1 9 th February 2008 © New Carbon Finance, 2007 Cap and Trade Systems: The European Experience Milo Sjardin Head, New Carbon Finance North America

© New Carbon Finance, Structure Principles of Cap-and-Trade Cap-and-Trade: Current and Future European Union Emissions Trading Scheme (EU ETS) Overview Demand and Supply Fundamentals Successes Lessons Learned Conclusions

© New Carbon Finance, Provides certainty of the level of emissions reductions (through setting a cap on emissions levels) 2.Ensures that emissions reductions take place where cost is lowest, thereby minimising cost for a given level of required abatement If an installation emits more than it is allocated, must buy back its deficit from the market at the market price. If an installation emits less than is allocated, eg through abatement measures, it can sell this surplus on the market. The Principles of Cap-and-Trade Systems

© New Carbon Finance, World Carbon Markets – Current and Future Developing countries Japan, NZ & [Canada] CEE, Russia & Ukraine EU ETS EU 15 countries CERs AAU/GISs EUAs ERUs AAU/GIS EUAs AAU/GISs CERs ERUs EUAs Carbon commodities Australia Source: New Carbon Finance Kyoto Annex 1 Carbon schemes Kyoto Supply (CDMI) Private Schemes Other Keidanren US: RGGI California WCI Federal? NZ VERs Voluntary Market

© New Carbon Finance, Global Trade in GHG Emissions = $30bn in 2006  180% Annual Growth Source: New Carbon Finance, World Bank $11 bn $30 bn $56 bn * * 2007 preliminary (conservative) estimate

© New Carbon Finance, European Emissions Trading Scheme – Overview “ Cap and trade ” scheme covering mostly CO2 emissions from combustion processes (approx 46% of EU CO2 emissions) Phase 1 EU ETS ‘ learning phase ’ Phase 2 EU ETS ‘ Kyoto Commitment Period ’ Phase 3 EU ETS – ‘ ? ’ All EU-27 countries covered including over 11,000 (mostly private) installations from sectors: power generation, large combustion plants, cement, steel, oil refining, pulp & paper, ceramics, aviation. Majority of allowances allocated for free - range of methods, including historical emissions, projected emissions, sector benchmarks etc Banking/borrowing was NOT allowed from Phase I to Phase II, thereafter unlimited. Targets are legally binding, and carry a penalty of € 100/t from 2008 onwards For compliance installations can also import credits from abroad: these can be obtained through either the Clean Development Mechanism or the Joint Implementation under the Kyoto Protocol

© New Carbon Finance, Historic EU ETS Price Development Prices generally follow fundamentals: fuel prices, policy decisions, etc. Market confidence in Phase II increases as stricter NAPs decisions are made Drop off in electricity demand due to mild weather, decrease in fuel prices, surplus comes on to market. Verified emissions data released Increased demand from utilities, higher gas prices Source: New Carbon Finance, ECX, Reuters

© New Carbon Finance, ,700 1,900 2,100 2,300 2,500 2,700 2, MtCO2/yr CBM Projections (actual coverage) Historical data (based on 2005 verified emissions) CBM Projections (INDEX) Allocation (incl reserves) EU ETS fundamentals – forget Phase I, Phase II short, Phase III even shorter Previous estimates of emissions projections: creating surplus Source: New Carbon Finance BAU Emissions Allocation Demand: 440Mt/yr Phase III Phase II Phase I Demand: 290Mt/yr

© New Carbon Finance, ,0001,5002,0002,5003,000 Cumulative MtCO2 saved Cost (€/tCO2) Phase II Demand and Supply: demand mostly met by credits from abroad CDM and JI Credit Supply Demand Level: 1,460Mt Outside of CDM/JI abatement opportunities centre around fuel switching in the power sector. These opportunities range from € 10 – 150/t depending on plant and fuel prices. Banking causes small amount of internal abatement required in Europe, this can be at relatively low cost (with current forward gas prices): equilibrium price at € 27/t.

© New Carbon Finance, Apart from Fundamentals…., Market Behaviour also plays a large role Source: New Carbon Finance Phase I has shown that utilities are constant buyers whereas industrials hold on due to uncertainties of future needs This behaviour is likely to be repeated albeit less extreme New Carbon Finance Survey (Oct 06) of all EU ETS Participants (Total 585 responses) Number of responses = 389Emissions 306Mt

© New Carbon Finance, The European Emissions Trading Scheme – Successes Creation of the world ’ s largest cap-and-trade programme in just over two years (Directive of Oct 2003 – Implementation on Jan 2005) At this moment in time the EU ETS is the most certain element in the global carbon market out to 2020 with expected prices of $50/t. Efficient market with many participants and an increasing variety of financial products traded. No price cap so the market functions freely  sets right price signal Has brought the topic of carbon prices to the highest level of the boardrooms Key driving force of investment and technology transfer into projects in developing countries and emerging economies: currently over 2.6 billion tonnes of emission reductions expected by 2012 from 3,103 projects

© New Carbon Finance, The European Emissions Trading Scheme – Lessons Learned Experience: 1.Over-allocation, partly due to incorrect emissions data and optimistic projections 2.Wind-fall profits for the power sector and some industrial sectors 3.Prices going to zero as banking was not allowed between phases 4.High import levels for emission reductions from abroad 5.Varying stringency and coverage between countries Solution: 1.Scarcity is required in any cap- and-trade system: lower allocation 2.Increased auctioning: preventing wind-fall profits and stimulate low carbon investment 3.Banking and borrowing essential for stable prices and long term predictability 4.Increased focus on domestic emission reductions 5.Harmonised EU-wide cap and allocation methods

© New Carbon Finance, Conclusions 1.Cap-and-trade seems globally the preferred policy measure to ensure emission reductions 2.As the largest emissions trading system in the world, the EU ETS has so far been very successful in stimulating the transition to a carbon-constrained economy 3.At present the EU ETS is the most consistent element in the global carbon markets, providing investors with much needed certainty out to The EU has learned from the system ’ s initial faults and many of the issues will be rectified in the third phase: post 2012.

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© New Carbon Finance, Cap-and-Trade: Large Number of Initiatives across the Globe Current Directive Continuation of current directive European Emissions Trading Scheme California State targets + AB32 Kyoto Protocol Ongoing post 2012 discussions – likely to be for period longer than 5 years UNFCCC – Kyoto Protocol State targets to 2050 Regional Greenhouse Gas Initiative RGGI Model RuleExpected legislation US, Federal scheme 13 climate change bills proposed, Lieberman-Warner most successful Source: New Carbon Finance Targets Western Climate Initiative/ Midwestern Programme State Targets suggested, but many without targets set in law Expected legislation Chicago Climate Exchange Canada/Australia Expected legislation (Australia) or legislation already in place (Canada) Japan/New Zealand Legislation in place Expansion expected VER market (Voluntary Market) ?

© New Carbon Finance, Phase II: 80% of gross demand in the EU ETS will come from the power sector

© New Carbon Finance, Phase II: 50% of demand will come from four countries: Germany, Spain, Italy and Poland