by the dumping of surplus permits by industries in the EU looking for quick cash). So the headline to the WB press release: "Global Carbon Market Grows to $144 billion Despite Financial and Economic Turmoil" overlooks some rather awkward questions about a spike in trade that a result of manipulation (and, in some cases, outright fraud), on the one hand, and an increased volume of trade caused by companies dumping carbon permits, causing the price to collapse (!)

* The EU remains far and away the largest source of demand for Kyoto offsets (mainly CDM). If there's no Kyoto commitment post-2012 or new deal, the EU ETS will restricted purchases to offsets developed in LDCs, and to countries with bilateral deals with the EU (watch this space).

* The vast majority of CDM and JI credits issued now are being bought for purposes of financial speculation or to be “banked” by industrial users (so that they won't need to make changes in their emissions in the post-2012 period). Very few players need these credits in relation to current "compliance" requirements: either for companies to meet EU ETS targets, or countries to meet their Kyoto targets. The exceptions are a few large power producers in the EU (mostly in UK and Germany) who are "short" in ETS. Amongst governments, Spain and Italy account look set to account for almost half of the government purchases of Kyoto offsets (mostly CERs) by 2012.

* The WB estimate for the phase 2 surplus of permits in ETS is 970 million tons CO2. As of 2009, the total ETS emissions reduction for the period 2013-2020 projected by the EU was 2,642Mt CO2e. ie. almost 40 per cent of the claimed reduction would be met by permits banked from phase 2, on these figures.

( This is quite similar to what the UK NGO Sandbag concluded: they talked of up to 700 million surplus permits, plus up to 900 million offsets available in theory... and predicted 950 million tonnes as a likely figure to be carred over). This figure is additional to the 50% limit on CER use - so basically the EU can get away with making very few domestic reductions through to 2020. The picture looks even worse, incidentally, if you factor in secular trends towards industrial outsourcing, emissions that are already outsourced, international aviation and shipping, etc.

* If Bulgaria, the Czech Republic, Lithuania, Latvia, Hungary, and Romania win their ongoing legal cases against the European Commission on phase 2 allocations, this "could add another 164 million tons per year to the market" (ie. increasing the overall surplus)

* The WB also (unintentionally?) identifies a further quirk in the way that the EU will allocate. Although a 50% limit on the use of offsets is the overall figure, there will be far more generous allowances on offset use amongst those who might actually need to buy permits to meet their targets - ie. coal power producers in the UK and Germany, and plant operators in Spain and Italy (see p.63). It is hard to square this circle in a situation where all possible offsets are taken up, but since information in the market is far from "perfect" this is never going to be the case. So it seems the assumption is that the major purchasers can rely on offsets, but this over-reliance will be offset by the companies in the scheme that are over-allocated not buying offsets... so that the overall use of international offsets remains below the 50% claimed threshold

* Lack of confidence in the CDM led to a rise in AAU transactions. These are “hot air” permits, often backed by questionable and unregulated Green Investment Schemes. The main purchases were by Japan from the Czech Republic and Ukraine. (NB. this does not reflect the AAU transfer within the EU, which redistributes from East to West, helping the Western European countries to meet Kyoto targets)

* Carbon leakage isn't happening, despite what EU industry lobbyists claim: " a study that examined import and export data for goods whose production now incurs a carbon cost (i.e., cement and steel) found no leakage. By and large, net import trends prior to 2005 continued unchanged during 2005–07. This is not surprising since the cost of carbon has been just one of many costs that determine industrial production and location; the carbon price alone has not been a determining factor." (The study is referenced as A. D. Ellerman, F. J. Convery, C. de Perthuis, 2010, Pricing Carbon: The European Union Emissions Trading Scheme,Cambridge University Press. This is a pro-ETS and rather flawed book, although their analysis of this point is quite right i think, and consistent with a number of other assessments). For more on carbon leakage, see p.46 to p.48 of Carbon Trading: how it works and why it fails

* Hedging and speculation are now the main uses of the carbon market, rather than "compliance" with caps: (p.16) "The market, which used to be dominated by banks and utilities, witnessed a growing presence of funds, energy-trading firms, and increasingly sophisticated utilities and industrials that used the options market for hedging (both volumes and prices) and profit-making transactions.

The bulk of activity now comes from volatility and other relative value trades rather than asset-backed trades (i.e., financial and technical trades now account for a greater portion of market activity than do trades for compliance purposes)."

* Post-2013 EU industrial benchmarking allocation rules will incentivise “efficient” biomass and CCS

* And finally... some light relief - corruption is now a sign of a successfully "maturing" and "mainstreamed" market, it seems:

"The EU ETS was also marked by controversy during 2009. ... evidence surfaced of “carousel” Value-added Tax (VAT) fraud in countries like France and the United Kingdom and a phishing attempt was made on Germany’s national EUA registry. More recently, the “recycling” of surrendered CERs added to the challenges faced by the European ETS.

Ironically, however, these controversies provide evidence that the emissions market is maturing
and becoming mainstreamed within the European economy. Entities don’t seek out loopholes in
insignificant markets, fraudsters do not focus on small businesses... "