European CO2 traders cautiously welcome U.S. bill

(Reuters) - A U.S. Senate climate bill, unveiled on Wednesday, has garnered general support from European carbon market players, though some have raised concerns over a few components of the proposed legislation.

The draft bill, to be tabled by Democratic Senator John Kerry and independent Senator Joseph Lieberman, would introduce a price collar to curb wild volatility and restricts participation by parts of the financial sector.

"They want to avoid giving Wall Street a new market with which they can play," said Alessandro Vitelli, a director at London-based carbon market analysts IDEAcarbon.

The bill faces tough opposition from Republicans and even some Democrats, and as November's midterm elections are likely to result in a further dilution of Democrats' powers in Congress, its backers are keen to get it through quickly.

It seeks to cut U.S. carbon dioxide emissions from utilities, factories and transportation by 17 percent below 2005 levels by 2020, the same goals included in the climate bill passed by the House of Representatives in June.

The draft legislation did not specify, but sources said the carbon reduction requirements on utilities would begin in 2013.

It allows carbon permit prices to increase at a fixed rate over inflation and calls for an initial price collar. The $12 (8 pounds) floor would rise at 3 percent annually over inflation and the $25 ceiling at 5 percent annually over inflation.

"We'd rather see an ambitious emissions cap, as increasing the level of permits negates the environmental goal, which is the reason for the market in the first place," said Trevor Sikorski, director of carbon research at Barclays Capital.

Under the new Senate bill, in the event of unusually high carbon prices a strategic reserve would be tapped to ensure the availability of "price-certain allowances".

The European carbon market, which has neither price ceiling nor floor, saw permit prices spike to nearly 30 euros a tonne in July 2008, a run-up of 50 percent in the six months prior.

"We'd prefer a market without price caps and collars, but at this point we'd just like to see a U.S. market," Sikorski added.

MULTI-BILLION-DOLLAR OFFSET MARKET

The Kerry-Lieberman bill allows for the use of carbon offsets to ease the cost of abatement for participants, a feature widely supported by carbon market players, but details on the origin of these offsets were not published.

"We have to wait for the numbers on domestic versus international offsets, but the focus has been on more support for the domestic side simply as a way to keep jobs and revenues in the U.S," Vitelli said.

The Senate bill would accept domestic offsets generated from projects to plant trees, sequester carbon emissions under farm and grassland, and trap methane gas from coal mines, landfills and oil and gas pipelines.

"We establish a new multi-billion-dollar revenue stream for the agricultural sector through a domestic offset program that provides incentives for farmers to reduce emissions on their land," the bill said.

The bill also allows international, industrial sector-based offsets, offsets issued by an international body, and those from reduced deforestation, but it does not say how many.

The House bill passed last year allowed up to 2 billion tonnes of offsets into the scheme with an even split between domestic and international.

BarCap's Sikorski said it was too early to tell how big the offset market would be under the Senate bill, as utilities could switch to burning more natural gas than carbon-intensive coal as a way to cut emissions and avoid buying permits or offsets.

"Most of the short-term abatement you could get in the scheme will be from fuel-switching, particularly if U.S. gas prices stay low ... emissions from the U.S. power sector were down last year because gas was so cheap."

U.S. CO2 emissions from fossil fuels fell a record 7 percent in 2009, the Energy Information Administration said last week.

REGULATION

Carbon permits will be auctioned and only entities with a compliance obligation and a limited number of market makers would be allowed to participate, the bill said.

All participants in this primary market must be registered with the market regulating Commodity Futures Trading Commission.

"Participation in the secondary market will be open to all participants, but will only exist on a cash-cleared basis," the draft said, adding trade will be "highly regulated, exchange-traded and transparent".

"It will eliminate the pure, bilateral over the counter OTC.L market, but trading over exchanges will mitigate a great deal of risk," said Andy Ager, head of carbon trading at brokers Bache Commodities.

Ager said growing concerns over counterparty risk had prompted the European carbon market to shift away from bilateral OTC trading towards the exchange-traded market.

"This is better. The U.S. have a chance to make good the mistakes made in Europe," he added, referring to allegations of emissions trading fraud in the $100 billion European market.

(Additional reporting by Janet Lawrence; Editing by Sue Thomas)