Examination of Witnesses (Question Numbers
300-319)
Mr Miles Austin, Ms Coralie Laurencin, Mr Nick Haslam
and Mr Sam Fankhauser
8 OCTOBER 2008
Q300
Chairman:
Thank you all very much for coming and talking with
us and finding time to help us with what some of us still find
an extremely complex area of study. Can I explain two things to
you? One is that it is a formal evidence session. A transcript
will be taken. You will receive a copy of the transcript to look
through and correct any errors and slips that have arisen. Secondly,
we are being broadcast. Would you like to open by making any general
comments or would you prefer to go straight on to the question
and answer session?
Mr Fankhauser: We can go straight on.
Q301 Chairman: On the trajectory of the
carbon market, what has been happening? How has it changed over
recent years in terms of volume? How many allowances and credits
have been traded? How much are the values worth? In which direction
are things going? How do you account for the trajectory and obviously
what do you think the Commission's proposals are going to do for
the third phase of the ETS? How are they going to impact?
Mr Austin: I would like to have a crack
at what the Commission's proposals are going to do. The package
as a whole, the whole climate and energy package, is quite a positive
package. There are some very good features to it. The centralised
allocation by the European Commission is a hugely positive move.
There was a lot of what could have been interpreted as gamesmanship
in the national allocations in the last round. That will be avoided.
The move to 100% auction for the power sector will solve a lot
of controversy around windfall profits, or opportunity costs,
depending on what you like to call them. There are various other
very positive aspects to it. The treatment of the Clean Development
Mechanism under the package and the way it has been portrayed
is slightly less positive. There are two paths under the proposal.
One in the presence of international agreement and one in the
absence. In the presence of international agreement, the current
proposals would allow 72 million tonnes of CERs per year. To put
that into perspective, during the current phase of the EUETS,
270 million tonnes per year are allowed in. In the absence of
international agreement, nothing new is allowed in. This is a
major scaling down of Europe's engagement with the Clean Development
Mechanism via the EU ETS.
Mr Fankhauser: Maybe I can address the
first half of your question on what are the dynamics of the market
at the moment. In 2007, the common estimate that everybody used
was that the carbon market was at a volume of about 64 billion
US dollars. That is about double what it was in 2006 when it was
just over 30 and in 2005 it was around 11 or so billion dollars.
It is really growing very, very fast. I think the numbers for
this year are somewhere in the hundred billion US dollar range.
If you look at the composition of that market, about two thirds
or so is trade in the EU ETS. About one fifth is CDM and then
you have the various smaller markets like the voluntary market,
like joint implementation and the regional Australian scheme and
so on that make up the rest. The two big markets at this point
in time are the EU ETS, which is about two thirds of what is going
on and the CDM, which is about one fifth of what is going on.
In addition to just those volume numbers, there have been some
interesting structural developments in the market over the last
year or two in the sense that we have seen a change in the firms
that are in the market. We have seen a lot of market entry of
the mainstream, financial institutions over the last 18 months,
the investment banks, the hedge funds and so on. They have come
in and they have started to compete with the niche carbon players
that have dominated the area for a long time. The other thing
we are seeing is that the support industries are coming in. It
is not just people who produce carbon or do carbon projects; it
is also the support industries like IDEACarbon, which is an advisory
service. We start seeing a lot of exchanges coming into the space.
Two years ago, about 80% of the action happened over the counter.
Now we expect this year and next that 40% will actually happen
in exchanges. The corollary of that is that we start seeing more
complicated products, a lot of futures trading rather than spot
trading. We start seeing more derivative products. All those are
signs that the market is no longer an immature market. It still
is to some extent but we start seeing the maturity and we start
seeing the market behaving like any other financial asset.
Q302 Chairman: How do you account for
this development, this increase?
Mr Fankhauser: I think there are two
aspects. One is that the volumes have reached critical mass. You
could see that this was picking up for banks to have an interest
in. Also, the upward trajectory was interesting. There are very
few markets that double in size every year as the carbon market
has done. The judgment was made that the carbon market was here
to stay and so it was worth investing in it. I believe that is
still the judgment, whatever happens in 2012 and beyond. The judgment
is still there that there will be carbon markets. I think those
institutions are in the market for good now.
Viscount Brookeborough: Ecosecurities is the leading
company in the business of sourcing, developing and trading. How
many other businesses are in that business and what proportion
of the total do you take part in? How do you rate yourself among
others who are there?
Q303 Chairman: "Very good"
is the answer.
Mr Austin: If I did not have a colleague
from Climate Change Capital sat next to me, I would say we were
the largest, but we are definitely one of the largest in terms
of project developers. Our core business is to develop projects
in the developing world under the Clean Development Mechanism.
We have something like 400 plus projects in development at the
moment at various stages.
Q304 Viscount Brookeborough: What is
the total size of the business—not necessarily of yours
but of the total businesses like you involved in Europe?
Mr Austin: I do not know.
Mr Fankhauser: Ecosecurities is definitely
one. There is a ranking of the size of the portfolio that people
can look at in Reuters and on the internet. I think Ecosecurities
is one of the top three in terms of the size of portfolios.
Q305 Viscount Brookeborough: And the
other businesses that you are involved in?
Mr Fankhauser: IDEACarbon is different
in the sense that it does not take risk or ownership over carbon
assets. It is purely an advisory service.
Q306 Viscount Brookeborough: A consultancy?
Mr Fankhauser: Yes.
Q307Viscount Brookeborough: What are the aspects
of the draft Directive that your organisations and clients have
been following most closely during the progress of negotiations
in Brussels and what brings those points to interest?
Ms Laurencin: Like Ecosecurities, we
have been very focused on the aspect of dealing with the CDM because
that is where most of our business is located, in the origination
and the selling of credits from these development projects in
developing countries. We have been keen to understand how that
market is going to evolve. What we do not know today is both in
terms of volume that is allowed in and also the type of projects
that will be allowed, the quality debate. It is interesting to
see that the Commission and the vote yesterday in the Environmental
Committee in Parliament have given us a lot of insight as to what
that is going to be, but there are still a lot of questions pending,
especially on the quality side, on the types of projects that
we are going to be allowed to develop post-2012 and imported back
into the EU. Hopefully, we are going to get clarity on that but
it is going to take a couple of years until we know for certain
how this market is going to evolve.
Mr Austin: Yes, that is true. That is
one of the key effects of the current Bill. There is no certainty
in the market currently. It is very difficult to invest because
there is no clear signal as to what type of project to invest
in. There is no clear signal that there will be a market as such.
Even under the 30% pathway, the current proposals could be serviced
by existing projects something like four or five fold. There is
also a lack of certainty over when the switch to a 30% pathway
from the 20% pathway would happen. The general intention is that
it happens when a multilateral agreement is agreed but it is unclear
if it is when it is signed, when it is ratified by Europe, when
it comes into effect, all of which could be very different things.
If you look at the progress of Kyoto, there are years between
those events. That is the key, the uncertainty that this has created
because it makes for a very difficult investment climate which
is in the context of an already difficult investment climate.
Mr Fankhauser: It is worth emphasising
two aspects. One is the volume of the demand that there will be
in Europe, whether it is 1.4, 1.6 billion tons or any other number.
The other is the quality restrictions on projects, what level
of gold standard they would have to meet or any other restrictions
in terms of the countries they can come from and so on. That creates
a similar amount of uncertainty.
Q308 Chairman: Given the uncertainties
you refer to, is it inevitable that there will be this uncertainty
or could they be resolved?
Ms Laurencin: We deplore the uncertainty
but we understand that it is part of the deal, because the EU
is working out these provisions for ourselves, which are EU participants
in an EU-wide market, but we understand that the EU's other goal
in providing and creating this market is to embark as many other
countries as possible in the conclusion of a global, international
agreement on reducing greenhouse gas emissions. The EU wants to
be able to incentivise these countries to join as much as possible
and at the same time it wants to provide continuity for the investors
that we represent. Doing these two things can sometimes be a little
contradictory. It has to balance out the sort of tension that
there is between those two objectives, all the while knowing that
the international process is going to give us clarity later than
the discussions that we are having at EU level. There is a time
sensitivity and a dual aspect of negotiations going on. That is
part of the uncertainty and that is pretty much the state of the
business that we are involved in now. We understand and recognise
it. We deplore it but it is very difficult to see how that could
be different.
Q309 Viscount Brookeborough: Are you
really saying that the draft is not specific enough to indicate
where the opportunities lie for people to take this forward and
yet, if it was too specific, it would discourage too many other
people from joining?
Mr Austin: The draft Directive has a
qualitative limit. That is, post-2012, beyond CERs from least
developed countries, any credits that would be accepted in all
Member States would be admissible. The Commission has no idea
what that actually means, I have asked them. That is something
that could have been done with a certain amount of effort but
was not. Whilst there is a certain amount of necessary uncertainty
because there is an international negotiation process going on,
not just in the EU but also within the context of the successor
to Kyoto, there also is a certain amount of unnecessary uncertainty
being introduced
Q310 Viscount Brookeborough: You can
play within that system at the moment. Do you see that they are
about to approve issues that you want resolved to take the thing
forward?
Mr Austin: No.
Ms Laurencin: I think I agree. There
are issues that are left unclear. The reason for that is that
credit cannot be given until we see what our other international
partners are going to be doing. That is part of the game. It is
a difficulty that, as a business, we have to deal with but it
is one that is justified by the higher ambition which is to provide
a global framework which will not only create opportunities for
businesses like ours but to provide emissions reductions on a
wider scale.
Q311 Viscount Brookeborough: Could you
just give us a very simple example of a client who finds it is
secure in going forward and a business that is not able to go
forward because it feels too insecure at the moment? Where is
the demarcation?
Mr Austin: Currently, the key area of
clarity of areas is that we know projects in least developed countries
will probably be accepted. That would be an example of where there
would be a degree of investment certainty. However, we do not
know what the level of demand for those projects would be. In
the absence of international agreement, there would be no new
demand. There is a real unease about investing post-2012 at the
moment. It is also unclear exactly what use installations would
be able to make of CERs post-2012 as well. It is fairly clear
within the draft Directive, but the Directive will change and
that is part and parcel of the process. The whole thing is just
creating uncertainty. For instance, under the amendments from
the Environment Committee power generators from for instance Germany
or Spain would not be purchasing any CERs post-2012 because it
would be to their advantage to use up their full entitlement pre-2012.
That said, I think it is fairly clear that there will be further
changes when this reaches the Council of Ministers.
Mr Fankhauser: One area where we know
that developers are holding back is forestry, an example where
some players are keen to go but they are holding back. The firms
suffering from the uncertainty most are the project developers
and the intermediaries or the carbon funds like Ecosecurities.
The compliance firms within the EUETS I do not think are all that
much affected just yet. They are fairly busy trading European
allowances and they are thinking about whether or not they want
to import CDM but this has not really reached their desk. It is
just the professional project developers that are suffering from
the uncertainty at the moment.
Q312 Lord Cameron of Dillington: You
have obviously made your position pretty clear about the uncertainty
of the quantitative external emission credits. What about the
concept that this will make the domestic market really focus on
reducing emissions? In other words, there will be less leakage
if people are restricted
Mr Fankhauser: The first principles tell
you that trading is probably not a bad thing in the sense that
science tells us that the atmosphere does not care where the emissions
come from. Economics tell us that trade usually enhances welfare
so if you just stick to the first principle, as it were, carbon
trading is probably a good thing. There are some practicalities
obviously where markets do not fully work, where you want to worry
and for me there are two that I usually lump together under the
label "leakage". One is the worry that whatever happens
abroad, if you do a project, say, in China, it does not give you
the 100% emission reductions that the same action would in Europe.
That is a question of monitoring environmental integrity and perhaps
even cautious accounting. That is something that the system can
take care of. The second worry is one of lock-in, the idea that
if we build a coal fired power station now with the assumption
that we can offset those emissions through the CDM we will have
those assets on the books for the next 40 years and we may not
want them on the books for the next 40 years. But if we can make
that reasoning and understand the long-term dangers of doing that,
then people may not invest in coal-fired power stations. The question
then becomes one of the credibility of the regulatory pressure
on coal-fired power stations. Whatever the rules on the CDM, eventually
Europe will have a carbon free power sector and those firms will
have to comply with it. The lock-in is a real problem but it is
also a problem that, if the regulators can anticipate it, the
regulated firms can anticipate it as well. It is a matter of creating
consistency.
Mr Austin: In terms of emissions reductions,
the concept within the Kyoto Protocol is supplementarity where
the use of international credits should be supplemental to domestic
action, which is largely interpreted as being 50%. 50% of effort
can be covered with international credits. That is simply not
happening under phase three of the EUETS. It is a major move away
from the previous commitment. There is the question of lock-in
and I think it is quite important to bear in mind that the carbon
market cannot achieve everything. It is a very, very useful tool
but it is a tool that needs to be considered in the context of
a suite of other tools such as supplementary technology funding
for things like CCS to bring certain things online.
Q313 Lord Cameron of Dillington: The
debate to some extent has been about qualitative restrictions.
What about the quantitative restrictions? How do you audit them?
Sam, you said the system can take care of that but we have grave
doubts about whether the system can take care of that.
Mr Fankhauser: That was a little bit
of a cavalier statement. It is a serious concern that the environmental
integrity has to be ascertained. I have no doubt that there are
quite a few projects in the portfolio of the good people to my
right that are probably not additional but overall I think the
system does deliver. There are two ways in which you can take
all those worries into account. One is that you really monitor
very carefully, you double the scrutiny and you are doubly careful.
That is good but one eventually reaches a point where the transaction
costs related to that become too high. Another way is to accept
that on average in a portfolio a certain fraction is not properly
additional. One could devise a system where that is just factored
in. In terms of admin costs, that would be a lot easier. It would
probably be expensive in the sense that even the good projects
would lose a fraction of their carbon benefit. In that sense,
the system can be designed to take care of it but it is inherently
a complicated thing.
Mr Austin: In terms of the current system,
there is a clear possibility for improvement with the current
setup. The executive board of the Clean Development Mechanism
is currently undertaking scrutiny of nearly every project that
is submitted. Every project submits what is called a project design
document which is a 150 to 200 page long technical and economic
document that details every aspect of the project. The executive
board is largely composed of negotiators. Some of them have technical
skills; some of them have economic skills but not that many. This
is a body that meets six times a year for three or four days and
there is currently a huge backlog of projects as a result.
Q314 Lord Cameron of Dillington: What
are your views on access to historic external emissions credits
that have been carried over from phase two to phase three? A point
which has been put to us which is quite valid is that any new
industries will not have access to this—airlines and so
on. Shipping may come into it.
Ms Laurencin: It is a fair point that
any new industries will not be able to benefit from it, but overall
in the system it should be beneficial to all participants because
it should enable the pricing to be smoother and less volatile.
There will be fewer risks of prices being too different from one
phase to the next because participants can anticipate the fundamentals
and use their credits at the most appropriate times. One of the
issues with a nascent market which is immature is that you still
have significant policy risk and you still have a large number
of players which are new to the market and which may not have
a good vision of the fundamentals. Providing people with the ability
to bank their credits into future periods allows them to have
a longer term vision of the market, of the supply and demand fundamentals
and hopefully we will not see the volatility that we saw in phase
one, which is a very big hit from an investor's point of view.
Mr Austin: Also, if you disallowed banking
on CERs, installations would simply use up their entire CER allowance
in phase two and bank through EUAs instead, so you would still
have the same effect coming through. I understand that Defra has
a paper at the moment that outlines a mechanism for solving this
problem.
Mr Fankhauser: The fact that you can
bank, that we have created a continuous trading space from now
to 2020, is one of the really good design features. If you just
think back to phase one where things did not work out as they
should have, the price drop would have been a lot less if there
had been some sort of link between phase one and phase two. For
obvious pilot reasons, one did not have that but if one imagines
a link between phase one and phase two one would not have seen
the price drop that we have seen.
Q315 Lord Cameron of Dillington: You
are all obviously very keen on opening up the market as much as
possible. Do you have any views on the desirability of domestic
offsetting?
Mr Austin: In terms of setting up a JI-like
system within the UK?
Q316 Lord Cameron of Dillington: Yes.
Mr Austin: It is limited because of the
EU ETS for one thing. Anything that would affect the EU ETS would
be disallowed automatically so renewable energy projects would
be disallowed. Anything along those lines would be disallowed.
Forestry would be a key sector and in Germany I know a lot of
VAM and coal mine methane projects are taking place under JI,
so there is room in the UK for that to happen. I certainly think
that, for sectors that are not covered by the CRC or the EU ETS,
it would definitely be a way of beginning to engage them.
Mr Fankhauser: I have a slightly different
opinion. In this country, most sectors in one form or another
are subject to carbon type regulations say, through the CRC. The
transport sector is subject to carbon regulations. The only one
where it probably would work—I agree with you—is forestry
and, more generally, maybe land use and land use change.
Q317 Lord Wallace of Tankerness: So far,
these schemes we have had have tended to operate in isolation
from each other. Obviously, there are some bridges but if we are
looking to the future what do you regard as the main obstacles
of linking the different regional or national schemes that might
emerge?
Mr Fankhauser: The main one by far is
the stringency of those different systems. If you look at the
various proposals in the US, for example in Lieberman Warner,
they are all designed as low price systems. They have safety valves
in there if the price goes too high and things like that. The
EU ETS in a sense is designed as a high price system. Nobody admits
it but that is what people had in mind when the system was designed.
If you have a top price, according to Lieberman Warner, it would
have been about 20 euros. That is the maximum price the US system
would have allowed. Obviously, that is not at all compatible with
the European system where prices are expected to be in the thirties
before long. There is also a question of quality control in terms
of the offsets that are being let into the system. If the European
system has quality levels as to what type of projects are being
let in, it creates a back door if you link up with other systems
that have lower standards. The lower standard projects go into
that other system and that other system then exports its allowances
into the EU. Those are the two main issues. The more important
one is that high price and low price systems are hard to link.
The second, a lesser issue, is that you might have quality differentials
between the two different systems.
Q318 Lord Wallace of Tankerness: You
said in answer to an earlier question that what we have seen in
Europe is a pretty rapid maturing process. Do you think that is
going to happen elsewhere and that some of these differentials—I
can see the difficulty of linking these differentials—might
diminish as the market in more recent schemes matures?
Mr Fankhauser: I think the quality differentials
are very easily ironed out and there are efforts to do that. The
price differentials are a matter of political will more than a
matter of maturity of the system. It means that all the other
systems have to have the same willingness to impose the same carbon
costs on their economies.
Mr Austin: To give it some context, the
Regional Greenhouse Gas Initiative in America is currently trading
at about three dollars a tonne. It has a price valve at ten dollars
a tonne and when it hits ten dollars a tonne it will allow in
offsets from nearly everywhere, not just the CDM but other schemes
as well. The Commission on the sidelines seems to be looking at
a target price of about 40 euros a tonne to make CCS economical.
I cannot see where the motivation for the Americans to link would
be, when they are looking at a ceiling of $20 a tonne and Europe
is aiming for a floor of 40 euros a tonne.
Q319 Lord Wallace of Tankerness: Do you
think the structure of the draft Commission proposal allows these
links to be facilitated? Does it leave the door open to be able
to link up?
Ms Laurencin: It aims to definitely.
In the proposals that were accepted yesterday in the Environmental
Committee in Parliament, there is definitely a very specific text
that says the imported credits post 2012 in the EU should be able
to be accepted in other markets. There is a specific reference
to the US scheme, so definitely the EU has this in mind and does
want to move towards a situation where there is one carbon market
with one carbon price. In the short term, the question is how
long is the short term. Is it ten years or is it more? The issues
that you were just mentioning are difficult to overcome.
Mr Austin: RGGI also managed to bring
in an extra technical complication by using imperial tonnes rather
than metric tons as well, RGGI being the trading scheme in North
East America.
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