Carbon 2006

28 February 2006

Towards a truly global market

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 billion. 93% of the volumes in the project market came through CDM, at .2 397 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

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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.

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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 CO2equivalents 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 Mt, €52 million. The largest of these is the .8 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 [Mt] EU ETS total - OTC + exch.
- Bilateral

2005 [€ million] 127 [Mt] 362
n.a. n.a. 262 100

[€ million] 7 ,218
5,400 1,818

17
9.7 7.3

CDM CDM 2nd JI Other Sum

60 0 9 7 .9 94

188 0 27 34 377

397 4 28 7 .8 799

1,985 50 96 52 9,401

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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.

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

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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 carbonpower 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

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Table of contents
1 2 3 Introduction What is the carbon market? How does it work? 1 4 9

3.1 3.2
4

EU ETS CDM & JI
Market activity in 2005

9 11
15

4.1 4.2 4.3
5 6

EU ETS CDM and JI Other markets
Does it really work? Carbon Market Insight: The power of carbon

15 22 26
28 33

6.1 6.2 6.3
7

Higher spot prices Explaining increasing spot prices New complexities arising
What does the future hold?

33 34 38
40

7.1 7.2 6.1 6.1

Globally - still political uncertainties Where to now for EU ETS CDM and JI - long term investments? Towards a truly global market

40 41 44 45
51

Colophone

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28 February 2006

1. Introduction
The rumours of the Kyoto Protocol’s death were truly exaggerated. As the Protocol entered into force on 16 February 2005, the international carbon market – the cornerstone of the Kyoto agreement – was already showing healthy signs of increasing volumes. While the market for greenhouse gas (GHG) allowances and reduction credits had been in operation for some years already, the market had only recently moved beyond the embryonic stage. However, growth has since continued in all segments of the market, and 2005 has proved that the carbon market is indeed alive and well, although it has probably only reached the toddler stage. This report, Carbon 2006, provides a detailed overview of the global carbon market, with special attention to volumes and price trends in 2005. We also include a brief introduction to the market for those of you who might not be familiar with the detailed – and often highly complex – structure of this new commodity market. Particular attention is given to the EU Emissions Trading Scheme (ETS) and the project based Clean Development Mechanism (CDM) and Joint Implementation (JI). These market segments are by far the most advanced of the Kyoto related market mechanisms, although, as we shall see, they are at very different stages of maturity.

We also provide a special feature on carbon and power, discussing some of the impacts that carbon trading has had on the European power market. Finally, we look to the future and try to give some indications on where the market will move in the years ahead. Point Carbon regularly publishes in-depth analyses on international climate policy and the carbon market in our publication series Carbon Market Analyst (CMA) and Carbon Market Monitor (CMM). The analyses that have gone into the CMAs are to some extent reflected in this report, although the level of detailed is lower here.

800 participants in our web-survey
In addition to our regular reports, the web- and phone surveys have provided new data and a different perspective. A total of 800 individuals responded to our web-survey. Furthermore, 67 people were contacted by phone, giving detailed answers to a range of questions not asked in the web-based version. The in-depth interviews covered different sectors, and we got answers from 38 players from the Power & Heat sector, 21 from industry, and 8 from the financial sector. 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 %

Share of respondents

50 % 40 % 30 % 20 % 10 % 0%
No 0-0.5 Mt/yr 0.5-1Mt/yr emissions 1-5 Mt/yr 5-10 Mt/yr +10Mt/yr

Source: Point Carbon

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Carbon 2006

Figure 1.2 Mostly outside trading sectors
Respondents to the survey, broken down on sectors.

35 %
Share of respondents

30 % 25 % 20 % 15 % 10 % 5% 0%
Service prov. Other Power & Heat Industry Gov.mnt Oil/gas

Source: Point Carbon
respondents did not represent GHG emitting industries, while about 25% represented only small emission levels, i.e. below 0.5 Mt per year. 7 .5% of the respondents represented major emitters, with more than 10Mt per year. as 23% claimed that they would be engaging in trading soon, but as many as 47% said they were not trading at all. Of the ones who were trading, 9% were active in the EU ETS and 8% in both EUAs and CDM/JI. 11% said they did CDM/JI trading only.

19% of respondents from Power & Heat sector
The share of non-emitters is also reflected in the break-down of respondents on sectors, where as many as 31% were said to represent service providers, and 27% defined themselves as belonging in the Other category. 19% of the respondents came from the Power & Heat sector, 9% from industry and about 5% from oil/gas. As many as 55% of the respondents were from the EU, 36% from Northwestern Europe, 10% from Central and Eastern Europe, and 9% from Southern Europe. In addition, 5% were from European countries not in the EU. Of the remaining respondents 20% were from industrialised countries, whereas another 20% were from developing countries, i.e. non-Annex I countries.

28% trade one or more carbon commodities
This breakdown on respondents provides a backdrop for the further analysis in this report. Where appropriate, we will present answers based on limited responses. For instance, for certain answers we will not include the responses from non-emitting players or companies which have not yet initiated carbon trading internally. Where this is done it is clearly noted. Additional sources used in this report includes all of Point Carbon’s proprietary databases. Our project database contains 2,256 CDM projects and 513 JI projects, at all stages. We also maintain a transaction database, where we register all transactions that we learn of through our market intelligence services. In addition, we draw extensively on our forecasting services for the carbon, power and gas markets.

55% from EU, 20% from developing countries
28% of the respondents answered that they were trading one or more carbon commodities. As many

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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: Northwest Other Annex-1 Non-Annex1 EU: CEE EU: South Europe: 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

Source: Point Carbon

Both EUA and CDM/JI

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Carbon 2006

2. What is the carbon market?
In brief,the carbon market can be explained as the market resulting from buying and selling of emission allowances and reduction credits in order to enable countries and companies meet their GHG emission targets. Another way of looking at it is that it introduces a price for carbon - placing a cost on emissions and a value on reductions. This chapter gives a brief introduction to the concepts underlying the carbon market, focusing on countries’ Kyoto targets and the structure of the market mechanisms that can help achieve them. When the Kyoto Protocol was agreed in 1997 a , total of 39 industrialised countries (referred to in 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 subsequent multilateral climate negotiations under the UN umbrella before all the technicalities of the agreement were in place. Table 2.1 shows a selection of countries with significant GHG emissions and their respective Kyoto targets. As of 14 February 2006, 161 states and regional economic integration organizations

had ratified the Protocol, corresponding to 61.6% of total Annex I parties 1990 emissions. USA and Australia are noteworthy for being the only major industrialised countries not to ratify Kyoto. While the Kyoto Protocol does not impose emission reduction commitments on developing countries, they play a crucial role in the international carbon market. Countries, and also companies, can invest in emission reduction projects in non-Annex I countries and receive carbon credits in return for the resulting reductions. As we will show later in this report, developing countries are indeed already participating in a meaningful way – contrary to what has been argued by some opponents of the Kyoto Protocol.

How are countries meeting the Kyoto challenge?
In an issue of CMA “Kyoto progress: Will countries meet their targets?” (12 September 2005), we analysed how various countries were approaching their international climate commitment. The analysis was based on the latest available national reports 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 1990 as share of Annex 1 3.3% 8.5% 24.2% 7 .4% 4.3% 2.7% 3.1% 1.9% 29.8% 3.0% 17% not available 36.1% 2.1% Kyoto target, in % of 1990 emissions -6% -6% -8% -21% -12.5% 0% -6,5% +15% n.a -6% 0% 0% -7% +8%

Canada Japan EU 15 Germany UK France Italy Spain EU 25 Poland Russia Ukraine USA Australia

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emissions growth, and projections on countries’ future emission growth. Using 2010 as the reference year for the Kyoto period we estimated what the countries’ full five year shortfall would be without any new policies, domestic trading systems, or carbon procurement funds, denoting this as the businessas-usual (BAU) scenario. Figure 2.1 illustrates the BAU short positions for the most significant buyer countries/regions aggregated for the whole Kyoto period (2008-12). In terms of BAU emissions, the EU15 bubble has 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, while Canada and Japan are projected to have BAU emissions of 46% and 29% above their targets respectively. Overall BAU gap leaves countries 5,540 Mt short in the first Kyoto period.

lately, with a 15 Mt increase from the previous year reported for 2003. Given these short positions, we might ask: How can countries with such significant short positions meet their targets? From the governmental point of view, there are essentially three categories of options: (1) Establish domestic emission trading systems, (2) implement domestic non-market based policies, and (3) establish procurement programmes for purchases of allowances or credits from other countries. See also Table 2.2.

Emissions trading stimulates private sector reductions
The emission trading systems aims to stimulate the private sector to reduce emissions through internal abatement, external procurement, and trading. What is common for the governmental and corporate strategies is that they can both utilise credits from CDM and JI projects to meet their commitments. To date, only EU has a comprehensive emission trading system, while Japan, Canada and New Zealand are all considering whether, and how, to put up such systems. Obviously, all sectors contributing to emissions of GHGs are not included in the emission trading system, and consequently the governments themselves need additional policies

Countries BAU gap is 5,540 Mt for five-year Kyoto period
Within the EU15 the Member States with the biggest BAU gaps are Spain and Italy, at 660Mt and 620Mt, respectively. Spain has seen rapid economic growth coupled with rising emissions far beyond its provision to expand under the EU15 burden sharing agreement. Italian emissions have also soared

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

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Carbon 2006

Table 2.2 Governmental and corporate strategies for meeting Kyoto targets Governmental strategies Corporate strategies Establishing emission Procurement trading systems (ie EU programmes ETS) (CDM/JI/AAU) Internal trading (ie within EU ETS) External procurement and trading (ie CER/ ERU) Non-market policies (tech. dev, CO2-tax) Internal abatement strategies

for being in compliance with the Kyoto targets. For instance, approximately 44 % of GHG emissions within the EU are covered by the EU ETS.

policies for domestic abatement – constitute the political framing conditions that are decisive for how the market mechanisms actually work. To what extent have countries employed these strategies? And to what extent are they actually reducing emissions? Our analysis from 12 September 2005 looked at the full range of policies and mechanisms employed by all countries expected to be short in the Kyoto period. All governmental procurement programs were examined closely, considering actual and planned budgets in light of prices in the carbon market. We further investigated whether non-market policies already in place actually had any impacts, and estimated how much existing climate policy plans would contribute to the required reductions. Finally, we looked at allocations under existing or planned emissions trading systems and estimated how much these schemes would reduce. Figure 2.3 shows the final results, and that several countries still have a long way to go before they will meet their Kyoto targets. It should be noted that some countries, Japan in particular, have announced governmental procurement plans since the analysis was undertaken, and that the analysis simply applied the caps in the EU ETS phase 1 to phase 2. The recent guidance from the European Commission has made it clear that several countries will have to reduce their caps for the second phase.

Several countries with operational procurement programs
Thus, it will be essential for countries to also engage policies in other sectors. Non-market policies are typical domestic measures that will primarily impact sectors not subject to trading system and requirements, e.g. different renewable energy policies, environmental taxes and subsidies, and various voluntary programs. For instance in Japan, the Kyoto Protocol Target Achievement Plan contains a raft of new schemes and measures, nearly all of which are voluntary. Mandatory measures are limited to reporting emissions and efficiency rates, not actually reducing them. In 1997 the Japanese business federation, the Nippon Keidanren implemented its voluntary action plan on the environment. The plan currently covers 82% of industrial emissions embracing 34 industries. The third pillar of the governmental climate strategy, the procurement programmes, primarily aim at purchasing Certified Emission Reductions (CERs, from CDM projects) and Emission Reduction Units (ERUs, from JI projects), as well as Assigned Amount Units (AAUs, the “country allocation” under Kyoto). There are several countries with operational procurement programs, e.g. the Netherlands and Denmark, as well as a number of countries that 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 carbon market. In this respect, national policies such as the allocation of allowances to companies under EU ETS or implementation of non-market

Spain, Italy and Canada at bottom of league
Nevertheless, the figure gives a good indication on which countries that look set to meet their targets comfortably and which that will have to make some sacrifices.

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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 programmes

Governments

Private sector

EU ETS Internal trading, abatement

= Supply = Demand

Forwarding compliance

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

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Bottom of the league are Spain, Italy, Canada and Japan who all, it seems, will miss their targets by 20 per cent or more unless drastic action is taken. Still, there is little reason for other countries to be smug, almost all of the countries covered in the study have yet to develop credible policies and measures that will help them meet their Kyoto targets. Overall, our analysis finds that these measures might potentially reduce the Kyoto gap with some 50 % from the shortfall presented in figure 1. Still, major buyer countries experience a 2,740 Mt shortfall for the five-year period, or 548 Mt per year in the Kyoto period even when taking measures into account, leaving them 9.5% above their collective Kyoto target. An updated analysis on countries’ Kyoto progress will be presented in a forthcoming issue of Carbon Market Analyst, set for publication in early April 2006. Moreover, the carbon policies in non-EU countries will be further analysed in the CMA “Carbon around the world” scheduled for March 2006 , The above analysis clearly shows that the demand for allowances or credits is real. What then about supply? Several of the countries with Kyoto targets experienced economic downturn in the 1990s,

leaving them with substantial emission allowance (AAUs) to sell. These countries, located in Central and Eastern Europe, are also prime candidates for JI projects, as it is less costly to reduce emissions here than in Western Europe, Canada or Japan. Finally, there are about 100 non-Annex I countries which can qualify as hosts for CDM projects, and which could produce substantial reduction volumes that could be sold to emission-craving industrialised countries. Without going into too much detail on the analysis, it is clear that the potential supply in the carbon market is considerably larger than the aggregated demand. Figure 2.4 shows the net supply and demand in the 5-year Kyoto period, as estimated by Point Carbon. In particular, Russia has the potential to export significant amounts of allowances, although it is far from certain that they will do so. Our forecast for the CDM market also shows that developing countries will contribute substantial amounts, which could grow even higher than what we indicate here. Point Carbon monitors the situation in the major seller countries on a continuous basis and will publish several in-depth analyses on how their behaviour will impact on volumes and prices in the global carbon market.

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 Source: Point Carbon -4 -3 -2 -1 0 1 2

Gt CO2e

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3. How does it work?
While the previous chapter presented a general overview of how countries fare in respect to their Kyoto target, this chapter will focus on the mechanisms that are being employed to meet targets. We will give a brief introduction to the EU ETS, what it is and how it works, as well as a quick overview of CDM and JI. While the operation of these 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 refer to our regular report series.

outlining the upper level of allowances to be issued (the caps) and how these are allocated to sectors and individual installations within in each Member State (MS). The EU Commission (EC) has approved in total 6.3 billion allowances to be issued for the period 05-07 excluding allowances set aside to new , installations, resulting in an average of 2.1 billion allowances to be distributed each year. However, MS’ initial applications were for even more.

EC cut 300 Mt, 4% from initial volumes
The EC ended up cutting almost 300 Mt of allowances, or more than 4 % of the total volume, from the initial volumes of allowances as submitted in the draft NAPs. Comparing this to 2003 emissions, we find that the EU ETS covers 44 % of all greenhouse gas (GHG) emissions in the EU. The annual average cap is distributed among the MSs as shown in Figures 3.1 and 3.2. Germany is by far the MS with highest number of allowances (488 Mt/ year), followed by Italy, Poland and the UK pending around 250 Mt each for the first trading period, and France and Spain around 150 Mt. Together, these six countries constitute 71 % of the total allowances in the market.

3.1 EU ETS
The European Union Emissions Trading Scheme (EU ETS) works, simply put, by placing GHG emission limitations on a number of installations within specific sectors, and allowing the emission targets to be met through trading of EU emission allowances (EUAs). Thus, if the price of carbon is higher than the internal abatement cost, companies will – at least in theory – reduce internally and sell any unused allowances in the market. For installations that miss their target the penalty is €40/t CO2 on the shortfall in the 20052007 period, in addition to having to purchase the deficit on the market. The National Allocation Plans (NAPs), developed 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 2003 CAP

Source: Point Carbon

1990

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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 5 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 & heat Metals Cement, Lime & Glass Oil & gas Pulp and paper Others

Source: Point Carbon

Figures 3.1-2 also show calculated CO2- emissions for the years 1990 and 2003 in the sectors now covered by the EU ETS. The majority of the countries have had to reduce their emissions compared to their 2003 level.

Within each MS the allowances are allocated to existing installations in five main sectors. Figure 3.3 illustrates the distribution of allowances between these. The power & heat sector is by far the largest sector, accounting for 55 % of all allowances in the system, making the EU ETS primarily dependant on activities and changes within this sector.

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

Close to 10,000 installations now have commitments within the EU ETS. Figure 8 illustrates the distribution of allowances and installations categorised relative to the size of the installations. According to the currently available installation lists, there are 92 large installations with an allocation of more than 10 Mt CO2e in the 3-year period 0507 Together these account for only 0.9 % of the . total number of installations but for a whopping 34% of the total allowances. At the other end of the scale, we find that there are close to 9,000 small installations emitting less than 1 Mt CO2e, totalling only 19% of the allowances but more than 90% of all installations. However, it is the medium sized emitters, between 1 and 10 Mt, which have the largest amounts of allowances, accounting for 47% of the total amount.

of view, it does not make any difference whether NERs are made available through new installations or through auctions; they represent net supply to the market in any case.

3.2 CDM and JI
While the EU ETS is a consequence of countries taking on their Kyoto commitments, the two project based mechanisms are actually specified in the Kyoto Protocol itself. CDM is the only mechanism under the Kyoto Protocol involving countries that are not subject to binding greenhouse gas emission caps by the protocol – socalled non-Annex I countries, primarily consisting of developing nations. Under the CDM, investors from Annex I states, i.e. industrialised countries, receive Certified Emissions Reduction units (CERs) for the actual amount of greenhouse gas emissions reduction achieved through an emission reduction project, subject to host country agreement. CERs can be produced from projects initiated after 2000, and although most current projects are only contracted until 2012, there is no specific end date for the mechanism itself.

Medium-sized emitters account for 47% of total allocation
In addition to allocating allowances to existing installations, the MSs have in their NAPs set aside some allowances for new installations, the so called 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 between 120 – 180 Mt. Unused NERs might be made available to the market later in the first trading period. There are basically two options for how the NER surplus is dealt with, either by sale or auction, or cancellation. From a demand and supply point

Additionality is key component of CDM
A key component of the CDM is the requirement of additionality. CER units generated under the CDM will only be recognised when the reductions of

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Fig 3.5 Step-by-step
The different stages for a CDM project and some of the risk factors that might arise at the different stages,

Stages Project development Design docs. methodology Approval, Executive Board Implementation Certification

Risk factors
Initial stage failure Methodology rejected Non-approval Failure Delay Uncertified

1) Both participants are parties of the Kyoto Protocol. 2) Both participants have a national system for identification of GHG emissions from sources and storage using sinks. 3) Both participants have a computerised national registry compliant with international requirements. 4) Both participants have submitted a report for determining their initial assigned amounts. 5) Both participants annually submit a current inventory protocol fully compliant with Kyoto requirements. Hence, the track 1 system leaves much more up to the host nation than does track 2 and the CDM. Track 1 JI projects are still, however, required to substantiate additionality. While the above describes the project market in very broad terms, it is in fact a highly complicated market, 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 simplified picture of the different steps needed for a CDM project to produce credits, and some of the 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.

CER
greenhouse gas emissions are additional to any that would occur in the absence of the certified project activity. JI is the sister mechanism of CDM, allowing for GHG emission reduction projects to be carried out jointly between two or more developed Annex I countries, where one will act as investor/buyer and the other as host/seller. These projects will result in so-called Emission Reduction Units (ERUs), which can then be used for compliance by countries or companies. Although a test programme for JI has existed since 1999, the actual transfer of allowances will not begin until 2008.

Increased regulatory certainty lead to jump in CDM/JI activity
As expected, the increased regulatory certainty following Kyoto ratification by Russia, and subsequent entry into force of the Protocol, as well as the registration of the first CDM project on 18 November 2004 has lead to a jump in CDM activity. In addition to this come the improvements to the processes of the CDM Executive Board and the Methodology Panel. This can be seen clearly from the number of proposed CDM projects registered in Point Carbon’s 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 share of the increased number of projects has come in a few select countries. Figure 3.6 shows the number of projects in the Point Carbon database for selected countries at the end of 2004 compared to mid-December 2005.

Two broad categories under JI - Track 1 is very simplified
There are two broad categories under the JI, called track 1 and track 2. Whereas track 2 is essentially the same as the CDM (see above) with strong additionality requirements, track 1 is a very simplified procedure. The issuance of ERUs from a track 1 initiative can be done provided the following criteria are fulfilled by both buyer and seller:

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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

Number of Projects

250 200 150 100 50 0

Chile

Philippines

Source: Point Carbon

To year end 2004

Indonesia

Vietnam

Panama

Argentina

To Dec 2005

Table 3.1 CDM and JI host country rating Point Carbon’s assessment of major project hosts. CDM 1. India 2. China 3. Chile 4. Mexico 5. Brazil 6. Korea 7 Peru . 8. Morocco 9. South Africa 10. Argentina 11. Malaysia 12. Vietnam 13. Egypt 14. Indonesia 15. Thailand Dec 05 ABBB BBB BB+ BB+ B+ B+ B B B B CCC+ CCC CCC CCC Dec 04 (1, BBB) (5, B) (2, BBB) (7 B) , (3, BB) (4, BB) (6, B) (5, B) (10, CCC) (n.a.) (n.a.) (8, CCC) (n.a.) (11, CCC) (9, CCC) JI 1. Bulgaria 2. Romania 3. Poland 4. Hungary 5. Estonia 6. New Zealand 7 Chzech. Rep . 8. Slovakia 9. Russia 10 Ukraine Dec 05 BBB+ BBB BBBBB BB BBB+ B B BNov 04 (1, BBB) (4, BB) (5, BB) (6, BB) (7 BB) , (n.a.) (2, BBB) (3, BBB) (9, CCC) (8, B)

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Mexico

India

China

Brazil

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.

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4. Market activity in 2005
The volumes and values for the carbon market last year are based on registrations in our proprietary databases, interviews with market participants, and our assessment of policy developments and their potential market impacts. The analysis of the size of the CDM and JI market in 2005 is furthermore based on interviews with around 60 of the major players in the market, together with registrations in Point Carbon’s transaction database, and Point Carbon’s project database. See Box 4.1 for a further description of the methodology and Box 4.2 for a description of what is included in this analysis, and what is not. Table 4.1 presents the market activity in 2004 and 2005.

not in terms of physical volumes. In total, 262 million EU allowances (EUAs), worth €5.4 billion were transacted through brokers and exchanges in 2005, 79% of this through brokers. In addition, we estimate that the bilateral market (company-tocompany, not brokered or exchanged) did 100 Mt, €1.8 billion. CDM is by far the dominant of the two project-based mechanisms, and we find that contracts for 397 Mt, €1.9 billion were entered into in 2005. JI saw 28 Mt, €95 million contracted in Central and Eastern Europe (CEE). Other carbon markets remain insignificant in the larger picture, and did 7 Mt, €52 million in .8 2005. The New South Wales trading system remains the largest of these, at an estimated 93% of the financial value.

Carbon market did 799 Mt, €9.4 billion in 2005
We find that the global carbon market saw transactions toalling 799 Mt CO2e in 2005, corresponding to a financial value of €9.40 billion. See Figure 4.1 for an overview of historic volumes in the carbon market. In comparison, the market saw an estimated 94 Mt, €377 million in 2004. The growth and speed in the carbon market has been quite extraordinary, with an eight-fold increase in volume from 2004, and about 25 times larger financial values in 2005 compared to the previous year. The EU Emissions Trading Scheme (ETS) was the largest market segment in financial value, although

4.1 EU ETS
The past year saw significant growth in the European emissions trading market. In total, the market transacted 262 Mt CO2 through brokers and exchanges, corresponding to a financial volume of €5.4 billion. In addition to this comes an unreported direct bilateral market, which Point Carbon estimates to be 100 Mt, €1.8 billion. In comparison, the EU ETS did an estimated 17 Mt, €127 million in all segments in 2004. Although growth slowed down towards the end of the year, see Figure 4.2, each quarter saw record volumes and value. This growth has continued also in 2006, with the market trading 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 [Mt] EU ETS total - OTC + exch.
- Bilateral

2005 [€ million] 127 [Mt] 362
n.a. n.a. 262 100

[€ million] 7 ,218
5,400 1,818

17
9.7 7.3

CDM CDM 2nd JI Other Sum

60 0 9 7 .9 94

188 0 27 34 377

397 4 28 7 .8 799

1,985 50 96 52 9,401

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Carbon 2006

Figure 4.1 Stepstones
Contracted volumes 2003-2005, Mt CO2e.

New Values of Netherlands also did some volumes, assumed to be some hundred thousand tonnes, but that final figures were not available at the time of writing. ECX and Nord Pool both offer clearing of OTC contracts, which added significantly to the activity on the exchanges. We have not included this in the reported volume as it is already accounted for in the brokered market. In total, ECX did 59.0 Mt efp (exchange-for-physical) and Nord Pool cleared 14.7 Mt.

1 000 900 800 700 600 500 400 300 200 100 0 2003 2004 CDM JI 2005 EU ETS Other

Mt CO2e

European Climate Exchange is by far the largest of the lot
The direct bilateral market of EU allowances – company to company, no brokers or exchange involved - is notoriously hard to estimate. In 2004 we estimated that the bilateral market was about the same size as the brokered market. However, as 2005 has also brought the option of trading through exchanges one could imagine that several companies will have opted to do more directly through that channel. Nevertheless, all accounts indicate that there still is a substantial bilateral market. As part of our web-based Carbon Market Survey we asked respondents to indicate their best guess of the share of the bilateral market. Figure 4.5 shows the distribution of answers from all respondents with an existing Point Carbon subscription - in total 286 respondents at all levels of subscription (Standard, Plus, Premium and Project Manager). Although the

Source: Point Carbon

The majority of trading took place in the brokered (OTC) market, which did 207 Mt in total, a 79% share of the total OTC and exchange market. The different exchanges launched at various times throughout the year, and they also saw steady growth. The exchanges’ relative shares of the total daily volume were highest during the summer and at the end of the year, see Figure 4.3. The European Climate Exchange is by far the largest of the lot, with 63% of the exchange market. Nord Pool in second place did 24% of the reported exchanged volumes. Powernext of France became stronger towards the end of the year, overtaking Nord Pool in monthly volumes in December 2005. See Figure 4.4 for a breakdown of monthly volumes on 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.

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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.

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Figure 4.2. So good we had to show it twice
Quarterly volumes and values in the EU ETS in 2005, Mt and € million.

120 100 80
94%
14%

2 500
7% 137%

2 000

Mt CO2

60 40 20 0
46%

185

1 000 500 0

Q1 Q2 Q3 Source: Point Carbon

Q4

Q1

Q2

Q3

Q4

responses are spread somewhat evenly, there are some indications that the majority see the bilateral market as being somewhere between 10% and 50%. Based on this response we estimate that the bilateral market in 2005 was 100 Mt, or 27 .6% of the total volume. Although bilateral trading will have occurred at different times throughout the year, by applying the average price through the year we find that the bilateral market in 2005 corresponds to €1.8 billion. While we will certainly never know

exactly how much is traded bilaterally, this provides at least some transparency on what the companyto-company market might look like.

4.1.1 What drives the EUA price?
Prices increased significantly in the first half of 2005, going from about €7/t in February to almost €30/t in July, before ranging from €20/t to €24/t for the second half. Figure 4.6 shows the daily prices as reported by Point Carbon together with daily volumes in the OTC and exchanged markets.

Figure 4.3 More or less
The relative shares of daily volumes for the brokered and exchanged market in the EU ETS in 2005. Pure bilateral trades not included.

Price changes based on fuel prices and weather
What were the main drivers for the price development over the year? As in any market, the price is set by supply and demand. The supply is here determined first by the caps set under the different NAPs, together with the amount of reserve allowances and CDM credits coming into the market. Demand is set by the amount of emissions through the year in relation to the overall allocation. Briefly put, the allowance demand can be measured by estimating the emissions from the different sectors under the EU ETS and subtracting the caps. This produces what Point Carbon terms the emissions-to-cap (E-tC), our allowance demand indicator. The E-t-C will change on a continuous basis due to a number of factors, but in particular: weather, as All rights reserved © 2006

100 % 80 % 60 % 40 % 20 % 0%
3Ja n 3Fe 3- b M ar 3Ap 3- r M ay 3Ju n 3Ju 3- l Au g 3Se p 3O ct 3No 3- v De c

Source: Point Carbon

OTC

Exchanges

€ mill

1 500

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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% Powernext: 7.9% EEX: 4.3% EXAA: 0.3%

8

Mt CO2

6

4

2

0 Jan Feb Mar Apr May Jun Jul ECX Aug NordPool Sep Oct Nov EEX Dec EXAA Powernext

Source: Point Carbon

temperature determines power/heat demand and precipitation the potential for hydropower production; and fuel prices, as the relative price for coal and gas will determine which of the fuels will be used for power production. In other words, if the winter is cold and the gas-to-coal price differential widens, emissions will increase as more power is consumed and coal, which emits more GHGs per unit of output than gas, is the preferred fuel source. Thus, carbon prices will also increase. A different situation would occur in a mild and wet summer, where there is less demand for power and the rainfall increases the potential for hydropower production. Figure 4.5 What the readers think
Our subscribers’ best guess of the relative size of the bilateral market.

Have we seen evidence of the market reacting to these fundamentals? In fact, the first year of the EU ETS has shown that the market is indeed responding to changes in fuel prices and weather. Nevertheless, policy decisions still have the potential to shift prices. See Point Carbon’s Carbon Market Analyst “After the NAPs” from 3 November 2005 for a full discussion on which policy events we anticipate to impact on price development in the future.

Market is responding to fundamentals and policy events
Fig 4.7 shows the development of the EUA price throughout 2005 in relation to the impact from fuel and weather to the overall short position, i.e. the impact on Point Carbon’s allowance demand indicator E-t-C from relative coal/gas prices and temperature/precipitation. It is evident from the graph that the market is to a large extent trading on changes in the fundamentals. The correlation (R2) between the EUA price and the combined effect from fuel and weather was 0.92 over the year as a whole. The individual correlations to fuel prices and weather were 0.89 and 0.48, respectively. This is yet another signal of the market working effectively, as participants and observers clearly see that the market price is not arbitrary. However, some would still argue that the current price neglects fundamentals, in the sense that

90
Number of respondents

80 70 60 50 40 30 20 10 0
0-10%

Carbon Market Survey 2006 Q: What is your best guess of the bilateral market as percentage of total volume in EU ETS?

10-25% 25-50% 50-75% 75-90% 90-100%

Source: Point Carbon

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Figure 4.6 Volumes and prices
Daily closing prices and traded volumes in EU ETS in 2005

3500 3000 2500

ktCO2

1500 1000 500 0

24-Nov-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 30 25
€/t

R2 = 0,92

60 15 10 5 0
8-Mar 8-Aug 8-Sep 8-Apr 8-Feb 8-Jun 8-May 8-Oct 8-Jul 8-Nov 8-Dec

40 20 0 -20

Source: Point Carbon

EUA 2006

Fuel + weather (accumulated)

Mt CO2

20

23-Dec-05
140 120 100 80

3-May-05

4-Apr-05

29-Jul-05

3-Jan-05

29-Aug-05

27-Sep-05

26-Oct-05

1-Feb-05

1-Jun-05

30-Jun-05

2-Mar-05

€/t

2000

30 28 26 24 22 20 18 16 14 12 10 8 6

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“switching prices” in the UK are well above the EUA prices. Hence, one would need higher EUA prices and/or lower gas prices to trigger substantial switching from coal to gas.

Majority of trading due to power generators’ activities
Not only does the price relation to fundamentals tell us that the market has found reliable price indicators, it also shows to some extent which sectors that are active in the market. The Power & Heat sector, which is where the overall shortage has been placed, is used to trading on a daily basis, and importantly, is used to trading based on weather and fuel price changes. Although there are some (larger) industrial companies with their own trading departments, the majority of trading activity - and price development - in 2005 was due to power generators trading strategies. This dominance by the power sector has been used by many to criticise the system, in particular in light of the impact carbon costs have had on power prices. As we will touch upon later in this report, the increased spot prices in the German and Nordic power markets can to a large extent be explained by the introduction of emissions trading.

What do market participants see as the most important factors for carbon price development? Fig 4.8 shows the response from our survey, where it is evident that fuel prices are seen as the most important price determinant. Appoximately 45 % of the respondents considered fuel prices as the most 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 be the second most important factor in the short term. Many of the political factors should already have been cleared at this stage, but it is evident that this politically created market still looks to policy for announcements on supply, and to some extent also demand. It would clearly be a positive development if the importance of politics was reduced and replaced by a more predictable fundamental both as a risk and a price driver. This will probably happen as the EU ETS matures and confidence in its continuation accrues and the outcome of legal and regulatory tussles between the commission and MSs becomes more predictable.

Fuel prices most important in shortterm perspective
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% Source: Point Carbon 20 % 40 % 60 % 80 %

Share of responses Most important factor Second most important factor

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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 Source: Point Carbon Most important factor Second most important factor

future. In particular, this relates to the developments towards an international climate agreement to follow the Kyoto Protocol. Fig 4.9 shows what the respondents to our web-survey saw as the most important price drivers in the long-term. Political decisions are seen as by far the most important factor, while it should also be mentioned that CDM/ JI supply is seen as more important in the longterm than the short-term. This shows that market participants are looking to international policy for certainty on the future of the market, while at the same time they expect developing countries to participate in an active manner through CDM investments. As we will show in the following section, there is already evidence that this is taking place.

4.2 CDM and JI
Volumes in the project markets also increased considerably in 2005. The lion’s share of transactions still takes place in developing countries, where CDM contracts (ERPAs) worth 397 Mt CO2e were registered by Point Carbon, corresponding to an estimated financial value of €1.9 billon (7% discount rate). Thus, CDM accounted for 93% of the physical volumes transacted in the project market and 95% of the total financial value. The JI market is still considerably smaller than CDM, but nevertheless almost tripled in volume in 2005, growing to 28 Mt CO2e, €95 million, worth of reported transactions. Table 4.2 shows CDM and JI volumes in 2005 as registered by Point Carbon, together with estimates on the financial value.

Table 4.2 CDM still dominates the project market CDM and JI volumes registered by Point Carbon in 2005. For simplicity, all payment is assumed to be done on delivery, and a 7% discount rate is applied. Volume (Mt) CDM CDM 2nd JI 397 4 28 Financial value (€ million) 1,985 50 96

CDM saw 397 Mt, €1.9 billion. JI did 28 Mt, €95 million
In 2005, a total of 397 million certified emission reductions (CERs), at volume weighted average price of 6.7 €/CER, were contracted for future delivery. As for JI, the volume of emission reduction units (ERUs) contracted more than doubled, to 28 Mt, while the average price increased slightly to 5.1 €/t As Figure 4.10 shows, the volume has increased throughout with Q4 as by far the most hectic contracting period in terms of volume signed. To

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Figure 4.10 Most towards the end
Quarterly volumes in the CDM and JI markets in 2005, in Mt CO2e-

have shown increased support for the project base mechanisms, in particular China and Brazil. Also, large-scale projects are contributing significantly, with four HFC-23 decomposition projects signed in 2005. Some of the bottlenecks at the institutional level, both in host countries and at the CDM Executive Board, have been overcome, or are in the process of being removed. The CDM EB’s improved efficiency in approving methodologies and projects, and the positive signs in terms of establishment of the JI Supervisory Committee have both added to the increasing investment trend.

350 300 250 200 150 100 50 0 Q1 Q2 Source: Point Carbon Q3 Q4 CDM JI

Bottlenecks are being removed
China, India and Brazil are the main seller countries when it comes to numbers of CDM ERPAs. The large volumes in China are primarily due to a few large HFC-23 projects. For the JI market, Romania has been an active seller, but volumes become small when comparing to CDM market volumes. In fact, Brazil alone is about the same size as the total JI market. At the demand side, the implementation of the Linking Directive gives EU ETS installations the ability to use CERs directly for compliance. With increasing prices for EUA delivery it is evident that

some extent this might reflect when Point Carbon registered the transactions, but it also supports the trends seen in previous years when it comes to timing of contracts. There are several reasons for the substantial increase in the volume transacted throughout 2005. The most obvious reason is that the supply of potential projects has increased. By the end of 2005 there were more than 900 CDM and JI projects that had reached the public validation stage. Several host countries Figure 4.11 Where are the sellers?

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

300 250

Mt CO2e

200 150 100 50 0

Source: Point Carbon

O th er

Af O ric th a er Am er ic a O th er As ia

a

di a

Eu ro p

Br az il /U nk no w n

Ch

In

e

(J I)

in

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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.
Unknown 3% Governments 12 %
Waste 3% Renewable 6% CMM 7% Other 7%

Funds 43 % Private 42 %

Unknown 11 %

HFC 66 %

Source: Point Carbon

this has contributed to the demand for project credits. The increasing number of carbon funds has added further to the demand. This sector includes governmental procurement funds, private sector investment vehicles, and private-public funds (e.g. all World Bank funds). Point Carbon will return later in 2006 with an updated review of the different funds that are available for private sector investment. While CDM investments is now increasingly being dominated by private investors and funds, JI is still mainly attracting governmental buyers.

CDM market to have totalled 4 Mt, €50 million in 2005. Exchanges are also beginning to offer CDM related contracts. Carbon credit notes are being traded at the JSE Securities Exchange, providing a carbon based investor product, for delivery in 2008. However, the volumes have so far been measly, as only just below 20,000 tonnes were reported transacted in 2005, corresponding to around €200,000. Interestingly 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 and New Values offering CER auctions on their platform, saw around 1.5 million traded in 2005. Point Carbon does not register the CDM volumes through New Values separately, and this has already been included in the 397 Mt total.

Carbon funds add further to demand
Figure 4.12 shows an overview of buyer’s in the CDM and JI market, together with a breakdown of volumes on project type. As funds here include both 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 volumes involved with the decomposition of HFC23, a by-product in the production of the refrigerant HCFC-22, accounted for almost two thirds of the total volumes in the project market in 2005. In addition to the direct project market, with ERPA contracts, there is a considerable secondary market, where contracts for future delivery of CERs, not necessarily with a specific project attached, are entered into. However, this is primarily a companyto-company market, although some such contracts are offered through brokers, and it is difficult to get full overview of what is transacted in this market segment. Point Carbon estimates the secondary

4.2.1 What drives the CDM/JI prices?
Prices for both CDM and JI project contracts increased during 2005. This can mainly be explained by increased demand from EU ETS companies and the numerous carbon funds that became fully operational for purchasing credits. However, prices differ a lot from contract to contract, mainly based on the distribution of risk between buyer and seller. Moreover, mature projects are in general more expensive than projects that have not yet reached the Project Design Document level. Also, delivery is becoming more important. The price for credits delivered before the end of the EU ETS’ 20052007 period are currently fetching a premium . See

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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 1 2 3

Approx. price range (€/t CO2e) 3-6 5-10 9-14

Description Non-firm volume. Buyer buys what seller delivers even if emissions reductions turn out not to qualify as CERs. Non-firm volume. Contract contains preconditions, e.g. that the underlying project qualifies for the CDM. Firm volume. Contract contains preconditions (as above). Usually strong force majeure clauses and high credit rating requirements. 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.

4

12-14

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 Source: Point Carbon Most important factor Second most important factor

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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 Source: Point Carbon Most important factor Second most important factor

Box 4.3 for an overview of Point Carbon’s contract categories for CDM projects. Figures 4,13 and 4.14 show what the respondents to our web-survey saw as the most important price drivers in the short- and long-term. Decisions by the CDM Methodology Panel are seen as very important in the short term, as this is primarily what determines whether a specific project will qualify for CDM or not. It is also clear that the link between 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, and this will also increase the prices paid for said credits.

estimated €52 million. Figure 11 shows the volumes and value of these markets in 2005. We do not expect very significant growth in these markets. The UK ETS is in its final year, and the NSW scheme remains pretty stable from year to year. If any growth is to take place, CCX is the most likely candidate, as US companies might seize the opportunity to gain carbon trading experience and environmental credentials at the same time.

Other markets saw 7 Mt, .8 estimated to be worth €52 million UK ETS

4.3 Other markets
Although the carbon market now to all extent is focused on EU ETS and Kyoto instruments, there are still some other operational greenhouse gas trading systems that should be considered. By far the largest of these is the New South Wales Greenhouse Gas Abatement Scheme in Australia, which totals 78% of the physical volume in the other markets, and 93% of the financial value. In total, the other markets segment – which also includes the voluntary Chicago Climate Exchange in USA and the UK ETS, which will finally come to an end this year – clocked in 7 Mt CO2, corresponding to an .8

The UK ETS continues to cling to a straw. Point Carbon estimates that approximately 300,000 tonnes CO2 were transacted over the year, corresponding to a financial size of some GBP750,000 (€1.09 million estimated).

Australia
The New South Wales Greenhouse Gas Abatement Scheme reported 222 trades over 2005, with February and October the busiest months at 35 and 29 trades respectively. This marks delivery on contracts, whether spot or forwards, not when the contracts are agreed. The market has remained largely illiquid over the year, with some months All rights reserved © 2006

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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) UK ETS 4%

Financial value (€52million)

CCX 18 %

UK ETS 2% CCX 5% AUS NSW 78 % AUS NSW 93 %

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).

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5. Does it really work?
As the previous chapters have shown, the carbon market is now to all extents a fully operational commodity market. Volumes are large, but there is still room for considerable growth. Prices are reacting to fundamentals, although policy decisions still impact from time to time. All in all, the carbon market is a multi-billion euro industry which results in emission reductions that will help countries meet their Kyoto targets. But does it really work the way it should? There are still several shortcomings to the EU ETS, although they are primarily due to regulatory delays in Member State governments. In particular, the continuing uncertainty surrounding some national allocation plans (NAPs) is a problem for the market in general, but to a much greater degree for companies in the countries still lacking complete plans. At the time of writing, Italy, Poland and Hungary have all failed to publish installation levels NAPs, more than 1 year after the start of the trading system. The same goes for Luxembourg, Malta and Cyprus, although these countries were never expected to be of particular importance to the trading activity in the market

But the carbon market is to some extent much more than just environmental policy. The issuance of EUAs to more than 10,000 installations throughout Europe has in fact created a whole new currency, which can be used as hard capital. In total, the 3year allocation is currently valued at more than €153 bn. The recent guidance for phase 2 indicates that the full 5-year allocation for the 2008-2012 period would be some 2.063 bn allowances per year, which given current prices for Dec 2008 delivery values the underlying assets in that phase at more than €220 bn. It is obvious that certain operational procedures must be in place when dealing with amounts of this magnitude. It might, in fact, be worth looking at financial markets to see how they deal with announcements that will have direct impacts on the market. For example, if a decision which could provide a market signal is to be delivered, let’s say a meeting of the National Bank to adjust interest rates, it must be clearly specified in advance exactly when and how that message is to be delivered. Is this the case in the carbon market today? Alas, it is not. A decision which could have clear market implications is rarely announced clearly in advance. At times important decisions have caught both the market and observers by surprise. The situation which we have seen in the past, where decisions are unannounced and documents are leaked to, from and between Member States and business organisations, is not preferable in the long-run although it is definitely interesting for journalists and market analysts alike. Of course, there are differences between the carbon market and other financial markets. For instance, interest rates are usually not a matter of negotiation. Also, it is probably too much to ask the EC’s environmental directorate to change their entire modus operandi. Policy documents will always be leaked, and processes in governments will often take more time than expected.

Still several shortcomings to EU ETS
Furthermore, a number of countries have been almost criminally slow in putting up their registries, pushing very close to having infringement procedures opened due to the lack of proper operations. Only a few countries actually met the deadline set by the Commission, leaving major parts of the market operating without registries for large parts of the year. In early January 2006, a total of 7 national registries were listed as “not operating” , while all others were listed as “partially operational” . Although “partially” here means that the registries 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 needs considerable improvement. The lack of registries has been quoted by many throughout the year as a reason for why some companies, in particular potentially large sellers in Central and Eastern Europe, have stayed away from the market. Many buyers prefer spot trading with CEE players, due to credit lines. This implies that we will see more action from that region in 2006.

Market works even with assymetric information
Nevertheless, it is worth pointing out that the market works, albeit not effectively, in this situation. This proves that the market can work even if information is asymmetric. However, it does not take away the need for sufficient safeguard measures to be put in place so that the carbon market will know in advance

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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 Source: Point Carbon Industry No Oil/gas/refineries Do not know Power & heat

exactly when and how decisions are communicated. If this is done within both the EC and the Member States it will help to increase the effectiveness of the market even further. The EC’s track record in this field should indicate that they will be able to deal with this, as well as the other challenges ahead. Leaving aside whatever problems that remain with the market and uncertainties about policy issues regarding phase 2, to what extent has the EU ETS been effective in its first year of operation? The environmental effectiveness of the EU ETS must be seen in relation to whether the system will succeed in meeting the overarching goal: to reduce greenhouse gas emissions. This is in reality defined by the cap, and whether the system reduces emissions from a business-as-usual path. Of course, it also assumes that the system works; that companies stay in compliance and those failing to do so are penalised accordingly. The EU ETS will undoubtedly reduce emissions. As we have shown, most countries had to reduce their allocation in relation to their 2003 emissions. In sum, the EU ETS sectors had to reduce about 40 Mt, or 120 Mt for the three-year period, in relation to 2003 emissions. Furthermore, Point Carbon’s allowance demand indicator, Emissions-to-Cap (E-t-C), indicates that based on current EUA prices the system would

need to reduce emissions, or import considerable additional allowances and/or credits – through the New Entrant Reserve (NER) and/or CDM –in order to be in balance for the 3-year period. Even with our current assessment on the potential supply through NER and CDM, the market will still be short. It is, however, important to point out that the results of this analysis changes with relative fuel prices and weather conditions.

40% of industrial respondents say ETS lead to internal abatement
How do market participants view the effect of the EU ETS for their own operations? Fig 5.1 shows the response from industrial players participating in our web-survey. More than 40% of participants from the industrial sector said that the EU ETS has lead to internal abatement projects being carried out in their company. While the relative share of positive responses was lower for the oil/gas sector and the power & heat sector, in more than 25% of the cases the EU ETS has lead to reductions. However, internal abatement is only one of the pillars in the corporate emission reduction strategy. Companies can also purchase allowances and credits in the market. Or, in extreme cases, they can choose to relocate their entire business to a country where emission limitations do not apply.

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

Share of responses

40 %

20 %

0% Internal abatement Source: Point Carbon Trading CDM/JI Trading within EU ETS Relocation Other

Industry

Oil/gas/refineries

Power & heat

Figure 5.2 shows the different strategies chosen by the industrial players participating in the websurvey. About half of the respondents from the industrial sector said that internal abatement was their primary strategy, while only 18% of the power & heat respondents saw this as their first choice. These results further show that the power sector is primarily looking to the EU ETS, and also CDM/JI, as their best carbon strategy. This is in line with our other analyses, which show that the carbon market is to a large extent dominated by the power sector. It is also interesting to point out that only a very small minority of respondents pointed to relocation as an option, indicating that there is little actual evidence of carbon leakage taking place.

Little actual evidence of carbon leakage taking place
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 these reductions have been achieved. Establishing an effective and liquid marketplace is a necessary (but not sufficient) condition for achieving economic (cost) and institutional effectiveness. But when is a market liquid, or at least liquid enough? Can we look to other markets to find reliable indicators for liquidity that may be used for the EU ETS?

There is, alas, no universal definition of liquidity, or at least what constitutes sufficient liquidity. A working definition is that a market is liquid if participants can quickly execute (large-volume) transactions at low costs with minimal impact on market prices. To do this it will be necessary to have a sufficient number of participants with sufficient volumes at each side of the bid/offer spread. In reality, however, it will also require accurate, reliable and timely price discovery. As we have shown earlier in this report, the market is indeed reacting to fundamentals. This provides certainty that prices are not being randomly set, or at a minimum that the underlying reasons are measurable, unlike the case most often is with policy decisions. In addition, there are now a wide number of market service providers, giving participants access to reliable and timely prices. This leads us to conclude that the market is already meeting the necessary requirements in terms of price discovery.

Is the EU ETS liquid?
The remaining question is then whether we have seen sufficient volumes in the market. As this is the first compliance year of the EU ETS, there is little data for a comparative analysis. However, there are other environmental markets that provide some historical data. In particular, the US SO2 market is a prime candidate for comparing the liquidity of the

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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

Source: Point Carbon

EU ETS. This market has seen turnover increasing from 10% in 1995 (the first year of the market) to 70% in 1998 (the most liquid year to date). Average turnover in the period 1995 to 2003 was 50% per year. How does the EU ETS fare in comparison? In the first year of operation the market has seen annual turnover of 12.4% of total underlying assets (2005 allocation, not including NER). However, looking at the development throughout the year, it is clear that liquidity has picked up as the market has matured. One way to measure this is to look at how much was transacted in a week in relation to a “weekly cap” , i.e. the 5 day rolling average. This volatility measure has increased steadily, reaching more than 30% at periods in the last 3 months. This clearly shows that the market is becoming increasingly more liquid, and that more participants and more volumes have come to the market during the year.

even without full participation throughout the year. In sum, we find that the EU ETS is already a qualified success.

45% finds EU ETS a success, only 22% thinks the same of CDM/JI
Do survey participants agree with us? To some extent, yes. Figure 5.4 shows that the market finds the EU the EU ETS to be more mature than it was a year ago (67% agree), but that only a handful of respondents (10%) find it to be a mature market. In other words, the market still has some way to go before it reaches puberty. However, the market is already seen as a success (45%), and 55% find that if facilitates emission reductions. Furthermore, 47% of the respondents saw it as the most cost-effective way of reducing emissions. The situation is somewhat different for the CDM and JI markets. While half of the respondents thought it a more mature market than one year ago, as many 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 achieving actual reductions, only 22% thought that the project market was a success. One of the main criticisms towards the EU ETS has been its impact on power prices. We will discuss this in more detail in the next chapter.

The EU ETS is already a qualified success
As we have shown previously, there are still some improvements that can be made in terms of bringing all parties to market. Nevertheless, even with these shortcomings still present, we argue that the market now has real price discovery, reacts to changes in fundamentals, and enjoys several reliable market service providers. In addition, liquidity is increasing,

01.01.06

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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 costefficient way to reduce emissions EU ETS facilitates emissions reductions

EU ETS is a success

0%
Source: Point Carbon
Figure 5.5 CDM & JI maturity

20 %

40 %

60 %
Disagree

80 %
Agree

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%
Source: Point Carbon

20 %

40 %

60 %
Disagree Agree

80 %

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6. Carbon Market Insight: The power of carbon
Power prices have increased throughout Europe during 2005, and many have pointed to the introduction of EU emissions trading scheme (EU ETS) as an explanation. As previous chapters have shown, the Power & Heat sector is perhaps the most dominant within the EU ETS, and players within this sector now have to purchase allowances to meet their emission targets under the scheme. However, around 95% of the allowances have been received for free, through the grandfathering principle based on previous emissions from the generators’ installations. To what extent can high power prices be explained by emissions trading?

However, continental power markets are far from being fully liberalised, and there are still strong oligopolistic structures in the market where the actions of a few dominant players will influence the market strongly. Adding to this there are a number of other complexities at play, such as e.g. gaming strategies of generators and cross-border exchange. Perhaps the increase in power prices in 2004-5 cannot be fully explained by the introduction of carbon trading as the only factor? This chapter will discuss these questions more thoroughly by looking at price developments in two power markets in particular; the Nordic market (Nord Pool) and the German market (EEX). The picture painted here should be viewed as a general introduction to the new carbon-power complexity, rather than a detailed analysis on how much carbon has added to power prices. Such analyses require the use of complex models on a number of energy markets, as well as assumptions on the strategies chosen by players in the carbon and power markets. These topics will be covered in more detail in later issues of Point Carbon’s Carbon Market Analyst.

Can power price increases be explained by carbon alone?
As we will show, the introduction of carbon pricing for the power sector must be viewed in light of the opportunity cost principle. In a competitive power market, generators will bid in their production 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 value reflects the forgone value of the allowances that otherwise could have been sold. This added cost will then feed through to increased system marginal prices of power – across all time periods when fossil fuel stations are on the supply margin.

6.1 Higher spot prices
Figure 6.1 shows the development in period 2001 – 2005 for the German market (EEX) and the Nordic market (Nord Pool) given as average yearly spot prices. While annual averages are a poor indicator 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] Germany (EEX) Nordic (Nord Pool) Spain (Omel) The Netherlands (APX) Austria (EXAA) France (Powernext) Average 28.5 28.9 27.9 31.6 28.1 28.7 29.0 2005 [€/MWh] 46.0 29.3 53.6 52.4 46.7 46.6 45.8 Change [€/MWh] 17.5 0.4 25.7 20.8 18.6 17.9 16.8 Change [%] 61.4 1.4 92.1 65.8 66.1 62.4 57.9

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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 NP 2008 EEX Source: Point Carbon, NordPool and EEX
them here to give some rough idea on how power prices have developed so far in this decade. The average annual EEX spot price showed a moderate year-on-year increase to 2004, followed by a steep growth from 2004 to 2005. The average price for 2001 – 2004 is 26.2 €/MWh, while it was 46.0 €/MWh in 2005, representing a 75.0 % growth (61.4 % from 2004 to 2005). The forward contracts for 2006 – 2008 have further followed the bullish development of increasing power prices. As seen from Table 1, the development in Germany is also found in other European exchange markets, with a 57 % growth on average from 2004 to 2005. .6

Spot prices have increased throughout Europe
The development in the Nord Pool region shows a somewhat different trend. In 2001 the spot price was lower than the EEX price, while it increased, even above the EEX level, during the 2002 and 2003, before leveling off in 2004 and 2005. The average price for 2001 – 2004 is 28.9 €/MWh, while it was 29.3 €/MWh in 2005, indicating a 1.40 % increase (1.43 % from 2004 to 2005). The forward contracts for 2006 – 2008 are at an even higher level than in 2005.

We see that power prices in general made a big jump in 2005, and forward curves continue this upward trend in 2006-08. Moreover, the annual averages indicate that the EEX region experienced a more significant price growth than the Nordic region. Can the rise in the EEX spot prices in 2005 be attributed to the introduction of the EU ETS? Or is it the fuel prices? And why does the Nord Pool spot prices in 2005 seem to have been less affected by the EU ETS market. It is of course difficult to consider prices in the Nordic region without looking at the hydrology situation. To what extent have reservoir levels impacted on Nordic power prices? We will discuss these factors in some detail in the following sections.

6.2 Explaining increasing spot prices
As already mentioned, the European wholesale electricity market is far from fully liberalised, although there are considerable regional differences. The Nordic countries (the Nord Pool region) have moved quickly towards a truly competitive power market, while there is still a strong oligopolistic structure in Germany. Within this context we will seek to explain why we have seen the increasing spot and forward prices in 2005-2008 in the Nord Pool and EEX region.

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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 Fuel

40

50

60 CO2

Source: Point Carbon

Operation & Maintainance

6.2.1 German market (EEX)
As shown in Figure 6.1, the German market has experienced a considerable higher price level than in the Nordic spot market in 2005. One explanation to this is the energy mix in Germany, where fossil fuel plants are more often on the margin than in the Nordic region. For a thermal power plant, the full CO2 cost is added to the marginal production cost, and comes in addition to the cost of fuel and operation/ maintenance (O & M). Figure 6.2 illustrates the consequences of the carbon cost to the short run marginal costs for power production plants. In a fully competitive and liberalised power market, power producers will behave accordingly, while in a more oligopolistic market the actors will behave differently.

respectively. These plants emit around 0.9 tonne CO2/MWh (coal) and 0.4 tonne CO2/MWh (CCGT). This example shows that the introduction of EU ETS influences the electricity production costs in EU and also the merit order of the different production technologies. Figure 6.2 illustrates that the coal power plant in our example is the cheapest technology if the CO2 cost is disregarded, due to lowest fuel prices. With a EUA price of €22/t CO2 included, the coal power plant is still the prefered technology. However, if the EUA price reaches €44/ t, the CCGT plant will be the cheapest technology. Hence, the introduction of sufficiently high CO2 prices might induce fuel switching towards less carbon-intensive energy sources, which was an intended effect of the EU ETS. It should be stressed that the figures referred to here only apply to our example, and that in an actual 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 costs, and can go some way to explain the increases in power prices. We observe from figure 6.3 that the ‘SRMC coal incl. CO2‘ to a large extent follows the developments in EEX prices in 2005. In the beginning of 2005, the SRMC was around €30/MWh for a typical coal power

Carbon is part of power generators’ operating costs
In our example, the carbon cost is 53 % of the total SRMC for coal-based power plants (21.2 €/MWh) and 18 % for combined cycle gas turbine (CCGT) (9.1 €/MWh). The EUA cost in €/MWh depends on the efficiency rate and the emission factor of the power plants. Efficiency rates for power plants vary, but in this example we have used 39% and 53% as standards for coal power plants and CCGTs,

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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, CO2 allowance and operating and maintenance costs). During the summer of 2005, SRMC reached a peak of €50/MWh, due to rapidly increasing CO2 allowance prices. However, this cannot fully explain the peaks in power prices.

maximum 13.5 % of the total installed capacity is exposed to the EU ETS market and the cap on CO2 emissions. Due to the high hydro power fraction in the Nord Pool region, there has traditionally been a high correlation between the total energy reservoir and spot prices. For instance, the average correlation in 1996-2004 was 0.85, while the 52 weeks rolling correlation between the two quantities was between 0.6 and 0.95 from 1996-2004. Figure 6.4 illustrates that there seems to be a level-shift in the relationship between the energy reservoir levels and spot prices from January 2005. There was a marked divergence between reservoir levels and the spot price, before correlation was re-established, although at different levels than in previous years. As figure 4 shows, such energy reservoirs had previously resulted in spot prices in the 100-150 NOK/MWh area (12-19 €/MWh). What is the contribution from the EU ETS to this? The increasing spot prices in 2005, as well as the level shift in correlation between reservoir levels and prices, can partly be explained by the direct influence of carbon costs to Nordic producers. However, since only 13 % (at a maximum) of the generation stack is based on fossil fuel-based thermal production, there All rights reserved © 2006

Increasing gas prices explain some of the power price increase
Increasing fuel prices, in particular for gas, through this period will also go some way to explain the increased power prices. But this is also only one part of the explanation of the increasing power prices. Gas fired plants in Germany are seldom the marginal price setting power producer - with only a minor share of power plants in Germany being gas-fired - and are on the margin only for parts of a 24 hour period. In addition to the significance of carbon- and fuel prices to the spot prices, increased consumption in peak periods and potential imperfect market conditions, with few other than large actors being able to control the market, are explanations to the observed development in spot prices.

6.2.2 Nord Pool
How has the Nordic market been hit by the EU ETS? The supply side in the Nord Pool market consists of a substantial share of hydro power. Moreover,

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are other reasons for the relatively high NP spot prices in 2005. The consumption in the NP area has picked up this year, after the downturn caused by high prices in 2002-2003, and is now on the same level as in 2001, meaning well above the 1996-99 level. Although there have been some changes in the installed capacity since this period, the increased capacity does not reflect the increased demand for power. This implies more hours exposed to thermal power, and consequently an increase for spot prices due to the influence from EU ETS on thermal production based on fossil fuels.

economical to export power from the Nordic region to the German market.

Nordic power exports return Continental carbon costs
The physical transfer between the regions varies throughout the day. Traditionally, the German spot price has been lower than Nordic spot price during night time due to less flexible power production in Germany, creating net import to the Nordic region. In 2005, however, a new trend is observed as there was a net export from Nordic region to Germany even in the off-peak hours during night time, indicating altered spot price differentials between these regions compared to earlier. The increase of 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, it is plausible that the German power prices, which have increased for a multitude of reasons (including carbon), have had more to say for the power price increases in the Nordic region than the direct carbon costs themselves. A further reason for the increasingly interlinked carbon and power markets is the knowledge, and focus, that many carbon traders have brought with them to this emerging market. Most of the active

New incentives to export power from Nordic region
The level of cross-border trading between EEX and Nord Pool depends on the spot price differences between these regions. The higher spot price level in Germany, partly caused by the added carbon cost, as well as a wet season in the Nord Pool region, has thus contributed to a rise in the price difference between EEX and NP spot price and the NP forward prices as well, making the NP spot price in 2005 considerably below the EEX Base and the coal SRMC (incl. CO2). Thus, it has become more 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
800 700 600 -150 -130 -110 -90 -70 -50 -30 -10 10 30

NOK/MWh

400 300 200 100 0

96

96

96

97

97

98

98

99

99

01

01

01

02

02

03

03

04

04

05

Source: Point Carbon and NordPool

Spot price Energy Reservoir, deviation from Normal

05

0

0

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Deviation

500

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 ie s ing ing in g ing he dit Ot rad rad rad rad il t kt st mo al t c O Ga Co om Sto rc the O Source: Point Carbon ing ad r tr we Po

carbon traders have a background in power or fuel trading, see Figure 6.5. Although the carbon market to some extent operates on its own logic, it is clear that having many traders thinking along the lines they have done in previous positions will add further to the correlation between prices and commodities.

thus increasing demand for allowances. This leads us to argue that the introduction of the EU ETS could amplify price volatilities in the power market, for both upwards and downwards price movement.

6.3 New complexities arising
As seen above, the EU ETS hits both the NP and EEX regions, although somewhat differently. The main explanations for the differences are the fuel mix, the cross-border trading capacities and possibilities, weather conditions, as well as the fuel prices. In an already complex power market situation, carbon now enters the picture, creating new complexities and interplay between commodities.

Power prices impacted by climate policy uncertainty
Given the new carbon-power interplay, it is clear that power prices are also now influenced by uncertainties relating to climate policies and the carbon market. In particular the inflow of carbon credits, primarily through New Entrant Reserves (NERs) and Certified Emission Reductions (CER), is significant to the carbon price. Increased supply of these will reduce 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 Analyst, for instance “After the NAPs” (3 November 2005) and “Opening the floodgates” (16 December 2005) If these interplays continue also in the future, the carbon market will over time add a new and more complex dimension to the European energy markets, where energy markets will be impacted by the global climate policy agenda and international market for allowances and credits. This trend will become paramount towards 2008 as the EU ETS will increasingly be impacted by policy events and market developments outside Europe. All rights reserved © 2006

Many carbon traders with power market background
In addition to increasing the power price, the EU ETS could raise the volatility for power prices, through a so-called “double whammy” effect. During mild winters or cold summers power prices and volumes decrease because of reduced energy consumption. The opposite situation is found for cold winters and warm summers. But the same fundamentals apply to the carbon market (see Chapter 4), where increased power demand leads to increasing emissions, and

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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.

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7. What does the future hold?
Trading is already well under way in the second year of the EU ETS, and new projects are coming into the CDM and JI pipelines on a regular basis. But where will the carbon market go in the future? The market for EUAs with 2008 delivery has not yet fully taken off, and there are very few CDM/JI projects that extend beyond 2012. What are the challenges and opportunities that market participants will face in the years ahead? This chapter will explore some of the major developments expected to take place in the market in the near-term future, and discuss whether they will have any significant implications for current market activity.

Still, there is a difference between a theoretical supply and political reality. It is still uncertain exactly how many allowances that will be available from Russia and Ukraine, and how they will come to the market. In a previous issue of CMA (“Will the giants awake?” 22 March 2005) we concluded that the majority of these AAUs would be sold through political deals in a non-commoditised market. In our view this conclusion still stands.

More emphasis on JI and GIS
There will certainly be more emphasis on JI and Green Investment Scheme options in the years to come, but the developments in Russia and Ukraine so far do not indicate that there will be a market based on supply and demand for AAUs, where a true reference price emerges. We will continue to monitor the situation in these countries and return with an updated issue of the CMA where we look at countries’ and companies’ options for buying allowances on the eastern front. Nevertheless, the behaviour of both seller and buyer countries alike will depend on the expectations for a future climate agreement. While the future of the international climate cooperation is still being hotly debated, there are strong signals from the recent climate talks to indicate that at least the process towards an agreement for the post-2012 period is in safe hands. The crucial point in last year’s climate talks in Montreal came when the US delegation walked out of the negotiations on how to proceed with the discussions on a possible post-2012 agreement. While this could potentially have led to the whole talks breaking down, given the high importance placed on having the US onboard, it did in fact lead to the opposite. The US obstructionism, which went as far as even rejecting text previously agreed to at the G8 Gleneagles meeting, seemingly galvanised the other negotiating parties, and can ironically be seen as the most productive single action taken by any party at Montreal. It goes to show that when focus is placed on one common “adversary” the other negotiation parties , will more easily let their internal disagreements pass. In the end, of course, the USA returned to the table and signed the Montreal conclusions, rendering the Canadian hosted talks as the most productive

7.1 Globally - still political uncertainties
As we have discussed already, there is a potential surplus of allowances in the Kyoto period. In particular, the two giants on the sell side – Russia and Ukraine - will have more than enough emissions to meet what is left when/if domestic options and CDM/JI are exhausted. In fact, Russia and Ukraine can meet all other countries’ current carbon requirements and will still have large amounts of allowances left over, which they can then bank into a commitment period from 2013. Adding also the expected surplus in other Central and Eastern European countries we find that the potential supply would be about three times higher than the current Kyoto shortfall.

Increased influx of allowances from Eastern Europe would provide more emissions to industries
How would an increased influx of emission allowances from Eastern Europe impact the market? The primary importance would be that countries could allocate more emissions to their industries, as Kyoto compliance at the national level gets ensured through AAU trading. However, for the EU ETS this means that budgets for such procurement must be in place by Summer 2006, and that all plans for further procurement are substantiated. The second impact on the market would be that governments would not pursue CDM, and to some extent JI, opportunities in the same way as they’ve done so far. This would mean that there were more potential projects, and credits, available for the private sector.

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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 today Source: Point Carbon
climate round since Marrakech/Bonn (COP6/COP6 bis). Everything should now be in place for countries to start talks on a second commitment period under the Kyoto Protocol, starting in 2013. Furthermore, a number of countries have signalled that their domestic initiatives will have a lifetime well beyond 2012, clearly indicating that carbon emissions will have a cost (and reductions a value) also from 2013 and onwards. This must now be taken into account by anyone undertaking new investments in industry and the power sector, even if the regions where the investments will take place do not currently operate under carbon restrictions. Certain non-Annex I countries have also arisen as prime candidates for taking on reduction targets in the future, such as South Korea, Mexico, South Africa and Argentina.

Higher than today

economy. As Point Carbon has reported in several other publications, we do not see the AP6 as a viable solution to the global climate problem. It sets no target for emissions, a measurement for success is not in place, and it does not place a cost on emissions or a value on reductions. While it certainly will generate headlines in 2006, we don’t expect the actual output in terms of emission reductions to amount to much. In sum, the most pessimistic expectations for international climate policy in 2005 were not met. And the alternative solutions to the Kyoto/UNFCCC process have yet to produce anything that resembles more than just a talk-shop. The issue of climate change has gained increasing attention throughout the world, both through the G8 process and the 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 2006, it is now clear that this will not stand in the way of real progress under the UN umbrella.

No real substance in Asia-Pacific climate partnership
Alternatives to the Kyoto Protocol will no doubt be flaunted in the years to come. The most talked about candidate is the Asia-Pacific Partnership on Clean Development and Climate (AP6). The group, which consists of the US, China, Japan, India, South Korea and Australia, has launched eight publicprivate sector task forces, which will look into ways to reduce emissions in various sectors of the

7.2 Where to now for EU ETS?
The thousand (or perhaps billion) euros question in relation to EU ETS is: Where will the price of carbon be in the future? While this report does not in any way present price scenarios, there are some developments worth pointing out. Also, our survey has mapped what market participants anticipate one year ahead, as well as their expectations for the

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2008-2012 allocation. It should be mentioned that Point Carbon is currently developing an 08-12 model of Carbon Market Trader, our premium service to the most active players in the market. Further information on the second phase of EU ETS and long-term carbon prices will also be available in later issues of Point Carbon’s CMA publication. Figure 7 shows .1 the survey respondents’ expectations of an EUA price one year from now. Note that the majority of respondents answered the survey in December 2005, when prices ranged in the low €20/t. As many as 51% said that they expected the price one year down the road to be higher than what it was at the time. Only 20% said they expected it be lower.

become public in mid-May 2006, after which it is possible that the market could experience a shift in price levels – either up or down - if the outcome of the first year reporting is markedly different from what the market expected. The other crucial event this year is the submission of the allocation plans for the 2008-2012 period. The NAP 2 processes are to be finalised by 30 June 06, but the experience from the previous allocation round suggests that several countries might miss this deadline. A more likely scenario is that the overall allocations for phase 2 will be finalised by the end of 2006. The uncertainty related to NAP 2 is confirmed both in our web survey and by the interviewees in the phone survey. If the decisions regarding the new NAPs are further delayed this will also provide the market actors with reluctance and uncertainty, possibly impacting on both prices and liquidity. How has the market developed so far in 2006? Since the beginning of the year there has been increasing liquidity, with 91 Mt traded by 10 February, as well as increasing prices, going from just below €22/t at end of December 2005 to just below €28/t in early February. Based on this, what do we expect from the market for the rest of the year? First, it is clear that 2006 could easily see very large volumes being transacted. With daily volumes of more than 3 Mt, as we have seen so far this year, and the expectations

51% expect prices to increase over next year
Of course, as we have already shown, the price of carbon depends to a large extent on fuel prices and power demand. While the survey did not go into detail on which factors that would lead to the different prices one year from now, it is clear that there is a general feeling of the market being overall short. The first checkpoint for this assumption will be the first true-up period. As companies submit allowances and verified emission reports for 2005 it will give some indications on how short (or long) the market was in 2005. This data is expected to

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 5 0
tri Lu a xe m bo ur g Fi nl an d Be lg iu m Po rtu ga N et l he rla nd s Sl ov en ia G er m an y Sp ai n D en m Au s Ire la nd k ar Ita ly

Source: Point Carbon

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

50 % 40 % 30 % 20 % 10 % 0%

Share of responses

Much looser Somewhat than today looser than today Source: Point Carbon

Like the 05- Somewhat Much tighter 07 period tighter than than today today

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 important Source: Point Carbon 2 3 4 5 - Very important

of more players coming to market as the remaining registries come online, we could easily see almost a tripling of volumes in 2006. Prices will of course be an important factor in this forecast, and if the price movement is too great in either direction it is likely to lead to reduced liquidity. There is, however, a big question that looms large on the horison: What will be the outcome of the NAP process for phase 2. The recent guidance by the EC sends a strong signal that a number of Member

States are expected to reduce their overall caps quite significantly, unless they can show to substantiated budgets and plans for procurement of credits or allowances from overseas. The EC guidance states that no country will be allowed to increase their caps from the first phase, and that countries which are not on track to meet their Kyoto targets will have to transpose their Kyoto commitment down to the ETS sectors, without changing the overall coverage of the sectors.

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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 %
Share of responses

50 % 40 % 30 % 20 % 10 % 0% Lower than 05-07 About the same as 05-07 Higher than in the 0507 period

Source: Point Carbon

Figure 7 shows the countries that will have to .2 reduce the most from their phase 1 allocations if they do not engage in procurement of credits and allowances. It should be pointed out that some of the countries in Figure 7 already have operational .2 procurement programs, e.g. Denmark and Austria, and that their caps will not necessarily be reduced by as much as this figure indicates. The expectation of reduced allocations is also shared by our survey respondents, see Figure 7 .3. A majority of 54% of the respondents expect the allocation for phase 2 to be somewhat tighter than today, whereas 25% expect it to be much higher. Only 8% expected it to be looser than in phase 1.

The long-term carbon price is not only important in terms of internal abatement, but must be taken into consideration when investment decisions or company strategies are made. The survey respondents representing sectors under the EU ETS answered overwhelmingly that long-term carbon prices were important when considering new investments in their industry, see Figure 7 .5. It is clear in this respect that it will be important to develop a long-term price signal that will allow companies to internalise these expectations into their own operations. With the current political climate and the close relationship that is developing between carbonand power prices we find it unlikely that the EU will meet the Western European shortfall only by 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 strengthen their carbon procurement budgets. This is, however, not as easy as it might sound. The CDM market still has some way to go before it is fully up to speed, and the JI market has yet to be put into operation. In the following section we will look more closely at our expectations for the project market.

Only 8% expect looser allocations in Phase 2 than in Phase 1
This is further reflected in participants’ expectations for internal abatement to take place in the 2008-2012 period compared to the current phase of EU ETS, see Figure 7 Only 3% of the survey respondents .4. expect there to be less internal abatement initiatives in the future, and as many as 24% expect there to 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 operating under carbon constraints, but it might also reflect an expectation of higher prices.

7.3 CDM/JI - long term investments?
The higher than expected EUA prices have dramatically increased the private sector’s appetite for credits from CDM and JI. This has lead us to

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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 currently massive investments in JI and CDM imply that the project based mechanisms are posed to be significant mechanisms for compliance under the Kyoto Protocol. The increased activity has also reduced the concentration in the market, both on the sell and buy side, and there is now a plethora of organisations involved with the projects market. The strong private sector involvement has also lead to discovery of large-scale reductions potentials that few were aware of some years ago, such as HFC and N2O. The significantly increased funding for the Executive Board, together with streamlining of procedures, has further drastically reduced transaction costs and risks for investors. countries are years ahead of what we see for the largest potential sellers under the Kyoto Protocol, e.g. Russia and Ukraine

CDM will survive even without Kyoto successor
Still, even with the investments currently taking place, we will be far from realising the potential under the Kyoto Protocol. We are nowhere close to implementing all marginal projects, and there will still be a considerable potential for low-cost reductions in many years to come. It seems clear that the CDM will survive even without a successor agreement to the Kyoto Protocol. However, it is more uncertain whether JI will. In any case, the negotiations of post-2012 commitments will be on the back of the certainty that significant credit volumes will be provided by on-going projects.

More than 70% expect CER prices to increase over next year
The respondents to our survey expect the prices for CDM credits to increase over the next year. Figure 7 shows that more than 70% expect the price of .6 an issued CER to be higher in year than what it was in December 2005. It is also clear that CDM is the current mechanism of choice, proving that developing countries are taking their participation in this market seriously. National frameworks for project approval in developing

7.4 Towards a truly global market
The EU ETS has established itself as the only truly commoditised segment of the global carbon market. This is, however, likely to change in the not too distant future. What other developments might we see in the next years? While we will most likely see a commoditisation of CERs over the next couple of years, it is clear that the project market has some way to go. A well-

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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 capand-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.

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Carbon glossary

A
AA and AAU, see Assigned Amount and Assigned Amount Units. Additionality Under the Kyoto Protocol, certificates from JI and the CDM (see explanations below) will be awarded only to project-based activities where emissions reductions are “additional to those that otherwise would occur” The issue has to be elaborated further . by the Parties to the Kyoto Protocol, and on the basis of practical experiences. Annex B Countries Annex B countries are the 39 emissions-capped countries listed in Annex B of the Kyoto Protocol. Annex I Countries Annex I countries are the 36 countries and economies in transition listed in Annex I of the UNFCCC. Belarus and Turkey are listed in Annex I but not Annex B; and Croatia, Liechtenstein, Monaco and Slovenia are listed in Annex B but not Annex I. In practice, however, Annex I of the UNFCCC and Annex B of the Kyoto Protocol are often used interchangeably. Annex II Countries Annex II of the UNFCCC includes all original OECD member countries plus the European Union. Assigned Amount (AA) and Assigned Amount Units (AAUs) The assigned amount is the total amount of greenhouse gas that each Annex B country is allowed to emit during the first commitment period (see explanation below) of the Kyoto Protocol. An Assigned Amount Unit (AAU) is a tradable unit of 1 tCO2e.

Bull Someone who thinks market prices will rise. Business As Usual Scenario (BAU) A business as usual scenario is a policy neutral reference case of future emissions, i.e. projections of future emission levels in the absence of changes in current policies, economics and technology.

C
Cap and Trade A Cap and Trade system is an emissions trading system, where total emissions are limited or ‘capped’. The Kyoto Protocol is a cap and trade system in the sense that emissions from Annex B countries are capped and that excess permits might be traded. However, normally cap and trade systems will not include mechanisms such as the CDM, which will allow for more permits to enter the system, i.e. beyond the cap. Carbon Dioxide Equivalent (CO2e) This is a measurement unit used to indicate the global warming potential (GWP) of greenhouse gases. Carbon dioxide is the reference gas against which other greenhouse gases are measured. CDM, see Clean Development Mechanism. CDM EB, see Clean Development Mechanism Executive Board. CERs, see Certified Emission Reductions. Certification The certification process is the phase of a CDM or JI project when permits are issued on the basis of calculated emissions reductions and verification, possibly by a third party. Certified Emission Reductions (CERs) CERs are permits generated through the CDM. Clean Development Mechanism (CDM) The CDM is a mechanism for project-based emission reduction activities in developing countries. Certificates will be generated through the CDM from projects that lead to certifiable emissions reductions that would otherwise not occur. Clean Development Mechanism (CDM) Executive Board (EB) The CDM EB is accountable to the Conference of the Parties to the Kyoto Protocol (see below). It registers validated project activities as CDM projects. Commitment Period The five-year Kyoto Protocol Commitment Period is scheduled to run from calendar year 2008 to calendar year-end 2012.

B
Backwardation A market condition in which a futures price is lower in the distant delivery months than in the near delivery months. The opposite of contango (see below). Baseline and Baseline Scenario The baseline represents forecasted emissions under a business-as-usual (BAU) scenario, often referred to as the ‘baseline scenario’ i.e. expected emissions if the emission reduction activities were not implemented. BAU, see Business As Usual Scenario. Bear Someone who thinks market prices will decline.

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Carbon glossary
Contango A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. The opposite of backwardation. COP, see Conference of the Parties. Conference of Parties (COP) The COP is the supreme body of the United Nations Framework Convention on Climate Change (UNFCCC). The last conference (COP-11/MOP1) was held in Montreal, Canada in November/December 2005. Countries with Economies in Transition (EIT) Countries that are in the transition from a planned economy to a market-based economy, i.e. the Central and East European countries, Russia, and the former republics of the Soviet Union.

additional funding is to be made available for such projects.

G
Grandfathering Method for allocation of emissions, where permits are allocated, usually free of charge, to emitters and firms on the basis of historical emissions. Greenhouse gases (GHGs) Greenhouse gases (GHGs) are trace gases that control energy flows in the Earth’s atmosphere by absorbing infra-red radiation. Some GHGs occur naturally in the atmosphere, while others result from human activities. There are six GHGs covered under the Kyoto Protocol - carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (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. Emission Reduction Unit (ERU) Permits achieved through a Joint Implementation project. Emissions to Cap (E-t-C): Emissions-to-cap (E-t-C) is calculated by subtracting the seasonally adjusted cap from emissions (actual or forecasted). This metric gives an indication of whether the market (for a specific period) is producing more or less than the seasonally adjusted 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), suggesting a buy (sell) signal. Emissions Trading Emissions Trading allows for transfer of allowances or credits across international borders. However, it is a general term often used for the three Kyoto mechanisms: JI, CDM and emissions trading. ERU, see Emission Reduction Unit. EU ETS, European Union Emissions Trading System.

H
Host Country A host country is the country where a JI or CDM project is physically located. Hot Air Excess permits that have occurred due to economic collapse or declined production for reasons not directly related to intentional efforts to curb emissions.

J
JI, see Joint Implementation. Joint Implementation (JI) Joint Implementation is a mechanism for transfer of emissions permits from one Annex B country to another. JI generates ERUs on the basis of emission reduction projects leading to quantifiable emissions reductions.

F
Financial additionality CDM projects have to be financially additional, which means that the projects that Annex I countries support within the framework of the CDM should not be financed by official development aid, but that

K
Kyoto Protocol The Kyoto Protocol originated at COP-3 to the UNFCCC in Kyoto, Japan, December 1997 It specifies . emission obligations for the Annex B countries and defines the three so-called Kyoto mechanisms: JI,

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Carbon glossary
CDM and emissions trading. It entered into force on 16 February 2006

S
Supplementarity A requirement in the Kyoto Protocol stating that emissions trading should be a supplement to 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 supplementarity should be interpreted.

M
MAC, see Marginal Abatement Cost. Marginal Abatement Cost (MAC) The marginal abatement cost is the cost of reducing emissions with one additional unit. Aggregated marginal costs over a number of projects or activities define the marginal abatement cost curve. Memorandum of Understanding (MoU) A MoU is an agreement between two parties that aims to formally recognise a joint desire to ultimately conclude an agreement or to achieve goals jointly. It may or may not have legal backing of sanction, depending upon how it is constructed. MoUs are often used as a basis for CDM/JI projects.

U
United Nations Framework Convention on Climate Change (UNFCCC) The UNFCCC was established 1992 at the Rio Earth Summit. It is the overall framework guiding the international climate negotiations. Its main objective is “stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic (man-made) interference with the climate system” .

N
National Authorities and Designated National Authorities The national authority is the official body representing the Government which takes part in the arrangement of CDM/JI projects. For JI host countries, the national authority approves the projects and issues the emission reduction units. For CDM host countries, the designated national authority issues a nonobjection 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.

V
Verification In order for AIJ, CDM and JI projects to have a formalised validation of an emission reduction stream, a recognised independent third party must confirm that claimed emissions reduction activity has occurred.

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.

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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?

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Carbon 2006

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copyright © 2006 All rights reserved. No portion of this publication may be photocopied, reproduced, scanned into an electronic retrieval system, copied to a database, retransmitted, forwarded or otherwise redistributed without prior written authorisation from Point Carbon.

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