The European Union's Emissions Trading Scheme (EU ETS) did, at first glance, look like it went off a cliff over the last two weeks, with the price of a carbon dioxide (CO2) allowance (EUA) falling from $38/ton to $14/ton. What happened is that countries within the EU began to report their actual emissions for 2005. Since 2005 was the first year of operation for the ETS, this is the first time we've had real emissions figures for member countries. Those reports showed that emissions in several EU countries totaled less than what observers had expected. Thus, companies and countries will need significantly fewer emissions reductions credits for compliance than originally anticipated. The reports are not actually due until Monday, May 15th, and several countries have yet to report their emissions, so the market may be in for some more turmoil, whether upward or downward.

It's important to bear in mind that this first phase of the EU ETS, which runs from 2005-2007, was never intended to result in dramatic reductions in CO2 emissions. The original price expectations for the 2005-2007 period were in the $5-10 range, consistent with the idea of a testing period leading up to the Kyoto Protocol's first commitment period running from 2008-2012. The price surge to more than $30/ton over the course of the past year has surprised everyone. The high prices can be attributed to several factors, including a fear that countries would need more reductions than foreseen; radical changes in oil and gas prices with the effect of increasing the cost of switching from coal to gas for electricity generation; a shortage of near-term reductions from developing countries; and increasing speculation that prices would continue to rise indefinitely.
As countries have begun to report their 2005 emissions numbers over the last two weeks, the market has reacted - with a vengeance. The price of EUAs has decreased by 60%. In interpreting these recent events, however, we have to remember several key points:
  • The price fall affects first phase EUAs through 2007 but doesn’t really have implications (other than a psychological one) for the great majority of projects that are intended to supply the Kyoto Protocol market starting in 2008.
  • There is no reason to assume that the recent price fall will affect credit prices over the longer term. In fact, if this leads to tighter allocations for the second phase of the EU ETS, it could increase demand and prices for credits after 2007. In addition, the price drop could reduce the amount of speculative capital coming into the market in the near term. While such a reduction could affect the ability to raise capital in some markets, it could result in more robust prices for projects that are available starting in 2008.
  • The recent events in the EU market reinforce our confidence in the approach we've been taking to forecasting credit prices. We look at supply and demand, particularly with respect to the market for credits coming from developing countries. The current lower EUA price is consistent with our projections for prices after 2007 based on our supply-demand analysis.
What has happened in Europe will probably prove to be an over-reaction to the previous "irrational market exuberance." It will be important to watch and see how this plays out for market speculators, whose role has been getting rather dangerous in contributing (in our view) to a "carbon dot com" bubble analogous to the technology "dot com" bubble. The EU ETS price drop does not change the overall dynamics of the GHG market, and could actually result in a healthier market going forward. Certainly, it will have been very painful for some people who speculated on the overly high prices, but it does not change the underlying "business case" for the GHG market.


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Dr. Mark C. Trexler has more than 25 years of energy and environmental experience, and has focused on global climate change since joining the World Resources Institute in 1988. He is now president of Trexler Climate + Energy Services, which provides strategic, market, and project services to clients around the world.