A Faltering Carbon Market Means a New Energy Crisis Looms For Europe

As we wait for a clear indication of what the European Central Bank (ECB) intends to do - or, perhaps more accurately, what European political realities allow it to do - yet another crisis has emerged.

This development strikes at the heart of an essential cog in the European energy strategy.

How this one plays out may actually tell us more about recovery prospects on the continent than any action from the EU in Brussels.

On Friday, the Danish Energy Agency released some of what analysts in the region had surmised for a while. The agency is a lobbying group emphasizing EU policies affecting both energy producers and consumers.

Its director of EU affairs, Ulrich Bang, declared in an email that the European Commission (EC, the administrative arm of the EU) had to take immediate action to protect the internal energy market within EU states.

At issue here is the carbon trading system, what most observers acknowledge is the "cornerstone" of the inside energy balance among the 27 EU countries.

Bang said that the system has "almost collapsed," a view widely shared by other European-based specialists.

The statement testified to a rising strain in the energy sector resulting from the push and pull of an ongoing credit crunch on the one hand and sluggish economic recovery prospects on the other.

Trouble in the World's Largest Cap-and-Trade Program

Carbon trading sits smack in the middle of this tug of war.

And its inability to generate adequate pricing may be the clearest indications yet that there are new problems forming.

This is the world's largest cap-and-trade program.

It has become a barometer for levels of investment in market production infrastructure and a projection of expected prospects for manufacturing and consumption.

It sets up an overall level of emissions permitted for the EU as a whole and then regulates the trade of carbon credits between companies. Low-polluting enterprises sell their excess "emission allowances" to more polluting factories - but for a price.

A cap-and-trade program allows companies to trade emission levels, in effect moving pollution allowances from more efficient operations (who do not need the credits) to less efficient ones (who do).

This has been a primary mechanism for bringing companies into EU policy parameters, and thereby integrating into a wider European market, former Eastern European factories that had operated within environmentally unfriendly situations.

The credit transfer, which provides time for those who are falling below EU standards and new investment capital for those who are exceeding standards, helps offset pollution.

As productivity levels increase, the more efficient operations tend to realize a better return on capital invested. Until recently, the trade cap-and-trade system had subsidized the main producers in Europe and stimulated an overall EU economic uptrend.

Not anymore.

A good indication of staggered EU economic prospects is the lower price commanded by the carbon credits.

The price goes down when there are declining incentives to sell the credits. Simply put, if the market participants don't see the potential for selling manufactured goods, there are fewer reasons to sell the credits.

This is an especially telling indicator in Europe, where the credit sellers will maximize capital, and the buyers will be able to use lower production costs to improve bottom lines.

The recent figures released by the market are not encouraging. The credits fell to a record 5.99 euros ($7.77) per metric ton in April, and permits for December were level at 7.80 euros on the London futures exchange on Friday. In contrast, four years ago, the price was about 30 euros per ton.

The major loser in such depressed prices is investment in alternative energy projects favored by environmental movements (and EC plans). "Based on [the price of carbon credits], not much money will be invested in green technology," Bang concluded.

Yet without the ability of moving credits from lower carbon emission sectors (which occurs when the credits are sold by better energy utilizing companies), the further application of alternative energy becomes more limited. Low credit prices produce such a result.

The EC has as its overarching goal the creation of a single regional electricity and gas market by 2014. Low carbon prices, combined with a series of other problems, make this a remote prospect, the Danish lobby group said.

However, that objective is compounded by the current political situation. "The EU's internal energy market is in a state of crisis," Bang said. "Member states do not comply with directives, while constantly introducing new subsidy mechanisms that distort competition."

Bang further noted that the EU's internal market is often presented as the bloc's biggest success story over the past 20 years. However, a political environment has not put a strain on the further collective pursuit of energy policy. Perhaps understating the case, Bang added, "There is a long way to go before we have an internal electricity and gas market in the EU."

At least in the short-term, as the carbon credit market goes, so goes the chances for a unified European energy space.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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