Going up in smoke & Government May Auction Carbon Credits

It had been billed as Europe's solution to reducing the impact that business and industry have on the environment. The system for trading carbon credits is the centrepiece of Europe's efforts to tackle climate change, but last week the market collapsed when it emerged that there were far more carbon credits in existence than had been thought.

The dramatic collapse is forcing governments across the European Union to confront difficult questions about whether the artificial market they set up really will have the desired effect of helping them meet the emission reduction targets agreed at the Kyoto environment summit.

Kyoto obliges almost 40 industrialised nations to cut emissions of heat-trapping gases by at least 5 per cent from 1990 levels by 2008-12. Since most of those gases are emitted by industry, a scheme was devised to give each company a quota for the amount of gases, such as carbon dioxide, it could release. Any emissions above that level would have to be paid for by purchasing a credit from someone with surplus allowances to sell.

Overnight that created a market in carbon credits, with banks and advisers such as KPMG and Ernst & Young stepping up to put vendors in touch with polluters. Entrepreneurs soon realised that huge amounts of money could be made by trading in carbon credits created by setting up carbon emission reduction schemes, mainly in developing economies.

The market's potential has led to a slew of companies listing on the Aim market in recent months; some are trading on eye--watering -valuations.

Climate Exchange, for example, has bought stakes in the Chicago Climate Exchange and the European Climate Exchange as well as stakes in businesses building biofuel plants and developing fuel-cell technology. The company said last September that its assets were worth 95p per share. Its shares today are worth 275p.

Agcert's volatile shares, meanwhile, have plunged by almost a third recently, but still value the -Dublin-based company at £317m. It recorded a loss of £12.3m last year and had no revenues, but says it will become -cashflow--positive this year and strongly profitable next.

Bill Haskell, Agcert's chief executive, explains that the company's business is installing enclosed storage and gas capture facilities for animal manure at intensive farming operations in South America. The methane produced by agriculture accounts for 20 per cent of carbon gas emissions, and methane is 20 times worse than carbon dioxide for the environment.

"The goal of Kyoto was to reduce the 20bn tonnes of carbon gases released each year by 5 per cent or 1bn tonnes," Haskell says. "That has now risen to 1.4bn tonnes and all that could be achieved by controlling emissions from agriculture."

The company has 450 methane capture facilities installed and has already been forward selling carbon credits. Haskell argues that last week's price crash in carbon credits was nothing more than a teething trouble for the market in its first full year of operation.

"Governments made liberal estimates of how much carbon they would emit and made it pretty easy to hit their targets. For phase two, which starts next year, they have got real measurements and the caps will be a lot lower," he says.

In the UK, the Government set up the Carbon Trust to advise on cutting carbon emissions and support the development of low carbon technologies.

Michael Grubb, the trust's chief economist, points out that there are a number of difficulties with how the European credits trading system is operating.

"The idea of setting caps on emissions from companies, allowing them to trade across Europe so they can find wherever emissions abatement is cheapest, all that economic theory is perfectly good and in that sense the system is a sensible one," he says. "But the big problem is what level you set the caps at. How do you go about it?"

He says the process is the subject of very strong lobbying and government nervousness. "I think the real problem is that setting caps based on projections has got really fundamental problems."

He points out that comp-anies have an incentive to overestimate their emissions to make their targets easy to beat and says that if the caps are set on past emissions, companies have no incentive to cut them as they will be rewarded with an even lower target for the following year.

"There are ways around these problems," he says, "but they require governments to have some guts and be willing to set standards across industries, which means that some companies will be significantly short of allowances."

He says that governments should instead hold auctions for permits to emit carbon gases. The UK market alone is worth around €10bn (£7bn) while across the EU the credits are this year worth around €50bn. The revenue raised could then be spent on envir-on-mental projects overseas.

One company that has decided to bypass the carbon credits market is HSBC, the world's third largest bank. It declared itself "carbon neutral" earlier this year following a programme of cutting emissions, buying energy from clean sources and offsetting the remainder.

John Williams, the bank's head of group sustainability, says HSBC produces around 700,000 tonnes of carbon dioxide each year, mainly from its buildings and through travel.

"We cut our emissions by about 20 per cent to 30 per cent but to offset the remainder we went out to tender on 117 carbon reduction projects," he says. "They had to be environmentally friendly and cost-effective, and the method had to be robust and credible."

In the end, the bank short-listed four projects, including a wind farm in New Zealand, an Australian composting project and bio-energy plants in India and Germany in which it decided to invest.

"This is a work in progress for HSBC," says Williams. "When we talk about our carbon neutrality going forwards we will speak much more about working with our clients. We can use our core lending function to invest in offset schemes. Our project finance business is already generating carbon credits."

Executives at less "green" companies will have to wait until this summer to hear what the EU has decided. With an excess 44m tonnes in carbon allowances last year, Brussels is coming under pressure to ensure that the scheme works more effectively in its next phase - from 2008 to 2012 - and is calling on governments to reduce their allocation of permits by an average of 6 per cent.

Government may auction carbon credits

The government is considering plans to stage an auction of carbon credits that could raise hundreds of millions or even billions of pounds from industry as part of a shake-up of Britain's role in the €50bn (£34bn) EU emissions trading scheme.

The Department for Environment, Food & Rural Affairs (Defra) confirmed that an auction process was "something that we are considering", but said no decision had been taken on how to proceed.

The market for carbon credits in Britain is worth around €10bn. However, it is not yet clear whether the Government would auction the entire UK allocation or whether the process would be applied to just a portion of the market. It also remains to be seen how much an auction would raise and to what use the proceeds would be put.

The funds raised from auctions held by other countries, such as Denmark and Ireland, have been earmarked for carbon dioxide reduction projects in developing countries or used to offset the running costs of the emissions trading scheme.

Under the scheme, users - such as power stations or cement plants - that emit more carbon dioxide than permitted are obliged to buy permits to cover extra emissions. If they emit less, they can sell the excess permits. A move to auction the permits would solve the problem of how to allocate carbon -credits.

It emerged last week that many European governments had been unduly generous with their allocations of credits, which allowed companies to profit from the scheme without cutting emissions.

Problems have also been identified in the UK with the way in which the allocations are set, with some experts arguing that perverse incentives that fail to encourage investment in carbon reduction are rife.

Michael Grubb, the chief economist of the Carbon Trust, a body set up by the Government to encourage carbon efficiency, said there were problems both with using previous emissions and with using projections.

"There is a strong case for the Government to look seriously at auctioning," he said. Auctions worked well in countries that tried them during the first phase of the scheme, he added.

The UK is supposed to submit by the end of June its proposals on how the next phase of the emissions trading scheme, which runs from 2008, should operate.

"We won't be in a position to make an announcement for a few weeks yet. At this stage we are just looking at ideas," Defra said.