In late January, the European Union unveiled two proposed schemes for reducing greenhouse gas emissions once the Kyoto Protocol expires at the end of 2012 – and in so doing, created the prospect of sideways markets subject to abrupt moves driven by announcements from closed-door meetings few are privy to.
It’s the kind of situation that fundamental traders with a long-term perspective and options traders find rewarding, but algo traders are wary of.
Smaller meetings will crystallize around the 14th and 15th Conferences of the Parties to the United Nations Framework Convention on Climate Change (COP 14 is slated for December of this year in Poland and COP 15 is slated for late next year in Denmark). Negotiators are supposed to have a global framework by the time COP 15 wraps up, and attention will then shift to implementation.
The EU’s trading scheme hinges on whether or not global reduction targets are in place after 2012. If no global targets are agreed to, the EU says it will still reduce its emissions to a level 20% below those of 1990 by the year 2020. If global reduction targets are in place, the EU will reduce its emissions to a level 30% below 1990 levels by the year 2020.
As for the European Union Emissions Trading Scheme (EU ETS) itself, the Commission will gradually reduce the allowances issued to a level 21% below the 2005 level by 2020 if the EU goes it alone, and to a level 31% below the 2005 level if there is a global regime in place.
Either way, the EU ETS will be expanded to include sectors currently not obligated to participate, while participants in some sectors – mostly the power sector – will have to buy their allowances at an auction, rather than receiving them for free.
“The EUA market will fluctuate between now and the end of 2009 based on how things play out globally,” says Dresdner Kleinwort trader Patrick Weber. “Paradoxically, prices will rise if the EU looks to be going it alone, but they will drop if it looks like there will be global reduction targets.”
That’s primarily because the EU has thrown down the gauntlet to the developing world by threatening to close off the Clean Development Mechanism (CDM, see main story) if the whole world isn’t on board.
“Under the current regime, a total of 1.4 billion tons can be offset via the CDM between 2008 and 2012,” says Weber. “The Commission is saying that if there is no global framework beyond 2012, then it will extend the limit of 1.4 billion tons through 2020 – essentially meaning no more CERs allowed, but you can bank the unused ones received in phase II and sell them for potentially more at a later stage.”
So, although reduction targets will be lower if the EU goes it alone, companies won’t have the option of funding low-cost abatement projects in the developing world to offset emissions at home. “We’re projecting a trading range between €30 and €40 per ton if the EU goes it alone, but of just €20 to €30 if there are global binding targets,” says Weber, adding that the upper limit will tend to correlate with the cost of switching from dirty to clean energy sources.
"This price also fluctuates with the cost of natural gas versus coal - so as natural gas and oil prices rise relative to coal, so do the costs of fuel switching, and the cost of emission allowances," he says. "Everyone has a slightly different way of calculating the cost of fuel switching, but we put it at €32 to €34 per ton at today's prices."
