Carbon markets: What price Durban?

Durban's last-minute effort to garner emissions reduction commitments from some 190 countries has been deemed an epoch-making event in the history of UNFCCC climate negotiations. Indeed, COP17 formalised: 1) The extension of Kyoto and the survival of its institutions and mechanisms; 2) A roadmap to a new “legal” treaty covering all nations agreed by 2015 and enacted by 2020; and 3) Agreement on the design of a Green Climate Fund (GCF). Considerable praise is due to the EU delegation for their role in guiding the negotiations.

However, like Cancun, Durban reveals how the UNFCCC process has continued to circumvent the difficult decisions. These decisions are required to both stabilise the climate and reinvigorate the currently glum international carbon market.

The details of the roadmap are non-existent and any new treaty enacted in 2020 would come into effect after global emissions should have peaked. Put simply, under this framework, avoiding dangerous climate change (ie. temperature rises to two degrees centigrade) is virtually unobtainable. This stark prognosis assumes the agreed deadlines are met. Historically this has not been the case, and considering the agreement is a framework, further delays could be incurred as progress typically stagnates over the development of detail.

Key Outcomes

The extension of Kyoto is welcome for two reasons. First, it goes someway to fill the political vacuum after the spectacular failure of Copenhagen in 2009 to come up with an internationally binding deal, and fledgling progress at Cancun last year. The extension of Kyoto sees a second commitment period running from January 1, 2013, until the end of 2017-20. Second, the Kyoto mechanisms, the Clean Development Mechanism (CDM) and Joint Implementation, can now continue post-2012.

The roadmap is an agreement between delegates to start negotiations for a new legally binding treaty to be decided on by 2015 and to come into force by 2020. The process is termed the Durban Platform for Enhanced Action, which will endeavor to develop a new protocol – another legal instrument or agreed outcome with legal force for all nations under the UNFCCC. The nature of the legal instrument is undecided. Likewise, the ambition (ie. emissions cuts) is undecided. According to the text, a work group is going to be established to bridge the ambition gap between the pledges made in both Copenhagen in 2009, and in Cancun in 2010, and those required to avoid dangerous climate change.

The design of the GCF – to channel up to $US100 billion a year by 2020 to poorer nations – was agreed, but achieved little on establishing where the money will come from. A proposal to generate capital from charging international shipping for their carbon emissions faced considerable opposition and it did not survive in the final text. The fund currently aims to distribute cash by loans and grants. This is a dubious means of attracting private sector capital and will likely remain a wholly unappealing investment proposition for institutions motivated by profit and loss.

Future Challenges

Empirically, Durban saved the UNFCCC negotiation process. But, like Cancun, it did little for the climate. From the perspective of political and multi-national cooperation, the achievements of Durban are notable and should not be understated.

That said, after Durban we effectively have a second Kyoto period without targets, a GCF without capital, and procedures without commitments. Attention will now turn to the first half of next year, after the EU agreed to act to finalise the details for the extension of Kyoto from the end of next year, and the launch of the GCF. The approximate deadline for these matters is May 2012.

The need to identify mechanisms for financing the GCF and delivering more ambitious emissions reduction commitments from all nations is urgently required. This comes at a time when the US, EU, India and China still remain deeply divided on the scale of the cuts they will accept.

Price Impact

Like Cancun, Durban will have a de minimis impact on carbon prices. A second Kyoto commitment period is great news for the CDM, as it now has the legal go ahead to continue post-2012. This, however, does little to combat the fundamental problem of oversupply. According to the Risoe CDM database and based on current demand – 1.7 billion from the EU and 350 million from Australia – the CER market is oversupplied 6/8 times from 2013-20. Unfortunately, unless the CER market sees some buy-side soon – which can only come from emission caps – prices will likely decay further. With developed countries showing clear signs of weaning themselves off CERs (Phase III of the EU ETS and the Californian cap and trade regime being the most obvious examples) I believe the only thing that can save the CER market is demand from Asia (notably China, India and Korea).

Phase III EUA prices are unlikely to get support from the Durban outcome, since the new agreement will come into force by 2020. Carbon traders will continue to anticipate national policy intentions, rather than international climate talks. In this regard there is room for optimism.

Fundamentally, due to the European economic situation there is little meaningful buy-side for carbon for the rest of Phase II and all technical signs point to further weakness over the short-to-medium term. Rallies over the last two months have failed to gather strength, and what was once the all-time low support of €8.75 now looks well out of reach. Meanwhile, the downside remains open and with the NER-300 now in hands of the EIB, flooding of an already flooded market is set to accelerate for the rest of Phase II. Assuming suppressed economic growth in Europe, without a reduction in the supply of EUAs, this Phase II oversupply will likely continue for the duration of Phase III.

This situation leaves the price of carbon in the hands of political intervention. Expect to see significant speculation with little utility buying until prices get very low. We have seen a game of cat-and-mouse played in the Eurozone in recent weeks with sovereign yields surging higher, as institutional investors send imminent signals to the ECB to intervene. Analogously, a similar situation could quickly prevail within the carbon markets.

The irony of the financial crisis is that the markets, not the politicians, have pushed the Eurozone down the path of ever-closer integration. Although European leaders are still struggling to come up with credible solutions for controlling sovereign debt crises, the European Commission does have the solution to control carbon market oversupply.

This is solution consistent with the implementation of austerity measures. Those EU nations that are struggling financially may look to bolster carbon market demand by withdrawing supply and then auctioning these permits to utilities throughout Phase III. The more EUAs they withdraw, the more the public coffers will be filled. Indeed, the champions of post-recession austerity have already done this: In December 2010, the UK government proposed to impose a carbon price floor on its main fossil fuel suppliers.

On December 20, 2011, the EU Environmental Committee (ENVI) will vote on the Phase III set-aside proposal. This event will have a more profound impact than Durban's tenuous achievements. Ratification could be in early Phase III. Exact timing will likely depend on the state of the European economy and the price of carbon. If the price of carbon falls further expect this legislation to be rapidly prioritized.

Matthew Gray is an emissions trading strategist. Views are my own: matthewcgray@gmail.com