Falling EUA & CER Prices – and the questions we should be asking

04Feb09

Over the last half of 2008 EUA and CER prices declined markedly. EUAs prices have fallen from their mid-2008 high of €30 to their current levels of just under €12; while CERs have fallen from their mid-year highs of €24 to current levels just above €10. The spread between EUA and CER prices has also narrowed from about €8 in Q2-08 to €2 in Q3-08 to about €1 in Q4-08. You can see this pretty clearly in the graph below (EUA – orange / CER – red).

EUA & CER Prices, 2008

EUA & CER Prices, 2008

Source: New Carbon Finance

This has led observers to pose a number of questions:

1/. Will EUA and CER prices continue to fall?

Yes. For the simple reason that the supply of EUAs is fixed and known through to 2020. As a result of the present economic downturn, EU CO2 emissions are falling (< 10 – 20% on the initial business-as-usual projections) and will continue to be depressed (at the very least) for some time to come. This fact, combined with the availability of CERs, means that there is likely to be a surplus of as much as 350 million EUA/CERs in the second phase of the EU ETS. This situation is exacerbated (from a supply-side point of view) by the banking provisions, which allow liable parties to carry over surplus allowances into the third phase of the EU ETS. These factors will result in low demand for EUAs, falling EUA prices, falling forward prices and narrowing spreads over the short and possibly medium term. Looking ahead the critical questions to be asking is how severe and sustained will the economic downturn be in Europe and to what extent could the supply of EUAs be adjusted by member states tightening their emission caps?

2./ Will CER prices support the EUA market?

No, not unless there is significant ex-EU demand and that seems unlikely given falling emissions in the main buying states (Japan, Canada, Australia) and the present availability of AAUs. Rather than CERs acting as a point of resistance to EUAs prices, the inverse is true. CER prices are being driven lower by the falling EUA price and declining demand from the EU. The factor that is sustaining CER prices at present is the Chinese Government’s minimum CER price of €8 that it imposes on all Chinese CDM projects (this minimum price was increased from €6 to €8 in about March 2008). Looking forward the critical questions to be asking are: will the Chinese Government maintain its minimum €8 price, or will they return it to the original €6 level? And will there be large volume demand for CERs from outside the EU?

3./ Could EUA prices fall below CER prices?

Strictly speaking EUA prices shouldn’t fall below CER prices, for the simple reason that if they did, sellers of CERs would exploit the price difference; selling CERs and buying back EUAs, which they would in turn sell-on once EUA prices rose. But this logic doesn’t necessarily hold if there is a surplus in the EU ETS and if that surplus can be banked in to the third phase. And this is probably the case. In such a scenario, the price of EUAs could in fact fall below the price of CERs without providing an arbitrage opportunity. But the caveat is that the price difference would have to remain less than the cost of carry of the EUAs. The cost of carry of an EUA priced at say €10, with a commercial rate of 3% per annum (simple), and held until 2013 would be €1.20.

4./ To what extent are market prices undermining environmental objectives?

Market prices aren’t undermining the environmental objectives of the EU ETS. Markets are simply doing what markets do: reflecting the state of demand and supply. Strictly speaking the environmental objectives expressed as a cap on emissions will still be met. But this requires a rather narrow definition of the environmental objectives of the EU ETS. In fact, the environmental objectives of the EU ETS are broader and include the promotion of environmental technologies, investment in emission reduction, real emissions reductions achieved by domestic action, encouraging a longer-term glide path to more significant emissions caps, the removal of support for environmentally damaging activities and industries and the leveling of the playing field for emerging technologies. Taking into account this broader definition of environmental objectives, then it is clear that the falling EUA prices do little to achieve these objectives – and given the potential for windfalls from the free, over-allocation of EUAs, they may even run counter to these objectives.

5./ Should governments intervene in the market, and if so how?

The only way of addressing this issue is to redress the demand and supply balance under the EU ETS – and that would require EU governments to intervene in the market to reduce the emission cap and therefore reduce the supply of EUAs, or to increase the coverage of the EU ETS and therefore increase demand for EUAs. The first option would set a dangerous precedent – raising the spectre of frequent government interventions and defeating the purpose of a market based mechanism. Alternatively, or in tandem, governments could expand the coverage of the EU ETS, as is in fact envisaged, and to allocate less EUAs to these new sectors and countries – but this is politically very sensitive. A more appropriate approach would be to further limit the eligibility of CERs in the second phase. This could be done simply; by adopting the rule already established for the third phase of the EU ETS and limiting the use of CERs to up to 50% of the emissions reduction task in phase 2. In one fell swoop, that would significantly reduce the quantity of CERs eligible up to 2012 and reignite demand for EUAs, while staying true to the principles of the EU ETS in encouraging domestic emission reductions.

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