Cornering the market

Do the peaks and troughs of the financial markets really hold the key to solving our environmental troubles? Faisal Islam investigates

Forget the eco warriors, ignore the oil majors and park Al Gore’s hybrid well away. It’s actually the masters of the financial universe that are, we’re told, going to save the world from the perils of climate change, while carrying on doing what they do best: making millions, and in some cases billions.

Welcome to the Carbon Market, aka ‘emissions trading’, where greed can never have been so green. Because ‘almost everything has a carbon footprint’, the protagonists think that carbon could one day become the most traded commodity in the globe. Half the current trading comes through London and the City of London is emerging as the world hub for carbon capitalism.

Kingston-upon-Thames is an unlikely hub for anything, but nestled in the greenery beside the river Thames lies a futuristic office block designed to accommodate a small army of planet-saving, carbon dioxide-sapping capitalists. Arthur Tait is in charge here, and his ambition is clear: to become the number one trader of carbon in the world.

Can ambition such as this – can the profit motive itself - really be the planetary saviour?

‘Effectively, yes,’ says Tait. ‘I think it’ll save it a lot more efficiently than a carbon tax would, or forcing draconian measures on countries that wouldn’t take those measures. So a market-driven force is probably the only way we’re going to save the planet.’

That, in part, is the point of this nascent market. Put a price on emitting carbon and then someone, somewhere, will take the money not to emit it. At the same time there are a whole load of brokers, traders, bankers, fund managers and lawyers trying to match supply with demand – making a packet, while retaining a planet-saving afterglow.

But guess who Mr Tait works for? A company whose other ambition is to be the world’s biggest supplier of hydrocarbon energy: Gazprom, the state-run Russian gas giant.

In the background his team of traders are barking into their trading phones, hustling deals, watching variables as diverse as temperature charts in Europe, the escalating price of crude oil and the negotiating position of the awkward Czechs over the allocation of the right to emit carbon in Europe. There are no pinstripes or strangely coloured blazers. The traders are casual but utterly focused on the latest information coming through their Reuters terminals.

‘From a standing start a few months ago, the people here will aim next year either to sell into the market or trade eight million tonnes of carbon reductions, but within the next three years grow that up to 80 to 85 million tonnes,’ says Tait.

His team has just signed a deal to buy up 1.3 million tonnes of CO² emissions savings made through upgrades to a polluting manufacturer in South Korea. The reductions have been certified to the United Nations standard. But that’s just the start of the wheeler-dealing. He takes me over to another floor of the building.

Carbon-neutral gas?

‘On Susan’s desk, what we’ll do instantaneously is sell on the bulk of those savings into the Japanese market,’ he says as Susan flogs, from a desk in Kingston, a million tonnes of finest-quality, unemitted Korean carbon to their near-neighbours in Japan. ‘Japan is very short of carbon.’

Of the 300,000 tonnes remaining, 70,000 is handed over to the trading desk to do smaller deals in the carbon market.

And 230,000 tonnes worth of carbon permits are sold to Gazprom’s commercial gas customers in the UK – in this instance, a major supermarket. It’s a remarkable ‘dual-fuel’ deal. Gazprom provides the supermarket the hydrocarbon-rich gas, and it also supplies the permits to offset the consequent emission of CO² from burning the fuel. It’s a popular new product: carbon-neutral gas.

‘Zero-carbon oil’ is probably being developed, somewhere in the world, right now (the brand name could be ‘crude, with a conscience’). For detractors, carbon-neutral gas is a startling symbol of carbon-trading’s false dawn.

Last year, the detractors numbered one rather unlikely man: Andris Piebalgs, the straight-from-the-hip Baltic bruiser who serves as the European Commissioner for Energy. He shares responsibility for Europe’s pioneering four-year-old emissions trading scheme. It’s known, in the jargon, as a ‘cap-and-trade’ scheme.

Countries, certain industries and companies have their emissions of carbon dioxide capped at a specific negotiated level. The right to emit that carbon is then handed out by the government in the form of a permit. Polluters emitting carbon require a credit for every tonne put out into the air.

Emit less than your allocated permit allows and surplus credits can be sold on the market: so polluters are paid to emit less carbon. Emit more than your allocation and you need to buy new credits, a financial punishment for overpolluters. The price is then set by the interaction of supply and demand for the credits. If all traders are emitting too much carbon, the price of permits will sky rocket.

The higher the price of carbon credits, the greater the incentive for these industries to rein in their emissions. That’s the theory, at any rate.

It is complicated, but it isn’t rocket science. The real difficulty, however, is in setting up the system in the first place, which brings us back to Mr Piebalgs.

His trailblazing European Trading Scheme (ETS) tripped over itself in Phase 1. The price of carbon crashed from an effective 30 per tonne to a pointless price of €0.63 (about 50p). But when, a year ago, I cheekily asked him if the ETS had been a failure, no-one expected him to say ‘yes’. He did.

‘Yes, I would describe it as a failure. If the price is less than €1 it is a failure,’ he told me. ‘And we also know the reasons.’

Commissioner Piebalgs went on to say that the price of carbon needed to be at least €20 to €30 per tonne. ‘If you want to create a market you shouldn’t make too many compromises – and the mistakes were obvious. If you give allowances for free, on a not very clear basis, you can expect that you have too many allowances and that’s what happened.’

Phase 1 of this scheme is now over, and earlier this year the European Commission launched its plan for Phase 3, rectifying these problems. We are currently in Phase 2, which is somewhere in between. The carbon price is back up above €20 per tonne and, say traders, teething problems are being ironed out.

‘The ETS is now entering its first real phase, so it had an initial phase where people might have criticised it for not working, but it did actually achieve its objectives in that it was really only trying to set up the market,’ says Arthur Tait. ‘The problem came because in the preliminary phase people didn’t necessarily know their emissions, so it ended up, in effect, that the targets were over-allocated, which people didn’t really realise until right near the end, so that’s why the price crashed.’

There are cursory lessons from those first few years, however, and not just within Europe but in New Zealand, Australia and, above all, the USA, where horse-trading about carbon emissions has become a regular feature of the presidential debates. The hope is that within five or 10 years, all of these schemes will interact, leading to a globalised carbon trade that could save several billion tonnes of carbon.

As Piebalgs said, the problem was that too many permits were allocated to Europe’s polluters. Industry had lobbied hard in the first experimental phase of the pioneering scheme.

Europe’s polluters would play ball, but they did not want to see their share prices slump. The end result was the collapsing carbon price, and no real cuts in carbon emissions.

In 2006, UK emissions from the power sector, which is the main sector covered by the emissions trading scheme, had gone up by six per cent on the year before. The price was so low that companies and power stations were able to pollute more and just buy very cheap allowances to cover the differences.

The answer would come from politicians being far stricter on the allocation of carbon permits. But there was another problem: not only were far too many permits handed out, all but seven per cent were handed out completely free, to the worst polluters.

‘Giving out permits free is like giving out money free,’ says Professor Paul Klemperer, a Government adviser on auctions from Oxford University. ‘Having any system of emissions permits will raise consumer prices, and those price-rises automatically compensate the companies for the costs of the permits. If you then give out the permits free, you’re compensating the companies twice. There is no need to give them extra windfall profits by giving away the permits.’

The result was predictable. Carbon trading forced up the price paid for electricity in Europe, benefiting power companies. Yet for the polluters, the cost of being part of the trading scheme was precisely nothing. Europe’s worst polluters were effectively handed billions of pounds of windfall profits from the scheme. In fact, the ETS was routinely mentioned by City analysts as a reason to buy shares in power companies and other heavy carbon polluters. In the end, a scheme designed to provide incentives to cut carbon emissions only succeeded in handing over billions to the worst offenders.

Precise numbers are hard to come by. A report for WWF by analysts Point Carbon puts the windfalls to power generators in Phase 2 of the ETS between now and 2012 at an incredible £50 billion. Ofgem, the UK energy regulator, sees windfall profits at £9 billion in Britain alone, but billions have already been made in the first phase of the trading scheme, which ended last year.

No surprise, then, that major US polluters and power companies are lobbying hard for the same helping hand, the same multibillion-dollar windfalls, from embryonic US emissions trading schemes.

Even the oil supermajors are feeling a little sidelined by this bonanza. Some of the biggest oil names are lobbying for ‘upstream cap-and-trade’ in the US, where carbon credits are earned and traded by the companies actually physically removing hydrocarbons from the ground, rather than those who actually burn the oil, gas and coal.

Paying the polluters

For economists such as Paul Klemperer, this jackpot was utterly predictable. ‘An emissions permits system that’s implemented this way makes even the most polluting firms better off,’ he says.

Carbon trading in and of itself should reward clean companies, punish dirty companies and channel the world’s investment to those parts of the world where £1 can save the emission of the largest volume of carbon dioxide.

‘A tonne of carbon saved above Beijing is the same as a tonne saved above Birmingham,’ is a carbon market mantra, but free permits have, in essence, been a rather expensive bribe to get power companies to participate in the scheme. It’s an entire field of juicy carrots, with little threat of a stick.

So great has been the carbon carrot crop, in the form of multibillion-pound windfalls, that they are now the subject of a unseemly four-way scrap.

The power companies say they need to keep on to them to invest in hugely expensive ‘green energy’ sources, such as wind, hydro and even nuclear. National governments, however, can see the Euro signs ringing, and have spotted a potential fiscal jackpot. Consumer groups, meanwhile, have been decrying the rising energy prices, as well as the superwindfall profits of energy companies, and want the money to be used to cut energy prices. And then there’s Europe lurking in the background. A superstate entity with a flag but no supranational tax base. Until now?

In January this year, the European Union launched its proposals to reform the carbon trading scheme in the post-2012 Phase 3 in order to rectify the Phase 1 fiasco.

As expected, allocations are tighter, the straitjacket is more uncomfortable for polluters, so the Emissions Trading Scheme should begin to bite.

Even more importantly, however, Europe’s nations were given the green light to auction rather than donate to their polluters the right to emit carbon. Instead of being allocated for free the amount of carbon you polluted last year (known as ‘grandfathering’), Europe’s polluters would have to enter a competitive auction for every tonne of carbon they wished to send into the atmosphere.

The economists predict that the net effect of that would be a swipe of the entire multibillion-pound windfall for European exchequers: arguably the biggest tax raid in history, and one sanctioned on green grounds.

So small wonder that the Chancellor of the UK Exchequer, Alistair Darling announced that Britain would push ahead with 100 per cent auctions of carbon permits for electricity producers as soon as Phase 3 starts. ‘It’s been wrong that electricity providers have got a windfall gain,’ Mr Darling says.

It was a move announced with little fanfare at his first Budget. The ‘green tax’ measures highlighted in the next day’s papers made much of extra vehicle excise duty, worth a few hundred million pounds. One hundred per cent auctioning of carbon permits is a potential headline-grabber worth 10 to 20 times as much. Mr Darling did not disagree that it would be worth billions of pounds, but would not give a number.

‘It’s not possible to say how much,’ he said. ‘It will raise money, but it’s surely money we can use to do other things to help with climate change – for example, transport.’

It seems a rather innocuous remark, but it is important for two reasons: first the hint of hypothecation, the earmarking of a green tax for green spending. Second, it indicates that the Treasury is expecting a fairly huge windfall – the creation of an entirely new green tax base. Forget fiddling with congestion charges, a few quid extra for your high-performance engine or the renewables obligation, this is the real deal.

A green-tinged windfall

Professor Paul Klemperer has an idea how much it is worth. He was the auction theorist behind the government’s £22 billion auction of third-generation mobile phone licenses, a decade ago. He believes the Government could raise even more – between £25 billion and £35 billion over the seven-year third phase of the European Emissions Trading Scheme. Across the whole European Union, governments could raise more than £200 billion.

‘The amount of money raised will depend on a number of things,’ says the Oxford University economist. ‘The number of permits you choose to sell and technological developments, but a ballpark figure raised in the UK would be £4 billion to £5 billion per year, and in Europe six or seven times as much, which comes to £30 billion per year.’

So if you thought carbon trading was too complicated or boring to merit the attention of an eco warrior, there’s £200 billion reasons why you might well be wrong.

Mr Darling himself suggested such funds could be spent on green transport projects. As a general rule, the British Treasury is rather sniffy about earmarking taxes for specific spending pledges, but the proceeds of carbon trading are so clearly green-tinged that even the Chancellor of the Exchequer seems ready to contemplate it. The hint of hypothecation creates the ultimate game of fantasy ecologist. A fleet of British TGVs could consign the carbon-spewing Manchester-London flight to history. German-style local transport infrastructures would drive cars off the road. Investing in CCS (carbon capture and storage) or wind farms, would be another option to green our energy-consumption.

When the Conservative Party talks of ‘taxing what you burn, not what you earn’, is it talking about using these proceeds to cut income tax? These auctions could raise enough to decrease the basic rate of Income Tax from 20p to 18p.

German leader Angela Merkel has suggested that the windfall could be used to boost aid budgets in order to help meet the millennium development goals.

Or perhaps the Treasury tendency will triumph and the money could simply go towards paying down Government debt, as was the case with the proceeds of the mobile phone auction.

Another government quango, Ofgem, has already come up with the idea of using ETS windfalls to help alleviate fuel poverty. The net result of that would be a mass recycling of money. Carbon trading raises energy prices. That increases fuel poverty, but incentivises better use of carbon-based fuels. This scheme would simply lower prices again, with a spot of redistribution.The more pertinent point from Ofgem’s analysis is its estimate of the £9 billion of windfalls being made by British utilities in Phase 2, between now and 2012. Even as the Chancellor of the Exchequer himself concedes that electricity companies’ windfalls are ‘wrong’ post-2012, nothing is being done about the same £9 billion bonanza before 2012. Energy companies are beginning to go public on their unhappiness about this windfall disappearing. Shell boss Jeroen Van der Veer recently suggested that such moves could see the oil giant stop all investment in Europe. A month after those comments the company pulled out of a key wind farm investment in Britain.

Other energy companies have broken ranks, such as Centrica, owner of British Gas.

‘Over the long term, clearly it is important that power generated from high-carbon sources such as coal should start to pay the cost of those carbon emissions, and what’s been happening in Europe up until now is that a number of those coal generators have got free carbon credits, which will continue until 2012,’ says Sam Laidlaw, chief executive of Centrica. ‘What we’re talking about is the regime after 2012, and we do believe that everybody should start to pay for the carbon they’re putting into the atmosphere through an auctioning system. So we are a supporter of full auctioning from 2012.’

Centrica, alongside other energy companies, seems very wary of some sort of windfall tax being used to extend the principle conceded after 2012 to the billions being made before then. Plans to invest in expensive new greener forms of energy require huge capital investments, says the industry, but economists, such as Paul Klemperer, point out that free permits are a highly inefficient way to encourage investment in clean technology.

Climate change or energy insecurity?

Decisions over how far to go on grabbing these windfalls are at the very heart of government’s Jekyll and Hyde relationship with energy companies. Yes, governments are worried about climate change arising from burning too much hydrocarbon, and wish to coax energy companies into line, yet in the same breath they are possibly even more terrified about energy insecurity, and feel pressured to help the same companies to extract as much hydrocarbon as possible to keep European homes warm. Clearly these two agendas are not always coherent.

That can be seen back in Kingston. Gazprom’s vision is to marry its unrivalled supply of hydrocarbon gas from Siberia to Russia’s highly inefficient industrial base, ripe for carbon-saving technology. Russia could be the Opec of the carbon market.

‘We’ll instigate projects in Russia. Those projects will reduce emissions. We’ll get certificates for those and trade those here too,’ says Arthur Tait. Gazprom would become a one-stop shop for ‘low-carbon’ gas.

Could the same reductions have been achieved with regulation? Possibly, but that would have required a different set of international negotiations. A carbon tax? Well, the economists say that 100 per cent auctioning combined with cap-and-trade more or less approximates to a carbon tax, but trading is far more politically feasible in many countries than the actual introduction of a new tax.

So here’s the rub. Forget that carbon trading was a fiasco in its first years, this multibillion bribe for polluters to play ball has already been paid. There is now a huge pot of money, ostensibly being raised from people paying energy bills for ‘green’ reasons. How should this pot of tens of billions of pounds be spent? And who should spend it? Energy companies or governments? Or should it be given back to hard-pressed European consumers by cutting their energy bills, and thus totally undermine the rationale for carbon trading in the first place?

The carbon market is like no other, because it is utterly underpinned by political will. Politicians decide who gets the right to emit carbon in the first place. They then argue internationally over how this should be divided up between countries. The lesson of the past four years is that it has proved difficult enough at the European level, and yet the Stern Report and others say spreading this scheme across the whole globe is what’s really required to save the world from climate change. It’s down to the world’s politicians to show that this is not just hot air.

Faisal Islam ( is economics correspondent at Channel 4 News



This article first appeared in the Ecologist June 2006