Carbon: Europe's Lessons for the U.S.

This is supposed to be the year of the green economy. U.S. President Barack Obama's $787 billion stimulus package has earmarked billions of dollars for renewable energy and efficiency projects. Pundits expect America to reverse its hostility to the Kyoto Protocol on Climate Change and lead this year's negotiations for its successor. And some form of federally mandated U.S. carbon dioxide credit-trading scheme is expected by the end of 2010.

Yet before investors get carried away over clean tech, they should heed a few sobering lessons from Europe's almost decade-long experiment to create a more climate-friendly economy. Sure, the region's eco-innovation has won global plaudits, but the economic downturn is quickly taking the shine off Europe's effort to cut CO2 emissions. Widespread government subsidies, for instance, made countries such as Denmark, Germany, and Spain into global leaders in renewable energy. But now, lower subsidies and a lack of project financing from banks due to the credit crisis are whacking investment in clean energy. European green energy investments fell by 13.7% in the second half of 2008 from the same period in 2007, to $21.2 billion, according to researcher New Carbon Finance. In North America, the toll is far worse: Over the same period, clean energy investment there fell by nearly half, to $10.7 billion.

Cap-and-Trade Carbon Market

Of perhaps even greater concern are the travails of Europe's four-year-old carbon-trading system. The multibillion-dollar cap-and-trade carbon market, known as the European Union Emissions Trading Scheme (EU ETS), has become the blueprint for the expected U.S. federal carbon scheme. Companies are granted a certain number of carbon units (the "cap") that they can sell on the open market if their CO2 output falls below its assigned level or buy as needed to offset output above the limit.

Problem is, the price of carbon credits in Europe has plummeted by two-thirds since July 2008 because of tumbling commodity prices and contracting industrial output. The more it costs to offset CO2 production, the greater incentive companies have to switch to more environmentally friendly technologies. Yet analysts reckon the current price of less than €10 ($13) per metric ton of CO2, compared with last summer's highs of €30 ($38), just doesn't provide enough economic impetus to go green. In other words, it's cheaper to pollute.

"The carbon price volatility has hurt long-term investment in renewables," says Colette Lewiner, global energy, utilities, and chemicals leader at consultancy Capgemini (CAPP.PA). "When the price is so low, it plays no role in investment decisions concerning lower CO2-generating power plants."

Reverting to Coal

The steep fall in the price of carbon credits is sending ripples through European industry and power companies. According to New Carbon Finance analyst Olivier Lejeune, last year's record carbon price led many of Europe's utilities—which constitute the largest sector covered under the ETS—to switch from highly polluting coal-fired plants to more efficient natural gas facilities. But after emissions costs began to fall, energy companies reverted to coal because it was more economic to buy cheap carbon credits in the market than continue using more environmentally friendly natural gas. "Recently, the use of coal has massively intensified," Lejeune says.

For clean tech investors who had been banking on high carbon prices to subsidize costlier but eco-friendlier technologies, the rest of 2009 doesn't look promising. Market analyst firm Point Carbon now forecasts Europe's 2009 CO2 price will be a mere €12 ($15) per metric ton, down from an earlier estimate of €22 ($28). For next year analysts reckon the price to climb only to €19 ($24)—still less than the roughly €25 threshold above which green tech starts to become more cost-effective. By comparison, the 2010 price on Chicago Climate Exchange's, a voluntary carbon market in the U.S., stands around $2 per metric ton.

That should raise red flags for Obama's so-called Green Team, whose ranks include Nobel Prize-winning Energy Secretary Steven Chu. It supports a U.S. cap-and-trade emissions scheme to combat climate change. Yet Europe's initial attempts at a carbon market between 2005 and 2007 were highly criticized after an over-allocation of CO2 credits caused the price companies paid to offset carbon to hit almost zero. A year into the market's second phase, experts wonder whether this ETS 2.0, which has a tougher emissions cap to resolve past problems, also will fail to bolster green investment.

Traders of CO2 Credits

"The low price has been disappointing from the point of view of reducing carbon but has created revenue opportunities for companies trading on the EU ETS," says Patrick Birley, CEO of the European Climate Exchange (ECX), Europe's largest carbon trading platform. Birley notes that trading on ECX in January rose 68% from the year before.

Indeed, the only investors making steady returns from Europe's foray into carbon markets appear to be the traders who buy and sell CO2 credits on a daily basis. Point Carbon estimates $90 billion worth of allowances were traded on the EU ETS last year, compared with the paltry $240 million worth that exchanged hands on New England's similar Regional Greenhouse Gas Initiative.

Yet the more-than-doubling of EU ETS' annual trading value last year hasn't translated into similar reductions in carbon emissions. In fact, estimates show Europe's CO2 fell just 3% annually in 2008. That, combined with the freefall in the carbon price, has led many to question whether the EU ETS is actually greening the economy. Says Capgemini's Lewiner: "In theory, cap-and-trade is a good system. But in practice, it doesn't work that well."

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