The European Commission has appealed to the European Council and Parliament to take decisive and quick action to protect the EU Emissions Trading System (ETS) from becoming ineffective as a policy tool to incentivise investments that cut carbon, a leaked draft document on the state of the carbon market shows.
Proposed restorative steps could include the banning of offsets from the system, the document said.
The regulatory uncertainty has already depressed offset prices, widening their discount to the EU-issued allowances.
The draft report, which outlines a number of steps that can be taken to tackle the oversupply and weak prices that are plaguing the ETS, makes two recommendations:
n The elimination of any "legal uncertainty" about a change in the auctioning timetable for Phase III (2013-2020) along with a request for the Climate Change Committee to decide on the matter before the end of the year.
n A discussion regarding potential measures that would more "profoundly and permanently" redress supply and demand imbalances on the market.
Measures mooted by the report, apart from reviewing the auction timetable, include: increasing the region's carbon-reduction targets to 30% in 2020; retiring some carbon allowances; and cutting or limiting "much more" the use of offsetting credits in the EU ETS.
"Without international credits, the surplus in the EU ETS by 2020 would potentially be only around one-quarter of the presently expected surplus," the draft reads.
Operators included in the EU ETS can use cheaper certified emission reductions (CERs) and emission reduction units (ERUs) to cover a share of their emissions and comply with the system.
Tuesday's draft suggests a wider curtailing of the use of offsets, however, after another draft revealed the EU is already looking at cutting the use of ERUs as of 2013 (see separate story).
The uncertainty around offsets has helped to widen the spread to EU allowances (EUAs), a market participant said on Monday.
"Big insecurity in the market led to a €7.87/tonne of CO2 equivalent [tCO2e] spread between EUAs and CERs during Monday's session," a second source added - a figure that he labelled "huge" and "extremely wide".
Indeed, on both 19 and 22 October, the EUA 2012 contract closed at a premium of €6.80/tCO2e against the corresponding CER contract. Although this was below the intra-session high, it was still the widest settling spread for the two contracts to date, according to ICIS data, and 63% above the year's average closing spread of €4.17/tCO2e.
The weak ERU price has helped to drag down CERs, further widening their discount to EUAs.
However, even though resisting the strong downward move observed on offsets, EUAs also suffered from the regulatory uncertainty that the EU has given rise to in terms of the EU ETS.
"There is still no decision on back loading - no news today. They said they would get back to the market last week, but didn't," the first source said.
The EU is now expected to publish details of its auction delay proposal in less than a month's time, on 14 November.
"It's starting to get late, people usually liquidate towards the end of the year to make their financial [statements] look good. But if there is no news on back loading, people don't want to take long positions, and they don't want to sell, so there will just be another overflow [of allowances] into next year," the second source said.
Analyst Matteo Mazzoni said in a briefing note on Tuesday: "It is well [known] that the market for the Clean Development Mechanism [CDM] is remarkably weak at the moment. Nevertheless, the price of CERs has usually mirrored the price of EUAs. That is not happening any more. The rumours of an ERU ban proposal pushed the price of CER further down, with Dec '12 CER losing 51% and closing the week at €1.10/tCO2e."
He added that the situation had led to panic-selling, which helped to depress prices further on Monday: "Because of the uncertainty on ERUs, everyone is trying to liquidate positions if they can't they try to swap them. The market is very unsure of what's going on."
He pointed out that the EU Environment Council, which meets this Thursday, should also shed more light on the EU's position ahead of the Doha climate summit at the end of 2012. This should shed more light on the future of the CDM, Mazzoni added, which will then have an impact on CER prices.
Unless the market receives bullish news on offsets, the spreads to allowances could widen further because EUAs are expected to remain relatively stable.
"Macroeconomic variables have been strongly influencing the EUA market recently. Risk sentiment within the wider financial markets has been volatile, but broadly neutral over the past few weeks," said Matthew Gray, carbon analyst at commodities dealer Jefferies Bache, on Tuesday, also in a briefing note. "We expect it to stay this way."
The Environment Council is meeting next on 25 October, when it is expected to discuss the back loading proposal as a temporary measure to help support the market. MLDB