Plunging price of carbon may threaten investment

The price of carbon has lost almost two-thirds of its value in the past six months, threatening future investments in the energy sector and undermining confidence in the second phase of Europe's Emissions Trading Scheme (ETS). An EU permit to emit one tonne of CO2 cost €10.15 (£8.86) at the end of last week, down from €28.50 in mid-2008 and a far cry from forecasts of up to €40.

The most bearish experts are now predicting that the price could fallas low as €9 as global recession, reduced manufacturing output, and the concomitant reduction in consumption of fossil fuels, feeds through to reduce the need for carbon emissions permits.

The danger is that business plans for infrastructure projects like power stations and wind farms will founder. In the first phase of the EU ETS, which ran from 2005 to 2008, permits were vastly over-issued, pushing the price of carbon to less than €1 and rendering the mechanism meaningless as a predictable revenue stream.

A major price drop in the second phase of the scheme, which runs to 2012, could cause a repeat crisis of confidence by throwing future projections into question.

Jeff Chapman, the chief executive of the Carbon Capture and Storage Association, said: "The problem is that investors can't bank on a future value of carbon. It is impossible to take a project proposal to a bank based on a future price because we have seen the price collapse once before, and it is now doing it again."

There are now questions about whether government policies might change as the economic climate worsens. Paul Golby, the chief executive of E.ON, said: "There is a confidence issue around whether governments will keep their nerve. The plan was to keep tightening the carbon market to push the price up and encourage low-carbon investment.

"The question now is whether governments back away from that, and seek to ameliorate the effect of the recession on hard-hit industries by keeping the carbon price low."

Supporters of the trading scheme interpret the fluctuations of the carbon price in line with wider economic indicators as evidence of a mature and well-functioning market.

Henrik Hasselknippe, the director of Carbon Analysis at PointCarbon, said: "What we are seeing now is carbon functioning as a commodity and reacting to the same fundamentals as any other market in the world. It would be much more worrying if carbon stayed high because that would indicate something was wrong."

But the low price is already having a tangible effect. Under the Kyoto Protocol's Clean Development Mechanism (CDM), industrialised countries can invest in overseas low-carbon projects as a cheaper alternative to pursuing such schemes at home. But with EU carbon prices coming down to within an ace of costs in China or India, the differential is no longer enough justification.

"At the moment, people are holding off investing in these projects because profitability is dwindling with lower emissions prices," Mr Hasselknippe said. "Saving just one extra euro isn't enough to make people go to China."

Despite the gloom in the rest of the economy, carbon trading has flourished since the start of phase two of the EU ETS last January, under which fewer permits were issued, and a proportion will be auctioned for the first time.

Last year was a bumper year for the European Climate Exchange (ECX). Some 2.8bn tonnes of emissions were traded, a massive 170 per cent rise on 2007. Patrick Birley, the ECX chief executive, said: "The exchange had a fantastic year, although it was hard to walk around the City feeling good about our volumes when so many of our friends were being clubbed."