September 11, 2008

EU ETS Turns Sour for Poland and Other Neighboring Eastern European Countries

Phase I of the EU Emissions Trading Scheme saw some of the heaviest polluting countries - such as Poland - reap windfall profits following the over-allocation of free carbon credits. In Phases II and III, however, Poland and its smaller central and Eastern European neighbors face the reverse situation, having been disproportionately targeted by Brussels.

It is widely argued that Phase I of the EU Emissions Trading Scheme (EU ETS) delivered increased electricity prices, sub-optimal carbon abatement and windfall profits for power generators across Europe.

Indeed, the over allocation of free emission allowances in Phase I of the EU ETS exerted upward pressures on the price of wholesale electricity, as power generators reaped hundreds of millions of euros a year by passing on to customers the theoretical cost of buying carbon permits. In essence, power generators pocketed windfall profits, as the revenue they earned passing CO2 opportunity costs to the consumer exceeded the level of compliance costs they incurred under the EU ETS scheme.

Under Phase I of the EU ETS, windfall gains will have been greatest in countries - such as Poland - where the ratio of CO2 emitted to power generated was highest; where the ratio of CO2 costs passed through to wholesale power prices was largest, and where the greatest percentage of free allowances was allocated to the power sector. However, the low average carbon price of E0.22 over the February 2007 to April 2008 period will have had a dampening effect on the scale of windfall profits and pass-through to the wholesale power price.

Phase II is very different: the potential for abusing the mechanism is much higher, as is the level of potential windfall profits across many countries. The divergence in 2007 and 2008 EU emission allowance (EUA) prices has substantially increased the potential and scale of windfall profits in the power sector, as well as the potential upward effect on wholesale power prices. With the average carbon price over the February to July 2008 period nearly a hundredfold higher at E20.55, Datamonitor estimates that the aggregated cost of carbon in the UK, Germany, Spain, Italy and Poland alone will be in the region of E21.5 billion during the second period of the EU ETS.

However, relief is now expected in the form of long-awaited and much-needed European carbon allowance auctions from 2013 onwards, much to the consternation of countries such as Poland and its Eastern European neighbors. Following dramatic economic decline in the 1990s, the former Soviet states effectively enjoyed less stringent Kyoto targets and were therefore considered natural sellers in the EU ETS. In Phase II, these natural sellers have had their ETS allocations slashed following Brussels' decision to deliberately target new member states to curb a potential excess of credits, as seen in Phase I. As a result, Poland boasts Europe's fifth largest estimated carbon allowance deficit behind Germany, the UK, Italy and Spain. Evidence suggests that these countries will be structurally short carbon credits in 2008, based on their total respective 2007 emissions.

With the December 2008 EUA price currently oscillating between E23 and E25, it is no surprise that Poland has been one of the most vocal critics of the proposed shift from the current free allocation system to a pan-European auctioning mechanism. The proposed shift would have a detrimental effect on Polish electricity prices and the country's economy as a whole, mainly because Poland generates 96% of its power from coal-fired power plants. Datamonitor's latest carbon intensity estimates place Poland among the worst polluters in the EU27, with an average of 1,104kg of CO2 per MWh of power produced. The country has a total annual power output of 163TWh, which represents 180,000,000 tonnes of CO2 emitted at an estimated annual cost of E4.14 billion (based on the current December 2008 EAU price of E23).

Poland's situation is made worse as evidence suggests that Phase II of the EU ETS will be a lot tighter than Phase I, which has long-term bullish implications for EUA demand and pricing. Indeed, deflated carbon prices are likely to be short-lived, based on actual allocations to incumbents in 2008 of 1,983 million tons (Mt) of CO2, against estimated 2007 pro-forma emissions of 2,247Mt. Accordingly, recent pricing forecasts suggest that EUAs could easily reach E40 by the end of the year.

It is increasingly likely that European countries will see a dramatic rise in the need for carbon abatement in Phase II of the EU ETS, and to a much larger extent in Phase III. Price and demand forecasts therefore reflect the need for fuel-switching and new combined-cycle gas turbine capacity by 2020 across Europe. However, Poland's lack of fuel switching availability suggests that Polish power generators will use the largest possible amount of the total allocations available to them over 2008-20 to reduce compliance costs over 2008-12, which would augment the need for investment in additional low-carbon power generation capacity required for compliance over Phase III.

Against a backdrop of windfall profits in Phase I of the EU ETS, it seems that the tables have now turned for Poland, as it will be challenged with significant power generation environmental costs in Phase III. A silver lining will, however, come in the guise of a E1 billion annual windfall from the proceeds of permit auctions in richer member states, and E3 billion annually from the auctioning of government permits.