Phase1 of emissions trading
July 18th 2006

The trading of EU carbon dioxide allowances (EUAs) has been going on for almost twoyears now, with trading volumes and interest in the market growing almostexponentially during that time. But the market continues to surprise many, with someanalysts even predicting its complete demise earlier this year. Many companies are alsostill unsure how it affects them and how they could or should participate

While pre-market trading had beentaking place for several monthsbeforehand, January 1st 2005 saw thestart of Phase 1 of the European UnionEmissions Trading Scheme (EU ETS). A nervous startled to prices initially dipping, only then to quadrupleby the end of June 2005: analysts had predictedtrading values ranging from 5 to 25 euros/TCO2 andin just six months they were all proved right!

Next came the first of the market's dramatic correctionsas, with prices nearing 30 euros, a wave of profit-takingby traders led to prices tumbling by a third in less thantwo weeks; the market then held broadly stable until theend of the year.

Traded volumes grew healthily during 2005, triplingfrom approximately 30 million tonnes in the first quarterto 90 million tonnes in the last quarter. In the first quarterof 2006 the market accounted for the bulk of the $6.6billion-worth of emissions allowances traded globally.

The first half of 2006 has seen even greater volatility than2005 prices climbing to a peak of 30.50 euros at theend of April, before crashing off as leaked results of anofficial EU audit revealed many states emitted less CO2than expected in 2005 and so had excess EUAs to sell onthe market. This led some observers to claim theallowances could become worthless - but in realitythey reached a low of 8.30 euros, and then reboundedto 20 euros, before settling back around 15 euros.

The EU survey gave the first true indication of marketlength for 2005 and for Phase 1 (2005-2007) as a whole.This, along with the associated price swings, has had anumber of effects. Many of the speculators who werestarting to enter the market have been noticeably quieterand there is now a definite air of caution. Considerablefocus has also been placed on Phase 2 (2008-2012), asmany believe that Phase 1 will ultimately be long and thatit is 2008 onwards when tighter NAPs (National AllocationPlans) will make for a more challenging market.

Players still have mixed views on which fundamentalshave the greatest impact on market price. While soaringgas and oil markets have often correlated strongly, onother occasions German electricity prices, a changingcoal/gas price differential or even temperature andprecipitation levels have appeared to be the main driver.

However, more than anything else, the political natureof this market has driven price, with NAPannouncements from EU states, for example,consistently leading to market adjustments.

In answer to the question "Will this market fly or fail?", wecan clearly see much to be positive about. More andmore counterparties are involved in the market,volumes have grown dramatically and it must beremembered that Phase 1 was always essentially a trialperiod: no-one should be surprised that a scheme ofsuch complexity would be imperfect at the first attempt.

While cement manufacturers, utilities, iron and steelworksand ceramics and glass makers appear to be the industrialsectors most affected by the EU ETS as their inclusion inthe Phase 1 allocation process is mandatory the schemehas much wider implications. It affects all businesses, asthe price of EUAs is factored into electricity costs bygenerators and passed downstream. Also, moreindustries are likely to be pulled into mandatory trading asthe scheme evolves and is extended.

More articles from WEE News Desk: