KEY POINTS:
Within the next three months the Government will make economically fateful decisions about the design of an emissions trading scheme.
Though some partisan pushing and shoving continues, both major parties support emissions trading. It will form part of the environment in which businesses have to operate.
In Europe, which has had a trading scheme since 2005, forward prices for 2008 are more than €20 ($37) a tonne of carbon dioxide - the sort of serious carbon price that commands attention in corporate boardrooms. The lessons to be learned from Europe's experience of emissions trading so far are bound to loom large in the Government's deliberations.
They are already evident in the most substantial of the business sector's submissions, the Institute of Economic Research's report commissioned by Business New Zealand and most of the largest emitters. So what have the Europeans done right, and what did they get wrong?
TAKE A BOW
Firstly, there is a market where three years ago there was none. The European Emissions Trading Scheme (ETS) covers thousands of installations across the EU, from power stations and steel mills to large hospitals, collectively responsible for 45 per cent of its CO2 emissions.
Last year more than a billion tonnes of CO2 were transacted in deals worth €18 billion. It represents more than two-thirds of global carbon trading by volume and about four-fifths by value. For there to be a market on this scale requires a complex infrastructure, almost entirely provided by the private sector.
There must be credible data on the emissions from some 15,000 installations. Verification is done by private sector auditors. There are carbon brokerages to intermediate transactions, as about half of the trading is over-the-counter, as well as exchanges (principally the European Carbon Exchange, operating mainly in London).
There is a need for impartial news and analysis provided by the likes of Point Carbon, which is also carving out a role, akin to the credit rating agencies in the debt market, in the risk-weighting of projects which give rise to tradeable credits under Kyoto's clean development mechanism (CDM).
BUT DOES IT WORK?
The market came in for a lot of criticism a year ago when prices collapsed once it became clear European Governments had been over-generous in allocating allowances. From the standpoint of the environmental organisations it was a calamity. "When the price falls everyone loses, especially leaders which have made investments and taken the biggest risks," says Sanjeev Kumar of the World Wildlife Fund.
But for those in the carbon trading business, it was the market working as it should. So long as market participants believed the market was short, with demand likely to exceed supply, the price rose. Once the first hard data on emissions came out, for 2005, it was clear the market was long and the price accordingly fell. As for whether it has yet had any effect in curbing emissions - the object of the exercise - opinions differ.
"We have seen minor emissions reductions." says Kumar. But a World Bank report on the carbon market cites research by Denny Ellerman at the Massachusetts Institute of Technology, which suggests emissions in 2005 were reduced by somewhere between 50 million and 200 million tonnes.
A survey by Point Carbon found 65 per cent of firms reporting that the European ETS had resulted in moves to reduce emissions within their companies. It is a striking turnaround from last year's survey, when 15 per cent of respondents said internal abatement measures had been initiated.
AND BEYOND EUROPE?
The European ETS is also credited with being a major spur to the expansion of the CDM market. CDM was set up under the Kyoto Protocol to encourage projects in developing countries to reduce their emissions and foster the diffusion of climate-friendly technology.
Projects approved by a UN agency set up for the purpose generate credits called certified emissions reductions (CERs) which countries with obligations under Kyoto can use to satisfy their obligations towards each other.
The European ETS allows the use of CERs to meet firms' obligations but only up to a point (l5 per cent on average), reflecting Kyoto's requirement that they should only be supplementary to emissions reductions at home. The World Bank estimates turnover in the CDM market last year was US$5.25 billion ($7.2 billion), twice the 2005 total.
WHAT NOT TO DO
The European ETS's first phase, from 2005-07, was always intended to be a learning period. Most of the lessons learned relate to the process of allocating allowances to emitters.
In the interests of minimising resistance to the scheme the initial allocation of allowances was almost all issued free rather than auctioned, but that meant that companies with the market power to pass on the market price of carbon to their customers - notably the electricity generators - were able to make massive windfall profits. Gratis allocation put them in the same position that hydro generators would be in New Zealand, receiving a wholesale electricity price which includes the price of carbon without having to pay it.
The obvious remedy is to require the generators to buy their allowances through an auction system, but under the rules of the European ETS that will not be possible before 2013.
Another drawback in the European scheme has been to grandfather allocations - granting firms enough allowances to cover their emissions at some recent date. That penalises firms which had taken early action to reduce their emissions and rewards those which did not.
The preferable approach of benchmarking - allocating only enough allowance to cover world's best practice for a comparable plant - gives incentives to improve their emissions performance. That should be easier to do in New Zealand, with a handful of large emitters, and no equivalence to the division of responsibility between national Governments and the European Commission.
The commission has to sign off the national allocation plans put up by member states and the second round of allocations, now almost completed, for the 2008-12 period, has been much more rigorous. It recently cut Estonia's proposal by half, for instance.
GOOD DATA IS VITAL
A key reason for overallocation in the European scheme's first round was the absence of accurate, verified data on emissions from installations. In its absence Governments had little choice but to use proxies or accept companies' estimates.
It was only when the first crop of such data came that it was apparent the market would have an excess supply of up to 10 per cent. That would have mattered less if there had been provision for banking or carrying forward allowance to future periods. That shortcoming has been corrected. When companies are making capital investments in assets with long lives, credible signals about the longer-term level of ambition on climate change are vital.
The European leaders' commitment in January to a 20 per cent cut in emissions (from 1990 levels) by 2020 - or 30 per cent if a sufficient level of commitment from other developed and leading developing countries is forthcoming - should be seen in that context.
COULD NEW ZEALAND JOIN?
Finance Minister Michael Cullen said in Parliament last week that he expected the scheme the Government was devising would allow for international trading. In principle the European ETS is open to linkage with emissions trading systems in other developed countries which have ratified Kyoto.
That would mean the mutual recognition of the instruments traded in the linked schemes. For New Zealand the advantage would be much greater liquidity. In principle, the broader the market the greater the chances of accessing lower-cost emissions reductions. But, like monetary union, the smaller party has to accept the results of policy decisions made by, and solely for the benefit of, the larger party. There might be practical difficulties, too.
The New Zealand Government has indicated it favours a scheme that includes, eventually, all the greenhouse gases, not just carbon dioxide, and all sectors including transport, agriculture and forestry. That reflects the fact that half of New Zealand's emissions come not from energy but from land use.
The Government has signalled it is attracted to using trading both to incentivise new forest plant and to discourage deforestation. Forest credits are debarred from the European scheme.
There a concern that the carbon flows in forests cannot be measured and monitored reliably. And a change in land uses is considered less permanent than, say, switching a power station from coal to gas.
Brian Fallow visited Brussels as a guest of the EU Visitor Programme.
How it works
Emissions trading, selling and buying the rights to emit the greenhouse gases that are blamed for global warming, is also called cap-and-trade.
The cap delivers the environmental benefit, limiting emissions, and the trading delivers it at the least cost.
A firm in a sector covered by the scheme has to account for its emissions over a period, that is, it has to hold enough credits to surrender to the Government to cover them.
Where does it get them from? That depends on decisions yet to be taken but it will need to buy them from one of the following:* The Government through an auction.
* On the market from another firm which has managed to reduce its emission below its allotted level.
* Someone who has planted a new forest and gets credits from the Government for the carbon dioxide it removes from the atmosphere.
* The international market. The Kyoto Protocol allows credits called CERs (certified emission reductions) to be generated by projects which reduce emissions in developing countries. There is a UN body which certifies them.
The total number of allowances the Government puts in through free allocation or by auction is the cap.
Emissions above that cap have to be covered by something that removes greenhouse gases from the atmosphere or avoids emissions that would otherwise have occurred, regardless of where in the world that reduction takes place.
It is a commercial decision for a firm whether to cut emissions or buy credits from someone else who could do it more cheaply.
Key decisions for the Government in designing the scheme are:
* Where to set the overall cap.
* What sectors to include and when.
* How to allocate the allowances - who gets them free (and then how many) and who has to buy them.
* What limits to put on the ability to import CERs.
* Whether to allow forest sink credits as offsets and if so from what base year.
