Latest figures from the summer issue of the Global Carbon Report, researched and published by leading market intelligence provider IDEAcarbon, suggest that carbon is currently undervalued in light of changing market fundamentals. July 2008 saw a dramatic fall in the price of carbon. The December 2008 price of European Union Allowances (EUAs) - credits allocated to installations in the EU covered by the EU Emissions Trading Scheme - fell by 25% from a high on July 1 of €29.33 to a low on August 4 of €21.21. The price of secondary CERs - credits produced by Clean Development Mechanism (CDM) projects in developing countries - fell by almost 20% over the same period.
However, IDEAcarbon's Global Carbon Report suggests that, although a correction was necessary, this low price is at odds with other factors at work in the market, such as supply and demand.
Firstly, little has changed in terms of the supply pipeline since the last market review. In March IDEAcarbon estimated that the CDM would produce 1.6 billion credits (1.6 GTCO2e) by the end of 2012, with Joint Implementation (JI) projects adding a further 90 million tonnes to the supply.
It is unlikely that the entire 1.69 billion credits will be offered to the market during the 2008 - 2012 period. Investors are likely to bank a portion of the credits in order to sell in the post-2012 market if they feel this offers better prospects.
Secondly, demand dynamics for the EU ETS are changing. The January 2008 climate change package by the European Commission included an aggregate CDM/JI quota of 1.4 billion tonnes for 2008-2020. For most installations, the best response to this structure was to achieve phase II compliance through internal abatement (such as fuel switching) and save the CERs for phase III.
However, more recent discussions in the European Parliament have now changed that logic. The latest proposals give firms a much stronger incentive to use up their phase II quota since unused quota may no longer be carried over. Surplus CERs can always be swapped for EUAs, however, which can then be banked.
The financial merits of this strategy will depend on the cost of internal abatement. Installations will compare the cost of buying CERs or EUAs with the cost of reducing emissions internally, either now or in phase III.
Estimates of ETS-internal compliance costs in 2020 vary from as low as €15 to about €60 per tonne, measured in today's prices. This is equivalent to €20 - €80 per tonne in current value terms, assuming 2.5% inflation. The upper end of this range is probably too high, however, especially if a serious effort is made to increase energy efficiency - a likelihood for any business given current energy prices.
As a result of these supply and demand conditions, a mid-point of €45 per tonne in current value terms seems reasonable. This implies an average phase II price of €29 for EUAs and €24 for CERs.
If this is correct, the current price of carbon seems well below the long-term trend level. We should expect carbon prices to rally over the medium term.
For more information on the Global Carbon Report please visit www.ideacarbon.com
Background
Changes in EU-ETS
The latest proposal from the Parliament incentivises EU ETS installations to limit their phase II demand to 6.5% of their 2005 emissions. If they do so they obtain additional quota for phase III (see the CARBONfirst Supplement of July 2008). The proposal also incentivises installations to go up to that limit since unused quota can no longer be carried over into phase III. Installations would buy up CERs, swap any surplus for EUAs and bank the EUAs. If installations were to maximise their CER/ERU intake in this way, CER demand from the EU ETS would be 1.1 billion tonnes in phase II and 1.7 billion tonnes overall.
About the Global Carbon Report
The Global Carbon Report provides an in-depth and model-based analysis of the global carbon markets and the underlying fundamentals that drive it. It looks at recent developments in the Kyoto market, the EU ETS, other regional schemes and the voluntary market. The Global Carbon Report was launched in September 2007 and is updated on a quarterly basis.
Sir Nicholas Stern, Vice Chairman, IDEAglobal Group, comments: "IDEAcarbon is bringing to the market high quality analysis and independent judgement and assessment. This is especially important in a new market such as that for carbon"
Ian Johnson, Chairman, IDEAcarbon says: "Rigorous research and empirical analysis is crucial for the further development of the carbon markets globally. The Global Carbon Report makes an important contribution and will be an invaluable resource to both carbon market participants and policy makers alike"
