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Europe Fails Kyoto Standards as Trading Scheme Helps Polluters

By Mathew Carr and Saijel Kishan

July 17 (Bloomberg) -- When European Union officials created a market for trading pollution credits, they boasted it was a "cost-conscious way'' to save the planet from global warming.

Five years later, the 25-nation EU is failing to meet the Kyoto Protocol's carbon-dioxide emission standards. Rather than help protect the environment, the trading system has led to increases in electricity prices of more than 50 percent and record profits for RWE AG and other utilities.

"I don't suppose the environment has noticed the European emissions trading scheme,'' said William Blyth, director of Oxford Energy Associates in Oxford, England, and a former International Energy Agency official who advises businesses on energy and climate change policy. The electricity companies and emissions traders "have done very well.''

The plan, unveiled by EU Environment Commissioner Margot Wallstroem in October, 2001, was to grant permits to 12,000 power plants, factories, oil rigs and refineries. Each permit represented the right to produce a metric ton of carbon dioxide, and could be traded like any commodity. The system was supposed to motivate companies to reduce carbon dioxide and sell their extra permits for profit.

The $44 billion-a-year market is "an environmental and economic failure,'' according to Open Europe, a policy group that assesses EU laws.

At least 12 of the 25 EU nations are at risk of missing their Kyoto pledge, according to EU estimates. Among the 15 original EU members, 11 are unlikely to meet the pollution standards, including Germany, Italy and Spain, three of Europe's five largest economies.

Lax Demands

The mistake came when the European Commission allowed the bloc's 25 governments to provide too many permits and seek fewer restrictions on pollution. The group fell behind schedule to meet the Kyoto target of an 8 percent reduction in carbon dioxide emissions by 2012. As of 2004, the most recent data available, the EU had cut back by 0.9 percent, when compared with the benchmark year of 1990.

A record rise in natural gas prices encouraged power producers to burn dirtier coal. After that switch, carbon dioxide permit prices quintupled from 6.05 euros ($7.66) in January 2005 to 30.70 euros ($39) in April of this year.

Sensing opportunity, banks including Morgan Stanley and Barclays Plc started trading the permits. Speculators such as the $12 billion Citadel Investment Group LLC hedge fund followed.

Because of the failure in Europe, member-states will have to invest in developing countries if they are to meet the Kyoto goal, said Abyd Karmali, managing director in London for ICF Consulting Inc., a Fairfax, Virginia, environmental and technology policy adviser. Under a United Nations program, companies can help developing nations reduce pollution, and count those savings against their goals in Europe.

Karmali estimates that at least half of Europe's reductions will have to occur outside its borders to attain the 2012 Kyoto target. ``It will be very difficult for the EU to do it any other way,'' he said.

Temperatures Rise

The program has had little effect on global warming. Temperatures may climb as much as 5.8 degrees Celsius (10.4 degrees Fahrenheit) in the next 100 years, according to the Web site of the U.K. Department for Environment, Food and Rural Affairs.

Rather than hurt profits at power producers, the program became a justification for higher electricity prices, as the cost of carbon pollution got passed on to consumers.

In Germany, Europe's largest economy, average wholesale electricity prices for delivery the next day surged 61 percent last year. The U.K.'s gain was 66 percent. Both jumps were larger than the 46 percent increase in Brent crude oil.

"The utilities have enjoyed windfall profits,'' said Tony White, head of research at Climate Change Capital and a former Citigroup Inc. analyst.

'Certainty and Clarity'

The power companies say the program will work, in time.

"Emissions trading is the best means of actually delivering further investment in low-carbon generation for the least cost,'' said Leon Flexman, spokesman for the U.K. unit of Essen, Germany - based RWE, Europe's biggest producer of carbon dioxide. "It gives us the certainty and clarity we need to make investment decisions on generators that might cost billions of pounds and last for decades.''

Criticism that the market is "adding nothing for a high cost'' is short sighted, said Andrew Gygax, senior emissions trader at E.ON's U.K. unit.  "Fuel switching is likely to return'' as natural gas prices fall, he said, slowing coal consumption.

And governments will become more demanding later in the program, said Andrew Hanson, a spokesman for Windsor, England- based Centrica Plc, the U.K.'s largest energy supplier.

"There were too many favorable allocations'' of carbon dioxide in the first three-year phase of the program, he said. "We believe it will get more sensible in the second and third phases.''

Hedge Funds Join

Hedge funds have been lured by volatile prices and the prospect for greater returns than from stocks and bonds. Carbon permit prices have gained 90 percent since the start of 2005, compared with a 27 percent increase in the Morgan Stanley Capital International Europe Index, a regional equity benchmark.

There are 12 hedge funds dedicated to trading emissions, compared with three a year ago, according to Peter Fusaro, co- founder of the Energy Hedge Fund Center in The Woodlands, Texas. He declined to name them.

"There are more funds that are about to be launched,'' Fusaro said. "It's just the start. Environment plus financials is an attractive combination for investors.''

Citadel, the $12 billion Chicago hedge fund that's returned 26 percent a year, last month joined a European exchange for carbon allowances. Carbon Trading Fund Ltd., a London-based hedge fund, said in May it wants to raise as much as 125 million euros to buy and sell EU carbon-dioxide emission-allowance options and alternative-energy stocks.

U.S. Success

A unit of London-based Man Group Plc, the world's largest hedge-fund company, called the emissions market "a new playground'' in the April edition of the Retirement Mutual Fund Quarterly Review.

While the EU took the lead in pushing nations to set targets for cutting carbon dioxide, U.S. President George W. Bush withdrew from Kyoto in March 2001, saying the program was too costly. The U.S. has a trading system that reduced emissions by mandating reductions in pollution.

U.S. sulfur dioxide emissions per dollar of gross domestic product fell by 83 percent in the 21 years through 2001, largely because of the compulsory trading system, according to a 2004 study backed by the Center for Clean Air Policy in Washington. Sulfur dioxide is an element of so-called acid rain.

`Up to Brussels'

The EU emissions system may never reach its goal unless the European Commission forces member-states to demand more reductions in pollution, said Per Lekander, an analyst at UBS AG in London.

All but three countries -- the U.K., Austria and Spain -- granted more permits than were needed in the first phase, sending prices down 46 percent from the high reached in April and diminishing the incentive for companies to cut emissions.

"It's essentially up to Brussels'' to make the system work, Lekander said. Grants for a second phase of the emissions trading program, starting in 2008, are slated to be set this year.