Key words :
Kyoto Protocol, EU ETS and Determinants of CO2 Prices
21 Sep, 2007 12:26 pm
The Kyoto Protocol is the international response to climate change. By ratifying the Kyoto Protocol, industrialized countries make the commitment to reduce their global greenhouse gases emissions by at least 5% from the emissions in 1990 on average during the period 2008 to 2012. The European Union has a global objective of emission reduction of 8% distributed among the European Countries. There are 6 greenhouse gases but their warming potential is homogenized by a unit measure called CO2-equivalent (CO2-e). This means that all greenhouse gases emissions are measured in CO2-e independently of the gas that provokes them.
Under this scheme, European large CO2-e emitting installations (representing almost half of Europe’s CO2-e emissions), receive permits from their government to emit tonnes of CO2-e. The allocation of the allowances among the companies is done through the National Allocation Plans that each Member State in the EU has to submit to the European Commission. By this process a clear scarcity has been created and a broad range of agents are required to possess rights for their use for compliance. These permits, called European Union Allowances (EUA), can be traded in several spot, futures, and options markets, whenever the installations fulfil their targets at the scheduled time.
Although the main objective of the EU ETS is the reduction of emissions, considering practitioner’s opinion, perhaps the most important objective is the establishment of a market price level for allowances. This means that European CO2-e emitting installations will be aware of the environmental consequences of their polluting activities. The question then is what are the factors that determine the price level of CO2 permits? An empirical analysis of the main determinants of 2005 CO2 prices published in The Energy Journal shows that both weather and non-weather variables affect daily CO2 prices traded during the year 2005 but with delivery in December 2005. The energy variables considered are those that best represent the energy markets in Europe for oil, natural gas, and coal. That is, Brent and Natural Gas prices traded at the International Petroleum Exchange, and TFS API2 coal prices. As to what affects the weather variables, the authors have taken into account the weather in Germany and in Europe. It is not easy to introduce weather variables in order to explain non-weather variables such as CO2 prices. In this case, the authors have considered the existence of persistence and extreme weather. That is, the days when the weather has an influence on CO2 prices are those that accomplish two conditions. First, there is extreme weather on that day and, second, there is extreme weather on the five previous days. The first condition refers to the existence of extreme weather and the second one to the persistence. The results show that the most important variables in the determination of CO2 prices are the Brent and Natural Gas prices. But surprisingly there is no influence of coal prices. Related to the weather variables, extremely hot and cold days in Germany have a positive influence on CO2 prices. This is not the case either for extremely rainy or dry days. These results are coherent with what some models and market participants would expect and therefore the CO2 market in its first year was not as irrational as some participants and observers have suggested.
However, after the release of the verified emissions for the year 2005, that took place in May 2006, the prices for Phase I decreased drastically. The evidence that the allocations for the Phase I had been too generous provoked a huge amount of commentaries about the usefulness of the market. After that, the European Commission signalled that it would be much more restrictive with the Phase II National Allocation Plans and the prices for Phase II are now around 20 euros.
Maria Mansanet-Bataller, Angel Pardo and Enric Valor, CO2 Prices, Energy and Weather, The Energy Journal, Volume 28, Number 3.