Mark Lewis, the Paris-based head of commodities research at Deutsche Bank, is one of the leading analysts of the international carbon markets.

In this interview with Climate Spectator during a visit to Australia, Lewis discusses the recent volatility in the international carbon price, the outlook for the next few years, and the situation in Australia. He tells CS editor Giles Parkinson that:

- The short term outlook for carbon is uncertain, particularly with grave doubts about the strength of the European economy.

- The mid-term forecast remains strong and predicts a price of around €20/tonne of CO2-e by 2015.

- Concerns that a new government would repeal the carbon legislation may affect investment decisions and will be closely watched by international investors.

- There is no doubt that the EU carbon price has been effective in diverting money away from the heavy emitting energy sources and towards low carbon investments.

Here is an edited transcript of the interview.

Giles Parkinson: The European carbon market has been down, what, 30 or 40 per cent in the last month or so, and then last week it shot up 20 per cent. Has it ever been so volatile?

Mark Lewis: Well, it’s clearly been driven by two things. I mean you could talk about the volatility going back to March really. The one indisputably positive thing that has happened this year for carbon prices has been the change in German nuclear policy, and that was really what drove the bull market in carbon and German power from March through to, I guess, the end of May, beginning of June. And really prices have been on a downward trend structurally since the end of May, beginning of June.

GP: So, what happened in that bull period? Where did it go from and to?

ML: Well, really it was just a bit of euphoria on the back of the big change in German energy policy, the decision to phase out nuclear power and the immediate shutdown of eight German nuclear reactors. That increased output is going to have to be made up from coal and gas, primarily; some imports, but domestic coal and gas generation. So German emissions will certainly go up. So that was what drove that three-month bull market in emissions and power.

And then really I think, Giles, what happened was market sentiment started to turn and fear began to escalate over the economic risk emanating from southern Europe, which is something we’ve pointed to as the big caveat on all of our assumptions, really, for the last 12 months. But it really started to overwhelm sentiment from the end of May and you had, in particular, the very, very severe risk around Greek debt culminating in June – that was when the market really fell very aggressively. It fell 20 per cent in one week from about €15/tonne down to €11/tonne, and ever since the middle of June, you’ve had this big fear factor about the outlook for the European economy and therefore the risk of further downgrades to emissions estimates.

The big trend has been this change in sentiment and it’s been driven by fear about the economic outlook for Europe; and secondly, by the European Union introducing tougher measures for energy efficiency improvements which, if the EU is successful in implementing tougher measures for energy efficiency, then other things being equal, that would be expected to reduce electricity consumption and therefore, other things being equal, would reduce emissions as well.

And thirdly, the concern about the political wrangling over the inclusion of foreign, i.e. non EU airlines, in the European trading scheme from next year, because remember from first of January next year, in theory and in law at the moment, as things stand, every flight coming into and leaving the European Union will be subject to an emissions reduction obligation, and that obligation will extend both the European and non European airlines. Now, that is the subject of a lot of contention. The American airlines have launched a legal challenge against the European Union on that point, which is going to be heard over the next two or three months. So that’s weighing on market sentiment as well, because if the American airlines were to succeed in this legal battle and if, as a consequence, basically all of the non-European flights were excluded from this scheme, then the amount of credits required would be lower, the demand for allowances would be lower, so that would have a negative impact as well.

GP: What about the snap back last week then?

ML: I think what’s happening there is that every so often if the prices seem to fall too quickly and too precipitately, the German utilities in particular will jump in and buy them. The big difference is that last time around in early 2009, when the price got all the way down to €8/tonne, you had a lot of selling by industrial companies who were long allowances and wanted to monetise some of that length. What is different this time around is that the selling is being driven more by the speculative community. It’s not being driven by naturally long industrial companies and I think the main reason for that is number one they are not yet in the same kind of financial straits that they were in early 2009.

And number two, they are now looking at the next trading period and saying to themselves, well yes, we’re long at the moment for the current trading period, but at some point in the next trading period we will actually have to start buying allowances, so what’s the point of selling some of our surplus allowances today if we’re ultimately going to have to buy in the market at a later date and possibly at a higher price? So, that’s something that’s come through in a number of conversations I’ve had with a lot of European industrials, so I would…

GP: So, there are two things that happened there. It seems that the market has started to develop a sort of got a depth about it and a maturity about it,  maybe that’s because of the incoming third phase of the system.

ML: I think that’s right.

GP: And the other one is that it’s still very much a market which is hostage to changes in regulation.

ML: Yes. I think that’s right. Absolutely.

GP:  So, where do you see the prices then?  Where do you see the prices at the end of this year? And I guess what’s interesting for Australia is where do you see those prices this time next year when Australia has a carbon price?

ML: That is a trickier question. That really is the trickier question.  I think to be honest it’s… so much depends on what happens now with the European economy and I can’t deny that I’m feeling a bit more pessimistic about that than I was even two months ago, so I think that is going to be key. I would still expect prices to post a recovery from current levels, because at the end of the day there are still significant amounts of carbon buying that have to take place on the part of the German utilities. But you know, realistically, I don’t see prices recovering to the levels we were at prior to the change in sentiment at the end of May, beginning of June. But maybe prices could rally back up towards €15/tonne.

GP: Ok. And where do you see them in 2015 then, when Australia is supposed to change to a price set by markets?

ML: I think we’re a bit more confident there about moving into the third trading phase and again really with the big caveat that this is still premised on the fact that Europe manages to avoid a double dip recession - because I think if that happens we and everybody else would be forced to revise our views on that, simply because you would have a bigger surplus of allowances for the industrial sectors in particular and therefore a lower level of price tension.

But on the assumption we can at least avoid a double dip recession and remain albeit in an anaemic period of growth, we’d… we would see at the moment prices going back up towards the €20/tonne level by 2015, 2016. That’s really because the one thing that does start to happen from 2013 is that the cap declines consecutively year on year. So, the cap for 2013 is about a hundred million tonnes lower than the cap for 2012, and then every year thereafter the cap falls by about thirty-five to forty million tonnes per year.

GP: So, in fact it’s probably taken three iterations for European market to get to what it probably should be… well, approaching something like it should be operating I guess.

ML:  I think that’s right. But then in some ways I suppose that’s almost inevitable given the fact that Europe was the first one to look at this.  You’d have to think that Australia having been able to observe what’s happened in the European market would be able to get it right as it were from an earlier stage once it starts getting up and running.

GP: Now, Australian emitters and liable parties are going to be able to source emissions from the international market. Is the international market going to be big enough in 2015 for them to find enough permits?

ML: That is another pretty big question, isn’t it? To be honest that is the most difficult and complex and arcane part of the market because, you know, the big problem that we’ve had in the international market, the CDM market, over the last two years is that Europe has effectively become the sole buyer of credits and therefore the European Union, whenever it has decided to intervene in terms of the rules allowing European companies to use these allowances, have had a very big say in how the CDM develops.

So, I still think there will be a very ample supply of CDM credits over the period 2013 to 2020 which would enable Australian companies from 2015 to go in to that market and buy, so I do think the market is going to be sufficiently broad and sufficiently liquid, but there’s no doubt that the CDM market has not developed in the way that it would have done had Australia and some of these other industrial countries entered the market, two or three years ago as looked likely.

If you turn the clock back three years, this is not where you would have expected this CDM market to come to. What you’ve been seeing now is the last push for people to register projects before the end of 2012. That has become a kind of key date for all CDM project developers because from the first of January 2013, as far as the European scheme is concerned, only credits generated from projects registered… newly registered in the very poorest developing countries, the LDCs, will be eligible for use in the European scheme.

So, if I have a project that I want to develop in China and I manage to get that project registered with the UN by the thirty-first of December 2012, then the credits will be eligible in the ETS, but if the same project is only registered from the first of January, then those credits will not be eligible in the ETS.

GP: So, where will those credits go?

ML: Giles, you’re  seeing a big wave of… a big push right at the moment for people to get those projects registered. What will happen I think almost inevitably, and probably pretty soon in the next three to six months, is that people will say well, there’s just no way we can get a new project registered in time, so what’s the point of even developing?

GP: So, what are the implications then? It sounds like for the near term, then, the price is probably going to stay low because there’s going to be a surplus of projects, and then after that there might be actually the opposite effect …

ML:  I think it would depend on how confident developers were about future demand. There’s no problem actually I don’t think in terms of sufficient supply for the next three, four, five years because all of the projects that are registered before the end of 2012 will still be eligible for inclusion in the ETS.  But unless and until developers feel that in addition to Australia you’re going to have other jurisdictions really providing a market, then there will be a huge slowdown in the rate of development of new projects from the end of this year, beginning of next year because people will say well, what’s the point, we’re not going to get it registered in time and apart from Europe there isn’t really a market?

GP: So, the Australian market is not really big enough to interest them?

ML: Well, if people have the confidence that politically it’s going to still be in place by 2015, yes. I think yes. But I think as an external observer to the Australian scene, that’s the risk that I would see observing this, that you don’t have political consensus on the setting up of this carbon trading scheme in Australia.

GP: So, if there’s not the confidence in them investing in those projects, then in fact there’ll be a shortage of supply and therefore the price of international carbon will actually go up…

ML: Yes.

GP: … and possibly mean that it’ll be not much cheaper, if at all, than the Australian market price?

ML: Right. I mean it would trade closer to the Australian market in price. It would probably still be a bit cheaper I think. I think that’s a fair assumption. But these are pretty dynamic variables and so much will depend on the actions of other countries. And, it’s not true to say though that Australia is going to be the only one. It looks like South Korea is going to have a scheme up and running by 2015 as well, and then you’ve got California moving ahead from the first of January 2013 now, although the difference in California’s case is that, for the time being at least, they’re not going to allow offsets from outside California and the US, so the impact of California is going to be pretty marginal I think.

The real issue is whether South Korea or Australia, Japan and possibly China can develop a momentum to rival that of Europe. For Australia, I think if the market is sufficiently confident that there will not be a change to that legislation, that the carbon market will not be rescinded or revoked by an incoming government, then that would clearly give you a lot more confidence, but I guess that’s a problem not only for potential developers of CDM projects.

It’s a problem for industrial companies that want to invest in Australia. At the moment if you’re a power generator in Australia or any kind of industrial company looking at a long term investment, do you assume that there’s going to be a carbon price in 2015 or not? There’s a very big political question to be asked over that, isn’t there?

GP: There is. Tell us about Kyoto. If the Kyoto Protocol is not renewed – it expires at the end of 2012 – what is the practical effect of that on international carbon markets?

ML: Again that is a slightly moot question in it seems pretty clear that as far as the existence of the flexible mechanisms are concerned, there is certainly no reason why the CDM cannot exist outside of the Kyoto commitment period. I think having spoken to many, many different people representing many, many different views in the carbon market, the consensus in the carbon market is that the CDM mechanism does not require a second commitment period, to use the language of the UNFCCC, for the CDM to remain viable. There is no sunset clause in the CDM in the way that there is a sunset clause in Kyoto. So, as far as the CDM is concerned, we think that can continue.

GP: Do the carbon markets have enough credibility and permanence about them that encourages industrial investors to make investment that’s required to decrease emissions?

ML: Well, I think that is the key question, isn’t it. And frankly that is the one clear thing you can say already from the European experience is that yes, it is having a very clear and direct impact on the investment decisions being made by the industries covered by it. One obvious way of showing that in the European context is that you know have far fewer companies planning to build conventional coal-fired power stations in Europe. It’s very clear that the new build option of choice as far as fossil fuel plants are concerned is gas and that gas has 50 per cent of the emissions of coal-fired power plants, so people are clearly saying well, it’s just too big a risk to build a new coal-fired power plant because given the life, expected lifetime, of a power plant, 30 to 40 years, if you think that emissions prices are going to rise continually over a 30-40 year period, then clearly building a coal-fired power plant is a very big gamble in terms of the return you’re going to make. So, there’s no question that it has already had a significant impact on the investment decision making process in European industry and I don’t think that’s debatable anymore. There’s very clear evidence that that is happening.

GP: Terrific. Excellent. Thanks very much Mark.

ML: Not at all.