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Carbon 2006

Towards a truly global market


28 February 2006

TO THE POINT

The world’s largest ever carbon market survey More than 800 participants in our web-survey and 67 in-depth
interviews, combined with Point Carbon’s proprietary databases and market intelligence services, makes
this the most comprehensive carbon market report to date.

Global carbon market transactions worth €9.4 billion in 2005. The EU ETS did an estimated 362 Mt CO2, at an
estimated financial value of €7.2 billion. 93% of the volumes in the project market came through CDM, at
397 Mt CO2e, €1.9 billion. JI did 28 Mt, €95 million.

China is largest CDM seller. More than 70% of CDM volumes came from a few large HFC-23 reduction
projects in China. There are also several projects in India and Brazil.

CDM buy side is dominated by private sector. Driven by high EU ETS prices together with an increasing
number of carbon funds.

Japan enters market in earnest. The European private sector activity will continue to dominate the market,
but Japanese public and private sector will add further to demand for project credits in 2006. Canada is
conspicuous by its absence from the market.

The EU ETS is a qualified success. The weekly turnover in EU ETS has been increasing steadily. The market
is reacting to fundamentals, although policy (non-)decisions also still constitute a price driver. 45% of
survey respondents found the EU ETS to be a success.

CDM/JI still has some way to go. Only 7% of survey respondents find the project market to be mature, and
only 22% find them to be a success.

The cost of carbon cannot fully explain the increase in power prices. Increasing fuel prices, increased
demand, as well as generators’ strategies have also contributed to power price increases. The impact of
carbon costs on power prices, and vice versa, has created new interplays between energy commodities
and strengthened energy market interactions.

Market is still best option for world to make transition to low-carbon economy. Unlike technology-based
alternatives, the carbon market places a cost on emissions and a value on reductions, and leads to large
scale reductions in the near term.

This report was published at Point Carbon’s 3rd annual conference, Carbon Market Insights 2006 in
Copenhagen 28 February - 2 March 2006. For more information, see www.pointcarbon.com

All rights reserved © 2006 Point Carbon


Carbon 2006

About Point Carbon:


Point Carbon is the leading provider of independent analysis, forecasting, market intelligence
and news for the power, gas and carbon emissions markets. Point Carbon has more than
14 000 subscribers in over 150 countries. Our reports are translated into Japanese, Chinese,
Portuguese, German, French, Spanish and Russian. Among our clients are BP, Dupont, Norsk
Hydro, RWE, Shell and Vattenfall. Point Carbon has offices in Oslo (HQ), London, Kiev, Brussels,
Hamburg and Tokyo.

The company has expanded rapidly in recent years and now has an international team of more
than 60 employees. The competencies of our staff include international and regional climate
policy; mathematical and economic modelling; forecasting methodologies; methods for expert
evaluation and energy industries analysis.

The in-depth knowledge of power, gas and CO2 emissions market dynamics positions Point
Carbon as the number-one supplier of analysis on price-driving fundamentals for European
energy and environmental markets.

About the report:


This report was written and edited by Henrik Hasselknippe and Kjetil Røine.
For citations, please refer to: Point Carbon (2006): ”Carbon 2006.” Hasselknippe, H. and K. Røine eds.
60 pages.

ii All rights reserved © 2006 Point Carbon


28 February 2006

Executive Summary

This report has been based on a number of different sources. First, Point Carbon’s proprietary databases
give an overview of the number of projects and their volumes. Our carbon project database contains at total
of 2,769 projects, and is to our knowledge the world’s largest. In addition, our web-based survey attracted
800 respondents, and we have further conducted in-depth interviews with 67 selected key market players.

Point Carbon estimates that the international carbon market in 2005 transacted a total of 799 Mt CO2-
equivalents worth approximately €9,400 million. In comparison, the market in 2004 saw an estimated 94 Mt
CO2e, worth €377 million.

The EU Emissions Trading Scheme saw the largest financial values in the previous year. In total, the brokered
and exchanged market did 262 Mt CO2, corresponding to €5.4 billion. Brokers did 79% of this volume,
whereas the ECX was by far the largest exchange, with 63.4% of the exchanged volume. Point Carbon
further estimates that the direct bilateral market (company-to-company, not through brokers or exchanges)
did 100 Mt, €1.8 billion in 2005. Annualised turnover increased to over 12% (OTC and exchange volumes
only).

The Clean Development Mechanism (CDM) remains the largest market segment in terms of volume. Point
Carbon estimates that emission reduction purchase agreements (ERPAs) corresponding to 397 Mt CO2e
were entered into in 2005. Assuming payment on delivery and a 7% discount rate, this is valued at €1.9
billion. The other project based mechanism, Joint Implementation (JI) did 28 Mt, €96 million. There is also
a small market for secondary CDM trading, this is expected to increase in the future, but is currently held
back by transaction log delays.

Other market remain insignificant in the larger picture, at 7.8 Mt, €52 million. The largest of these is the
NSW scheme in Australia, accounting for 93% of the financial value in this segment.

Table 1: Reported volumes and values 2004 and 2005


Reported and estimated volumes 2004 and 2005 , in million tonnes of carbon dioxide equivalents and €. Bilateral
ETS for 2005 estimated as 27% of total EU ETS volume at average EUA price through the year.

2004 2005
[Mt] [€ million] [Mt] [€ million]
EU ETS total 17 127 362 7,218
- OTC + exch. 9.7 n.a. 262 5,400
- Bilateral 7.3 n.a. 100 1,818
CDM 60 188 397 1,985
CDM 2nd 0 0 4 50
JI 9 27 28 96
Other 7.9 34 7.8 52
Sum 94 377 799 9,401

iii All rights reserved © 2006 Point Carbon


Carbon 2006

Executive Summary

But does the system work? We have seen very little evidence of actual fuel-switching or internal abatement
taking place. On the other hand, the market is working effectively, with reliable price discovery and increasing
volatility. Furthermore, the EU ETS is leading to substantial private sector investments in CDM, and to some
extent JI. In balance, we find that the EU ETS is a qualified success after its first year of operation. Survey
participants agree with us on this, at least to some extent. 45% of the respondents find that the EU ETS is
already a success. Only 22% think the same of the CDM/JI markets. However, only a handful of people find
the markets to be mature, 10% for EU ETS and 7% for CDM/JI.

One of the shortcomings of the EU ETS relates to the way the EC and Member States release information
to the market. With carbon now acting as hard currency, it would be wise to look to financial markets to
see how information is distributed. The European Commission has shown that it has a more important
role in emissions trading than other parts of EU’s environmental policy, and can be expected to meet this
challenge. Nevertheless, the market has shown that it can work even with asymmetric information

The introduction of carbon costs on power producers’ operation has also created new complexities with
other energy commodities, in particular power prices. The cross commodity impacts have also strengthened
interactions energy markets. We expect the debate on carbon’s impact on power prices to continue in 2006.
However, carbon costs cannot fully explain the increases in power prices. Increasing fuel prices, in particular
for gas, through 2005 have also contributed significantly. Also, increasing demand for power has an impact,
as well as generators’ trading strategies.

The survey respondents are bullish on prices. Only 20% expect the EUA price in one year to be lower than
it was in December 2005. More than 70% expect the price of an issued CER to increase over the same
time period. The market expects tighter allocations for EU ETS phase 2. Only 8% expect the allocation
for the next round to be looser than in the current phase. 25% expect it to be much tighter. Furthermore,
24% expect there to be more internal abatement in the next phase. It is also evident that carbon costs are
now taken into account for new investments. More than 40% see carbon costs as very important for new
investments in their industry.

CDM is set to be the project mechanism of choice, also in the future. Developing countries are indeed
taking their participation in the market seriously, and are years ahead of large JI sellers when it comes
to project approval frameworks. It also seems clear that the CDM will survive even without a successor
agreement to the Kyoto Protocol.

Technology based alternatives to the Kyoto Protocol are expected to be pushed forwards as viable options
for the future international climate cooperation. However, we do not find there to be much substance
in these plans. For an agreement to work it is essential that there is a price on carbon, and a value on
reductions, thus incentivising private sector investments in new technologies. Currently, the carbon
market remains the best option for enabling the transfer to a less carbon-intensive global economy.

iv All rights reserved © 2006 Point Carbon


28 February 2006

Foreword

In many ways, the year 2005 marks the birth of a and markets have become correlated in ways they
global carbon market. The unexpected high price have never been before – driven by the carbon
of allowances in Europe caught most players by market – requiring a broader spectre of factors to
surprise. During a period of a few months, carbon be taken into account when assessing trading and
trading suddenly came on the agenda in boardrooms investment strategies.
across Europe. This report attempts to document
how the sudden emergence of a global carbon Finally, evidence suggests that the carbon market
market has unfolded, and how it has affected leads to large-scale emission reductions. While
emitters of greenhouse gases – and their markets limited abatement appears to have taken place in
– in ways that few anticipated one year ago. Europe so far, there is no doubt that the unexpectedly
high European carbon price has been pivotal in
It has been a massive effort making this report. More terms of generating investments in projects under
than 800 readers responded to Point Carbon’s web- the Clean Development Mechanism.
poll carried out in November-December 2005. The
web-poll was complimented by in-depth interviews Until six months ago, we in Point Carbon were
with more than 60 key players: traders, industry pessimistic about the reductions that would be
representatives and service providers. Also, our daily generated by such projects. But the explosive
recording of carbon transactions has been invaluable growth lately has changed our minds. Credits
for documenting how the market has developed. from abatement projects under CDM and JI today
have the prospect of becoming a major avenue for
When analysing the results from the survey and ensuring compliance with the Kyoto Protocol.
the transaction data, three important conclusions
spring to light. Firstly, although the value of the Moreover, these projects often bring about
carbon market increased by 2500% from 2004 to economic, social and environmental benefits for the
€9.4bn in 2005, and now involves players in close local communities: e.g. close to half of the 2,769
to 150 countries, it is still early days. Traded volumes JI and CDM projects registered in Point Carbon’s
compared to the underlying volume are still far below database utilise renewable energy.
what we can observe in other markets.
You will find more about these trends – and a number
Moreover, among the participants there is a of others – in the present report, which we plan to
widespread feeling of the market being immature, provide as an annual publication.
e.g. only approximately 10 per cent of the respondents
agreed to our poll’s statement of the EU ETS being A considerable amount of work has gone into making
a mature market. Through the involvement of more it and we believe it represents the most thoroughly
players – and an increasing internationalisation of the researched overview of the global market. Hopefully,
market – volumes can be expected to grow rapidly it will provide you with a useful source of reference
also in the years to come. and we hope you will enjoy reading it as much as we
have enjoyed making it.
Secondly, strong links to the energy markets
are evident. The carbon market has significantly Kristian Tangen
increased power prices, and the development of the Director Research & Advisory
power markets strongly impact carbon prices. This Point Carbon
should come as no surprise as power production is
major source of greenhouse gases emissions.

But there is more to it than that. Most of the active


carbon traders have a background in power or fuel
trading, and they have brought with them this
knowledge and experience into the carbon market.
One consequence is that prices across commodities

v All rights reserved © 2006 Point Carbon


Carbon 2006

From the editors

This report had not been possible without the contribution of numerous people.
First and foremost, we would like to thank the 800 persons who participated
in our web-survey, as well as the 67 key market players who took the time to be
interviewed on the phone. As you will see, your inputs have been invaluable in
the making of this report.

Thanks also go to everyone at Point Carbon, for their tireless efforts in maintaining
our proprietary databases and models. It is only due to your combined efforts
that we have been able to put this report together. Our CDM and JI team have
contributed through the development of the Carbon Project Manager, which has
been used frequently throughout during the making of this report. Our EU ETS
team has contributed through the Carbon Market Trader. And the Power & Gas
team has contributed analysis and thinking on the chapter focusing on carbon-
power complexities.

Some of our colleagues deserve special thanks and attention for their contribution
to this report: Kristian Tangen for guidance and overall coordination. Anders
Skogen for setting up the web-survey. Miles Austin and Therese Karlseng for
calling around to more than one hundred people in the carbon market. Anne
Katrin Brevik for sparring and comments on the power/carbon debacle. Liza
Baeza for giving a helping hand with the layout and design. And finally, Kevin
Gould and Kjell Olav Kristiansen for providing valuable comments in the final
stages.

We hope that you find this report interesting and that it is useful for your
continued work in the carbon market. As this is the first annual report of this
kind, we encourage you to give us comments and feedback through the regular
channels (see Colophone). We look forward to meeting you all at our conference,
and look forward to producing another version of this report in 2007.

Henrik Hasselknippe and Kjetil Røine


Editors

vi All rights reserved © 2006 Point Carbon


28 February 2006

Table of contents

1 Introduction 1

2 What is the carbon market? 4

3 How does it work? 9

3.1 EU ETS 9

3.2 CDM & JI 11

4 Market activity in 2005 15

4.1 EU ETS 15

4.2 CDM and JI 22

4.3 Other markets 26

5 Does it really work? 28

6 Carbon Market Insight: The power of 33

carbon
6.1 Higher spot prices 33
6.2 Explaining increasing spot prices 34
6.3 New complexities arising 38
7 What does the future hold? 40
7.1 Globally - still political uncertainties 40
7.2 Where to now for EU ETS 41
6.1 CDM and JI - long term investments? 44
6.1 Towards a truly global market 45

Colophone 51

vii All rights reserved © 2006 Point Carbon


28 February 2006

1. Introduction We also provide a special feature on carbon and


power, discussing some of the impacts that carbon
The rumours of the Kyoto Protocol’s death were truly
trading has had on the European power market.
exaggerated. As the Protocol entered into force on 16
Finally, we look to the future and try to give some
February 2005, the international carbon market – the
indications on where the market will move in the
cornerstone of the Kyoto agreement – was already
years ahead.
showing healthy signs of increasing volumes. While
the market for greenhouse gas (GHG) allowances
Point Carbon regularly publishes in-depth analyses on
and reduction credits had been in operation for some
international climate policy and the carbon market in
years already, the market had only recently moved
our publication series Carbon Market Analyst (CMA)
beyond the embryonic stage. However, growth has
and Carbon Market Monitor (CMM). The analyses
since continued in all segments of the market, and
that have gone into the CMAs are to some extent
2005 has proved that the carbon market is indeed
reflected in this report, although the level of detailed
alive and well, although it has probably only reached
is lower here.
the toddler stage.

This report, Carbon 2006, provides a detailed


800 participants in our web-survey
overview of the global carbon market, with special
attention to volumes and price trends in 2005. We
In addition to our regular reports, the web- and phone
also include a brief introduction to the market for
surveys have provided new data and a different
those of you who might not be familiar with the
perspective. A total of 800 individuals responded
detailed – and often highly complex – structure of
to our web-survey. Furthermore, 67 people were
this new commodity market.
contacted by phone, giving detailed answers to
a range of questions not asked in the web-based
Particular attention is given to the EU Emissions
version. The in-depth interviews covered different
Trading Scheme (ETS) and the project based
sectors, and we got answers from 38 players from
Clean Development Mechanism (CDM) and Joint
the Power & Heat sector, 21 from industry, and 8
Implementation (JI). These market segments are by
from the financial sector.
far the most advanced of the Kyoto related market
mechanisms, although, as we shall see, they are at
very different stages of maturity. Figures 1.1-1.4 show the distribution of the
respondents to the web-survey. Half of the

Figure 1.1 Some big, many small


Respondents to the survey, broken down on their company’s annual emissions level.

60 %

50 %
Share of respondents

40 %

30 %

20 %

10 %

0%
No 0-0.5 Mt/yr 0.5-1Mt/yr 1-5 Mt/yr 5-10 Mt/yr +10Mt/yr
emissions
Source: Point Carbon

1 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 1.2 Mostly outside trading sectors


Respondents to the survey, broken down on sectors.

35 %
30 %
Share of respondents

25 %
20 %
15 %
10 %
5%
0%
Service Other Power & Industry Gov.mnt Oil/gas
prov. Heat

Source: Point Carbon

respondents did not represent GHG emitting as 23% claimed that they would be engaging in
industries, while about 25% represented only small trading soon, but as many as 47% said they were
emission levels, i.e. below 0.5 Mt per year. 7.5% of not trading at all. Of the ones who were trading, 9%
the respondents represented major emitters, with were active in the EU ETS and 8% in both EUAs and
more than 10Mt per year. CDM/JI. 11% said they did CDM/JI trading only.

19% of respondents from Power &


Heat sector 28% trade one or more carbon
commodities
The share of non-emitters is also reflected in the
break-down of respondents on sectors, where This breakdown on respondents provides a backdrop
as many as 31% were said to represent service for the further analysis in this report. Where
providers, and 27% defined themselves as belonging appropriate, we will present answers based on
in the Other category. 19% of the respondents came limited responses. For instance, for certain answers
from the Power & Heat sector, 9% from industry we will not include the responses from non-emitting
and about 5% from oil/gas. players or companies which have not yet initiated
carbon trading internally. Where this is done it is
As many as 55% of the respondents were from clearly noted.
the EU, 36% from Northwestern Europe, 10% from
Central and Eastern Europe, and 9% from Southern Additional sources used in this report includes all of
Europe. In addition, 5% were from European Point Carbon’s proprietary databases. Our project
countries not in the EU. Of the remaining respondents database contains 2,256 CDM projects and 513 JI
20% were from industrialised countries, whereas projects, at all stages. We also maintain a transaction
another 20% were from developing countries, i.e. database, where we register all transactions that we
non-Annex I countries. learn of through our market intelligence services. In
addition, we draw extensively on our forecasting
55% from EU, 20% from developing services for the carbon, power and gas markets.
countries

28% of the respondents answered that they were


trading one or more carbon commodities. As many

2 All rights reserved © 2006 Point Carbon


28 February 2006

Figure 1.3 European responses


Respondents to the survey, broken down on geographic location. Annex 1 refers to industrialised
countries as defined under UNFCCC. CEE: Central and Eastern Europe

40 %
35 %
Share of respondents

30 %
25 %
20 %
15 %
10 %
5%
0%
EU: Other Non-Annex- EU: CEE EU: South Europe:
Northwest Annex-1 1 Non-EU

Source: Point Carbon

Figure 1.4 Only some trading actively


Respondents to the survey, broken down on trading activity.

50 %

40 %
Share of responses

30 %

20 %

10 %

0%
No Will be soon CDM/JI EUA Both EUA
and CDM/JI
Source: Point Carbon

3 All rights reserved © 2006 Point Carbon


Carbon 2006

2. What is the carbon market? had ratified the Protocol, corresponding to 61.6%
of total Annex I parties 1990 emissions. USA and
In brief,the carbon market can be explained as
Australia are noteworthy for being the only major
the market resulting from buying and selling of
industrialised countries not to ratify Kyoto.
emission allowances and reduction credits in order
to enable countries and companies meet their GHG
While the Kyoto Protocol does not impose
emission targets. Another way of looking at it is that
emission reduction commitments on developing
it introduces a price for carbon - placing a cost on
countries, they play a crucial role in the international
emissions and a value on reductions. This chapter
carbon market. Countries, and also companies, can
gives a brief introduction to the concepts underlying
invest in emission reduction projects in non-Annex
the carbon market, focusing on countries’ Kyoto
I countries and receive carbon credits in return for
targets and the structure of the market mechanisms
the resulting reductions. As we will show later in
that can help achieve them.
this report, developing countries are indeed already
participating in a meaningful way – contrary to what
When the Kyoto Protocol was agreed in 1997, a
has been argued by some opponents of the Kyoto
total of 39 industrialised countries (referred to in
Protocol.
treaty terminology as Annex B countries) were given
specific emission limitations for the 2008 to 2012
period. It did, however, take a number of years and How are countries meeting the
subsequent multilateral climate negotiations under Kyoto challenge?
the UN umbrella before all the technicalities of the
agreement were in place.
In an issue of CMA “Kyoto progress: Will countries
meet their targets?” (12 September 2005), we
Table 2.1 shows a selection of countries with
analysed how various countries were approaching
significant GHG emissions and their respective
their international climate commitment. The analysis
Kyoto targets. As of 14 February 2006, 161 states
was based on the latest available national reports
and regional economic integration organizations
on GHG emissions, reported figures for historic

Table 2.1 The Premier League


Selected countries’ commitments under the Kyoto Protocol for the period 2008-12. Targets for individual
Germany, UK, Italy and Spain under the EU 15’s burden sharing agreement.

Country GHG emissions in Kyoto target, in %


1990 as share of of 1990 emissions
Annex 1
Canada 3.3% -6%
Japan 8.5% -6%
EU 15 24.2% -8%
Germany 7.4% -21%
UK 4.3% -12.5%
France 2.7% 0%
Italy 3.1% -6,5%
Spain 1.9% +15%
EU 25 29.8% n.a
Poland 3.0% -6%
Russia 17% 0%
Ukraine not available 0%
USA 36.1% -7%
Australia 2.1% +8%

4 All rights reserved © 2006 Point Carbon


28 February 2006

emissions growth, and projections on countries’ lately, with a 15 Mt increase from the previous year
future emission growth. Using 2010 as the reference reported for 2003.
year for the Kyoto period we estimated what the
countries’ full five year shortfall would be without any Given these short positions, we might ask: How
new policies, domestic trading systems, or carbon can countries with such significant short positions
procurement funds, denoting this as the business- meet their targets? From the governmental point
as-usual (BAU) scenario. Figure 2.1 illustrates the of view, there are essentially three categories of
BAU short positions for the most significant buyer options: (1) Establish domestic emission trading
countries/regions aggregated for the whole Kyoto systems, (2) implement domestic non-market based
period (2008-12). policies, and (3) establish procurement programmes
for purchases of allowances or credits from other
In terms of BAU emissions, the EU15 bubble has countries. See also Table 2.2.
by far the largest gap to fill in terms of tonnage.
However, this should be viewed cautiously as it
is merely 12.5% above the EU15’s Kyoto target,
Emissions trading stimulates private
while Canada and Japan are projected to have BAU
sector reductions
emissions of 46% and 29% above their targets
respectively. Overall BAU gap leaves countries 5,540 The emission trading systems aims to stimulate the
Mt short in the first Kyoto period. private sector to reduce emissions through internal
abatement, external procurement, and trading. What
is common for the governmental and corporate
Countries BAU gap is 5,540 Mt for strategies is that they can both utilise credits from
five-year Kyoto period CDM and JI projects to meet their commitments.

To date, only EU has a comprehensive emission


Within the EU15 the Member States with the trading system, while Japan, Canada and New
biggest BAU gaps are Spain and Italy, at 660Mt and Zealand are all considering whether, and how, to put
620Mt, respectively. Spain has seen rapid economic up such systems. Obviously, all sectors contributing
growth coupled with rising emissions far beyond its to emissions of GHGs are not included in the
provision to expand under the EU15 burden sharing emission trading system, and consequently the
agreement. Italian emissions have also soared governments themselves need additional policies

Figure 2.1 Strong growth if unchecked


Business-as-usual emissions for world regions, i.e. no additional policies or measures
implemented, for the aggregate 5-year Kyoto period 2008-2012, in Mt CO2e. Source: Carbon Market
Analyst 12 September 2005.

EU 15

Japan

Canada

Other

0 500 1 000 1 500 2 000 2 500


Source: Point Carbon Mt CO2e

5 All rights reserved © 2006 Point Carbon


Carbon 2006

Table 2.2 Governmental and corporate strategies for meeting Kyoto targets

Governmental Establishing emission Procurement Non-market policies


strategies trading systems (ie EU programmes (tech. dev, CO2-tax)
ETS) (CDM/JI/AAU)
Corporate strategies Internal trading (ie External Internal abatement
within EU ETS) procurement and strategies
trading (ie CER/
ERU)

for being in compliance with the Kyoto targets. For policies for domestic abatement – constitute the
instance, approximately 44 % of GHG emissions political framing conditions that are decisive for how
within the EU are covered by the EU ETS. the market mechanisms actually work.

To what extent have countries employed these


Several countries with operational strategies? And to what extent are they actually
procurement programs reducing emissions? Our analysis from 12
September 2005 looked at the full range of policies
Thus, it will be essential for countries to also and mechanisms employed by all countries expected
engage policies in other sectors. Non-market to be short in the Kyoto period. All governmental
policies are typical domestic measures that will procurement programs were examined closely,
primarily impact sectors not subject to trading considering actual and planned budgets in light of
system and requirements, e.g. different renewable prices in the carbon market. We further investigated
energy policies, environmental taxes and subsidies, whether non-market policies already in place actually
and various voluntary programs. For instance in had any impacts, and estimated how much existing
Japan, the Kyoto Protocol Target Achievement Plan climate policy plans would contribute to the required
contains a raft of new schemes and measures, reductions. Finally, we looked at allocations under
nearly all of which are voluntary. Mandatory existing or planned emissions trading systems
measures are limited to reporting emissions and and estimated how much these schemes would
efficiency rates, not actually reducing them. In reduce.
1997 the Japanese business federation, the Nippon
Keidanren implemented its voluntary action plan on Figure 2.3 shows the final results, and that several
the environment. The plan currently covers 82% of countries still have a long way to go before they
industrial emissions embracing 34 industries. will meet their Kyoto targets. It should be noted
that some countries, Japan in particular, have
The third pillar of the governmental climate strategy, announced governmental procurement plans since
the procurement programmes, primarily aim at the analysis was undertaken, and that the analysis
purchasing Certified Emission Reductions (CERs, simply applied the caps in the EU ETS phase 1 to
from CDM projects) and Emission Reduction phase 2. The recent guidance from the European
Units (ERUs, from JI projects), as well as Assigned Commission has made it clear that several countries
Amount Units (AAUs, the “country allocation” under will have to reduce their caps for the second phase.
Kyoto). There are several countries with operational
procurement programs, e.g. the Netherlands and Spain, Italy and Canada at bottom of
Denmark, as well as a number of countries that league
have invested in funds for procurement, e.g. the
different World Bank funds. Figure 2.2 further shows
how these different strategies all add up to form the Nevertheless, the figure gives a good indication on
carbon market. In this respect, national policies - which countries that look set to meet their targets
such as the allocation of allowances to companies comfortably and which that will have to make some
under EU ETS or implementation of non-market sacrifices.

6 All rights reserved © 2006 Point Carbon


28 February 2006

Figure 2.2 How it works, at least in theory


The interplay of flexible mechanisms, purchasing programmes and trading schemes. Non-market
policies and overall allocations set the frame.

Political framing decisions

Gov. AAU sales JPN/CAN/NZ

CDM/JI

Gov. Purchase EU ETS


programmes Governments Private sector Internal trading,
abatement

= Supply Forwarding
compliance
= Demand

Political framing decisions

Figure 2.3 Winners and sinners


Relative distance to the Kyoto target for countries covered in the study after all policies and programs have been
accounted for. Assumes that current allocation in EU ETS continues in phase 2.

Sweden
Switzerland
UK
Netherlands
France
Germany
Denmark
Belgium
Greece
Finland
New Zealand
Austria
Ireland
Portugal
Norway
Japan
Canada
Italy
Spain

-10 % -5 % 0% 5% 10 % 15 % 20 % 25 %

Source: Point Carbon

7 All rights reserved © 2006 Point Carbon


Carbon 2006

Bottom of the league are Spain, Italy, Canada and leaving them with substantial emission allowance
Japan who all, it seems, will miss their targets by 20 (AAUs) to sell. These countries, located in Central
per cent or more unless drastic action is taken. Still, and Eastern Europe, are also prime candidates for
there is little reason for other countries to be smug, JI projects, as it is less costly to reduce emissions
almost all of the countries covered in the study have here than in Western Europe, Canada or Japan.
yet to develop credible policies and measures that Finally, there are about 100 non-Annex I countries
will help them meet their Kyoto targets. which can qualify as hosts for CDM projects, and
which could produce substantial reduction volumes
Overall, our analysis finds that these measures that could be sold to emission-craving industrialised
might potentially reduce the Kyoto gap with some countries.
50 % from the shortfall presented in figure 1.
Still, major buyer countries experience a 2,740 Mt Without going into too much detail on the analysis, it
shortfall for the five-year period, or 548 Mt per year is clear that the potential supply in the carbon market
in the Kyoto period even when taking measures into is considerably larger than the aggregated demand.
account, leaving them 9.5% above their collective Figure 2.4 shows the net supply and demand in the
Kyoto target. 5-year Kyoto period, as estimated by Point Carbon.
In particular, Russia has the potential to export
An updated analysis on countries’ Kyoto progress significant amounts of allowances, although it is far
will be presented in a forthcoming issue of Carbon from certain that they will do so. Our forecast for the
Market Analyst, set for publication in early April 2006. CDM market also shows that developing countries
Moreover, the carbon policies in non-EU countries will contribute substantial amounts, which could
will be further analysed in the CMA “Carbon around grow even higher than what we indicate here. Point
the world”, scheduled for March 2006 Carbon monitors the situation in the major seller
countries on a continuous basis and will publish
The above analysis clearly shows that the demand several in-depth analyses on how their behaviour will
for allowances or credits is real. What then about impact on volumes and prices in the global carbon
supply? Several of the countries with Kyoto targets market.
experienced economic downturn in the 1990s,

Figure 2.4 Potential supply more than enough


Net short and long positions for countries and regions, i.e. when all policies and procurement plans have been
accounted for. Aggregated for the 5-year Kyoto period

EU 15
Japan
Canada
Other
Ukraine
Eastern Europe
Russia

-5 -4 -3 -2 -1 0 1 2
Gt CO2e
Source: Point Carbon

8 All rights reserved © 2006 Point Carbon


28 February 2006

3. How does it work? outlining the upper level of allowances to be issued


(the caps) and how these are allocated to sectors
While the previous chapter presented a general
and individual installations within in each Member
overview of how countries fare in respect to
State (MS). The EU Commission (EC) has approved
their Kyoto target, this chapter will focus on the
in total 6.3 billion allowances to be issued for the
mechanisms that are being employed to meet
period 05-07, excluding allowances set aside to new
targets. We will give a brief introduction to the EU
installations, resulting in an average of 2.1 billion
ETS, what it is and how it works, as well as a quick
allowances to be distributed each year. However,
overview of CDM and JI. While the operation of these
MS’ initial applications were for even more.
mechanisms is much more complex than what can
be conveyed within these pages, this gives at least a
general introduction. For more detailed analyses we EC cut 300 Mt, 4% from initial
refer to our regular report series. volumes
3.1 EU ETS The EC ended up cutting almost 300 Mt of
The European Union Emissions Trading Scheme (EU allowances, or more than 4 % of the total volume,
ETS) works, simply put, by placing GHG emission from the initial volumes of allowances as submitted
limitations on a number of installations within specific in the draft NAPs. Comparing this to 2003
sectors, and allowing the emission targets to be met emissions, we find that the EU ETS covers 44 % of
through trading of EU emission allowances (EUAs). all greenhouse gas (GHG) emissions in the EU.
Thus, if the price of carbon is higher than the internal
abatement cost, companies will – at least in theory The annual average cap is distributed among the MSs
– reduce internally and sell any unused allowances as shown in Figures 3.1 and 3.2. Germany is by far
in the market. For installations that miss their target the MS with highest number of allowances (488 Mt/
the penalty is €40/t CO2 on the shortfall in the 2005- year), followed by Italy, Poland and the UK pending
2007 period, in addition to having to purchase the around 250 Mt each for the first trading period, and
deficit on the market. France and Spain around 150 Mt. Together, these six
countries constitute 71 % of the total allowances in
The National Allocation Plans (NAPs), developed the market.
by each member state and approved by the
Commission, set the overall structure of EU ETS by

Fig 3.1. The big emitters…


EU member states with more than 100 Mt in aggregated allocations for the 2005-2007 period. Emissions in
ETS sectors in 1990, 2003 and allocated in 2005, in Mt CO2.

600

500

400
Mt

300

200

100

0
DEU GBR POL ITA ESP FRA CZE NLD GRC BEL FIN PRT DNK
Source: Point Carbon 1990 2003 CAP

9 All rights reserved © 2006 Point Carbon


Carbon 2006

Fig 3.2. ..and the smaller ones


Total allocations to some of the smaller EU member states, aggregated for period 05-07. Emissions in ETS sectors
in 1990, 2003 and allocated in 2005, in Mt CO2.

45

40

35

30

25
Mt

20

15

10

0
AUT HUN SVK SWE IRL EST LTU SVN CYP LVA LUX MAL

Source: Point Carbon 1990 2003 CAP

Fig 3.3 Power & heat in driver’s seat


Total EU ETS allocations on sector level, aggregate for 2005-2007 period, in Mt CO2.

4 000
3 500
3 000
2 500
Mt

2 000
1 500
1 000
500
0
Power & Metals Cement, Oil & gas Pulp and Others
heat Lime & paper
Glass
Source: Point Carbon

Figures 3.1-2 also show calculated CO2- emissions Within each MS the allowances are allocated to
for the years 1990 and 2003 in the sectors now existing installations in five main sectors. Figure 3.3
covered by the EU ETS. The majority of the countries illustrates the distribution of allowances between
have had to reduce their emissions compared to these. The power & heat sector is by far the largest
their 2003 level. sector, accounting for 55 % of all allowances in the
system, making the EU ETS primarily dependant on
activities and changes within this sector.

10 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 3.4 When size matters


Distribution of allowances and number of installations according to size categories for installations; less than 1 Mt, between
1 and 10 Mt, and larger than 10 Mt.

100

80

60
%

40

20

0
< 1 Mt 1 Mt < x < 10 Mt > 10 Mt
Source: Point Carbon Allowances Installations

Close to 10,000 installations now have of view, it does not make any difference whether
commitments within the EU ETS. Figure 8 illustrates NERs are made available through new installations
the distribution of allowances and installations or through auctions; they represent net supply to
categorised relative to the size of the installations. the market in any case.
According to the currently available installation lists,
there are 92 large installations with an allocation 3.2 CDM and JI
of more than 10 Mt CO2e in the 3-year period 05- While the EU ETS is a consequence of countries
07. Together these account for only 0.9 % of the taking on their Kyoto commitments, the two project
total number of installations but for a whopping based mechanisms are actually specified in the
34% of the total allowances. At the other end of the Kyoto Protocol itself.
scale, we find that there are close to 9,000 small
installations emitting less than 1 Mt CO2e, totalling CDM is the only mechanism under the Kyoto Protocol
only 19% of the allowances but more than 90% of involving countries that are not subject to binding
all installations. However, it is the medium sized greenhouse gas emission caps by the protocol – so-
emitters, between 1 and 10 Mt, which have the called non-Annex I countries, primarily consisting
largest amounts of allowances, accounting for 47% of developing nations. Under the CDM, investors
of the total amount. from Annex I states, i.e. industrialised countries,
receive Certified Emissions Reduction units (CERs)
Medium-sized emitters account for for the actual amount of greenhouse gas emissions
47% of total allocation reduction achieved through an emission reduction
project, subject to host country agreement. CERs
can be produced from projects initiated after
In addition to allocating allowances to existing 2000, and although most current projects are only
installations, the MSs have in their NAPs set aside contracted until 2012, there is no specific end date
some allowances for new installations, the so called for the mechanism itself.
New Entrant Reserves (NER). Based on the current
version of MS NAPs, the total potential supply of
allowances from NERs for the 05-07 period is Additionality is key component of
between 120 – 180 Mt. Unused NERs might be CDM
made available to the market later in the first trading
period. There are basically two options for how the A key component of the CDM is the requirement of
NER surplus is dealt with, either by sale or auction, additionality. CER units generated under the CDM
or cancellation. From a demand and supply point will only be recognised when the reductions of

11 All rights reserved © 2006 Point Carbon


Carbon 2006

1) Both participants are parties of the Kyoto Protocol.


Fig 3.5 Step-by-step 2) Both participants have a national system for
The different stages for a CDM project and some of the risk identification of GHG emissions from sources and
factors that might arise at the different stages, storage using sinks. 3) Both participants have a
computerised national registry compliant with
international requirements. 4) Both participants
Stages Risk factors
have submitted a report for determining their initial
assigned amounts. 5) Both participants annually
Project submit a current inventory protocol fully compliant
Initial stage
development failure with Kyoto requirements.

Design docs. Methodology Hence, the track 1 system leaves much more up
methodology rejected to the host nation than does track 2 and the CDM.
Track 1 JI projects are still, however, required to
Approval, substantiate additionality.
Non-approval
Executive Board
While the above describes the project market in very
Failure broad terms, it is in fact a highly complicated market,
Implementation Delay with several steps and bureaucratic processes to go
through before credits are issued and can be used
for compliance purposes. Figure 3.5 shows a very
Certification Uncertified
simplified picture of the different steps needed for
a CDM project to produce credits, and some of the
CER risks involved at different stages. In this context, the
process for JI track 2 can be assumed to be fairly
similar, although there will be different institutions
involved.
greenhouse gas emissions are additional to any that
would occur in the absence of the certified project
activity.
Increased regulatory certainty lead
to jump in CDM/JI activity
JI is the sister mechanism of CDM, allowing for GHG
emission reduction projects to be carried out jointly As expected, the increased regulatory certainty
between two or more developed Annex I countries, following Kyoto ratification by Russia, and
where one will act as investor/buyer and the other subsequent entry into force of the Protocol, as well
as host/seller. These projects will result in so-called as the registration of the first CDM project on 18
Emission Reduction Units (ERUs), which can then November 2004 has lead to a jump in CDM activity.
be used for compliance by countries or companies. In addition to this come the improvements to the
Although a test programme for JI has existed since processes of the CDM Executive Board and the
1999, the actual transfer of allowances will not begin Methodology Panel.
until 2008.
This can be seen clearly from the number of
Two broad categories under JI - Track proposed CDM projects registered in Point Carbon’s
1 is very simplified database, which more than doubled throughout the
year, from 980 to 1965 projects. Currently, there are
2,256 CDM projects in the database. A significant
There are two broad categories under the JI, called share of the increased number of projects has come
track 1 and track 2. Whereas track 2 is essentially in a few select countries. Figure 3.6 shows the
the same as the CDM (see above) with strong number of projects in the Point Carbon database for
additionality requirements, track 1 is a very simplified selected countries at the end of 2004 compared to
procedure. The issuance of ERUs from a track 1 mid-December 2005.
initiative can be done provided the following criteria
are fulfilled by both buyer and seller:

12 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 3.6 Project growth


The number of projects registered in Point Carbon’s project database, at the end of 2004 and in December 2005.

350

300

250
Number of Projects

200

150

100

50

0
Chile

Philippines

Mexico
India

China

Brazil

Panama

Vietnam

Argentina

Indonesia

Source: Point Carbon To year end 2004 To Dec 2005

Table 3.1 CDM and JI host country rating


Point Carbon’s assessment of major project hosts.

CDM Dec 05 Dec 04 JI Dec 05 Nov 04


1. India A- (1, BBB) 1. Bulgaria BBB+ (1, BBB)
2. China BBB (5, B) 2. Romania BBB (4, BB)
3. Chile BBB (2, BBB) 3. Poland BBB- (5, BB)
4. Mexico BB+ (7, B) 4. Hungary BB (6, BB)
5. Brazil BB+ (3, BB) 5. Estonia BB (7, BB)
6. Korea B+ (4, BB) 6. New Zealand BB- (n.a.)
7. Peru B+ (6, B) 7. Chzech. Rep B+ (2, BBB)
8. Morocco B (5, B) 8. Slovakia B (3, BBB)
9. South Africa B (10, CCC) 9. Russia B (9, CCC)
10. Argentina B (n.a.) 10 Ukraine B- (8, B)
11. Malaysia B (n.a.)
12. Vietnam CCC+ (8, CCC)
13. Egypt CCC (n.a.)
14. Indonesia CCC (11, CCC)
15. Thailand CCC (9, CCC)

13 All rights reserved © 2006 Point Carbon


Carbon 2006

We see that growth was significant throughout


the year, testifying to the increase of activity in the
carbon project market. India and China are particularly
noteworthy, having more than doubled the number
of projects through the year. Still, this is somewhat
misleading as the graph shows projects at all stages
of development. India and Brazil are the countries
with most projects at Project Design Document
(PDD) level or higher, 186 and 101 respectively,
while China currently has a modest 35 projects at
the same stages.

However, although counting the numbers of projects


in the different countries tells us something about
where the activity levels might be the greatest, it
does not tell us where the reduction potential will
be the highest.

Of the 10 host countries in our database with the


largest estimated volume by 2012, China, India
and Brazil are responsible for about 63% of the
total volume for all projects at PDD stage shown in
table 3.1. It must, however, be stressed that these
have not been adjusted for the possibility that the
various projects might not be implemented after all,
that they might be implemented later than stated in
the PDD, or that they will deliver fewer reductions
than aimed for. The risk factor is an essential part of
the CDM/JI market, and as we will see later in this
report it is an important parameter for the price paid
for different projects.

China, India and Brazil dominate the


sell side

Point Carbon monitors developments in all major


CDM and JI host countries, and rates them according
to their attractiveness as project hosts. Based on
an assessment of the country’s CDM- or JI-related
organisations and institutions, its investment climate
and its CDM/JI project status, Point Carbon evaluates
whether the country in question is attractive for
CDM or JI investments. Table 3.1 shows the ratings
for the major host countries and how they ranked at
the end of 2005 in comparison to their standing at
the beginning of the year.

The following chapter will go into detail on the type of


projects that were contracted in different countries
in 2005. Later chapters will discuss whether the
CDM/JI mechanisms are functioning as intended,
and how they might develop in the future.

14 All rights reserved © 2006 Point Carbon


28 February 2006

4. Market activity in 2005 not in terms of physical volumes. In total, 262


million EU allowances (EUAs), worth €5.4 billion
The volumes and values for the carbon market last
were transacted through brokers and exchanges
year are based on registrations in our proprietary
in 2005, 79% of this through brokers. In addition,
databases, interviews with market participants, and
we estimate that the bilateral market (company-to-
our assessment of policy developments and their
company, not brokered or exchanged) did 100 Mt,
potential market impacts. The analysis of the size
€1.8 billion.
of the CDM and JI market in 2005 is furthermore
based on interviews with around 60 of the major
CDM is by far the dominant of the two project-based
players in the market, together with registrations
mechanisms, and we find that contracts for 397 Mt,
in Point Carbon’s transaction database, and Point
€1.9 billion were entered into in 2005. JI saw 28 Mt,
Carbon’s project database. See Box 4.1 for a further
€95 million contracted in Central and Eastern Europe
description of the methodology and Box 4.2 for a
(CEE). Other carbon markets remain insignificant
description of what is included in this analysis, and
in the larger picture, and did 7.8 Mt, €52 million in
what is not. Table 4.1 presents the market activity in
2005. The New South Wales trading system remains
2004 and 2005.
the largest of these, at an estimated 93% of the
financial value.
Carbon market did 799 Mt, €9.4
billion in 2005
4.1 EU ETS
We find that the global carbon market saw transactions The past year saw significant growth in the
toalling 799 Mt CO2e in 2005, corresponding to a European emissions trading market. In total, the
financial value of €9.40 billion. See Figure 4.1 for an market transacted 262 Mt CO2 through brokers and
overview of historic volumes in the carbon market. exchanges, corresponding to a financial volume of
In comparison, the market saw an estimated 94 Mt, €5.4 billion. In addition to this comes an unreported
€377 million in 2004. The growth and speed in the direct bilateral market, which Point Carbon estimates
carbon market has been quite extraordinary, with an to be 100 Mt, €1.8 billion. In comparison, the EU
eight-fold increase in volume from 2004, and about ETS did an estimated 17 Mt, €127 million in all
25 times larger financial values in 2005 compared to segments in 2004. Although growth slowed down
the previous year. towards the end of the year, see Figure 4.2, each
quarter saw record volumes and value. This growth
The EU Emissions Trading Scheme (ETS) was the has continued also in 2006, with the market trading
largest market segment in financial value, although 91 Mt, €2.3 billion year-to-date (10 February).

Table 4.1: Reported volumes and values 2004 and 2005


Reported and estimated volumes 2004 and 2005 , in million tonnes of carbon dioxide equivalents and €. Bilateral
ETS for 2005 estimated as 27% of total EU ETS volume at average EUA price through the year.

2004 2005
[Mt] [€ million] [Mt] [€ million]
EU ETS total 17 127 362 7,218
- OTC + exch. 9.7 n.a. 262 5,400
- Bilateral 7.3 n.a. 100 1,818
CDM 60 188 397 1,985
CDM 2nd 0 0 4 50
JI 9 27 28 96
Other 7.9 34 7.8 52
Sum 94 377 799 9,401

15 All rights reserved © 2006 Point Carbon


Carbon 2006

New Values of Netherlands also did some volumes,


Figure 4.1 Stepstones assumed to be some hundred thousand tonnes, but
Contracted volumes 2003-2005, Mt CO2e. that final figures were not available at the time of
writing.

1 000 ECX and Nord Pool both offer clearing of OTC


900 contracts, which added significantly to the activity
800 on the exchanges. We have not included this in the
700 reported volume as it is already accounted for in
Mt CO2e

600 the brokered market. In total, ECX did 59.0 Mt efp


500 (exchange-for-physical) and Nord Pool cleared 14.7
400
Mt.
300
200
100 European Climate Exchange is by far
0 the largest of the lot
2003 2004 2005
Source: Point Carbon CDM JI EU ETS Other
The direct bilateral market of EU allowances
– company to company, no brokers or exchange
involved - is notoriously hard to estimate. In 2004
The majority of trading took place in the brokered we estimated that the bilateral market was about
(OTC) market, which did 207 Mt in total, a 79% the same size as the brokered market. However, as
share of the total OTC and exchange market. The 2005 has also brought the option of trading through
different exchanges launched at various times exchanges one could imagine that several companies
throughout the year, and they also saw steady will have opted to do more directly through that
growth. The exchanges’ relative shares of the total channel. Nevertheless, all accounts indicate that
daily volume were highest during the summer and there still is a substantial bilateral market.
at the end of the year, see Figure 4.3. The European
Climate Exchange is by far the largest of the lot, As part of our web-based Carbon Market Survey we
with 63% of the exchange market. Nord Pool in asked respondents to indicate their best guess of
second place did 24% of the reported exchanged the share of the bilateral market. Figure 4.5 shows
volumes. Powernext of France became stronger the distribution of answers from all respondents with
towards the end of the year, overtaking Nord Pool an existing Point Carbon subscription - in total 286
in monthly volumes in December 2005. See Figure respondents at all levels of subscription (Standard,
4.4 for a breakdown of monthly volumes on the Plus, Premium and Project Manager). Although the
different carbon exchanges. It should be noted that

Box 4.1 What is counted, what is it worth?

What? Point Carbon’s methodology for estimating and forecasting the carbon market has been in use since our
first publications in 2001. The methodology differs from that seen in other market assessments, e.g. by the
World Bank. One reason for this difference is that our proprietary transaction database registers only broker
transactions/contracts and signed Emission Reduction Purchase Agreements (ERPAs) that are reported to us.
This will produce a different, and in our view more accurate, result than also including volumes in term sheets.
We also differentiate between reported contracts/transactions and an estimated “hidden” market; notably
bilateral deals in EU ETS and undisclosed contracts in CDM and JI.

How much? The time value of money makes the value of a contract different from signing to delivery. This is
especially evident for forward streams such as CDM/JI projects with long lifetimes and distant deliveries. For
the purpose of illustration, we discount all contract values to the year they were signed using a 7% discount
rate, based on their proposed deliveries. For simplicity, we assume all payment to be done on delivery, although
some contracts have partial up-front payments.

16 All rights reserved © 2006 Point Carbon


28 February 2006

Box 4.2 What is included, what is not?

The carbon market has historically been fragmented, and although the vast majority of trading activity now
takes place in the EU ETS, CDM and JI segments, there are still some deals involving greenhouse gas credits
that we do not include in our analysis and forecast. This might be the case if no actual contract has been signed
or transaction has taken place, or if there is no standardised tradable unit involved in a transaction.

Included
Kyoto markets: CDM, JI, AAU
Mandatory emissions trading: EU ETS, UK ETS, New South Wales (Australia)
Voluntary emissions trading: CCX (USA)

For the EU ETS we report transactions in the brokered (OTC) market and the volumes on exchanges. However,
we do not include clearing (e.g. exchange for physical) of OTC contracts through exchanges. In addition, we
estimate the size of the pure bilateral market (outside brokers and exchanges).

For CDM and JI we include only emission reductions purchase agreements (ERPAs) signed by both Seller(s)
and Buyer(s). We furthermore only report contracts based on future delivery, as there will be no liquid spot
market until the International Transaction Log (ITL) is up and running in April 2007, at the earliest. We also
include forward sales of issued/approved and non-issued/approved CERs/ERUs in the secondary market. In
addition, we include auctions of CERs through the New Values platform, and transactions of Carbon Credit
Notes through the Johannesburg Stock Exchange.

Not included
Domestic project tenders: Programs where companies can apply to their government in order to receive
emission credits or allowances based on specific projects, e.g. in the past this has applied to New Zealand’s
PRE Tender. Although these programs might result in the allocation of actual credits or allowances that can
be traded on the market, the initial allocation of the credits from the government to the company or project
developer is not counted as a transaction. If the project volumes are sold on to a buyer we count the volumes
once that contract is registered.

There are also US states with caps on emissions and plans for trading, but as long as there is no activity in
these potential markets they will not be included.

Various voluntary programs: Several voluntary programs exist where companies or organisations engage in
deals that include transfers of carbon credits, e.g the Oregon Climate Trust, which uses its funds to acquire
emission reductions from a number of sources. These credits are normally not transferable to operational
trading systems. There is also a growing retail sector, selling various carbon credits to companies, organisations
and individuals. Typical retail initiatives include e.g. programs for offsetting emissions from air travel.

Various stand-alone deals: Some companies have undertaken carbon credits deals that are so far not related
to any program or system. Many of these are done for company internal emission requirements, or used for
Corporate Social Responsibility reporting purposes. If these credits are sold to any operational system they are
reported under that market segment.

17 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 4.2. So good we had to show it twice


Quarterly volumes and values in the EU ETS in 2005, Mt and € million.

120 2 500
7%
100 14%
137% 2 000
80 94%
1 500
Mt CO2

€ mill
60
46% 1 000
40 185

20 500

0 0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Source: Point Carbon

responses are spread somewhat evenly, there are exactly how much is traded bilaterally, this provides
some indications that the majority see the bilateral at least some transparency on what the company-
market as being somewhere between 10% and to-company market might look like.
50%.

Based on this response we estimate that the 4.1.1 What drives the EUA price?
bilateral market in 2005 was 100 Mt, or 27.6% of Prices increased significantly in the first half of
the total volume. Although bilateral trading will have 2005, going from about €7/t in February to almost
occurred at different times throughout the year, €30/t in July, before ranging from €20/t to €24/t for
by applying the average price through the year we the second half. Figure 4.6 shows the daily prices
find that the bilateral market in 2005 corresponds as reported by Point Carbon together with daily
to €1.8 billion. While we will certainly never know volumes in the OTC and exchanged markets.

Price changes based on fuel prices


Figure 4.3 More or less and weather
The relative shares of daily volumes for the brokered and
exchanged market in the EU ETS in 2005. Pure bilateral
What were the main drivers for the price development
trades not included.
over the year? As in any market, the price is set by
100 % supply and demand. The supply is here determined
first by the caps set under the different NAPs,
80 % together with the amount of reserve allowances
and CDM credits coming into the market. Demand
60 %
is set by the amount of emissions through the year
40 % in relation to the overall allocation. Briefly put, the
allowance demand can be measured by estimating
20 % the emissions from the different sectors under the
EU ETS and subtracting the caps. This produces
0%
what Point Carbon terms the emissions-to-cap (E-t-
C), our allowance demand indicator.
3- v
c
3- l
g
p
3- r
n

3- b

ay

n
ar

ct
Ju
Ap

No
De
Ja

Ju

Au
Se
Fe
M

O
M

3-
3-

3-

3-

3-
3-

3-

3-

Source: Point Carbon OTC Exchanges The E-t-C will change on a continuous basis due to
a number of factors, but in particular: weather, as

18 All rights reserved © 2006 Point Carbon


28 February 2006

Figure 4.4: Exchanges grow too


Monthly volumes of EUA trades in 2005 at the different carbon exchanges, in Mt CO2.
10
Volum e s thro u g h 2 0 0 5
ECX: 63.4%
Nord Pool: 24.0%
8 Powernext: 7.9%
EEX: 4.3%
EXAA: 0.3%
6
Mt CO2

0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: Point Carbon ECX NordPool Powernext EEX EXAA

temperature determines power/heat demand and Have we seen evidence of the market reacting to
precipitation the potential for hydropower production; these fundamentals? In fact, the first year of the EU
and fuel prices, as the relative price for coal and gas ETS has shown that the market is indeed responding
will determine which of the fuels will be used for to changes in fuel prices and weather. Nevertheless,
power production. In other words, if the winter is policy decisions still have the potential to shift prices.
cold and the gas-to-coal price differential widens, See Point Carbon’s Carbon Market Analyst “After the
emissions will increase as more power is consumed NAPs” from 3 November 2005 for a full discussion
and coal, which emits more GHGs per unit of output on which policy events we anticipate to impact on
than gas, is the preferred fuel source. Thus, carbon price development in the future.
prices will also increase. A different situation would
occur in a mild and wet summer, where there is Market is responding to
less demand for power and the rainfall increases the fundamentals and policy events
potential for hydropower production.

Fig 4.7 shows the development of the EUA price


Figure 4.5 What the readers think throughout 2005 in relation to the impact from
Our subscribers’ best guess of the relative size of the fuel and weather to the overall short position, i.e.
bilateral market. the impact on Point Carbon’s allowance demand
Carbon Market Survey 2006 indicator E-t-C from relative coal/gas prices and
90
Q: What is your best guess of temperature/precipitation. It is evident from the
80 the bilateral market as graph that the market is to a large extent trading on
Number of respondents

70 percentage of total volume in changes in the fundamentals. The correlation (R2)


60 EU ETS? between the EUA price and the combined effect
50 from fuel and weather was 0.92 over the year as a
40 whole. The individual correlations to fuel prices and
weather were 0.89 and 0.48, respectively. This is
30
yet another signal of the market working effectively,
20 as participants and observers clearly see that the
10 market price is not arbitrary.
0
0-10% 10-25% 25-50% 50-75% 75-90% 90-100% However, some would still argue that the current
Source: Point Carbon price neglects fundamentals, in the sense that

19 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 4.6 Volumes and prices


Daily closing prices and traded volumes in EU ETS in 2005

3500 30
28
3000 26
2500 24
22
2000 20
ktCO2

18

€/t
1500 16
14
1000 12
500 10
8
0 6
24-Nov-05

23-Dec-05
3-Jan-05

4-Apr-05

3-May-05

29-Jul-05

29-Aug-05
1-Feb-05

26-Oct-05
2-Mar-05

1-Jun-05

30-Jun-05

27-Sep-05

Source: Point Carbon's Carbon Market Trader Volume Price

Figure 4.7 Driven by fuel prices


EUA prices from 8 Feb to end Nov 2005, left axis in €/t, compared to the changes to Point Carbon’s allowance demand
indicator E-t-C from fuel prices and weather, accumulated throughout 2005, right axis in Mt CO2.

35 140
R2 = 0,92
30 120

100
25
80
20
Mt CO2
€/t

60
15
40
10
20
5 0

0 -20
8-Aug

8-Sep
8-Feb

8-Mar

8-Apr

8-May

8-Jun

8-Jul

8-Oct

8-Nov

8-Dec

Source: Point Carbon EUA 2006 Fuel + weather (accumulated)

20 All rights reserved © 2006 Point Carbon


28 February 2006

“switching prices” in the UK are well above the What do market participants see as the most
EUA prices. Hence, one would need higher EUA important factors for carbon price development?
prices and/or lower gas prices to trigger substantial Fig 4.8 shows the response from our survey, where
switching from coal to gas. it is evident that fuel prices are seen as the most
important price determinant. Appoximately 45 % of
Majority of trading due to power the respondents considered fuel prices as the most
generators’ activities important factor, while more than 20 % considered
it to be the second most important factor. It is also
interesting to note that political factors are seen to
Not only does the price relation to fundamentals tell be the second most important factor in the short
us that the market has found reliable price indicators, term. Many of the political factors should already
it also shows to some extent which sectors that are have been cleared at this stage, but it is evident that
active in the market. The Power & Heat sector, which this politically created market still looks to policy for
is where the overall shortage has been placed, is announcements on supply, and to some extent also
used to trading on a daily basis, and importantly, demand.
is used to trading based on weather and fuel price
changes. Although there are some (larger) industrial It would clearly be a positive development if the
companies with their own trading departments, the importance of politics was reduced and replaced by
majority of trading activity - and price development a more predictable fundamental both as a risk and a
- in 2005 was due to power generators trading price driver. This will probably happen as the EU ETS
strategies. matures and confidence in its continuation accrues
and the outcome of legal and regulatory tussles
This dominance by the power sector has been used between the commission and MSs becomes more
by many to criticise the system, in particular in light predictable.
of the impact carbon costs have had on power
prices. As we will touch upon later in this report, Fuel prices most important in short-
the increased spot prices in the German and Nordic term perspective
power markets can to a large extent be explained by
the introduction of emissions trading. There are, however, political developments that
cannot be expected to be solved in the immediate

Figure 4.8 Short-term price drivers in the EU ETS


Based on responses from our web-survey

Fuel/other commodity prices

Political factors

Weather

CDM/JI supply

Long-term prices

Other factors

0% 20 % 40 % 60 % 80 %
Share of responses
Most important factor
Source: Point Carbon Second most important factor

21 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 4.9 Long-term price drivers in the EU ETS


Based on responses from our web-survey

Political factors

Fuel/other commodity prices

CDM/JI supply

Weather

Long-term prices

Other factors

0% 20 % 40 % 60 % 80 %
Share of responses
Most important factor
Source: Point Carbon Second most important factor

future. In particular, this relates to the developments 4.2 CDM and JI


towards an international climate agreement to Volumes in the project markets also increased
follow the Kyoto Protocol. Fig 4.9 shows what the considerably in 2005. The lion’s share of transactions
respondents to our web-survey saw as the most still takes place in developing countries, where
important price drivers in the long-term. Political CDM contracts (ERPAs) worth 397 Mt CO2e were
decisions are seen as by far the most important registered by Point Carbon, corresponding to an
factor, while it should also be mentioned that CDM/ estimated financial value of €1.9 billon (7% discount
JI supply is seen as more important in the long- rate). Thus, CDM accounted for 93% of the physical
term than the short-term. This shows that market volumes transacted in the project market and 95%
participants are looking to international policy for of the total financial value. The JI market is still
certainty on the future of the market, while at considerably smaller than CDM, but nevertheless
the same time they expect developing countries almost tripled in volume in 2005, growing to 28 Mt
to participate in an active manner through CDM CO2e, €95 million, worth of reported transactions.
investments. As we will show in the following Table 4.2 shows CDM and JI volumes in 2005 as
section, there is already evidence that this is taking registered by Point Carbon, together with estimates
place. on the financial value.

CDM saw 397 Mt, €1.9 billion. JI did


Table 4.2 CDM still dominates the project market 28 Mt, €95 million
CDM and JI volumes registered by Point Carbon in
2005. For simplicity, all payment is assumed to be
In 2005, a total of 397 million certified emission
done on delivery, and a 7% discount rate is applied.
reductions (CERs), at volume weighted average
price of 6.7 €/CER, were contracted for future
Volume Financial value delivery. As for JI, the volume of emission reduction
(Mt) (€ million) units (ERUs) contracted more than doubled, to 28
Mt, while the average price increased slightly to 5.1
CDM 397 1,985
€/t As Figure 4.10 shows, the volume has increased
CDM 2nd 4 50 throughout with Q4 as by far the most hectic
JI 28 96 contracting period in terms of volume signed. To

22 All rights reserved © 2006 Point Carbon


28 February 2006

have shown increased support for the project base


Figure 4.10 Most towards the end mechanisms, in particular China and Brazil. Also,
Quarterly volumes in the CDM and JI markets in 2005, in Mt large-scale projects are contributing significantly,
CO2e- with four HFC-23 decomposition projects signed in
2005.
350 Some of the bottlenecks at the institutional level,
300 both in host countries and at the CDM Executive
250 Board, have been overcome, or are in the process of
being removed. The CDM EB’s improved efficiency
200 in approving methodologies and projects, and the
150 positive signs in terms of establishment of the JI
100 Supervisory Committee have both added to the
increasing investment trend.
50
0 Bottlenecks are being removed
Q1 Q2 Q3 Q4
Source: Point Carbon CDM JI
China, India and Brazil are the main seller countries
when it comes to numbers of CDM ERPAs. The
some extent this might reflect when Point Carbon large volumes in China are primarily due to a few
registered the transactions, but it also supports the large HFC-23 projects. For the JI market, Romania
trends seen in previous years when it comes to has been an active seller, but volumes become
timing of contracts. small when comparing to CDM market volumes. In
fact, Brazil alone is about the same size as the total
There are several reasons for the substantial increase JI market.
in the volume transacted throughout 2005. The most
obvious reason is that the supply of potential projects At the demand side, the implementation of the
has increased. By the end of 2005 there were more Linking Directive gives EU ETS installations the
than 900 CDM and JI projects that had reached ability to use CERs directly for compliance. With
the public validation stage. Several host countries increasing prices for EUA delivery it is evident that

Figure 4.11 Where are the sellers?


Contract volumes in different host countries, as registered by Point Carbon,
in Mt CO2e.

300
250
200
Mt CO2e

150
100
50
0
a

a
il

a
I)

ia
az
di
in

ric

ic
w
(J

As
er
Ch

In

Br

no

Af
e

Am

er
p

nk
ro

th
/U
Eu

O
er
er

th
th

O
O

Source: Point Carbon

23 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 4.12 Who’s buying what?


The relative share of CDM and JI buyers, and the relative share of different project types, by
volume. CMM: coal mine methane.
Other
Unknown Waste
7%
3% Governments 3%
12 % Renewable
6%
CMM
7%
Funds
43 % Unknown
11 %
Private HFC
42 % 66 %

Source: Point Carbon

this has contributed to the demand for project CDM market to have totalled 4 Mt, €50 million in
credits. The increasing number of carbon funds has 2005.
added further to the demand. This sector includes
governmental procurement funds, private sector Exchanges are also beginning to offer CDM related
investment vehicles, and private-public funds (e.g. contracts. Carbon credit notes are being traded at the
all World Bank funds). Point Carbon will return later in JSE Securities Exchange, providing a carbon based
2006 with an updated review of the different funds investor product, for delivery in 2008. However, the
that are available for private sector investment. volumes have so far been measly, as only just below
While CDM investments is now increasingly being 20,000 tonnes were reported transacted in 2005,
dominated by private investors and funds, JI is still corresponding to around €200,000. Interestingly
mainly attracting governmental buyers. though, prices for carbon credit notes at JSE remain
substantially below EUA prices, currently trading at
about €14/t. The other exchange option, with Asian
Carbon funds add further to demand Carbon and New Values offering CER auctions on
their platform, saw around 1.5 million traded in 2005.
Figure 4.12 shows an overview of buyer’s in the Point Carbon does not register the CDM volumes
CDM and JI market, together with a breakdown of through New Values separately, and this has already
volumes on project type. As funds here include both been included in the 397 Mt total.
private sector and government investments, it is
clear that the private sector is by far the dominant
CDM investor. In terms of project types the large 4.2.1 What drives the CDM/JI prices?
volumes involved with the decomposition of HFC- Prices for both CDM and JI project contracts
23, a by-product in the production of the refrigerant increased during 2005. This can mainly be explained
HCFC-22, accounted for almost two thirds of the by increased demand from EU ETS companies
total volumes in the project market in 2005. and the numerous carbon funds that became fully
operational for purchasing credits. However, prices
In addition to the direct project market, with ERPA differ a lot from contract to contract, mainly based
contracts, there is a considerable secondary market, on the distribution of risk between buyer and seller.
where contracts for future delivery of CERs, not
necessarily with a specific project attached, are Moreover, mature projects are in general more
entered into. However, this is primarily a company- expensive than projects that have not yet reached
to-company market, although some such contracts the Project Design Document level. Also, delivery
are offered through brokers, and it is difficult to get is becoming more important. The price for credits
full overview of what is transacted in this market delivered before the end of the EU ETS’ 2005-
segment. Point Carbon estimates the secondary 2007 period are currently fetching a premium . See

24 All rights reserved © 2006 Point Carbon


28 February 2006

Box 4.1 Point Carbon’s CER contract categories


Point Carbon has developed forward Certified Emissions Reductions (CER) contract categories in order to
provide a tool to structure prices and forward CERs according to consistent criteria. The categories are based
on how different risks are distributed between seller and buyer. The categories are broad, and prices vary within
them, according to specific risk factors linked to project or market maturity. Currently, the largest share of
forward CER transactions are found in category 2 and 3.

Price category Approx. price Description


range (€/t CO2e)
1 3-6 Non-firm volume. Buyer buys what seller delivers even if
emissions reductions turn out not to qualify as CERs.
2 5-10 Non-firm volume. Contract contains preconditions, e.g. that
the underlying project qualifies for the CDM.
3 9-14 Firm volume. Contract contains preconditions (as above).
Usually strong force majeure clauses and high credit rating
requirements.
4 12-14 Firm volume. No preconditions. Forward spot trades will in
the future fit this category. Currently only the JSE’s Carbon
Credit Notes fit under this category.

Figure 4.13 Short-term price drivers for CDM and JI


Based on responses from our web-survey

CDM Methodology panel

EU ETS 08-12 price

Political factors

Earlier deals

Other factors

AAU prices

0% 20 % 40 % 60 %
Share of responses
Most important factor
Source: Point Carbon Second most important factor

25 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 4.14 Long-term price drivers for CDM and JI


Based on responses from our web-survey

Political factors

EU ETS 08-12 price

CDM Methodology panel

AAU prices

Earlier deals

Other factors

0% 20 % 40 % 60 %
Share of responses
Most important factor
Source: Point Carbon Second most important factor

Box 4.3 for an overview of Point Carbon’s contract estimated €52 million. Figure 11 shows the volumes
categories for CDM projects. and value of these markets in 2005.

Figures 4,13 and 4.14 show what the respondents We do not expect very significant growth in these
to our web-survey saw as the most important markets. The UK ETS is in its final year, and the
price drivers in the short- and long-term. Decisions NSW scheme remains pretty stable from year to
by the CDM Methodology Panel are seen as very year. If any growth is to take place, CCX is the most
important in the short term, as this is primarily what likely candidate, as US companies might seize the
determines whether a specific project will qualify for opportunity to gain carbon trading experience and
CDM or not. It is also clear that the link between environmental credentials at the same time.
EUA prices and CDM/JI contracts are viewed by
many as a relevant issue. Increasing EU ETS prices
will tend to increase demand for imported credits,
Other markets saw 7.8 Mt,
and this will also increase the prices paid for said
estimated to be worth €52 million
credits.
UK ETS
4.3 Other markets The UK ETS continues to cling to a straw. Point Carbon
estimates that approximately 300,000 tonnes CO2
Although the carbon market now to all extent is
were transacted over the year, corresponding to a
focused on EU ETS and Kyoto instruments, there are
financial size of some GBP750,000 (€1.09 million
still some other operational greenhouse gas trading
estimated).
systems that should be considered.

By far the largest of these is the New South Wales Australia


Greenhouse Gas Abatement Scheme in Australia, The New South Wales Greenhouse Gas Abatement
which totals 78% of the physical volume in the other Scheme reported 222 trades over 2005, with
markets, and 93% of the financial value. In total, the February and October the busiest months at 35
other markets segment – which also includes the and 29 trades respectively. This marks delivery on
voluntary Chicago Climate Exchange in USA and contracts, whether spot or forwards, not when the
the UK ETS, which will finally come to an end this contracts are agreed. The market has remained
year – clocked in 7.8 Mt CO2, corresponding to an largely illiquid over the year, with some months

26 All rights reserved © 2006 Point Carbon


28 February 2006
Figure 4.15: And now for something completely different...
The relative share of other carbon markets, physical volume and financial value.

Physical volumes (7.8 Mt CO2) Financial value (€52million)


UK ETS
4%
CCX
18 % UK ETS
2%

CCX
5%

AUS NSW
AUS NSW 93 %
78 %
Source: Point Carbon

seeing just a handful of trades and sideways price


movement. 6.1 million tonnes of CO2 were reported
as transferred, corresponding to an estimated
financial size of AUS$78.2 million (€48.5 million
estimated).

USA
The Chicago Climate Exchange grew considerably
in 2005, from 77 to 129 members. Furthermore,
the participants agreed to extend the programme
for four more years, with a new tentative end date
in 2010. Last year was also the busiest year yet
for the exchange, although it remains a relatively
illiquid market. In total the market saw 1.43 Mt CO2
transacted, corresponding to US$2.83 million (€2.37
million estimated).

27 All rights reserved © 2006 Point Carbon


Carbon 2006

5. Does it really work? But the carbon market is to some extent much more
than just environmental policy. The issuance of
As the previous chapters have shown, the carbon
EUAs to more than 10,000 installations throughout
market is now to all extents a fully operational
Europe has in fact created a whole new currency,
commodity market. Volumes are large, but there
which can be used as hard capital. In total, the 3-
is still room for considerable growth. Prices are
year allocation is currently valued at more than €153
reacting to fundamentals, although policy decisions
bn. The recent guidance for phase 2 indicates that
still impact from time to time. All in all, the carbon
the full 5-year allocation for the 2008-2012 period
market is a multi-billion euro industry which results
would be some 2.063 bn allowances per year, which
in emission reductions that will help countries meet
given current prices for Dec 2008 delivery values the
their Kyoto targets. But does it really work the way
underlying assets in that phase at more than €220
it should?
bn. It is obvious that certain operational procedures
must be in place when dealing with amounts of
There are still several shortcomings to the EU ETS,
this magnitude. It might, in fact, be worth looking
although they are primarily due to regulatory delays
at financial markets to see how they deal with
in Member State governments. In particular, the
announcements that will have direct impacts on
continuing uncertainty surrounding some national
the market. For example, if a decision which could
allocation plans (NAPs) is a problem for the market in
provide a market signal is to be delivered, let’s say
general, but to a much greater degree for companies
a meeting of the National Bank to adjust interest
in the countries still lacking complete plans. At the
rates, it must be clearly specified in advance exactly
time of writing, Italy, Poland and Hungary have all
when and how that message is to be delivered.
failed to publish installation levels NAPs, more than
1 year after the start of the trading system. The
Is this the case in the carbon market today? Alas,
same goes for Luxembourg, Malta and Cyprus,
it is not. A decision which could have clear market
although these countries were never expected to be
implications is rarely announced clearly in advance.
of particular importance to the trading activity in the
At times important decisions have caught both the
market
market and observers by surprise. The situation
which we have seen in the past, where decisions
Still several shortcomings to EU ETS are unannounced and documents are leaked to,
from and between Member States and business
organisations, is not preferable in the long-run -
Furthermore, a number of countries have been
although it is definitely interesting for journalists and
almost criminally slow in putting up their registries,
market analysts alike.
pushing very close to having infringement
procedures opened due to the lack of proper
Of course, there are differences between the
operations. Only a few countries actually met the
carbon market and other financial markets. For
deadline set by the Commission, leaving major parts
instance, interest rates are usually not a matter of
of the market operating without registries for large
negotiation. Also, it is probably too much to ask the
parts of the year. In early January 2006, a total of
EC’s environmental directorate to change their entire
7 national registries were listed as “not operating”,
modus operandi. Policy documents will always be
while all others were listed as “partially operational”.
leaked, and processes in governments will often
Although “partially” here means that the registries
take more time than expected.
to all extent and purposes are sufficiently up and
running, at least to meet the requirements of the
market today, it is clear that the registry situation still Market works even with assymetric
needs considerable improvement. information
The lack of registries has been quoted by many
Nevertheless, it is worth pointing out that the market
throughout the year as a reason for why some
works, albeit not effectively, in this situation. This
companies, in particular potentially large sellers in
proves that the market can work even if information
Central and Eastern Europe, have stayed away from
is asymmetric. However, it does not take away the
the market. Many buyers prefer spot trading with
need for sufficient safeguard measures to be put in
CEE players, due to credit lines. This implies that
place so that the carbon market will know in advance
we will see more action from that region in 2006.

28 All rights reserved © 2006 Point Carbon


28 February 2006

Figure 5.1 Has the EU ETS triggered internal abatement projects in your company?
Based on responses from our web-survey

60 %
Share of responses

40 %

20 %

0%
Yes No Do not know

Source:
Point Carbon Industry Oil/gas/refineries Power & heat

exactly when and how decisions are communicated. need to reduce emissions, or import considerable
If this is done within both the EC and the Member additional allowances and/or credits – through the
States it will help to increase the effectiveness of New Entrant Reserve (NER) and/or CDM –in order
the market even further. The EC’s track record in this to be in balance for the 3-year period. Even with our
field should indicate that they will be able to deal current assessment on the potential supply through
with this, as well as the other challenges ahead. NER and CDM, the market will still be short. It is,
however, important to point out that the results of
Leaving aside whatever problems that remain with this analysis changes with relative fuel prices and
the market and uncertainties about policy issues weather conditions.
regarding phase 2, to what extent has the EU ETS
been effective in its first year of operation?
40% of industrial respondents say
The environmental effectiveness of the EU ETS ETS lead to internal abatement
must be seen in relation to whether the system
will succeed in meeting the overarching goal: How do market participants view the effect of the
to reduce greenhouse gas emissions. This is in EU ETS for their own operations? Fig 5.1 shows the
reality defined by the cap, and whether the system response from industrial players participating in our
reduces emissions from a business-as-usual path. web-survey. More than 40% of participants from
Of course, it also assumes that the system works; the industrial sector said that the EU ETS has lead
that companies stay in compliance and those failing to internal abatement projects being carried out in
to do so are penalised accordingly. their company. While the relative share of positive
responses was lower for the oil/gas sector and the
The EU ETS will undoubtedly reduce emissions. power & heat sector, in more than 25% of the cases
As we have shown, most countries had to reduce the EU ETS has lead to reductions.
their allocation in relation to their 2003 emissions.
In sum, the EU ETS sectors had to reduce about 40 However, internal abatement is only one of the
Mt, or 120 Mt for the three-year period, in relation to pillars in the corporate emission reduction strategy.
2003 emissions. Companies can also purchase allowances and
credits in the market. Or, in extreme cases, they can
Furthermore, Point Carbon’s allowance demand choose to relocate their entire business to a country
indicator, Emissions-to-Cap (E-t-C), indicates that where emission limitations do not apply.
based on current EUA prices the system would

29 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 5.2 What is your primary strategy for complying with EU ETS?
Based on responses from our web-survey

40 %
Share of responses

20 %

0%
Internal Trading Trading Relocation Other
abatement CDM/JI within EU
ETS
Source: Point
Carbon Industry Oil/gas/refineries Power & heat

Figure 5.2 shows the different strategies chosen There is, alas, no universal definition of liquidity, or at
by the industrial players participating in the web- least what constitutes sufficient liquidity. A working
survey. About half of the respondents from the definition is that a market is liquid if participants
industrial sector said that internal abatement was can quickly execute (large-volume) transactions at
their primary strategy, while only 18% of the power low costs with minimal impact on market prices.
& heat respondents saw this as their first choice. To do this it will be necessary to have a sufficient
These results further show that the power sector number of participants with sufficient volumes at
is primarily looking to the EU ETS, and also CDM/JI, each side of the bid/offer spread. In reality, however,
as their best carbon strategy. This is in line with our it will also require accurate, reliable and timely price
other analyses, which show that the carbon market discovery. As we have shown earlier in this report,
is to a large extent dominated by the power sector. It the market is indeed reacting to fundamentals.
is also interesting to point out that only a very small This provides certainty that prices are not being
minority of respondents pointed to relocation as an randomly set, or at a minimum that the underlying
option, indicating that there is little actual evidence reasons are measurable, unlike the case most often
of carbon leakage taking place. is with policy decisions. In addition, there are now
a wide number of market service providers, giving
Little actual evidence of carbon participants access to reliable and timely prices.
leakage taking place This leads us to conclude that the market is already
meeting the necessary requirements in terms of
price discovery.
However, just meeting the targets will not be enough
for emissions trading to be judged a success. It will
also be crucial to determine the manner in which Is the EU ETS liquid?
these reductions have been achieved. Establishing
an effective and liquid marketplace is a necessary The remaining question is then whether we have
(but not sufficient) condition for achieving economic seen sufficient volumes in the market. As this is the
(cost) and institutional effectiveness. But when is first compliance year of the EU ETS, there is little
a market liquid, or at least liquid enough? Can we data for a comparative analysis. However, there are
look to other markets to find reliable indicators for other environmental markets that provide some
liquidity that may be used for the EU ETS? historical data. In particular, the US SO2 market is
a prime candidate for comparing the liquidity of the

30 All rights reserved © 2006 Point Carbon


28 February 2006

Figure 5.3 Its rollercoaster time


Annualised weekly turnover (5 day rolling average) in the EU ETS, in % of total underlying assets. Linear trendline
added.

45 %
40 %
35 %
30 %
25 %
20 %
15 %
10 %
5%
0%
01.12.04

01.01.05

01.02.05

01.03.05

01.04.05

01.05.05

01.06.05

01.07.05

01.08.05

01.09.05

01.10.05

01.11.05

01.12.05

01.01.06
Source: Point Carbon

EU ETS. This market has seen turnover increasing even without full participation throughout the year.
from 10% in 1995 (the first year of the market) to In sum, we find that the EU ETS is already a qualified
70% in 1998 (the most liquid year to date). Average success.
turnover in the period 1995 to 2003 was 50% per
year. 45% finds EU ETS a success, only
22% thinks the same of CDM/JI
How does the EU ETS fare in comparison? In the
first year of operation the market has seen annual Do survey participants agree with us? To some
turnover of 12.4% of total underlying assets (2005 extent, yes. Figure 5.4 shows that the market finds
allocation, not including NER). However, looking at the EU the EU ETS to be more mature than it was
the development throughout the year, it is clear that a year ago (67% agree), but that only a handful of
liquidity has picked up as the market has matured. respondents (10%) find it to be a mature market. In
One way to measure this is to look at how much was other words, the market still has some way to go
transacted in a week in relation to a “weekly cap”, before it reaches puberty. However, the market is
i.e. the 5 day rolling average. This volatility measure already seen as a success (45%), and 55% find that
has increased steadily, reaching more than 30% at if facilitates emission reductions. Furthermore, 47%
periods in the last 3 months. This clearly shows that of the respondents saw it as the most cost-effective
the market is becoming increasingly more liquid, way of reducing emissions.
and that more participants and more volumes have
come to the market during the year. The situation is somewhat different for the CDM and
JI markets. While half of the respondents thought it
The EU ETS is already a qualified a more mature market than one year ago, as many
success as 21% disagreed with this. Also, only 7% found
it to be a mature market. Importantly, while the
project markets are viewed as cost-effective ways of
As we have shown previously, there are still some achieving actual reductions, only 22% thought that
improvements that can be made in terms of bringing the project market was a success.
all parties to market. Nevertheless, even with these
shortcomings still present, we argue that the market One of the main criticisms towards the EU ETS has
now has real price discovery, reacts to changes in been its impact on power prices. We will discuss
fundamentals, and enjoys several reliable market this in more detail in the next chapter.
service providers. In addition, liquidity is increasing,

31 All rights reserved © 2006 Point Carbon


Carbon 2006

Figure 5.4 EU ETS maturity


Based on responses from our web-survey

EU ETS is more mature


now than one year ago

EU ETS is a mature market

EU ETS is the most cost-


efficient way to reduce
emissions

EU ETS facilitates
emissions reductions

EU ETS is a success

0% 20 % 40 % 60 % 80 %
Source: Point Carbon Disagree Agree

Figure 5.5 CDM & JI maturity


Based on responses from our web-survey

The CDM&JI market is


more mature now than one
year ago

The CDM&JI market is a


mature market

The CDM&JI market is the


most cost-efficient way to
reduce emissions

The CDM&JI market


facilitates emissions
reductions

The CDM&JI market is a


success

0% 20 % 40 % 60 % 80 %

Source: Point Carbon Disagree Agree

32 All rights reserved © 2006 Point Carbon


28 February 2006

6. Carbon Market Insight:


The power of carbon However, continental power markets are far from
being fully liberalised, and there are still strong
Power prices have increased throughout Europe oligopolistic structures in the market where the
during 2005, and many have pointed to the actions of a few dominant players will influence the
introduction of EU emissions trading scheme (EU market strongly. Adding to this there are a number
ETS) as an explanation. As previous chapters have of other complexities at play, such as e.g. gaming
shown, the Power & Heat sector is perhaps the most strategies of generators and cross-border exchange.
dominant within the EU ETS, and players within this Perhaps the increase in power prices in 2004-5
sector now have to purchase allowances to meet cannot be fully explained by the introduction of
their emission targets under the scheme. However, carbon trading as the only factor?
around 95% of the allowances have been received
for free, through the grandfathering principle This chapter will discuss these questions more
based on previous emissions from the generators’ thoroughly by looking at price developments in
installations. To what extent can high power prices two power markets in particular; the Nordic market
be explained by emissions trading? (Nord Pool) and the German market (EEX). The
picture painted here should be viewed as a general
introduction to the new carbon-power complexity,
Can power price increases be rather than a detailed analysis on how much carbon
explained by carbon alone? has added to power prices. Such analyses require
the use of complex models on a number of energy
As we will show, the introduction of carbon pricing markets, as well as assumptions on the strategies
for the power sector must be viewed in light of the chosen by players in the carbon and power markets.
opportunity cost principle. In a competitive power These topics will be covered in more detail in later
market, generators will bid in their production issues of Point Carbon’s Carbon Market Analyst.
according to their short-run marginal costs (SRMC).
In this case, for fossil fuel producers the value of
allowances necessary to back their power generation
is part of the plant’s marginal cost of production. The 6.1 Higher spot prices
value reflects the forgone value of the allowances Figure 6.1 shows the development in period 2001
that otherwise could have been sold. This added cost – 2005 for the German market (EEX) and the Nordic
will then feed through to increased system marginal market (Nord Pool) given as average yearly spot
prices of power – across all time periods when fossil prices. While annual averages are a poor indicator
fuel stations are on the supply margin. on how power markets function, we have included

Table 6.1: Spot prices going up...


The average spot prices on various European power exchanges, measured in €/MWh. Source: Point
Carbon, except from the numbers from Spain and the Netherlands which aer taken from Montel Power
News.

2004 [€/MWh] 2005 [€/MWh] Change [€/MWh] Change [%]


Germany (EEX) 28.5 46.0 17.5 61.4
Nordic (Nord Pool) 28.9 29.3 0.4 1.4
Spain (Omel) 27.9 53.6 25.7 92.1
The Netherlands (APX) 31.6 52.4 20.8 65.8
Austria (EXAA) 28.1 46.7 18.6 66.1
France (Powernext) 28.7 46.6 17.9 62.4
Average 29.0 45.8 16.8 57.9

33 All rights reserved © 2006 Point Carbon


Carbon 2006

Fig 6.1. ... and up...


Average yearly spot and forward prices at Nord Pool (NP) and Phelix (EEX),
given in €/MWh. The forward contracts are from 30 December 2005.

60

50

40

30

20

10

0
2001 2002 2003 2004 2005 2006 2007 2008

Source: Point Carbon, NordPool and EEX NP EEX

them here to give some rough idea on how power We see that power prices in general made a big jump
prices have developed so far in this decade. in 2005, and forward curves continue this upward
trend in 2006-08. Moreover, the annual averages
The average annual EEX spot price showed a indicate that the EEX region experienced a more
moderate year-on-year increase to 2004, followed significant price growth than the Nordic region. Can
by a steep growth from 2004 to 2005. The average the rise in the EEX spot prices in 2005 be attributed
price for 2001 – 2004 is 26.2 €/MWh, while it was to the introduction of the EU ETS? Or is it the fuel
46.0 €/MWh in 2005, representing a 75.0 % growth prices? And why does the Nord Pool spot prices
(61.4 % from 2004 to 2005). The forward contracts in 2005 seem to have been less affected by the
for 2006 – 2008 have further followed the bullish EU ETS market. It is of course difficult to consider
development of increasing power prices. As seen prices in the Nordic region without looking at the
from Table 1, the development in Germany is also hydrology situation. To what extent have reservoir
found in other European exchange markets, with a levels impacted on Nordic power prices? We will
57.6 % growth on average from 2004 to 2005. discuss these factors in some detail in the following
sections.
Spot prices have increased
throughout Europe 6.2 Explaining increasing spot prices
As already mentioned, the European wholesale
The development in the Nord Pool region shows a electricity market is far from fully liberalised, although
somewhat different trend. In 2001 the spot price there are considerable regional differences. The
was lower than the EEX price, while it increased, Nordic countries (the Nord Pool region) have moved
even above the EEX level, during the 2002 and 2003, quickly towards a truly competitive power market,
before leveling off in 2004 and 2005. The average while there is still a strong oligopolistic structure
price for 2001 – 2004 is 28.9 €/MWh, while it was in Germany. Within this context we will seek to
29.3 €/MWh in 2005, indicating a 1.40 % increase explain why we have seen the increasing spot and
(1.43 % from 2004 to 2005). The forward contracts forward prices in 2005-2008 in the Nord Pool and
for 2006 – 2008 are at an even higher level than in EEX region.
2005.

34 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 6.2. CO2 on the margin


Short run marginal cost (SRMC) for a coal and gas fired power plant, EUA
price of €22/t¸ in €/MWh. Coal and gas prices are from 27 December 2005.

Coal

CCGT

0 10 20 30 40 50 60

Source: Point Carbon Fuel Operation & Maintainance CO2

respectively. These plants emit around 0.9 tonne


6.2.1 German market (EEX) CO2/MWh (coal) and 0.4 tonne CO2/MWh (CCGT).
As shown in Figure 6.1, the German market has
experienced a considerable higher price level than This example shows that the introduction of EU
in the Nordic spot market in 2005. One explanation ETS influences the electricity production costs
to this is the energy mix in Germany, where fossil in EU and also the merit order of the different
fuel plants are more often on the margin than in the production technologies. Figure 6.2 illustrates that
Nordic region. the coal power plant in our example is the cheapest
technology if the CO2 cost is disregarded, due to
For a thermal power plant, the full CO2 cost is added lowest fuel prices. With a EUA price of €22/t CO2
to the marginal production cost, and comes in addition included, the coal power plant is still the prefered
to the cost of fuel and operation/ maintenance (O technology. However, if the EUA price reaches €44/
& M). Figure 6.2 illustrates the consequences of t, the CCGT plant will be the cheapest technology.
the carbon cost to the short run marginal costs Hence, the introduction of sufficiently high CO2
for power production plants. In a fully competitive prices might induce fuel switching towards less
and liberalised power market, power producers will carbon-intensive energy sources, which was an
behave accordingly, while in a more oligopolistic intended effect of the EU ETS.
market the actors will behave differently.
It should be stressed that the figures referred to
Carbon is part of power generators’ here only apply to our example, and that in an actual
operating costs market situation there are other factors coming into
play. Nevertheless, our example shows that carbon
costs are now a part of the power plants’ operating
In our example, the carbon cost is 53 % of the total costs, and can go some way to explain the increases
SRMC for coal-based power plants (21.2 €/MWh) in power prices.
and 18 % for combined cycle gas turbine (CCGT)
(9.1 €/MWh). The EUA cost in €/MWh depends on We observe from figure 6.3 that the ‘SRMC coal incl.
the efficiency rate and the emission factor of the CO2‘ to a large extent follows the developments in
power plants. Efficiency rates for power plants vary, EEX prices in 2005. In the beginning of 2005, the
but in this example we have used 39% and 53% SRMC was around €30/MWh for a typical coal power
as standards for coal power plants and CCGTs,

35 All rights reserved © 2006 Point Carbon


Carbon 2006

Fig 6.3 On the run...


Short run marginal costs (SRMC) for coal and gas power plants and EEX spot
price measured in €/MWh for the period 2003 - 2005
100

80

60

40

20

0
Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05

Source: Point Carbon and EEX EEX Base SRMC Coal SRMC coal incl. CO2

plant with efficiency rate of 39% (including fuel cost, maximum 13.5 % of the total installed capacity is
CO2 allowance and operating and maintenance exposed to the EU ETS market and the cap on CO2
costs). During the summer of 2005, SRMC reached emissions.
a peak of €50/MWh, due to rapidly increasing CO2
allowance prices. However, this cannot fully explain Due to the high hydro power fraction in the Nord Pool
the peaks in power prices. region, there has traditionally been a high correlation
between the total energy reservoir and spot prices.
Increasing gas prices explain some
For instance, the average correlation in 1996-2004
of the power price increase was 0.85, while the 52 weeks rolling correlation
between the two quantities was between 0.6 and
Increasing fuel prices, in particular for gas, through 0.95 from 1996-2004.
this period will also go some way to explain the
increased power prices. But this is also only one Figure 6.4 illustrates that there seems to be a
part of the explanation of the increasing power level-shift in the relationship between the energy
prices. Gas fired plants in Germany are seldom the reservoir levels and spot prices from January 2005.
marginal price setting power producer - with only There was a marked divergence between reservoir
a minor share of power plants in Germany being levels and the spot price, before correlation was
gas-fired - and are on the margin only for parts of re-established, although at different levels than
a 24 hour period. In addition to the significance of in previous years. As figure 4 shows, such energy
carbon- and fuel prices to the spot prices, increased reservoirs had previously resulted in spot prices in
consumption in peak periods and potential imperfect the 100-150 NOK/MWh area (12-19 €/MWh). What
market conditions, with few other than large actors is the contribution from the EU ETS to this?
being able to control the market, are explanations to
the observed development in spot prices. The increasing spot prices in 2005, as well as the
level shift in correlation between reservoir levels and
6.2.2 Nord Pool prices, can partly be explained by the direct influence
of carbon costs to Nordic producers. However, since
How has the Nordic market been hit by the EU ETS?
only 13 % (at a maximum) of the generation stack is
The supply side in the Nord Pool market consists
based on fossil fuel-based thermal production, there
of a substantial share of hydro power. Moreover,

36 All rights reserved © 2006 Point Carbon


28 February 2006

are other reasons for the relatively high NP spot economical to export power from the Nordic region
prices in 2005. to the German market.

The consumption in the NP area has picked up this


year, after the downturn caused by high prices in Nordic power exports return
2002-2003, and is now on the same level as in 2001, Continental carbon costs
meaning well above the 1996-99 level. Although
there have been some changes in the installed The physical transfer between the regions varies
capacity since this period, the increased capacity throughout the day. Traditionally, the German spot
does not reflect the increased demand for power. price has been lower than Nordic spot price during
This implies more hours exposed to thermal power, night time due to less flexible power production in
and consequently an increase for spot prices due to Germany, creating net import to the Nordic region.
the influence from EU ETS on thermal production In 2005, however, a new trend is observed as there
based on fossil fuels. was a net export from Nordic region to Germany
even in the off-peak hours during night time,
indicating altered spot price differentials between
New incentives to export power these regions compared to earlier. The increase of
from Nordic region cross-border trading due to the price differential
will also be a major part of the explanation for why
prices in the Nordic region increased in 2005. Thus,
The level of cross-border trading between EEX and it is plausible that the German power prices, which
Nord Pool depends on the spot price differences have increased for a multitude of reasons (including
between these regions. The higher spot price level carbon), have had more to say for the power price
in Germany, partly caused by the added carbon increases in the Nordic region than the direct carbon
cost, as well as a wet season in the Nord Pool costs themselves.
region, has thus contributed to a rise in the price
difference between EEX and NP spot price and the A further reason for the increasingly interlinked
NP forward prices as well, making the NP spot price carbon and power markets is the knowledge, and
in 2005 considerably below the EEX Base and the focus, that many carbon traders have brought with
coal SRMC (incl. CO2). Thus, it has become more them to this emerging market. Most of the active

Fig 6.4 A sort of goodbye...


Total energy reservoir in Norway and Sweden (deviation from normal) and
Nord Pool spot price [NOK/MWh] for the period 1996 - 2005

800 -150

700 -130

-110
600
-90
500
NOK/MWh

Deviation

-70
400
-50
300
-30
200
-10

100 10

0 30
96
96
96
97
97
98
98
99
99

01
01
01
02
02
03
03
04
04
05
05
0
0

Spot price
Source: Point Carbon and NordPool Energy Reservoir, deviation from Normal

37 All rights reserved © 2006 Point Carbon


Carbon 2006

Fig 6.5 Powered by experience


The background of active traders. Answers limited to those respondents who said they were trading the
EU ETS actively. Multiple choice answers were allowed for, thus total share exceeds 100%.

50 %
Share of respondents

40 %

30 %

20 %

10 %

0%
r g s g g g g
he itie
din d in din din din
Ot traod tra l tra tra l tra
r m s i k a
weom Ga O
Sto
c Co
Porc
the
O
Source: Point Carbon

carbon traders have a background in power or fuel thus increasing demand for allowances. This leads
trading, see Figure 6.5. Although the carbon market us to argue that the introduction of the EU ETS
to some extent operates on its own logic, it is clear could amplify price volatilities in the power market,
that having many traders thinking along the lines for both upwards and downwards price movement.
they have done in previous positions will add further
to the correlation between prices and commodities.
Power prices impacted by climate
policy uncertainty
6.3 New complexities arising
As seen above, the EU ETS hits both the NP and EEX Given the new carbon-power interplay, it is clear that
regions, although somewhat differently. The main power prices are also now influenced by uncertainties
explanations for the differences are the fuel mix, relating to climate policies and the carbon market.
the cross-border trading capacities and possibilities, In particular the inflow of carbon credits, primarily
weather conditions, as well as the fuel prices. In through New Entrant Reserves (NERs) and Certified
an already complex power market situation, carbon Emission Reductions (CER), is significant to the
now enters the picture, creating new complexities carbon price. Increased supply of these will reduce
and interplay between commodities. the price on EUAs and consequently also on power.
Thorough discussions on this can be found in
previous issues of Point Carbon’s Carbon Market
Many carbon traders with power Analyst, for instance “After the NAPs” (3 November
market background 2005) and “Opening the floodgates” (16 December
2005)

In addition to increasing the power price, the EU ETS If these interplays continue also in the future,
could raise the volatility for power prices, through the carbon market will over time add a new and
a so-called “double whammy” effect. During mild more complex dimension to the European energy
winters or cold summers power prices and volumes markets, where energy markets will be impacted by
decrease because of reduced energy consumption. the global climate policy agenda and international
The opposite situation is found for cold winters and market for allowances and credits. This trend will
warm summers. But the same fundamentals apply to become paramount towards 2008 as the EU ETS
the carbon market (see Chapter 4), where increased will increasingly be impacted by policy events and
power demand leads to increasing emissions, and market developments outside Europe.

38 All rights reserved © 2006 Point Carbon


28 February 2006

The most important international policy events that


will impact the EU ETS are: the establishment of
Japanese and Canadian trading schemes that will be
indirectly linked to the EU ETS; the approval process
for Joint Implementation and the Clean Development
Mechanism; as well the international negotiations
over a post-2012 agreement. On the market side,
demand and supply of credits from JI and CDM
and the behaviour of big sellers such as Russia and
Ukraine will be macro-drivers also in the EU ETS, but
there might also be an increasing linkage between
the European, Japanese and Canadian power market
caused by emissions trading.

Newfound complexity necessitates


new analytical frameworks and
models

This newfound complexity will necessitate analytical


frameworks and models that are more complex than
the ones currently in use. The liberalisation process
of the European energy market combined with
emissions trading means that over time all energy
carriers and carbon will have to be considered as
interrelating factors. Moreover, the analyses and
models will have to cover a larger geographical
area, both on the supply and demand side as the
European energy markets become more dependent
on global trends, in particular on the carbon side. As
the markets, particularly for allowances, will continue
to be strongly affected by long-drawn political
processes, a good understanding of international
politics and policies will be crucial in order to trade
effectively.

39 All rights reserved © 2006 Point Carbon


Carbon 2006

7. What does the future hold? Still, there is a difference between a theoretical
supply and political reality. It is still uncertain exactly
Trading is already well under way in the second year
how many allowances that will be available from
of the EU ETS, and new projects are coming into
Russia and Ukraine, and how they will come to
the CDM and JI pipelines on a regular basis. But
the market. In a previous issue of CMA (“Will the
where will the carbon market go in the future? The
giants awake?” 22 March 2005) we concluded that
market for EUAs with 2008 delivery has not yet fully
the majority of these AAUs would be sold through
taken off, and there are very few CDM/JI projects
political deals in a non-commoditised market. In our
that extend beyond 2012. What are the challenges
view this conclusion still stands.
and opportunities that market participants will face
in the years ahead?
More emphasis on JI and GIS
This chapter will explore some of the major
developments expected to take place in the market
There will certainly be more emphasis on JI and
in the near-term future, and discuss whether they
Green Investment Scheme options in the years to
will have any significant implications for current
come, but the developments in Russia and Ukraine
market activity.
so far do not indicate that there will be a market
based on supply and demand for AAUs, where a
7.1 Globally - still political uncertainties true reference price emerges. We will continue to
As we have discussed already, there is a potential monitor the situation in these countries and return
surplus of allowances in the Kyoto period. In particular, with an updated issue of the CMA where we look
the two giants on the sell side – Russia and Ukraine at countries’ and companies’ options for buying
- will have more than enough emissions to meet allowances on the eastern front.
what is left when/if domestic options and CDM/JI
are exhausted. In fact, Russia and Ukraine can meet Nevertheless, the behaviour of both seller and buyer
all other countries’ current carbon requirements countries alike will depend on the expectations for
and will still have large amounts of allowances left a future climate agreement. While the future of the
over, which they can then bank into a commitment international climate cooperation is still being hotly
period from 2013. Adding also the expected surplus debated, there are strong signals from the recent
in other Central and Eastern European countries we climate talks to indicate that at least the process
find that the potential supply would be about three towards an agreement for the post-2012 period is
times higher than the current Kyoto shortfall. in safe hands.

The crucial point in last year’s climate talks in


Increased influx of allowances from Montreal came when the US delegation walked
Eastern Europe would provide more out of the negotiations on how to proceed with the
emissions to industries discussions on a possible post-2012 agreement.
While this could potentially have led to the whole
How would an increased influx of emission talks breaking down, given the high importance
allowances from Eastern Europe impact the market? placed on having the US onboard, it did in fact lead
The primary importance would be that countries to the opposite. The US obstructionism, which went
could allocate more emissions to their industries, as as far as even rejecting text previously agreed to at
Kyoto compliance at the national level gets ensured the G8 Gleneagles meeting, seemingly galvanised
through AAU trading. However, for the EU ETS this the other negotiating parties, and can ironically be
means that budgets for such procurement must be in seen as the most productive single action taken by
place by Summer 2006, and that all plans for further any party at Montreal.
procurement are substantiated. The second impact
on the market would be that governments would not It goes to show that when focus is placed on one
pursue CDM, and to some extent JI, opportunities common “adversary”, the other negotiation parties
in the same way as they’ve done so far. This would will more easily let their internal disagreements pass.
mean that there were more potential projects, and In the end, of course, the USA returned to the table
credits, available for the private sector. and signed the Montreal conclusions, rendering
the Canadian hosted talks as the most productive

40 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 7.1 Where will the EU ETS price be one year from now?
Based on responses from our web-survey

60 %
Share of responses

40 %

20 %

0%
Lower than today At same level as Higher than
today today
Source: Point Carbon

climate round since Marrakech/Bonn (COP6/COP6 economy. As Point Carbon has reported in several
bis). other publications, we do not see the AP6 as a
viable solution to the global climate problem. It sets
Everything should now be in place for countries to no target for emissions, a measurement for success
start talks on a second commitment period under is not in place, and it does not place a cost on
the Kyoto Protocol, starting in 2013. Furthermore, emissions or a value on reductions. While it certainly
a number of countries have signalled that their will generate headlines in 2006, we don’t expect the
domestic initiatives will have a lifetime well beyond actual output in terms of emission reductions to
2012, clearly indicating that carbon emissions will amount to much.
have a cost (and reductions a value) also from 2013
and onwards. This must now be taken into account In sum, the most pessimistic expectations for
by anyone undertaking new investments in industry international climate policy in 2005 were not met.
and the power sector, even if the regions where the And the alternative solutions to the Kyoto/UNFCCC
investments will take place do not currently operate process have yet to produce anything that resembles
under carbon restrictions. Certain non-Annex I more than just a talk-shop. The issue of climate
countries have also arisen as prime candidates for change has gained increasing attention throughout
taking on reduction targets in the future, such as the world, both through the G8 process and the
South Korea, Mexico, South Africa and Argentina. UNFCCC negotiations, as well as the AP6. Although
the turn towards technology in the rhetoric of many
key players can be expected to continue also in
No real substance in Asia-Pacific 2006, it is now clear that this will not stand in the
climate partnership way of real progress under the UN umbrella.

Alternatives to the Kyoto Protocol will no doubt


7.2 Where to now for EU ETS?
be flaunted in the years to come. The most talked The thousand (or perhaps billion) euros question
about candidate is the Asia-Pacific Partnership on in relation to EU ETS is: Where will the price of
Clean Development and Climate (AP6). The group, carbon be in the future? While this report does not
which consists of the US, China, Japan, India, South in any way present price scenarios, there are some
Korea and Australia, has launched eight public- developments worth pointing out. Also, our survey
private sector task forces, which will look into has mapped what market participants anticipate
ways to reduce emissions in various sectors of the one year ahead, as well as their expectations for the

41 All rights reserved © 2006 Point Carbon


Carbon 2006

2008-2012 allocation. It should be mentioned that become public in mid-May 2006, after which it is
Point Carbon is currently developing an 08-12 model possible that the market could experience a shift
of Carbon Market Trader, our premium service in price levels – either up or down - if the outcome
to the most active players in the market. Further of the first year reporting is markedly different from
information on the second phase of EU ETS and what the market expected.
long-term carbon prices will also be available in later
issues of Point Carbon’s CMA publication. The other crucial event this year is the submission
of the allocation plans for the 2008-2012 period.
Figure 7.1 shows the survey respondents’ The NAP 2 processes are to be finalised by 30 June
expectations of an EUA price one year from now. 06, but the experience from the previous allocation
Note that the majority of respondents answered round suggests that several countries might miss
the survey in December 2005, when prices ranged this deadline. A more likely scenario is that the
in the low €20/t. As many as 51% said that they overall allocations for phase 2 will be finalised by
expected the price one year down the road to be the end of 2006. The uncertainty related to NAP
higher than what it was at the time. Only 20% said 2 is confirmed both in our web survey and by the
they expected it be lower. interviewees in the phone survey. If the decisions
regarding the new NAPs are further delayed this will
51% expect prices to increase over also provide the market actors with reluctance and
next year uncertainty, possibly impacting on both prices and
liquidity.
Of course, as we have already shown, the price of
carbon depends to a large extent on fuel prices How has the market developed so far in 2006? Since
and power demand. While the survey did not go the beginning of the year there has been increasing
into detail on which factors that would lead to the liquidity, with 91 Mt traded by 10 February, as well
different prices one year from now, it is clear that as increasing prices, going from just below €22/t at
there is a general feeling of the market being overall end of December 2005 to just below €28/t in early
short. The first checkpoint for this assumption will February. Based on this, what do we expect from
be the first true-up period. As companies submit the market for the rest of the year? First, it is clear
allowances and verified emission reports for 2005 that 2006 could easily see very large volumes being
it will give some indications on how short (or long) transacted. With daily volumes of more than 3 Mt, as
the market was in 2005. This data is expected to we have seen so far this year, and the expectations

Fig 7.2 Phase 2 reducers?


The relative reduction from Phase 1 caps needed for countries to meet their Kyoto commitments, as
indicated in the EC guidance for the 2008-2012 period.

30
% reduction from phase 1

25

20

15

10

0
g
k

ly

nd

ia

y
n

l
ga
ar

tri

an
nd
ur

ai

an

Ita

en
iu
la
Sp

rtu
m

bo

m
nl

rla
lg

ov
Ire
Au
en

Fi

Be

er
Po
m

he

Sl
D

G
xe

et
Lu

Source: Point Carbon

42 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 7.3 What do you expect from the allocation process 2008-2012?
Based on responses to our web-survey

50 %

40 %
Share of responses

30 %

20 %

10 %

0%
Much looser Somewhat Like the 05- Somewhat Much tighter
than today looser than 07 period tighter than than today
today today
Source: Point Carbon

Fig 7.4 How important is the long-term carbon price for new investments in your industry?
Based on web-survey. Limited to respondents representing GHG emitting industries.

40 %
Share of responses

20 %

0%
1 - Not 2 3 4 5 - Very
important important

Source: Point Carbon

of more players coming to market as the remaining States are expected to reduce their overall caps quite
registries come online, we could easily see almost a significantly, unless they can show to substantiated
tripling of volumes in 2006. Prices will of course be budgets and plans for procurement of credits or
an important factor in this forecast, and if the price allowances from overseas. The EC guidance states
movement is too great in either direction it is likely that no country will be allowed to increase their caps
to lead to reduced liquidity. from the first phase, and that countries which are
not on track to meet their Kyoto targets will have
There is, however, a big question that looms large on to transpose their Kyoto commitment down to the
the horison: What will be the outcome of the NAP ETS sectors, without changing the overall coverage
process for phase 2. The recent guidance by the of the sectors.
EC sends a strong signal that a number of Member

43 All rights reserved © 2006 Point Carbon


Carbon 2006

Fig 7.5 What level of internal abatement initiatives do you foresee in EU ETS 2008-2012
compared to 2005-2007?
Based on web-survey.

60 %

50 %
Share of responses

40 %

30 %

20 %

10 %

0%
Lower than 05-07 About the same as Higher than in the 05-
05-07 07 period
Source: Point Carbon

Figure 7.2 shows the countries that will have to The long-term carbon price is not only important
reduce the most from their phase 1 allocations if in terms of internal abatement, but must be taken
they do not engage in procurement of credits and into consideration when investment decisions
allowances. It should be pointed out that some of or company strategies are made. The survey
the countries in Figure 7.2 already have operational respondents representing sectors under the EU
procurement programs, e.g. Denmark and Austria, ETS answered overwhelmingly that long-term
and that their caps will not necessarily be reduced carbon prices were important when considering
by as much as this figure indicates. new investments in their industry, see Figure 7.5.
It is clear in this respect that it will be important
The expectation of reduced allocations is also to develop a long-term price signal that will allow
shared by our survey respondents, see Figure 7.3. companies to internalise these expectations into
A majority of 54% of the respondents expect the their own operations.
allocation for phase 2 to be somewhat tighter than
today, whereas 25% expect it to be much higher. With the current political climate and the close
Only 8% expected it to be looser than in phase 1. relationship that is developing between carbon-
and power prices we find it unlikely that the EU
Only 8% expect looser allocations in will meet the Western European shortfall only by
Phase 2 than in Phase 1 strengthening the caps under EU ETS for the Kyoto
period. Instead, we expect that most countries
in Western Europe will realise that they need to
This is further reflected in participants’ expectations strengthen their carbon procurement budgets. This
for internal abatement to take place in the 2008-2012 is, however, not as easy as it might sound. The CDM
period compared to the current phase of EU ETS, market still has some way to go before it is fully up
see Figure 7.4. Only 3% of the survey respondents to speed, and the JI market has yet to be put into
expect there to be less internal abatement initiatives operation. In the following section we will look more
in the future, and as many as 24% expect there to closely at our expectations for the project market.
be more abatement in the 08-12 period than in 05-07.
To some extent this will be a natural consequence
of companies having had more time to adjust to
7.3 CDM/JI - long term investments?
operating under carbon constraints, but it might also The higher than expected EUA prices have
reflect an expectation of higher prices. dramatically increased the private sector’s appetite
for credits from CDM and JI. This has lead us to

44 All rights reserved © 2006 Point Carbon


28 February 2006

Fig 7.6 Where is the price of an issued CER one year from now?
Based on responses to our web-survey

80 %
Share of responses

60 %

40 %

20 %

0%
Lower than today As today Higher than today

Source: Point Carbon

change our perceptions for the project market. The countries are years ahead of what we see for the
currently massive investments in JI and CDM imply largest potential sellers under the Kyoto Protocol,
that the project based mechanisms are posed to be e.g. Russia and Ukraine
significant mechanisms for compliance under the
Kyoto Protocol.
CDM will survive even without
The increased activity has also reduced the Kyoto successor
concentration in the market, both on the sell and buy
side, and there is now a plethora of organisations Still, even with the investments currently taking
involved with the projects market. The strong place, we will be far from realising the potential
private sector involvement has also lead to discovery under the Kyoto Protocol. We are nowhere close to
of large-scale reductions potentials that few were implementing all marginal projects, and there will still
aware of some years ago, such as HFC and N2O. be a considerable potential for low-cost reductions
The significantly increased funding for the Executive in many years to come. It seems clear that the CDM
Board, together with streamlining of procedures, will survive even without a successor agreement to
has further drastically reduced transaction costs and the Kyoto Protocol. However, it is more uncertain
risks for investors. whether JI will. In any case, the negotiations of
post-2012 commitments will be on the back of the
More than 70% expect CER prices certainty that significant credit volumes will be
to increase over next year provided by on-going projects.

The respondents to our survey expect the prices for


7.4 Towards a truly global market
CDM credits to increase over the next year. Figure The EU ETS has established itself as the only truly
7.6 shows that more than 70% expect the price of commoditised segment of the global carbon market.
an issued CER to be higher in year than what it was This is, however, likely to change in the not too
in December 2005. distant future. What other developments might we
see in the next years?
It is also clear that CDM is the current mechanism of
choice, proving that developing countries are taking While we will most likely see a commoditisation
their participation in this market seriously. National of CERs over the next couple of years, it is clear
frameworks for project approval in developing that the project market has some way to go. A well-

45 All rights reserved © 2006 Point Carbon


Carbon 2006

functioning CER market will bridge the international


market segments and lead to an internationalisation
of the EU market. Thus, CERs will constitute the
link between the markets, and there might not be
the need to develop direct links, i.e. through mutual
recognition of allowances, before post-2012.

EU ETS could remain the main driver


for years to come

Still, given the size and liquidity of the EU market, it


could remain the main driver of the carbon market in
many years ahead, by setting the reference price for
other carbon markets, possibly even beyond 2012.
This implies that the carbon market is currently
very vulnerable to changes in the EUA price. If the
EU ETS prices should collapse, it will remove much
of the drive for market activity in the other market
segments.

As we have shown in this analysis, countries are very


far from meeting their Kyoto commitments even
when taking into account their planned policies and
measures, as well as current purchase programs. This
will have direct implications for the negotiations on a
post-2012 climate agreement. While we believe it is
currently unrealistic in light of the major challenges
posed by the on-going negotiations, clarity about
post-2012 commitments would be advantageous (to
put it mildly) for fostering abatement measures that
will deliver long-term reductions.

Carbon market remains best option


for transition to low-carbon economy

Technology-type climate agreements are not likely to


deliver anywhere near the emissions reductions we
are currently anticipating from the carbon market,
in particular through CDM. They are, however,
discussed by many as an alternative for the post-2012
world. If several countries were to seek technology
programs as an alternative to an international cap-
and-trade agreement such as the Kyoto Protocol,
we see it as likely that emissions will continue to
rise rapidly, making it even more difficult to meet
the goal of the UNFCCC, to avoid dangerous climate
change. The market is functioning, and remains our
best option for developing a less carbon-intensive
global economy.

46 All rights reserved © 2006 Point Carbon


28 February 2006

Carbon glossary
A Bull
Someone who thinks market prices will rise.
Business As Usual Scenario (BAU)
AA and AAU, see Assigned Amount and Assigned A business as usual scenario is a policy neutral
Amount Units. reference case of future emissions, i.e. projections
Additionality of future emission levels in the absence of changes
Under the Kyoto Protocol, certificates from JI and in current policies, economics and technology.
the CDM (see explanations below) will be awarded
only to project-based activities where emissions
reductions are “additional to those that otherwise C
would occur”. The issue has to be elaborated further
by the Parties to the Kyoto Protocol, and on the basis Cap and Trade
of practical experiences. A Cap and Trade system is an emissions trading
Annex B Countries system, where total emissions are limited or
Annex B countries are the 39 emissions-capped ‘capped’. The Kyoto Protocol is a cap and trade
countries listed in Annex B of the Kyoto Protocol. system in the sense that emissions from Annex
Annex I Countries B countries are capped and that excess permits
Annex I countries are the 36 countries and economies might be traded. However, normally cap and trade
in transition listed in Annex I of the UNFCCC. Belarus systems will not include mechanisms such as the
and Turkey are listed in Annex I but not Annex B; CDM, which will allow for more permits to enter the
and Croatia, Liechtenstein, Monaco and Slovenia system, i.e. beyond the cap.
are listed in Annex B but not Annex I. In practice, Carbon Dioxide Equivalent (CO2e)
however, Annex I of the UNFCCC and Annex B of This is a measurement unit used to indicate the
the Kyoto Protocol are often used interchangeably. global warming potential (GWP) of greenhouse
Annex II Countries gases. Carbon dioxide is the reference gas against
Annex II of the UNFCCC includes all original OECD which other greenhouse gases are measured.
member countries plus the European Union. CDM, see Clean Development Mechanism.
Assigned Amount (AA) and Assigned Amount Units CDM EB, see Clean Development Mechanism
(AAUs) Executive Board.
The assigned amount is the total amount of CERs, see Certified Emission Reductions.
greenhouse gas that each Annex B country is Certification
allowed to emit during the first commitment period The certification process is the phase of a CDM or
(see explanation below) of the Kyoto Protocol. An JI project when permits are issued on the basis of
Assigned Amount Unit (AAU) is a tradable unit of 1 calculated emissions reductions and verification,
tCO2e. possibly by a third party.
Certified Emission Reductions (CERs)
CERs are permits generated through the CDM.
B Clean Development Mechanism (CDM)
The CDM is a mechanism for project-based emission
Backwardation reduction activities in developing countries.
A market condition in which a futures price is lower in Certificates will be generated through the CDM from
the distant delivery months than in the near delivery projects that lead to certifiable emissions reductions
months. The opposite of contango (see below). that would otherwise not occur.
Baseline and Baseline Scenario Clean Development Mechanism (CDM) Executive Board
The baseline represents forecasted emissions (EB)
under a business-as-usual (BAU) scenario, often The CDM EB is accountable to the Conference of the
referred to as the ‘baseline scenario’ i.e. expected Parties to the Kyoto Protocol (see below). It registers
emissions if the emission reduction activities were validated project activities as CDM projects.
not implemented. Commitment Period
BAU, see Business As Usual Scenario. The five-year Kyoto Protocol Commitment Period is
Bear scheduled to run from calendar year 2008 to calendar
Someone who thinks market prices will decline. year-end 2012.

47 All rights reserved © 2006 Point Carbon


Carbon 2006

Carbon glossary additional funding is to be made available for such


projects.
Contango
A condition in which distant delivery prices for futures
exceed spot prices, often due to the costs of G
storing and insuring the underlying commodity. The
opposite of backwardation. Grandfathering
COP, see Conference of the Parties. Method for allocation of emissions, where permits
Conference of Parties (COP) are allocated, usually free of charge, to emitters and
The COP is the supreme body of the United firms on the basis of historical emissions.
Nations Framework Convention on Climate Change Greenhouse gases (GHGs)
(UNFCCC). The last conference (COP-11/MOP1) was Greenhouse gases (GHGs) are trace gases that
held in Montreal, Canada in November/December control energy flows in the Earth’s atmosphere by
2005. absorbing infra-red radiation. Some GHGs occur
Countries with Economies in Transition (EIT) naturally in the atmosphere, while others result from
Countries that are in the transition from a planned human activities. There are six GHGs covered under
economy to a market-based economy, i.e. the the Kyoto Protocol - carbon dioxide (CO2), methane
Central and East European countries, Russia, and (CH4), nitrous oxide (N2O), hydrofluorocarbons
the former republics of the Soviet Union. (HFCs), perfluorocarbons (PFCs) and sulphur
hexafluoride (SF6). CO2 is the most important GHG
released by human activities.
E
EIT, see Countries with Economies in Transition.
H
Emission Reduction Unit (ERU)
Permits achieved through a Joint Implementation Host Country
project. A host country is the country where a JI or CDM
Emissions to Cap (E-t-C): project is physically located.
Emissions-to-cap (E-t-C) is calculated by subtracting Hot Air
the seasonally adjusted cap from emissions (actual Excess permits that have occurred due to economic
or forecasted). This metric gives an indication collapse or declined production for reasons not
of whether the market (for a specific period) is directly related to intentional efforts to curb
producing more or less than the seasonally adjusted emissions.
cap for that same period. More specifically, if not
taking CERs into account, a positive (negative) E-C
means that the market is fundamentally short (long), J
suggesting a buy (sell) signal.
Emissions Trading JI, see Joint Implementation.
Emissions Trading allows for transfer of allowances Joint Implementation (JI)
or credits across international borders. However, Joint Implementation is a mechanism for transfer
it is a general term often used for the three Kyoto of emissions permits from one Annex B country to
mechanisms: JI, CDM and emissions trading. another. JI generates ERUs on the basis of emission
ERU, see Emission Reduction Unit. reduction projects leading to quantifiable emissions
EU ETS, European Union Emissions Trading System. reductions.

F K
Financial additionality Kyoto Protocol
CDM projects have to be financially additional, which The Kyoto Protocol originated at COP-3 to the
means that the projects that Annex I countries UNFCCC in Kyoto, Japan, December 1997. It specifies
support within the framework of the CDM should emission obligations for the Annex B countries and
not be financed by official development aid, but that defines the three so-called Kyoto mechanisms: JI,

48 All rights reserved © 2006 Point Carbon


28 February 2006

Carbon glossary S
CDM and emissions trading. It entered into force on
16 February 2006 Supplementarity
A requirement in the Kyoto Protocol stating that
emissions trading should be a supplement to
M domestic action. It reflects the request of the
European Union to limit the use of the Kyoto Protocol
flexibility mechanisms. It is still not determined how
MAC, see Marginal Abatement Cost.
supplementarity should be interpreted.
Marginal Abatement Cost (MAC)
The marginal abatement cost is the cost of reducing
emissions with one additional unit. Aggregated U
marginal costs over a number of projects or activities
define the marginal abatement cost curve.
Memorandum of Understanding (MoU) United Nations Framework Convention on Climate
A MoU is an agreement between two parties that Change (UNFCCC)
aims to formally recognise a joint desire to ultimately The UNFCCC was established 1992 at the Rio Earth
conclude an agreement or to achieve goals jointly. Summit. It is the overall framework guiding the
It may or may not have legal backing of sanction, international climate negotiations. Its main objective
depending upon how it is constructed. MoUs are is “stabilisation of greenhouse gas concentrations
often used as a basis for CDM/JI projects. in the atmosphere at a level that would prevent
dangerous anthropogenic (man-made) interference
with the climate system”.
N
National Authorities and Designated National V
Authorities
The national authority is the official body representing Verification
the Government which takes part in the arrangement In order for AIJ, CDM and JI projects to have a
of CDM/JI projects. For JI host countries, the national formalised validation of an emission reduction
authority approves the projects and issues the stream, a recognised independent third party must
emission reduction units. For CDM host countries, confirm that claimed emissions reduction activity
the designated national authority issues a non- has occurred.
objection letter necessary for the project approval.
Non-Annex I countries
Annex I is an Annex in the UNFCCC listing those
countries that are signatories to the Convention and
committed to emission reductions. The Non-Annex
I countries are developing countries, and they have
no emission reduction targets.

P
Permit
Permits are often used for denoting the tradable
units under the Kyoto Protocol, i.e. AAUs, ERU or
CERs.
Project Design Document (PDD)
Document completed by project developers in order
to register their project under the CDM.

49 All rights reserved © 2006 Point Carbon


Carbon 2006

Recent reports
14.02.06 Outlook for 2006
An overview of activity in the global carbon market in 2005, together with our forecast for 2006.
We expect growth to continue in all market segments and find that the financial value of the
market could more than triple this year.

24.01.06 Lessons learned in 2005


An analysis of the major events in the carbon market last year. We discuss the effectiveness of
the EU ETS; volumes delivered by CDM/JI; possible improvements to how policy information
and decisions are communicated to the market; and the future for international climate policy.

09.01.06 Power of carbon: The umbrella of commodities


An analysis of the impact of carbon on European power prices. We investigate this by looking
at developments in spot prices in the German and Nordic power markets. A discussion of the
effects of carbon in an increasingly integrated power market is also presented.

16.12.05 CDM & JI supply forecast: Opening the floodgates


Our updated forecast of CERs and ERUs to be produced to 2012. We also discuss sensitivities
regarding risk adjustment of projects, and implications CDM and JI volumes will have for price
developments and future international climate policy.

03.11.05 After the NAPs: Price implications for EU ETS in phase 1


The final structure of the EU ETS and price scenarios for the 2005-2007 period. We discuss the
assumptions for the key price determinants driving carbon prices, in particular in relation to
New Entrant Reserves and CDM credits used for compliance.

12.09.05 Kyoto progress report: Will countries meet their targets?


An overview of how far countries are down the road to meeting their Kyoto targets. We have
updated our emission forecasts and estimated the future impacts of all known policies and
measures. The analysis then discusses where the additional cuts can be made and what the
impacts will be on the carbon market.

Upcoming reports

Carbon around the world: An overview of carbon trading outside the EU ETS. What are the
prospects for a market developiong in Canada or Japan? What about USA or Australia? How
will this impact on prices?

Kyoto progress update: What is the overall supply and demand under the Kyoto market. Which
countries will meet their commitments, and who still has some way to go? This analysis will set
the stage for our long term price forecast.

EU ETS phase II: Allocations under the EU ETS phase II will be crucial in shaping the carbon
market in the medium term. What will be the price implications of the NAPs that are currently
being drafted in EU member states?

Long term carbon prices: What will carbon prices be in the period to 2020? What will be
the main price drivers? How could international climate negotiations develop? Where will
the supply of allowances come from? Who will have the greatest demand for credits and
allowances?

50 All rights reserved © 2006 Point Carbon


Carbon 2006

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A Point Carbon publication fb@pointcarbon.com
copyright © 2006 All rights reserved.
No portion of this publication may be Japan
photocopied, reproduced, scanned into JPower
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