Understanding the market

Carbon trading is gaining momentum. There is now a real basis for a global market, and demand is predicted to grow rapidly
Miles Austin & Jill Barker


While the concept of carbon trading has been on the radar since the signing of the Kyoto Protocol in 1997, it has only really started to take off over the last two years through the European Emissions Trading Scheme (EU ETS).

There is now a live traded price for CO2 similar to any other commodity. In addition to EU Allowances (EUA), which are the permits allocated to participants in the EU ETS, the flexibility mechanisms of Kyoto have created a class of carbon credits – CERs and ERUs – that provide another source of global CO2 assets.

Through the growing number of schemes and products, there now exists a real platform for the development of an increasingly sophisticated, liquid and at some stage global market for carbon emissions.

The international market for carbon credits grew in value to an estimated $30B (£15B) in 2006, three times greater than the previous year. And it is predicted that demand will grow as countries in the developed world are unlikely to meet their Kyoto target of reducing their greenhouse gas emissions by an average of 5.2% below the year 1990 by 2012.

Although the term carbon trading is used, what is actually being traded in all cases is emissions rights measured in tonnes of CO2. The warming potential of other greenhouse gases covered by the Kyoto Protocol is measured in terms of the equivalent amount of CO2 that would have the same warming effect: CO2e.

In addition to setting the first ever international target for reducing greenhouse gas emissions, the Kyoto Protocol was groundbreaking as it established, for the first time, a means for developing countries to get involved in climate change mitigation, enabling a market-based solution to an environmental problem and bringing the issue of greenhouse gases to the mainstream of clean energy planning.

The Kyoto Protocol approved the use of three flexible mechanisms for facilitating the achievement of its greenhouse gas emission reduction targets on a least cost basis:

  • Emissions trading, allowing the international transfer of national allocations of emission rights, between different Annex 1 countries
  • The Clean Development Mechanism (CDM), a mechanism which allows for the creation of certified emission reduction (CER) credits through emission reduction projects in developing countries, regulated by the CDM Executive Board
  • Joint implementation: the creation of emissions reduction credits undertaken through transnational investment between countries and/or companies of the Annex 1 (industrialised countries)

The EU ETS was designed with exactly this in mind, and is now the cornerstone of EU climate policy. Reports commissioned by the EU, estimate that the emissions savings made under the EU ETS will cost e2.9-3.7B (£2-2.6B). An estimate of what the cost would have been using alternative non-market policies set the figure at e6.8B (£4.7B), suggesting a saving of e3.1-3.9B (£2.1-2.7B).

The EU ETS covers all of the EU member states, with a total of more than 11,000 installations, receiving about 2.1 billion EUAs a year in the Phase I 2005-2007. Use of CERs and ERUs is capped, with the caps amounting to an average of around 10% per country.

Designed as a three-year test (in order to highlight any flaws in time to fix them for Phase II), Phase I of the EU ETS runs until the end of this year. Phase II of the EU ETS runs in parallel with the Kyoto Protocol’s First Commitment period 2008-12. In keeping with its test phase status, Phase I EUAs cannot be banked into Phase II. Part of the impetus for having a short initial test phase was the experience of the US SOx trading scheme. This was initially hampered by too many permits being issued, coupled with having no test phase and thus banking being allowed.

But in April of 2006 it rapidly became clear that, contrary to what the majority of the market was anticipating, the EU ETS had a surplus of EUAs. As a result, the Phase I EUA price fell from around e30 (£20.70), to e11 (£7.60) in a week. Subsequently, it has declined further, and, at the time of writing, is trading at around e0.15 (£0.10).

The reasons for the size of the surplus are open to debate. At a price of e30 (£20.70) per tonne, it is likely that some zero- and low-cost abatement took place. But the prime culprit was, and remains to this day, the historical emissions data that the Phase I allocation was based upon, coupled with projections for growth in industrial output.

Both of these were provided to government by industry, with no independent checks.

Under Phases I and II of the EU ETS, countries present a National Allocation Plan (NAP) to the European Commission (EC) for approval. The 2005 verified emissions data, coupled with the surplus of EUAs, has provided the EC with two useful tools to ensure Phase II does not have a surplus. Firstly, unlike the historical emissions data that Phase I was based upon, the 2005 emissions data is independently verified.

Secondly, it is inevitable that, given the speed and degree of the EUA price crash, some market participants lost money.

As stated, EUAs that were valued at e30 (£20.70) in April 2006, are currently valued at e0.15 (£0.10). This created pressure from the financial sector to ensure that Phase II was not overallocated. As a result of having both independently verified emissions data and the political capital to maintain a firm stance, the EC has cut 20 of the 23 proposed NAPs which it has ruled on to date.

The CDM

Today, the CDM is by far the more dominant Kyoto mechanism. As of May 2007, the CDM is projected to create around 2Btonnes of reductions to 2012, compared with joint implementation’s 153Mtonnes. The effect of the EU ETS has to a large extent helped to drive the scale of investment that has taken place. The World Bank, in its State and Trends of the Carbon Market 2007 report, estimated that in 2006 the CDM market accounted for US$5.2B (£2.6B) of transactions compared with US$2.6B in 2005. The same report estimated that the EU ETS accounted for US$24B (£11.8B) in 2006 compared with US$7.9B (£3.9) in 2005.

There are currently 803 registered emission reduction projects in the CDM pipeline, and the expected volume of CERs generated from registered projects until the end of 2012 is a massive 990 million. In financial terms, and taking a conservative approach, this output of emissions reductions equates to billions of dollars of additional revenue generated by developers.

Since many of the projects began to be contracted at the start of the decade, the majority of the large-scale and most profitable potential CDM projects or low-hanging fruit have been exploited. Now that project developers have to work harder to find suitable projects, we may see different technologies and geographies taking prominence.

In addition, the CDM Executive Board has recently approved the use of Programmatic CDM. This allows a CDM project activity where the emission reductions are achieved by multiple actions executed over time as a result of a government programme or a private-sector initiative. Examples include grant or soft loan programs to promote energy efficiency, fuel switching activities or the use of renewable energies by private households, in the transportation sector or by small enterprises, as well as voluntary or mandatory efficiency standards for equipment or facilities.

How are credits traded?

For installations under the EU ETS, trading of EUAs, CERs and ERUs takes place in a number of different ways. The most simple deal is bilateral trade where Company A sells a volume of emissions to Company B. This is normally done under an Emissions Reductions Purchase Agreement, for which various formats exist.

EUAs are also spot-traded on some exchanges but the primary form of EUA exchange trading is in futures. The European Climate Exchange captures 70% of exchange based EUA trades. It trades EUA futures for the years 2007-2012 to be delivered in December of the contract’s vintage. So, for instance, the December 2008 contract delivers in December 2008.

CER futures are currently being traded on the Nordpool exchange. These are delivered in December of the contract’s vintage. Another form of trading CERs is through swaps. Swaps are attractive to holders of EUAs, as CERs currently trade at a discount to the Phase II EUA price. Phase II EUAs are swapped either for a larger number of CERs, or, an alternative option which has proved popular is to carry out a one to one swap with the EUA vendor being paid a premium.

The CER to Phase II EUA price differential presents a number of obvious advantages. Firstly, it achieves the same compliance result as purchasing EUAs, but at less cost. In the event that a company over purchases CERs, they have the advantage over EUAs of being a global carbon currency which can be used for compliance in any country with an emissions target under Kyoto.

Currently, spot trading of CERs is not possible as the international registry international transaction log that will facilitate this is not yet connected to any country registries. For the EC, this is predicted to happen in December 2007. It is a fair assumption that spot trading will start almost instantly.

Miles Austin and Jill Barker are from EcoSecurities

www.ecosecurities.com

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