Carbon Pulse Dialogues are discussions about carbon markets and climate policy by a selection of leading experts.

More than 500 of South Korea’s biggest emitters met their 2015 compliance obligations under the scheme by the June 30 deadline.

But getting there wasn’t an easy ride. More than 40 lawsuits have been launched against the government on allocation issues. Prices at one stage rose to nearly $18/tonne to make Korea’s carbon price one of the world’s highest, while the market has struggled with liquidity and only some controversial government interventions in May and June unlocked supply.

The government recently restructured the administration of the ETS. What changes should the new caretakers consider to iron out key challenges to the market?

We have asked a number of experts and market participants. Their answers are posted below.

Anders Nordeng, Analyst, Thomson Reuters Point Carbon

Joo-jin Kim, Lawyer, ELPS

Jin Kim, Consultant, The ITC

Thomas Winklehner, CEO, Korea Carbon

Anders Nordeng:
Is the Korean ETS under-allocated or is it not? This should be a simple question, and yet the elements we need to answer it have kept eluding us. First, the Korean government was slow to share data, and when it finally did last week, it was in a raw form that demands more analysis.

When the K-ETS was launched in January 2015, many of the 525 or so companies subject to the scheme voiced strong protest, arguing that the number of emission allowances they had received was far from enough to account for their real needs. Some went as far as to sue the Ministry of Environment (MoE), who was then the regulatory authority.

An initial look at the raw data indicates the market was short some 15-20 million tonnes. However, once you add the 9-10 million taken from the reserve either as early action units, during the auction that took place in June, or through other special measures, we are left with a gap of some 5-10 m that needs to be covered by offsets and/or by borrowing from the 2016 allocations.

Irrespective of what will be the exact balance, what is striking to a European observer is the very limited liquidity. There are some 550 companies with an obligation to submit allowances to cover emissions. Some need more than they received, others have a surplus. There is a trading platform (the KRX exchange). Logically this should have been sufficient, no? Well, it clearly isn’t.

Thomson Reuters Point Carbon has estimated that throughout 2015 the traded volume of Korean carbon allowances (KAUs) was limited to some 300,000 units. Against an annual budget (allocation) of 543 m KAUs, this gives a turnover rate of less than 0.1. In comparison, the turnover rate in Europe is 2.75.

There are major differences between K-ETS and the EU ETS on which it is modelled, especially in terms of types of contracts and instruments, and who can be licensed as a carbon trader. To some extent this reflects a deliberate choice by the Korean government, alarmed as it was by the price volatility that has prevailed in the European carbon market. The MoE (with strong support from local companies) therefore decided to minimize the chances of speculative trading by limiting access (only compliance companies plus three state-owned banks are allowed to trade).

The strategy can be said to have worked in the sense that we have not seen rapid ups and downs. Instead prices have increased steadily from 7,860 KRW per KAU in January 2015 to the current bid price of around 17,000. And yet offered volumes are very limited. We believe that if the Korean government really wants to boost liquidity it needs to 1) allow forward contracts, and 2) allow middlemen, even at the risk of more speculation.

Joo-jin Kim: The first and foremost accomplishment of the K-ETS is that South Korean industry and regulators have begun to recognize that there is a price on carbon, and businesses will get more and more used to it as time passes.

However, at the same time, the K-ETS was one of Korea’s first environmental commodity markets. In fact, most Korean companies have barely any experience with energy commodities, as the sale of power and import of LNG is strictly regulated. This lack of experience with energy related commodities seems to be where the irregularities of K-ETS year one comes from.

Imagine a country where you can only purchase groceries from producers. No grocery stores, no Amazon, and only direct purchases from farmers. A little less than half of the houses are short of food, and a little bit more than half have a bit of leftovers. How would the desperate and starving households find out who has leftovers? Would the houses with marginal leftovers feel motivated to knock on their neighbours’ doors to sell a couple of potatoes? Should you expect a lot of trading to take place in such a market? Would market prices, if any, in such a market be reliable? Of course not, and this is pretty much what the K-ETS looks like. What other explanation do we have for the rise of credit prices despite a seven million ton (1.3%) long market?

On top of all this, the Korean government, nervous about complaints from industry groups over unexpectedly high credit prices concluded that “government intervention” is the solution. Hence comes the increase of borrowing limits and the release of market stability reserves, which only strengthened the belief in the market that “the government sets the price, and not the market.”

The Korean government should understand the basics of a market economy – that a working emissions market, which induces long term investments comes from predictable and reliable markets. Closing the market to third parties and relying on government intervention only undermines that credibility. In other words, the government should learn to sit back and relax. Third-party trading (i.e., trade by parties other than the 550 or so companies regulated under the K-ETS) should also be allowed as soon as possible, especially, if the government’s main concern is to tame the higher than expected prices.

Jin Kim: I think the first year of the Korean ETS was fairly successful. More than 500 companies complied with the scheme by submitting allowances to the government based on their 2015 emissions. Nevertheless, the first year illustrated several problems which should be closely reviewed and improved. Here, I would like to comment on two things: free allocation and market trade.

Free allocation

Unlike the industry’s initial claims of 10-20% under-allocation, it turned out that the companies that were short in 2015 were short by less than 5%. Thus, the government has concluded that the preliminary allocation level was reasonable, and commented that industry exaggerated the shortage. But I think there were still problems with the allocation. The K-ETS includes 23 industry groups from five sectors and over 500 companies have complied with the scheme in 2015. Although the overall allocation for 2015 did not seem harsh, several sub-industry groups have claimed that their allocation levels were unfair. In fact, the allocation adjustment factors (AAF) for some groups, such as petrochemicals and non-ferrous metals producers, were recognizably lower than others, such as steel and paper. The government did not provide sufficient and understandable explanations for these gaps. In consequence, many industry groups ended up filing lawsuits against the government.

I recommend the government establishes a more open and reliable process on deciding caps for each industry group. The government and industry both need to produce reliable data in order to set more reasonable caps.

Trading

During the first year a total 5.7 million permits and offsets traded in the market, accounting for only 1.1% of the total 2015 preliminary allocation. Furthermore, two companies alone bought 80% of the entire amount traded – mostly via the OTC market.

I think almost all long companies were reluctant to put their surplus for sale mainly because they had little faith in the long-term policy stability. The carbon market is an artificial mechanism created by the government, and thus its policy directions are extremely important for how well the market functions.

Companies will design carbon trading strategies and actually participate in the market when they think the government’s ETS policy will be somewhat reliable and stable. To ensure this, the government should provide more clear and long-term predictable policy directions.

However, providing clear direction does not mean that government should interfere in the market at any time. In June the government auctioned some of the market stability reserve. The auction’s starting price was $13.50 (16,200 won), more than 20% below the $17 secondary market price. The market price stayed at $14 after the auction.

Even though it is true that the auction contributed to increasing market liquidity and lowering the unit price, it sent somewhat misleading signals to market participants. Many companies were unhappy with some aspects of the auctions, such as the strict rules for participation and the low price floor.

Furthermore, many short companies now expect that they will be able to get below-market price allowances ahead of the compliance deadline from the government, so they think they don’t have to buy some of the allowances they need in the market.

I propose that the government in future is more careful in how and when with it releases the market stability reserve, and that it specifies the circumstances under which it will happen.

Thomas Winklehner: Establishing a new emissions trading system is always a daunting task that requires a lot of coordination and hard work to put all necessary processes in place. This has been no different for the Korean ETS. Initially the system suffered from lack of infrastructure to register new offset projects and to convert CERs to KOCs, but people worked hard to rectify those issues. The first KOCs were issued only a few months after the start of the K-ETS and paired with Korean compliance companies’ cautious approach to the market, this led to very low liquidity in the beginning.

The low level of liquidity has and remains to be a main concern for the K-ETS as a trading system. This is partly due to the decision to restrict access to non-compliance players, which was demonstrated by the Korea Exchange (KRX) only listing KAUs and KCUs for trading. As non-compliance players were not able to hold either KAUs or KCUs, this made it impossible for such companies to participate in the scheme.

Offset project developers were confined to the OTC market, which resulted in a lower degree of transparency and higher transaction costs as all KOC deals had to be negotiated on an OTC basis. Only a handful of compliance companies that converted CERs to KOCs were able to access the KRX, as they could convert KOC to KCU directly before offering them on KRX.

The recent auctions held by the government for KAUs were also severely restricted. Only compliance companies with a deficit of more than 10% were able to participate. The auctions only served to smooth over problems created by the lack of supply in the market, rather than providing price transparency or encourage more participation in the K-ETS.

In 2016, the framework for the K-ETS was changed. The government decided to shift responsibility from the Ministry of Environment to several other ministries. Additionally, it was decided to increase the amount of borrowing from 10% to 20% on an annual basis and to replace 2020 emissions reduction targets with 2030 targets.

The break-up of responsibilities has left the K-ETS in a form of limbo as the Ministry of Environment is no longer responsible for certain tasks while other ministries have not yet geared up to take on the new responsibilities. As such, new methodologies for the registration of offset projects are not currently progressing because responsibility for the task seems to be unclear at present.

Increasing the amount of borrowing allows companies to procrastinate and await new developments before taking action, as compliance with legislated targets can in most cases be achieved by simply borrowing from future allocations.

The shift from a 2020 to a 2030 emission reduction target is a mixed blessing. While it could be seen as providing for more certainty in long-term investments, it also reduces pressure in the short-term for companies to take action. It would have been advantageous to pair Korea’s longer-term ambitions with shorter-term targets to force companies to make progress towards their longer-term targets.

Considering that the K-ETS has already seen sweeping changes after one year of operation, it is likely that the shift to 2030 targets will encourage further delay in action as the rules might yet change substantially over the coming years.

Despite current problems, most notably the lack of liquidity, it is important to note that putting a price on pollution is an important step forward. Procedures for reporting and verification are now established and it has to be hoped that liquidity in the market will pick up to allow both compliance and non-compliance companies to interact in a central market place.

Hopefully the new setup of several coordinated ministries having responsibility will take the K-ETS forward instead of stifling development. To increase liquidity, the early introduction of international carbon credits should be considered in order to lower the compliance cost for industry and provide more ample supply of offset credits.