Soap bubbles by Walter Como cropped

The Carbon Bubble: Assessing the risk of a collapse of carbon markets using Credit Rating Statuses.

[Updated on 16 February 2012, reflecting new developments in media and European Parliament]

In this article I want to explore the risk of a collapse of carbon markets in the next years. There are signs indicating that the Kyoto carbon markets (e.g. CDM and AAU trading) might be on the verge of imploding. In an earlier post I showed how the EU ETS is facing redundancy due to a gigantic surplus of allowances. Though at the same time, when looking at texts being negotiated at UNFCCC sessions like the one in Durban, one sees a lot of enthusiasm and hype over new and bigger market based instruments.  What I will try to do here is to evaluate the existing market based instruments as from 2013, through a rating system not un-similar to the ones used by the credit rating agencies assessing the status of governments budgets and loan capacity. As an example we use the long-term ratings used by the credit rating agency Fitch. The main goal of this comparison is to visualise the investment risks in the current carbon markets. It is of course a, tongue in cheek, proof of concept and should be no means be seen as a full fledged quantitative and qualitative assessment. On the other hand, I am pretty sure that using these types of ratings to assess the current carbon market will make some policy makers sit-up and pay (more) attention. It can be seen as recommendation to develop a more comprehensive instrument to assess the health of the carbon market. With or without sophisticated rating standards, it is for all to see that an unmitigated future for most of the existing carbon markets is bleak, very bleak….

EU Emissions Trading System: Rated BB+ (non-investment grade) with negative outlook, unless short term intervention happens

For a more detailed assessment of the state of the EU ETS I refer to my earlier post related to the EU allowance surplus and how this might persist beyond 2020. The conclusion is that without an urgent significant political intervention in the market the EU ETS will not be a driving force for emission reductions in Europe on the short, medium and long term. Carbon prices will remain low and risk falling further if one or more of the following conditions are met:

  • Prolonged recession or lower economic growth in the European Economic Area
  • Permanent contraction of production capacity in Europe’s energy intensive industrial production such as the closures of steel plants by Arcelor Mittal and refining installations by Petroplus.
  • The full implementation of Europe’s renewable energy and energy efficiency goals and legislation
  • Unilateral actions by other EU Member States outside of the EU ETS such as the introduction of a carbon tax in the UK

With a short term intervention, removing between 1.4 to 2.4 Gigatonnes worth of allowances out of the market a gradual upgrade from BBB- to BBB+ is likely. If this short term intervention would be combined with an accelerated linear reduction of the EU ETS cap beyond 2020, higher ratings could be achieved. [On the side: It can be argued that a market such as the EU ETS in which supply is fixed but not the demand, would ever be able to reach a grade higher than  “Upper medium grade: A+”. Hence, there will always be a non-negligible and non-mitigatable risk for another surplus slump, leading to investors shying away from the EU ETS. ]

[Updated] Recent news articles in some high profile news outlets such as the Financial Times and Der Spiegel featuring similar concerns as the one in this blog are having an impact on EU policy makers.  It is now expected that Members of the European Parliament will support the principle of setting aside allowances in the auctions of EU ETS allowances through an amendment in the negotiations of the Energy Efficiency Directive. However all European Member States still need to support the same position and the commission has to implement it. It will be up to the Danish EU presidency to steer this through.  Also a partial solution through setting aside not enough allowances can be a risk. Therefore I have updated the status of the EU ETS to  BB+ with a “conditional” negative outlook. Once there is more certainty that such “set-aside” will materialise the status can again be reconsidered to move upwards. 


The EU Effort Sharing Decision Trading: Rated BB (speculative)

This might be news to (part of) the carbon market community but as from 2013 a new carbon trading system will be launched in the European Union. The Effort Sharing Decision, agreed on as part of the 2008 EU climate package, caps the emissions from all sectors not covered by the EU ETS (with the exception of international maritime transport and forestry).Under this decision, each EU Member State has to fulfil an emission reduction target by 2020 and in each year between 2013-2020 in a linear fashion. The over-all 2020 cap of the Effort Sharing sectors at EU level is −9% below 2005 levels. I am preparing a more elaborate post on the detailed workings of this very interesting and under-valued piece of EU climate legislation and will try to post that within the next 2 weeks.

What is important for now is that each Member State can achieve its target by purchasing Annual Emission Allocations (AEAs, yup there is acronym for that) from another Member State (with a surplus).  It is very similar to the EU ETS and to the Assigned Amount Unit (AAU) Kyoto Protocol trading. However, two essential issues need to be pointed out. First of all, the trading of those AEAs happens between Member States and not companies or private entities as in the EU ETS. Secondly, AAUs are not accepted as a compliance currency under the Effort Sharing Decision. This is important for later assessments below.

It appears that the Effort Sharing trading will face a similar issue as the one outlined for the EU ETS. There will be limited over-all demand. The latest assessments and projections of the evolution of emissions under the effort sharing sectors show that many EU Member States will meet or over-achieve their targets. On top of that, and not dissimilar to the EU ETS, there is competition with external credits from the Clean Development Mechanism which depending on the relative pricing with AEAs might affect demand.

Besides similar economic outlook parameters as under the EU ETS, the Effort Sharing trading faces another problem, which is of a more urgent matter, the lack of implementation. While the EU ETS rules for 2013-2020 are mostly implemented, the trading rules for the Effort Sharing Decision are not there yet. It seems unlikely that they will be ready before the start of the first Effort Sharing Decision trading period. There is a high level of uncertainty this market will be ready, at functional level, in time. Therefore the Effort Sharing trading is rated one level lower (BB, speculative) than the EU ETS. The outlook for the Effort Sharing Decision is neutral since there is no risk of a carry over of surplus allowances between 2008-2012 and 2013, the start of the Effort Sharing period. The risk of a full implementation of the renewables directive on the Effort Sharing Trading sectors is low since they do not include the power sector.

Upgrading the rating of the Effort Sharing Decision carbon market will happen under the following circumstances:

  • An increase of Europe’s 2020 climate ambition to 30% reflected in sharper 2020 targets for the Effort Sharing sectors of EU Member States
  • A smooth, transparent, complete and fast implementation of the trading regime under the Effort Sharing Decision

The Clean Development Mechanism: Rated CCC (extremely speculative) with negative outlook

The Clean Development Mechanism’s future is highly uncertain. First of all, part of its future is linked to the future of the Kyoto Protocol and in particular its participation and ambition level after 2012.  While outcome in Durban left the door open for a second commitment period under the Protocol, no such thing has been decided yet. Even if that would be the case, there are only few Parties to the Protocol that actually have said they would be fine with new post 2012 targets inscribed in one of its annexes. The EU being by far the biggest emitter among them and there are so far no commitments from Russia, Japan and of course US under a second commitment period of this protocol.

The Clean Development Mechanism and the price of the Certified Emission Reduction Units it creates is driven by the demand from developed countries. A new report by the UNFCCC shows that over 80% of the credits generated under the CDM go to the European Union and in particular its emissions trading system.

I think the attentive reader must feel what is coming next. If the EU seems to be the only significant party with the potential for significant demand for those credits after 2012, a lot will depend on whether there is such demand. As demonstrated above, there will be little if no demand for such additional credits in Europe after 2013. Actually it is worse. The European Union has expressed its willingness to move away from the CDM towards bigger (and better?) market based instruments after 2013. There is an exception for Least Developed Countries (LDCs) which still will be eligible to sell CERs to the EU ETS. For the rest, there is a warm-shut down foreseen for the eligibility of CDM credits under the EU ETS. Only credits in the pipeline from existing projects will remain eligible after 2013, with the exception of credits coming from HFC23 destruction projects and projects destroying N2O from adipic acid production. The latter two are as from early 2013 ineligible for compliance under the EU ETS.

The short story is that the biggest demand for (new) CDM credits will dry out quickly after 2013. This huge shortfall might be partially made up by demand from the new Australian carbon market but its volume will never make up the shortfall of losing EU ETS compliance demand.

The CDM is as such not far away from reaching “DDD – in default” status. To mitigate this and secure a higher level of investment trust in this mechanism a list of immediate and strict reforms are necessary:

  • Clarity, on short term, on whether there will be a second commitment period under the Kyoto Protocol, which Parties will participate and what will be their emission reduction targets.
  • On top of the above, it is highly recommended that all Parties which have pledged emission reductions, when confirming them under a second commitment period of the Kyoto protocol, move towards a higher ambition.
  • The CDM needs to be reformed and streamlined and could make room for more effective instruments which move beyond the project based level towards sectoral or national mechanisms. An example of this would be clarifying the relationship between the CDM, POAs (programs of activities), NAMAs (National Appropriate Mitigation Actions) and new market based instruments which are under construction…

The short term outlook on any of the above conditions materialising is low.

The Kyoto Protocol Assigned Amount Unit (AAU) Trading: Rated DDD (in default)

If you think the current and up-coming EU ETS surplus is bad, think again. Late 2011, UNEP estimated in its “emissions gap report” that the surplus Assigned Amount Units (the Kyoto protocol’s default compliance units) out of the first commitment period 2008-2012 would be between 9 and 13 billion tonnes CO2-equivalent. That is up to 3 times as much as Europe’s annual greenhouse gas emissions or almost twice those of the US or China. As things stand now, according to the current rules of the Kyoto Protocol, all of this surplus can be carried over into a second commitment period. At the same time, as mentioned above, there is no certainty that there will be such period and who will be part of it and at which level of emission reductions. Furthermore as mentioned above the biggest demand side of Assigned Amount Units, the European Union, will be closed for business as from 2013. Japan, another big AAU demander, will not even be part of second commitment period of the Kyoto Protocol. Russia’s and Ukraine’s 2020 emission reduction targets as pledged under the Copenhagen Accord seem to even increase this surplus. However, in Russia’s case, it is not even clear if that country will be part of a second phase under the Kyoto Protocol.

We expect in 2012, 2013 and 2014 some countries like Spain to use AAUs for compliance under the Kyoto Protocol’s first commitment period (which ends in 2012 but countries close the books on that period only 2014 when all emissions are known. It is just an accounting issue). However, these amounts will be marginally small compared to the over-all surplus.

As things currently stand there is little if no future for the AAU carbon market. The conditions to increase investment trust in this market are very similar to the ones mentioned for the Clean Development Mechanism:

  • Clarity, on short term, on whether there will be a second commitment period under the Kyoto Protocol, which Parties will participate and what will be their emission reduction targets.
  • On top of the above, it is highly recommended that all Parties which have pledged emission reductions, when confirming them under a second commitment period of the Kyoto protocol, move towards a higher ambition.
  • The overwhelming majority of the AAU surplus following the first commitment period of the Kyoto Protocol cannot enter the AAU market as from 2013 in an unrestricted manner. The UNFCCC climate negotiations have seen some interesting proposals to deal with this such as a proposal by the group of African countries limiting the carry over of AAUs to 1%.

Conclusions and advice for the future

It is not hard to find a common ground in most of the concerns on the future of existing carbon markets as expressed above. It boils down to a lack of demand. Without demand for credits, unit or allowances coming from more cost-effective mitigation options, those options will not materialise. All of the above mentioned carbon markets risk collapsing or becoming redundant if there are no immediate and in some cases dramatic interventions in the ambition level, caps or surpluses from the demand side of the carbon market. The EU and world need sharper climate targets and they need them soon.

In this perspective, talking about new (supply side) market based mechanisms, with an even broader scope than the CDM seems superfluous. There is no reason to expect the basis demand problem to go away if we replace the CDM with e.g. a sectoral based approach. To the contrary one would say. Most of the new mechanisms considered offer the perspective of a much higher level of credits to be generated.

Let’s prove this point with an example. We have seen the EU trying to wriggle its way out of this conundrum through the (de facto) abandoning of the CDM post 2012 and the quality restrictions on some CDM off-sets. Through such approach EU policy makers try to compensate their impotence to create more scarcity in the EU ETS. As such one or more new mechanisms might replace the room opened up by moving away from the CDM. The problem is that this room is still very small through the structural surplus in the EU ETS. The underlying problem must be solved first.

The conclusion to this post, hence, seems straightforward. The existing carbon markets can only be made healthy through deep and structural demand side interventions under the form of stricter caps and the destruction of surpluses. New carbon offset markets (the supply side) replacing the CDM will only operate if this demand side issue is rigorously addressed.


Picture credit: “Soap Bubbles” by Walter Como

One thought on “The Carbon Bubble: Assessing the risk of a collapse of carbon markets using Credit Rating Statuses.


    Fascinating post, Tomas. The AAU carryover issue alone should have enormous bearing on the prospects for any carbon markets around the world.

    I’m wondering whether there have been any major public admissions of failure from officials associated with the EU ETS? I’m thinking of the way Alan Greenspan informed a Senate committee in 2008 that the ‘entire intellectual edifice’ on which his own monetary policies were based was now in ruins.

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