The future of global carbon markets. The prospect of an international agreement and its impact on business

Transcription

1 The future of global carbon markets The prospect of an international agreement and its impact on business

2 Contents Executive summary 1 Overview of existing and planned carbon markets 3 Emissions trading systems 4 Kyoto flexible mechanisms 5 Domestic offset schemes 5 The voluntary carbon market 5 Outlook: an uncertain future 6 International policy 6 The clean development mechanism and new market mechanisms 8 The private sector: role and impact 9 Conclusion 15 This report has been produced by the IESE Business School for Ernst & Young. Our thanks to Max Horstink and Jan-Willem Bode, Associates at the IESE Business School, for their valuable contribution and insights to the report.

3 Executive summary Carbon markets are fast becoming a key policy instrument to combat climate change around the world. Companies that are not already carbon constrained will need to prepare themselves for carbon legislation in the short to medium term, and a low-carbon economy in the long run. This will be challenging, but it will also bring a wealth of opportunities that proactive firms will be able to benefit from. Leading companies are already incorporating future expected carbon prices required for innovative and currently expensive technology into their decision-making process. There has been a lack of clarity in recent years about a follow up to the Kyoto Protocol (KP), the legally binding international treaty, of which the first commitment period expires at the end of this year. In the absence of strong international policy drivers, individual nations and local authorities started a bottom-up process to develop low-carbon strategies of their own. For the first time since the signing of the United Nations Framework Convention on Climate Change (UNFCCC) in 1992, all countries, developed and developing alike, reached an international climate agreement when the Durban Platform was signed at the end of However, the scope and targets of the Platform are not yet defined. The objective of ongoing negotiations is agreement on the new future climate regime by 2015, which will apply to all parties from Despite the negative attention carbon markets have received in recent times (due to low prices, uncertain negotiations and lack of an international agreement), there is a real need for business to be aware and understand these markets as constant developments, particularly at a national level (see Table 2), will increasingly impact the private sector. 2 Up until now, companies have been able to take advantage of carbon markets through flexible mechanisms such as the Clean Development Mechanism (CDM). 3 Following the negotiations that resulted in the Durban Platform, a number of new market mechanisms are now in the run-up to implementation such as sectoral mechanisms and credited Nationally Appropriate Mitigation Actions (NAMAs), 4 which could also provide new opportunities for business. Systems and mechanisms such as these are part of what is known as the carbon market. All of these market elements will affect businesses in the future on an increasingly stringent and global scale. The paper will discuss the current state of carbon markets, how they will evolve until 2020 without a global climate agreement, how the Durban Platform could affect the markets after 2020, and how and where businesses will be affected. 1 See also Into the Unknown: Climate Change post Durban, Ernst & Young, To learn more, please refer to How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, Clean Development Mechanism, one of the flexible mechanisms of the KP. For more information, see Table 2. 4 See Table 2. The future of global carbon markets The prospect of an international agreement and its impact on business 1

4 Executive summary continued Key findings of this report include the following: The private sector will need to account for obligations in new carbon market systems and prepare for it in their bottom lines, regardless of developments at the international level. Companies will have to keep track of, and anticipate, international, regional and local climate policies. In the best case, a global carbon market is created through an ambitious multilateral agreement. This would provide clarity, certainty and transparency, set a global carbon price and create a level playing field. In the worst case, no global agreement is achieved, and corporates around the world will have to get used to an expanding patchwork of local and regional regulations and a blurry set of weak carbon prices. In both cases, there will be challenges and opportunities for the private sector. Developing countries, including China, are now introducing mandatory carbon markets for businesses. Stimulated by the potentially harmful effects of climate change, developing countries are very actively implementing national climate strategies. Countries such as Brazil, Chile, India, Indonesia, Mexico and South Africa propose to reduce the growth of their emissions by China and South Korea plan national ETSs. A range of other developing countries are assessing such schemes under the World Bank s Partnership for Market Readiness(PMR) fund. 5 Opportunities already exist for businesses to get involved in the design and trials of the scaled-up market mechanisms, with the aim to capitalize later. The private sector can play an important role in the development and execution of NAMAs which can drive emissions-reduction in developing countries. Businesses should establish direct partnerships with developing countries within the scope of NAMAs. Incentives for private financiers include returns through carbon credits, opportunities to open up new markets and products, increasing brand or investor value, and risk and supply chain management. After 2020, companies are likely to be carbon constrained in all the major emitting and emerging countries, and a global carbon market could appear. After this date, all major emitters and industrialized countries could be carbon-constrained domestically, and developing countries could provide offsets on a large scale through efficient market mechanisms. The linking up of these unilateral schemes combined with scaled-up market mechanisms would lead to a global carbon market. Sectoral mechanisms may be a catalyst for a global carbon market in the longer term and some sectors may be more affected than others. Global sectoral approaches will create a level playing field for the private sector. Sectoral crediting mechanisms will become important after 2020, and are potentially pilot schemes for sectoral trading mechanisms or domestic emissions trading systems (ETSs). Sectoral approaches in developing countries, along with linking of ETSs, could thus stimulate a global carbon market. This would not be a harmonized top-down system, but rather linked up unilateral schemes combined with scaled-up market mechanisms. 5 The Partnership for Market Readiness (PMR) is a grant-based, capacity building trust fund that provides funding and technical assistance for the collective innovation and piloting of market-based instruments for greenhouse gas emissions reduction. Source: 2 The future of global carbon markets The prospect of an international agreement and its impact on business

5 Overview of existing and planned carbon markets There is no global carbon market yet, but rather a dispersed set of regional markets at varying jurisdictional levels. The current carbon markets 6 are comprised of four main systems: Emissions trading or cap-and-trade systems for energy-intensive business sectors and governments Kyoto flexible mechanisms such as the CDM, both on a public and private level Domestic offset schemes The voluntary carbon market Table 2 provides details of these markets mechanisms. At present, there are a number of subnational, national and supranational voluntary and mandatory cap-and-trade schemes active in the EU, the US, Australia, New Zealand and Japan. 7 Developing countries such as China and South Korea are following suit. These schemes are usually designed as an important pillar in the overall climate change policy framework and mostly involve businesses. In the run up to the implementation of the Durban Platform, alternatives such as sectoral mechanisms and credited NAMAs are being considered. 8 All of these systems involve trading of carbon credits or allowances and are thus elements of what is known as the carbon market. All of these market elements will affect businesses now and in the future in one way or another. 9 According to the World Bank, the total value of the global carbon market in 2011 was US$176b. 10 From 2005 until 2011, the global market grew rapidly, from an initial value of US$11b. China will soon start a number of regional pilot schemes [for an ETS], and could have a national scheme in place by The largest driver for all the current carbon and climate regulation activity is the KP to the United Nations Convention on Climate Change, setting binding targets for 39 of the world s industrialized nations to reduce greenhouse gas emissions over the five-year period A second commitment period was negotiated at the end of 2011, albeit without Russia, the US, Canada and Japan. 7 Supranational level: Kyoto signatory countries, European Union ETS; national level: New Zealand; subnational level: US (Regional Greenhouse Gas Initiative), Australia (NSW). See also Table 2. 8 See Table 2. 9 To learn how, please refer to How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, State and Trends of the Carbon Market 2012; World Bank. The future of global carbon markets The prospect of an international agreement and its impact on business 3

6 Emissions trading systems Companies are increasingly affected by both voluntary and mandatory emissions trading systems (ETSs) around the world. At present, the European Emissions Trading System (EU ETS) takes up between 84% and 98% of the value of all carbon markets. 11 It covers energy-related emissions and process emissions from specified industrial activities. This includes power stations, refineries and offshore operations; iron and steel; cement and lime; paper; food and drink; glass; ceramics; engineering; and vehicle manufacture. The EU ETS covers about 50% of the EU s total CO 2e. In the US, the Regional Greenhouse Gas Initiative (RGGI), a regional cap-and-trade system involving the power sector in nine states and provinces in the US, has been active since New Zealand has an active national ETS and Australia has recently passed laws to follow suit from The next few years will see a number of countries and states introduce cap-and-trade systems to join the more established EU ETS. In 2013, California, the world s eighth-largest economy, will introduce a cap-and-trade system, which will become the world s second-largest ETS. This state-wide system will initially cover the power sector and large industrial facilities, which account for around 85% of California s greenhouse gas (GHG) emissions. From 2015, the system will be expanded to cover distributors of residential, commercial and transport fuels. The California ETS is designed to link up with other programs in order to increase environmental effectiveness and efficiency. The world s two biggest emitters, the US and China, are also contemplating national ETSs. Although the plans in the US have been deferred indefinitely due to the financial crisis, China will soon start a number of regional pilot schemes, and could have a national scheme in place by There are discussions about including the aviation sector. Korea is planning to launch a nationwide ETS by However, the bill to enact it has not yet been approved by Parliament. A number of other developing countries are assessing domestic trading schemes using grants from the World Bank s PMR fund. 14 These include Brazil, Chile, Mexico, Colombia, Thailand, Vietnam, South Africa, Turkey and Ukraine. The Mexican Government has already passed a climate bill that includes a domestic ETS. Most schemes are active at private sector level, except for the UN International Emissions Trading mechanism, which is one of the flexible mechanisms under the KP that takes place at government level only. Table 2 lists all active and planned ETSs. An important development in the carbon markets is the linkages of domestic systems. Australia and the European Commission agreed in August 2012 on a pathway toward fully linking their ETSs by This will allow the participants (businesses) of the two schemes to buy and use each other s carbon allowances. In 2008, Norway, Liechtenstein and Iceland connected their systems to the EU ETS. The EU has been discussing linkages to the Californian and Swiss ETSs as well, with a vision of an OECD-wide carbon market by 2015, extended to developing countries by This trend is important as it not only increases environmental and economic efficiency, but moreover, sets a path toward a global carbon price and a level playing field for businesses. 11 The EU ETS could theoretically make up almost 98% of the total market when taking into account the value of the secondary CDM market, which is driven mainly by the EU ETS. However, there is also demand from governments, as well as companies in Japan, New Zealand and from the voluntary market. Source: State and Trends of the Carbon Market 2011; World Bank, 2012 (2). 12 Australia has introduced a carbon tax from 1 July 2012, which will transition into an ETS by A recent report finds that 2015 may be too early for China to launch an ETS. Source: China s Carbon Emission Trading: An Overview of Current Development; Guoyi Han, Marie Olsson, Karl Hallding, David Lunsford; 2012 FORES. 14 The Partnership for Market Readiness (PMR) is a grant-based, capacity building trust fund that provides funding and technical assistance for the collective innovation and piloting of market-based instruments for greenhouse gas emissions reduction. Source: The future of global carbon markets The prospect of an international agreement and its impact on business

7 Kyoto flexible mechanisms The EU has been discussing linkages to the Californian and Swiss ETSs... with a vision of an OECD-wide carbon market by 2015, extending to developing countries by Flexible mechanisms were established under the KP to provide the industrialized country signatories with alternatives to reducing greenhouse gas (GHG) emissions domestically. There are three mechanisms: International Emissions Trading Joint Implementation (JI) The Clean Development Mechanism (CDM) 16 A second commitment period to the Protocol was negotiated at the 17th Conference of the Parties (COP 17) in Durban last December. This implies that the flexible mechanisms will continue until 2020 at least. Domestic offset schemes Domestic offset schemes are seen as a mechanism to stimulate further emission reductions and abatement investments in the non-traded sector. Project activity is carried out in the investor country and no other country is involved. 17 The voluntary carbon market Compared with the mandatory and voluntary cap-and-trade systems, the unregulated voluntary carbon market (VCM) is a very distinct carbon market. Although in terms of volume this market represents less than 0.3% of the global carbon market, it is interesting from a corporate strategy point of view and because of the rapid growth of the market. It provides carbon offsets to compensate for GHG emissions that are not covered by the compliance schemes. 16 See Table 2 for details. 17 See Table 2 for details. The future of global carbon markets The prospect of an international agreement and its impact on business 5

8 Outlook: an uncertain future International policy After the disappointing meeting of all countries that are part of the United Nations Framework Convention on Climate Change (UNFCCC) during Conference of Parties (COP) 15 in Copenhagen in 2009, the developments and future of carbon markets seemed to shift from a top-down to a bottom-up approach. Individual nations and local authorities were forced to develop low-carbon strategies of their own in the absence of strong international policy drivers. However, faith in the multilateral process was somewhat restored at the COP 16 talks in Cancún in For the first time since the signing of the UNFCCC in 1992, all countries, developed and developing alike, reached an international climate agreement when the COP 17 Durban Platform was signed at the end of Or rather, it was an agreement to agree in the future. Until 2020, climate policy will be driven by the domestic efforts of individual countries. Durban outcome The main decisions taken in Durban concern a mix of temporary commitments and tools. 18 The temporary commitments were: 1. Implementation of the voluntary pledge and review agreements through to 2020, which were previously initiated at COP 15 and COP Extension of the KP for a second commitment period until 2017 or 2020 without the US, Russia, Japan and Canada The Durban Platform for Enhanced Action a negotiation track that aims to agree on the targets and scope of a new future climate regime by 2015, applicable to all parties from 2020 Other important decisions taken in Durban concern mitigation, adaptation, technology and financing tools that need to be 21, 22 further developed over the next four years. The Copenhagen Accord and Cancún Agreements, established at COP 15 and COP 16, acknowledged the need to limit the global temperature increase to 2ºC or below, which scientists believe is needed to avoid the dangerous effects of climate change. However, the commitments made so far put us on a path to a temperature increase of 3.5ºC or more, which means there is an ambition or emissions gap. 23 This puts pressure on the level of commitment that needs to be agreed upon by 2015 under the Durban Platform, both in terms of targets and financing. Furthermore, it is important to notice that the nature and scope of the post-2020 agreements is by no means determined. Durban established an Ad Hoc Working Group on the Durban Platform for Enhanced Action (AWG-DPEA). This AWG-DPEA has the mandate to develop a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all parties. 24 A number of challenges need to be overcome: Targets still have to be defined. They could end up being weak and unable to drive domestic abatement. Even if it is ambitious, it is not clear whether the agreement will be sufficient to stabilize temperatures without increasing the scope of the individual voluntary Cancún pledges made until The option of an agreed outcome with legal force is ambiguous and, if chosen, may be viewed as not legally binding See also Into the Unknown: Climate Change post Durban, Ernst & Young, The Cancún Agreements of COP This means less than 15% of global emissions are covered by the Kyoto second commitment period. 21 Such as the development of a registry of developing countries National Appropriate Mitigation Actions (NAMAs) that will support the matching of NAMAs with finance. 22 Developed countries commitment to mobilize US$100 billion per year from 2020 for climate change mitigation and adaptation will be partly channeled through the UN-governed GCF. 23 Source: Climate Action Tracker 2011; 24 UNFCCC COP decision 1/CP The future of global carbon markets The prospect of an international agreement and its impact on business

9 The KP was signed by the US, but not ratified, leaving the world s largest emitter free of obligations when it came into force in There could potentially be opt-outs for countries under the Durban Platform as well. Canada may have set a dubious precedent by formally withdrawing from the KP. Pulling out of Kyoto before the end of the first commitment period allowed Canada to avoid paying penalties of up to CAN$14b (US$13.6b) for missing its targets. 26 Although Kyoto was legally binding in terms of targets committed to, a party has the legal right to withdraw from the Protocol. 27 It remains to be seen how a withdrawal right is dealt with in the implementation of the Durban Platform, as it could decrease confidence in a new deal. On the positive side: The agreement politically unites all countries and provides some certainty that there will be a legally binding outcome with commitments from all major emitters. The Durban Platform calls for more ambitious commitments than established in the Cancún pledges. Targets for the second commitment period of the KP still need to be negotiated and, in return for ratification, the EU may demand higher ambition from the Cancún pledges. The Durban Platform timeline may also provide the parties with adequate time to thoroughly prepare the road map and negotiations, and overcome the global financial crisis. Consensus among all parties will need to be reached on the three legal options (a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all parties) for the post-2020 agreement. The majority of parties will favor a legally binding agreement comparable with the KP, as opposed to the weaker third option. Meanwhile, independent of international policy developments, the bottom-up approach continues, with all kinds of domestic initiatives around the world. 28 The finance gap The private sector is the source of 86% of global investment, and therefore has a key role to play within climate finance. 29 Business involvement is critical in getting the large-scale investment and emissions reductions needed to address climate change. However, to utilize private sector funds, a strong commitment from the public policy sphere is needed. For climate goals to be set, arguably the two key issues to resolve are ambition and finance. Carbon markets are an important tool to reach the science-based emissions reduction goal and, as such, depend on putting an end to the financing hiatus. At COP 15 in Copenhagen, the international community agreed on fast-start financing of US$10b per year between 2010 and 2012, and subsequently mobilizing US$100b annually from 2020 for climate change mitigation and adaptation. It is not yet clear how this money will be structured nor what will happen between 2013 and Part of the US$100b will be channeled through the UN-governed Green Climate Fund (GCF). Furthermore, to close the emissions gap the World Economic Forum estimates the annual low-carbon funding requirement to be US$500b by 2020, while actual clean investment was valued at US$243b in The US$100b commitment is not enough to close this gap. Private finance is expected to cover a fair share of the deficiency, but the design of the funding is not yet worked out. A possible structure is that private finance is invested in CDM projects. Alternatively, a new market mechanism (see page 8) could bring returns through carbon credits or other projectrelated upsides (for example, electricity revenues). Further incentives for private financiers include the possibility to open up new markets and products, increase brand or investor value, and risk and supply chain management. 31 At any rate, financial participation of the private sector will require a strong commitment from the public policy sphere. 25 World Resources Institute 2011; 26 Source: Vancouver Sun, 12 December 2011; 27 Article 27 of the KP allows countries to withdraw three years after the Protocol is in force, and with a year s notice See page 4 on ETSs. 29 Fact sheet Financing climate change action, UNFCCC website, accessed 6 March Source: World Economic Forum and Bloomberg New Energy Finance (2011) Green Investing 2011: Reducing the Cost of Financing. 31 This is discussed at length in How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, The future of global carbon markets The prospect of an international agreement and its impact on business 7

10 The clean development mechanism and new market mechanisms To date, the CDM has been the main international mechanism for mitigation in developing countries. However, its slow bureaucratic process, complex design, costs and sensitivity to fraud have all drawn criticism. In addition, to achieve the large-scale emissions reductions that are required to combat climate change, the mechanism has proved limited. For these reasons, the UNFCCC has been working on significant reforms while alternative mechanisms have also been proposed to scale up offsetting volumes. 32 A number of new mechanisms are being considered to scale up offsetting in developing countries, namely bilateral and sectoral mechanisms, Reducing Emissions from Deforestation and Forest Degradation (REDD+) and credited NAMAs. These all aim to scale up the CDM significantly. Most of these mechanisms are still being designed and they are not likely to be launched before However, as Table 1 shows, they can present significant opportunities to the private sector. Discussions on NAMAs will be key for the business community. Companies with prior experience in the carbon markets are set to gain most as new mechanisms emerge. NAMAs can significantly reduce developing countries emissions, and they are likely to be implemented. As funding is essential, and public finance is limited, the private sector has an important role to play in the development of NAMAs. Developing countries should therefore establish direct partnerships with business within the scope of NAMAs, rather than solely rely on the GCF, in which the private sector will probably also invest. This kind of dual approach will speed up low-carbon development and increase efficiency. Table 1: new market mechanisms New market mechanisms Description Status Private sector involvement Bilateral offsetting crediting mechanism Agreement between a country with international emissions reduction targets and developing countries without such a target. The scheme will have similar objectives to the CDM, yet with a simplified administrative process and on a larger scale. Japan currently funding pilot projects. As with CDM, the private sector has a similar role to play through investments in return for offsets. REDD+ Mechanism to stop global deforestation by offering developing countries financial incentives to preserve forests in return for carbon credits. COP 16 in Cancún delivered an international agreement on the formation of the REDD mechanism. However, the design has not been established. Mechanism currently only operational in the voluntary carbon market. Key issue in the design is finance. Public finance will not be adequate for this kind of funding, which means that much depends on the private sector. At present mainly financials are involved in the carbon market forestry sector, financing projects in return for carbon credits for speculative or CSR purposes. Sectoral crediting mechanisms Design not established, however common idea is to credit emissions reductions achieved on aggregate in a specific sector below a certain predefined baseline. The scope could either be on sectors within one country or across sectors internationally. Subject to design and negotiations. As with CDM, the private sector has a role to play through investments in return for offsets. Sectoral trading mechanisms (Developing) country committing to legally binding emissions reduction targets for specific sectors under the UNFCCC umbrella. Rules and requirements would be comparable to an ETS. Subject to design and negotiations. Companies would be subject to a compliance regime such as through an ETS. NAMAs Very broad definition for voluntary emission reduction measures undertaken by developing countries that meet the needs of their specific national circumstances. They are expected to be one of the main vehicles for mitigation action in developing countries under a future climate agreement, and can take the form of policies or actions implemented at national, regional or local levels. NAMAs can be project-based (like the CDM), sectoral, or nationwide (for instance as an ETS). Possible inclusion of carbon crediting mechanisms. Scope and design unclear. As funding is essential, and public finance is limited, the private sector has an important role to play. Potential to present vast opportunities for companies. 32 Aiming at decreasing the administrative burden and transaction costs by introducing more automatic additionality testing as well as standardized baselines. 8 The future of global carbon markets The prospect of an international agreement and its impact on business

11 The private sector: role and impact So how are corporates affected by the carbon markets in different regions? We have seen that an increasing number of countries are implementing cap-and-trade systems. In the Ernst & Young paper How do companies do business in a carbon constrained world, published in March 2012, it was argued that the financial impact cap-and-trade schemes have had on corporates so far has been small or positive, but this will change. 33 The effect of carbon markets on a company s bottom line depends greatly on the maturity of the specific market, the rules and allocation methodology, and whether sectors are able to pass on costs. 34 Schemes like the EU ETS are usually divided into distinct phases, which allows for market improvements. During the first two phases of the EU ETS, there has been either only a slight or positive impact on corporate financials. But, in our view, as allocations become more stringent, the gap between high performers and low performers will widen. It is likely that the California cap-and-trade system that starts in 2013 and all other subsequent schemes will have a similar phased development. It will be interesting to assess the economic implications for the private sector of the current new trend for carbon compliance markets expanding to developing countries. 35 Will China and South Korea become more expensive after carbon regulation is introduced? Would there be advantages in investing in emerging markets as opposed to mature markets? How fast will the economic gap narrow? Factors to consider here include the type and scope of the global agreement, and whether sectors and markets will be linked. However, in the short to medium term, the rate of economic development will probably be much more influential than implementation of carbon legislation. Up to 2020 Although many businesses around the world will remain unaffected by carbon markets until 2020, those in the US, China, South Korea and Australia will need to look at setting up a carbon management strategy, monitoring emissions, learning how to trade carbon and lobbying the authorities. 36 The aviation sector may argue differently, in that it will be affected by carbon markets, as it claims to have limited options for abatement. However, as with the utilities, costs can be passed on to customers. It would be in the interest of the aviation sector to negotiate a global sectoral approach through the International Civil Aviation Organization (ICAO) as soon as possible. The recent international political disagreement over the inclusion of aviation in the EU ETS demonstrates that governments are predominantly focused on national interests rather than the bigger picture. 37 As well as those countries in the process of planning carbon markets (US, China, South Korea and Australia), firms in emerging markets will also need to start preparing as the shift in economic power from developed to developing economies accelerates. China and India will be the first two new economic powers. This places a responsibility on their shoulders and will put pressure on them to show leadership. China is already responding to this by easing up its stance in the climate negotiations. China is willing to take on targets after 2020 and is planning a national cap-and-trade system by India still has over half a billion poor people, but has developed a national climate strategy and implemented market mechanisms. 38 Although this is largely driven by their vulnerability to climate change, it also shows that the economics are changing. China and India will be the first countries to catch up, but nations in Latin America and Africa will not be far behind. 39 An interesting question is whether companies will be similarly affected under carbon regulation in the EU, California and China. As the EU ETS is far more mature, targets will be more stringent in the EU, and companies more experienced at monitoring emissions, and at carbon and trading strategies. However, that does not necessarily imply that EU companies will implement more expensive low-carbon measures, as that will be determined by the carbon price. Unless the EU ETS links up with the California and China ETSs (as mentioned earlier it has already agreed to link up with Australia), carbon prices will be different in each system. Prices will be subject to market fundamentals such as stringency of targets, fossil fuel prices, weather fluctuations and the underlying economic situation. 40, 41 As such, companies in China could theoretically be subject to higher carbon prices and more inclined to implement abatement measures. Given its maturity, market prices in the EU should be higher in the coming decade. 33 How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, i.e., installation versus sectoral approaches, free allocations versus auctioning. 35 See page 4 on current and planned carbon markets. 36 As discussed in How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, 2012, even Phase III of the EU ETS does not affect the participants much, as most of the sectors still get 100% of their allowances for free until At the beginning of the year, there was political turmoil when 23 countries including India, Russia, China and the US opposed the EU law to include airlines in the EU ETS covering all flights landing on or taking off from European soil, implying that non-eu carriers will also be affected by European carbon constraints. 38 Following on the 2008 National Action Plan on Climate Change (NAPCC), India launched two market-based mechanisms, a pilot energy efficiency certificate scheme in 2008 and a renewable energy certificate (REC) system in Source: The Economist, The World Economy a game of catch-up; September The trend of fossil fuel prices in general, and the relative price differential resulting from fuel switching from coal to gas appear to drive the matching trends in carbon prices. 41 Examples include the lack of hydropower in Norway or Spain due to dry weather conditions, hurricanes and more general changes in temperature and precipitation. The future of global carbon markets The prospect of an international agreement and its impact on business 9

12 Carbon prices have fluctuated dramatically over time, briefly reaching over 30 per tonne CO 2e in mid But in the past couple of years, the European Union Allowance (EUA) price (the current reference price in the carbon market) has not exceeded (US$19 US$26) per tonne CO 2e. 42 Most next-level abatement opportunities will need prices significantly higher than that to encourage companies to make the necessary investment decisions. However, due to a combination of post-2012 policy uncertainty and the Eurozone s worsening debt crisis, current EUA price levels are well under 10 per tonne CO 2e, and secondary Certified Emissions Reduction (CER) prices are even under 2 per tonne CO 2e. 43 This limits low-carbon actions to the cheapest of options on the abatement curve. Consequently, companies are more likely to purchase carbon credits on the market, thereby hampering investment in other options. Market analysts expect prices to recover somewhat during Phase III ( ) of the EU ETS. Depending on market fundamentals, quoted prices range between 10 and 25 per tonne CO 2e for the period Forecasts from before the economic crisis in 2007 saw a range of per tonne CO 2e for this period, which highlights the sensitivities of market analysis, particularly in terms of timing. In general, the carbon price should increase over time as markets mature and are expanded. In its emissions projections models, the UK Government uses prices of around 40 per tonne CO 2e in 2030 and over 100 per tonne CO 2e in Further important factors that a business must consider include the allocation rules and the politics that surround sectors. For instance, the power sector in the EU has been chosen by the European Commission to make large cuts in emissions to reach the overall target set for the EU ETS. The EU and California systems both target large emitters such as the power sector and large industrials. However the EU ETS, for example, will include the airline sector, while the California ETS will focus on emissions from residential, commercial and transport fuels. So at an international level, companies are affected in a different manner. In addition, the European Commission decided to protect certain sectors from competitive distortion outside the EU by granting them 100% of their allowances for free up until Therefore, until 2020 the impact on the private sector mostly relates to the administrative burden of entering an ETS rather than the negative effects on a company s balance sheet. During the same period, while the Durban Platform are being implemented, opportunities will exist for businesses to get involved in the design and trials of the scaled-up market mechanisms, with the aim to capitalize later. After 2020 The main conclusion regarding the implementation of the Durban Platform is that much uncertainty remains. The world gave itself four more years to come to terms with battling climate change. Although this may concentrate minds, many questions remain unanswered. What kind of commitments can we expect? Will there be any new market mechanisms to scale up emissions reductions? What is the effect on the shape and scope of carbon markets? Will companies be carbon constrained in the same way in China, the US and the EU? Scenarios We can attempt to answer these questions through a set of three distinct theoretical scenarios. Scenario A: Ambition A comprehensive, clear and ambitious multilateral agreement takes effect in All countries take on targets on an equity basis, with the major emitters and industrialized nations generally agreeing to cut emissions and developing countries generally accepting to limit the amount by which they increase emissions. 46, 47 New market mechanisms such as bilateral and sectoral approaches, NAMAs, and avoided deforestation schemes (REDD+) are implemented. Scenario B: Weak agreement A weak global agreement is reached, with targets that will not drive serious domestic mitigation. Some new market mechanisms will be implemented. Scenario C: No agreement There is no agreement whatsoever, the global financial crisis continues and countries pursue other priorities rather than responding to climate change. In effect this shifts us back to unilateralism and a bottom-up approach, where only a number of ambitious countries, regions and local authorities take the problem seriously. 42 At present the EU ETS takes up between 84% and 97% of the value of all carbon markets. The EU ETS could theoretically take up to 97% when taking into account the value of the secondary CDM market, which is driven mainly by the EU ETS. However, there is also demand from governments, as well as companies in Japan, New Zealand, and from the voluntary market. Source: State and Trends of the Carbon Market 2011; World Bank, At time of writing September 2012; source: 44 Société Générale sees an average price of over this period due to oversupply of allowances, a worsening EU economic outlook, and an expansion of low-carbon energy sources. Deutsche Bank thinks the 2020 price could reach if the European Commission tightens the EU ETS cap next year, in absence of that price could remain below Source: 46 Under the principle of common but differentiated responsibilities the KP placed a heavier burden on developed nations as they were responsible for climate change. 47 Under the KP the EU-15 collectively agreed to cut emissions by 8% by 2012 compared with 1990 levels. Under the burden sharing agreement some countries agreed to cut emissions while others would limit the increase of emissions. 10 The future of global carbon markets The prospect of an international agreement and its impact on business

13 Scenario A: Ambition An ambitious global climate treaty involving all countries agreed by 2015 will mean a large boost for low-carbon development and domestic action. This top-down approach will basically accelerate global action on all levels. It will stimulate developments in the carbon markets, increase and accelerate the chances of a true global carbon market, and a global carbon price or, more likely, prices. It will stimulate more nations, including developing countries, to implement domestic market mechanisms such as ETSs and domestic offset. These markets will aim to link up in the longer term. Sectoral approaches and mechanisms may be introduced, eventually leading to global systems. Under such a scenario, sectoral crediting mechanisms may become an important instrument, although it could be in the longer term only. The EU ETS is using sectoral compliance approaches for the third phase of the scheme, which starts in At present, developing countries do not share the EU s enthusiasm for the inclusion of voluntary sectoral offset mechanisms in the UNFCCC process. They regard them as potential predecessors to sectoral targets. However, countries such as China and Korea are planning domestic ETSs, and other emerging countries are contemplating such schemes, which basically put targets on sectors. Sectoral crediting mechanisms are potentially pilot schemes for sectoral trading mechanisms or domestic ETSs and therefore it is feasible that developing countries will use these mechanisms to gain experience for future decision-making. Supporting sectoral approaches in developing countries, as the EU does, could thus be a visionary way to stimulate a global carbon market. Conversely, as many countries are already considering domestic cap-and-trade systems, these could also be linked perhaps partially through sectoral mechanisms. 49 In this scenario, the first global sectoral schemes could be launched by Sectors such as aviation and shipping are already being scrutinized and could be the first sectors to see targets. In general, the ideal candidates will be carbon-intensive sectors with few actors that are able to pass on costs. They are relatively easy to manage and no competitive issues will arise from a global approach. Initial candidates besides the aviation and shipping sectors are the cement sector, iron and steel, and power generation. Sectoral mechanisms could help create a global carbon market along with linking emissions trading programs. Ultimately, global sectoral approaches will create a level playing field for the private sector. However, developing countries may initially argue that this goes against the common but differentiated responsibilities principle. Scenario A will also mean a new chance for the US Federal cap-and-trade scheme that was deferred in 2010 as well as the South Korean ETS plans. In the US, it will be important that the California ETS runs smoothly. By then it will have run for three years, and will provide important management information to the Federal government. The result of November s presidential election may influence the international environmental policy stance of the US, although much will depend on the stance of the House of Representatives. A China national ETS is planned for 2015, the same year as the deadline for a decision on the post-2020 international climate regime. Preparation for the ETS will help the Chinese to determine the extent of their future commitments. 50, 51 These new programs, together with the EU ETS, will potentially create a large demand for international offsets, which would need to be met through new market mechanisms. The CDM will not suffice. This will be the preferred scenario for the private sector. Most of the world s top 500 companies are already carbon constrained through regulations, and the rest of them expect to be in the short to medium term. They are taking action and are proactively lobbying their governments. 52 As discussed above, regardless of the negotiations at international level, an increasing number of countries and local authorities are implementing their own carbon regulation. This will affect firms in an increasing number of sectors. As the majority of these companies are multinational, they realize that to reduce regulatory uncertainty and increase competitiveness, a global agreement is needed in order to steer and linkup this patchwork of local regulation. Scenario A is therefore more in their interests than a diversified, discordant bottom-up trend. Such an agreement would provide the certainty and continuity needed to leverage private finance and move mitigation up the abatement curve. 48 The EU is setting pan-european sectoral caps and introducing benchmarking systems into the EU ETS from See Table A recent report however finds that 2015 may be too early for China to launch an ETS. Source: China s Carbon Emission Trading: An Overview of Current Development; Guoyi Han, Marie Olsson, Karl Hallding, David Lunsford; 2012 FORES. 51 Under the Cancún Agreements China pledged to cut carbon intensity by 17% by 2015, compared with 2010 levels, and cutting energy consumption intensity by 16%, relative to GDP. 52 See also: How do companies do business in a carbon constrained world: investment decisions and bottom line, Ernst & Young, The future of global carbon markets The prospect of an international agreement and its impact on business 11

14 Scenario B: Weak agreement A weak agreement will create uncertainty for business that could deter investment and undermine economic growth opportunities. Global supply of carbon allowances and offsets will exceed demand and carbon prices will remain low. Mitigation actions will still be defined by the left (cheap) side of the marginal abatement curve. Initiatives and markets will try to link up with each other to drive efficiency. Bilateral crediting mechanisms, NAMAs and REDD+ may still be launched but with limited scope, as demand will not be sufficient to accommodate large-scale offsetting. Carbon markets will thus fail in their objective to stimulate large-scale abatement in a cost-efficient way. For the private sector, this means more burden than opportunity. The bottom-up trend will see new carbon markets rise around the world, with varying rules and regulations. The administrative burden will be heavy. 53 At the same time, the private sector will not fully reap the benefits. Carbon prices remain low and provide little incentive to reduce emissions. This limits opportunities for the development of new services, products and investments, and to gain competitive advantages. In addition, this scenario will obstruct the UNFCCC goal of limiting global temperature increase to 2ºC. Physical risks such as natural resource scarcity and adaptation costs for companies would intensify. As such, this is not the 54, 55 preferred scenario for business. Scenario C: No agreement Under Scenario C, the international community fails to establish a multilateral agreement. 56 In effect, this means stepping back to a slow, bottom-up approach where a limited but slowly increasing number of nations and local authorities take action. The EU ETS and the California cap-and-trade systems will still move forward, and other countries will still implement new domestic policies and actions. But a common driver like the KP will be lacking, and the pace of global climate action will be slow. International financing mechanisms will have a limited scope and a myriad of regulations and schemes would evolve, following country-specific vision and needs. On a global level, security of supply and selfsufficiency would be the main drivers of low-carbon action, rather than climate change concerns. Ideal scenario A global climate treaty with long commitment periods, such as in scenario A, will provide an overall framework for national policies. It will make them more compatible and thus provide clarity and continuity for private investment. It could also level the international playing field for carbon-constrained firms, as governments would be less hesitant to implement more stringent measures and raise their ambition. After 2020, Scenario A will also stimulate high carbon price levels at a faster pace than the alternative scenarios. However, under Scenarios B and C progress will be very slow, because Governments will be afraid of competitive issues. As a result, carbon prices will remain low. Such a bottom-up process, which undermines economic efficiency and brings uncertainty, is not a preferred scenario for companies. Under Scenario C it would be unclear whether there will be a future international agreement, whether the impact of climate change will encourage companies to develop appropriate policies, and whether domestic or local bottom-up policies will continue without disruption. It is unlikely that companies will be on a level playing field and, furthermore, the global carbon price will be very much diminished. 53 See also: How do companies do business in a carbon constrained world: investment decisions and bottom line ; Ernst & Young; See also: How do companies do business in a carbon constrained world: investment decisions and bottom line ; Ernst & Young; It is estimated that adaptation costs will double with a 3ºC global average temperature rise. Source: Climate Action Tracker 2011, 56 See also: Into the Unknown: Climate Change post Durban, Ernst & Young, The future of global carbon markets The prospect of an international agreement and its impact on business

15 Adaptation In each of these scenarios, adaptation will become increasingly important. Scenario C will be the first to see climate change enter detrimental levels. The resulting physical risks will also impact the private sector. In the longer term, extreme weather may disrupt supply chains and damage physical assets. Sourcing may become problematic, and water scarcity could increase costs and interfere with manufacturing. Developing countries will be hit hardest. Dealing with the physical impact of climate change will require advanced risk management capabilities, in addition to robust models that encompass the various threats to which a company is exposed. Companies will need to develop adaptation strategies that include development of new services, products and investments and take into account effects on the supply chain and how resource scarcity could affect their bottom line. Businesses that are proactive will have an important strategic advantage and could potentially create value from it. Even if the world gets serious about preventing climate change, adaptation is a topic that firms will have to consider. Preparation and opportunities for business Regardless of the scenario, the road toward a low-carbon economy is bound to be a long and difficult one. The main accomplishment so far is that there has been an important shift in mentality and awareness. Leading businesses are preparing themselves through advanced risk management strategies and are following and participating in the international debate on climate change. They are working together with governments on ways to make carbon markets more efficient. The Japanese Government is working together with corporations such as Mitsubishi to design an effective Bilateral Offsetting Crediting Mechanism. 57 Under the European Technology Platform for Zero Emission Fossil Fuel Power Plants (ZEP), the European Commission is collaborating with utilities and petroleum companies such as Shell on an implementation framework for carbon capture and storage (CCS). The South Korean Government has asked European businesses for feedback on the EU ETS in order to develop their own cap-andtrade system effectively. Many multinationals recognize the opportunities associated with the scale-up of carbon markets, especially with future NAMA developments. Effective private sector participation in large-scale investment in emissions reduction projects requires clear market signals. Financial innovation is also key to unlocking the capital markets in order to fund the billions of dollars required to transform our economies to a low-carbon model. The appetite is there. Global investments in clean energy and technology increased by 30% to US$243b in 2010, despite the economic downturn. Cleantech investments not only offer a significant new opportunity, they also provide a means for companies to deal with a range of issues such as volatile energy prices, energy security, policy risk and natural resource scarcity. 58 Leading companies are already incorporating the expected future carbon prices into their decision-making process. An example is the current investments in CCS that would not have a sound business case under the current level of carbon prices. Companies such as Shell believe this technology would be economically sound under future carbon price scenarios. 59 A recent survey conducted by Ernst & Young found that more than half (54%) of the companies who responded believe that addressing climate change is an opportunity for their business. 60 However, at the same time, the survey showed that many companies remain unsure about how to take advantage of climate change-linked investment. 57 See Table The average annual growth rate between 2004 and 2008 was 37%, with a standstill in Source: World Economic Forum and Bloomberg New Energy Finance (2011) green Investing 2011: Reducing the Cost of Financing. 59 As discussed earlier, Shell is investing in CCS technology. 60 Durban Dynamics: navigating for progress on climate change, Ernst & Young, The future of global carbon markets The prospect of an international agreement and its impact on business 13

16 The end game Businesses across the world must prepare for a future where they are carbon constrained. Firms in developing countries that proactively engage now with low-carbon and adaptation strategies will gain a competitive advantage and reap the benefits later, when the countries in which they operate implement carbon policies. Developing countries are already very actively implementing national climate strategies (unlike some developed countries) because they will be hardest hit by climate change. These policies will rapidly mature and evolve over the years to come. Additionally, an increasing number of countries, developed and developing alike, have implemented or plan to implement carbon taxes. Sectors affected by these changes, such as utilities, are generally able to pass on the cost of carbon to their customers. However, those that anticipate carbon constraints have much to gain by refitting their equipment early, as allocations will be determined either through benchmarks or historical data. Will there be a true global carbon market? A global carbon market would create a worldwide level-playing field for companies. This could be imaginable for certain sectors such as cement, and iron and steel, which are characterized by few actors globally. Regulatory certainty is, however, a very important factor in decisions on clean technology investments. It is critical that authorities create trust and stability in the market as well as incentives for long-term investments. The most effective way of achieving this is through a robust global climate agreement in combination with similarly ambitious, complementary unilateral policies. Most companies would prefer rigorous, well-designed, transparent and long-term carbon regulation over less stringent, but more uncertain, regulation. A strong international agreement on climate change mitigation is therefore in the interest of the private sector. Carbon markets are a key mechanism of future climate finance, but they need to be expanded and reformed. There are high expectations from new scaled-up market mechanisms, but a demand for their credits is essential for them to be effective. According to many analysts, this would require higher mitigation targets in Annex I countries for any future carbon markets. Cap-and-trade systems in the US, China and the EU and other countries could also boost demand for international offsets. 61 Additionally, a decision at Durban to design new, market-based mechanisms could include a common core set of rules and procedures at the international level to allow for different forms of national implementation. This set of rules would define sectors and coverage of gases; criteria for determining baselines; sector targets and guidelines for monitoring, reporting and verification. The new and current mechanisms should co exist and could become an avenue to support NAMAs. Carbon markets are a key mechanism of future climate finance, but they need to be expanded and reformed. There are high expectations from new scaled-up market mechanisms, but a demand for their credits is essential for them to be effective. 61 Annex I Parties to the KP include the industrialized countries that were members of the OECD (Organisation for Economic Cooperation and Development) in 1992, plus countries with economies in transition (the EIT Parties), including the Russian Federation, the Baltic States, and several Central and Eastern European States. 14 The future of global carbon markets The prospect of an international agreement and its impact on business

17 Conclusion As carbon markets develop and new market mechanisms emerge there will be a tendency to link markets, creating at least partial level playing fields. However, do not expect a truly global carbon market, where all actors are equally constrained, to develop soon. Progress is frustrated by the large economic inequalities between the developed and developing world and the inability of policymakers to think and act beyond national interests and see the bigger picture. However, a global carbon market could be a system where all major emitters and industrialized countries are carbonconstrained domestically, and developing countries provide offsets on a large scale through efficient market mechanisms. Because political realities prevent a harmonized system from developing, this would probably happen by linking up domestic markets. To advance on the route to a low-carbon economy, such a market would need to be complemented by an increasingly robust carbon price. Such a price on emissions would ensure that all mitigation measures are being utilized following the marginal abatement curve. Combined with a stable continuing regulatory framework, this would spur investment and innovation and create opportunities for the private sector. Financial innovation is the key to unlocking the capital markets to fund the billions of dollars of private sector investment required to transform our economies to a low-carbon model. To reach such a scenario, the public and private sectors will need to cooperate and show leadership, while the private sector also comes to terms with the growing levels of carbon regulation around the world. Besides challenges, plenty of opportunities exist for the private sector within this framework. Many of these opportunities relate to scaled-up market mechanisms and NAMAs. The future of global carbon markets The prospect of an international agreement and its impact on business 15