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Downplaying the backload – Timid framing in the Commission's latest ETS proposal
posted by Damien on 30th Jul 2012

The carbon market community has waited with baited breath for progress on the proposed change to the Auction Regulations. Since Climate Commissioner Hedegaard first announced a “backloading” of auctions at the Horsens Ministerial in April, the carbon price has fluctuated as speculators seek to read the political landscape on when, whether and how many allowances will be withdrawn. The market had closed at a Phase 2 low of €6.04 back in April 4th, but rallied to €8.24 at the start of July on the promise of an imminent backloading proposal and a report on structural reforms.

Wednesday’s announcement however, has given little more than the promise that we will all have to hold our breath a little longer yet. The College of Commissioners has decided their safest course is to propose a legal clarification to the language in the ETS Directive before embarking on a backloading of the Phase 3 auctions which might result in a legal challenge. As early rumours spread of this deferral, the carbon price waned, dropping down 5% to 6.80 on the day of the announcement. The market has lowered its expectations that a political adjustment to supply will arrive soon.

The Commission’s timidity appears misplaced here, insofar as Phase 3 auctions have already been reprofiled – not once but twice. The auction regulations were first changed to allow 300 million allowances from the Phase 3 New Entrants Reserve to be sold over 2012 and 2013, and were changed again to bring 120 million Phase 3 allowances forward for the purposes of hedging by the electricity sector. So it appears that the Commission’s powers to alter the auction profile only become controversial when it is a back-loading, rather than a frontloading of allowances that is being proposed.

But this is legal timidity is not the only battle-scar the proposal has suffered in the inter-service consultation. The Commission proposes specifically to amend Article 10 (4) of the ETS Directive to read “the Commission shall, where appropriate, adapt the timetable for each period so as to ensure an orderly functioning of the market.” and this “orderly functioning” frames much of the discussion in the Staff Working Document (SWD) that accompanied Wednesday’s announcement.

Indeed, one of the points that the paper emphasizes is the way certain recent regulatory features of the scheme have exacerbated the imbalance between supply and demand. The paper specifically highlights how the industrial gas offset ban has triggered an influx of these credits into an already oversupplied market. It also highlights how it misjudged the demand for allowances in 2011 and 2012 when it brought forward Phase 3 allowances for electricity hedging.

“Orderly functioning” is a troubling new framing from the Commission, suggesting that the chief purpose of any backloading of allowances will be to smooth out temporary spikes in the surplus arising from recent regulatory hiccups, rather than addressing the larger background problem of the surplus itself.

The analysis in the SWD skips lightly over the recession – the event that essentially crippled the ETS as an effective instrument – describing the period of 2009 to mid-2011 as a “relatively stable period” against which the most recent and imminent supply spikes (especially 2011-2013) are noted and compared. In this paper it is volatility in the supply and price since mid-2011 that is made out to be the real bugbear rather than oversupply and weak abatement incentives, but volatility is the least of our worries in a market where, as Shell’s David Hone put it, the carbon price is effectively zero.

Indeed, the paper goes to some lengths to minimise the threats of the surplus, arguing that the linear reduction factor could exhaust the surplus by 2025, as if it weren’t a total catastrophe that Europe’s chief climate policy could be essentially superfluous for the first two decades of its existence. More alarmingly, the paper even goes so far as to argue that the surplus is a positive development!:

_ “A certain level of such a buffer promotes the proper functioning of the market by producing a more stable price signal. Without a buffer the market cannot absorb annual variations in market fundamentals affecting demand and supply and may therefore be prone to a more volatile pricing pattern.”_

The roadblock that this argument poses to environmental ambition cannot be underestimated, and is certain to limit the number of allowances withheld unless it is widely refuted. At the launch of our last annual ETS report in June, I asked Director General of DG Clima, Jos Delbeke, why the rumoured 1.2 billion upper figure in the backloading proposal was less than the 1.4 billion surplus expected by 2012, or the even larger surplus expected by 2020, to which he replied that the Commission was reluctant to remove the whole surplus because it would “reduce liquidity in the market.”

This argument would hold some water if the current surplus was achieved through investment in low-carbon technology, but it has overwhelmingly arrived through recessionary hot air. The Staff Working Paper concedes that the frontloading of Phase 3 allowances was misjudged because of economic forecasts which proved optimistic, but fails to concede the broader point that the Phase 3 ETS caps were much more comprehensively misjudged. Our review of independent past analysis finds that an additional 2.2.Gt of demand for ETS allowances was expected over 2008-2020 before the recession hit. Put differently, correcting for the effects of recession would require removing more allowances than the projected surplus out to 2012 or 2020, but this, of course, was always the aim of the ETS: to create an artificial scarcity of pollution rights that would drive environmental action.

Reading through the document, I had expected to see specific arguments proposed for the three different levels of backloading proposed – small (400 million), medium (900 million) and large (1200 million) – but little justification is given for these numbers, which beg the question: small, medium and large compared with what? 1.2 billion allowances is a very modest supply-side intervention compared against an unforeseen 2.2Gt drop in demand.

But reading between the lines, one begins to suspect that 400Mt figure loosely compensates for earlier frontloading of Phase 3 allowances (120Mt for power hedging plus NER300), the 900Mt figure adds in the rush on industrial offset credits and the effects of unused Phase 2 NER coming to market, and the final 1.2 billion figure looks like a correction for the Phase 2 surplus with a bit of a volatility buffer left to spare. In short, this does not look like the Commission is at this stage making a considered case for any particular scale of intervention, but given the reprofiling schedule outlined and the emphasis on return of the allowances to the market, the intervention is being presented as a smoothing out of recent regulatory aggravations to oversupply rather than a first step in remedying the oversupply itself. Commissioner Hedegaard’s press statement strengthens this reading: _ "The EU ETS has a growing surplus of allowances built up over the last few years. It is not wise to deliberately continue to flood a market that is already oversupplied.” _[Emphasis added].

Worryingly, this all seems to pave the way for a “small” or “medium” backloading of allowances to smooth out volatility, rather than the pre-emptive move to cancel all hot-air allowances the market desperately needs. It applies a sticking plaster to a gaping wound.

But if this reading is correct, the Commission should be wary of deferring all structural supply-side discussions to a later debate. Multiple piecemeal interventions in supply are anathema to a market which already involves a high degree of political risk and, whether the Commission likes it or not, many market participants will assume the allowances backloaded will not be returned to the market – indeed this is why some manufacturing sectors oppose the proposals. A small correction now might straightjacket the Commission later on when it seeks reform to the fundamentals of the scheme. We have already faced enough prevarications and delays. Now is the time to withhold a quantity of allowances commensurate with a permanent reform of Phase 3.

[Postscript: Wednesday also saw the Commission launch its consultation on the backloading proposal. We encourage all progressive stakeholders to take this opportunity to argue for a significant withholding of allowances commensurate with the effects of the recession (i.e. 2.2. billion allowances) with a view to their permanent cancellation in a later review of the Directive]

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panteleeza on 12th Aug 2012:
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