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Cutting emissions should be a clean business, but with carbon credits used to make a quick buck it is getting increasingly dirty

The scheme set up to reduce carbon emissions has apparently led to a E15 billion windfall for the UK’s largest emitters, the power generators. So what is the Emissions Trading Scheme (ETS) and how on earth did it get things so wrong?

In ratifying the Kyoto agreement countries in the European Union committed to reduce their emissions by an average of 5% against 1990 levels over the five years from 2008 to 2012. To help cut emissions the EU set up an ETS, which allows companies to buy in credits if they are unable to make the necessary reductions. The first phase of the trading scheme ran from 2005 to 2007. Now in the second phase, which runs from 2008 to 2012, this sees companies fined E100 for every tonne of CO2 they produce over their quota. A big incentive to cut pollution surely? Well no...

As a part of the trading scheme each country produced a National Allocation Plan (NAP) which stated how many allowances it would have and how these would be distributed. The idea being that the companies would have to make up any shortfall in their C02 allocation. Every tonne of CO2 is equal to one pollution allowance and as these can be traded they have a monetary value. In the UK the costs of the credits appeared in forward electricity prices almost immediately with a sharp spike occurring from 2005 onwards.

Bad credit

The problem, however, was that the first phase allocations were so generous that some ended up with a surplus of credits and the carbon prices slumped. The electricity prices corrected themselves but the correlation between the two has remained intact. There are less ‘free’ allocated credits in the second phase of the scheme so there should be a genuine deficit of credits but power companies will still enjoy the higher electricity prices, while their allocation will ensure they don’t have to pay for the credits on the entire output.

The perceived value of carbon credits and compliance has been a driver of soaring electricity prices and UK regulatory body Ofgem has called for a retroactive windfall tax to be placed on the power companies to recoup the money consumers have paid for credits that the companies have got free. Unsurprisingly the generators maintain this will deter investors at a time when generators need more funds to invest in renewable projects.

The E15 billion windfall figure has been generated by emissions trading analysts Point Carbon, who were commissioned by the WWF (formerly World Wildlife Fund) to measure the potential profits associated with the scheme. Horrified by the outcome, the WWF suggests that Germany’s windfall could be as high as E34 billion with the UK in second place with a windfall over 2008 to 2012 of some E8 million to E15 billion. ‘We have long been critical of the ETS design faults that provide cash for coal in the name of emissions reductions,’ says Sanjeev Kumar, WWF Emissions Trading Scheme Coordinator. ‘Europe’s experience should be a stark warning to the rest of the world on the danger of free allocations of pollution permits,’ he says.

Coal power generator Drax is the UK’s largest emitter of C02, coughing out 22.1 million tonnes in 2007. Despite this, in its break down of its sum-of-the-parts valuation for the company, analysts at ABN AMRO attribute £494 million to free carbon credits, a fair whack compared with its £2 billion market cap. Granted, it is investing heavily in improving the efficiency of its coal-powered plants and was one of the unlucky few to have a deficit of credits, leading to a net carbon cost in 2007 of £172 million. In fact, if the company receives no free credits from 2013, a proposal the EU is suggesting, the impact could be as much as 44p to the company’s share price valuation according to the analysts.

Drax is acutely aware of the dangers and took the opportunity in its latest results to argue its case against a full auctioning of credits. ‘We consider [it] a precipitous move which could be destabilising for the electricity sector... the purchase of Kyoto instruments in place of C02 emissions allowances could provide significant value potential for Drax, particularly in Phase III of the EU ETS when there should be greater opportunity for these trades.’ Which gives the impression it only wants to play if it is going to get something out of the scheme.

Nuclear fallout

The real winner is nuclear energy. Nuclear generators such as British Energy have sat back and enjoyed the resultant rise in power prices caused by the carbon costs without actually having to incur any of the costs themselves. In fact, the government has even touted the potential rewards from carbon credits as one of the key economic arguments for more nuclear build. Nuclear generation creates around five grams of C02 per kilowatt hour of generation. Compare that with 360 grams for gas and around 910 grams for coal and the argument becomes compelling. If a nuclear plant saves some five million tonnes of carbon emissions in a year then with an ETS carbon price of E20 per tonne that’s worth E100 million.

Some may argue that as the company’s generation is contributing to a reduction in C02 emissions it deserves this money, but what about the radioactive waste that needs to be contained and takes years before it is safe? Surely the idea was to help improve the economics for renewable generators, not swell the coffers of companies engaged in what some regard as the dirtiest generation of all.