New Carbon Trading Scheme Debuts

A $12 billion windfall is expected for British power companies because exceeding the emissions limits is largely free of cost

The UK's biggest polluters will reap a windfall of at least £6bn from rising power prices and the soaring value of carbon under the new European carbon trading scheme that critics say fails to correct the flaws of the system it replaced.

From yesterday, the second phase of the European Trading Scheme (ETS) took effect. Analysts have predicted that the price of carbon for 2008, already trading at about €22 per ton, could nearly double under the new regime, which sets much lower emissions ceilings for the participating countries than those that existed under the recently ended first phase. Critics argue, however, that the scheme, under which nearly all allowances are granted free of charge rather than having to be bought by big polluters, has created a distorted market in which the worst offenders will enjoy bumper profits while incurring no extra underlying cost for producing greenhouse gases.

Under the "Phase Two" of the ETS, which runs until 2012, 104 million tonnes in annual carbon allowances have been allocated to the major UK power generators, the single biggest source -- about one-third -- of the UK's total of CO2 emissions. At €22 per ton, those allowances are worth about €2.2bn (£1.6bn) annually. That amount could rise dramatically. Analysts at Deut-sche Bank predict that under the more stringent thresholds, the carbon price will rise to €35 per ton this year, while UBS forecasts an increase to €30.

Under the ETS, companies can sell any excess allowances and pocket the profits. They can also pass on the implied increase to generation costs to customers though higher energy tariffs, thus benefiting from the system without the desired effect of also being encouraged, through the payment of large carbon bills, to invest in new clean generation technologies. Jake Ulrich, the managing director of Centrica, said: "If companies and individuals are to be made to reduce their output of CO2, the ETS needs to be structured to make polluters pay. To do this, we need to eliminate the current free handouts of allowances to emit, which give big windfalls to polluters and do not encourage development of clean generation."

Phase Two is seen as a marked improvement on the 2004-2007 Phase One of the ETS, which was intended as a "test and learn" trial but had long since been written off as a failure. This was due in large part to a faulty structure under which each country, seeking to protect its domestic industries, was allowed to set its own artificially high carbon emissions allowances. The upshot was a glut of carbon credits -- granted based on those inflated estimates -- that led to the price sinking to as low as €1 per ton and essentially obliterating the intended effect of making emissions a serious cost for big polluters.

Under the phase two regime, up to 10 per cent of the credits allocated to each country can be auctioned off. Each country also had to submit for EU approval its emissions levels and the percentage of credits it expected it would need to meet the new targets. Yet critics say that by granting nearly all allowances -- 93 per cent of UK credits will be given gratis, with the remainder auctioned -- phase two does not adequately address the primary failing of phase one. Mr Ulrich said: "We want to see [free allowances] end from 2012 and instead [to] introduce 100 per cent auctioning in the power sector."

The next crucial development in the evolution of the ETS comes on 23 January, when the EU is expected to publish new draft directives for Phase Three of the scheme. Some power companies, as well as the UK Government, have lobbied for the full auctioning of carbon credits from 2013. They argue that that is the only way in which the true value of carbon can be established and will be a vital component of future investment decisions on clean energy technologies. Big emitters, such as Drax, would be sev-erely hobbled by such a regime.

An 850mw clean coal power plant that is equipped with carbon capture technology, for example, can cost up to £1.5bn to build, three times what it would cost to build a comparable coal-fired plant. Without a true, market-based price of carbon, companies will be unwilling to invest such sums. An industry source said: "We need a much higher carbon price for the economics to make sense."

In America this month, the Senate will begin debating the Lieberman-Warner Climate Security Act, a proposed cap-and-trade system similar to the ETS.

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