Richard Gallo

The Carbon Market: Obsolete or Opportunity?
by Richard Gallo

Those involved in carbon trading already know that the market last year was rife with problems. Spot prices fell, the market was used to commit theft, and governments couldn't seem to agree on emissions targets. Even now, critics continue to ramp up pressure on politicians to shelf carbon trading, claiming that it is a failure. The lack of clear direction has frustrated individual investors, industries, and traders.

In the face of these problems, many believe that the current system is broken and losing momentum. However, on closer examination, we find a market that is large, expanding and quickly becoming the standard solution to a major environmental problem.

       Emissions trading, also known as cap-and-trade, is a permit system meant to limit or cap the amount of greenhouse gas emissions a country, organization or corporation can emit. A computer simulation model developed in the 1960s demonstrated that the cap-and-trade system could reduce pollution. The system was established in the United States in the 1990s in order to combat the problem of acid rain, which was caused by power plant pollution. Today, various voluntary and enforced cap-and-trade systems exist. All are meant to encourage companies to build low-emissions power sources and improve existing facilities.

       A cap-and-trade system begins when a governing body establishes the emissions limit for its members. It then distributes or auctions emissions allowances that equal the total cap. Member firms that do not have enough allowances to cover their emissions must either make reductions or buy another firm's spare credits. The hope is that members will switch to cleaner and greener technologies in order to avoid paying more for emissions allowances.

       The European Union launched the European Union Emissions Trading Scheme (EU ETS ) in 2005. The EU ETS is the largest multinational emissions trading scheme in the world. The system covers more than 10,000 installations and allocates allowances based on emissions caps set by EU member states. Each country then tracks and validates the actual emissions. Allowances are retired at the end of each year.

       Under the current global trading scheme, one carbon credit is equal to one metric ton of carbon dioxide. Currently, there are four major types of carbon credits on the market:The European Union Allowances (EUA) of the EU ETS; the Emission Reduction Units (ERU) of the mandatory market mechanism; the Certified Emission Reductions (CER) of the mandatory market mechanism; and the Voluntary Emission Reductions (VCU/VER) of the voluntary market mechanisms. When trading internationally, the United Nations Framework Convention on Climate Change (UNFCC) validates the transfers. Within the EU, the European Commission (EU ETS) validates transfers.

Over the last couple years, a series of economic and fraudulent events damaged the carbon market and its reputation, affecting both supply and demand.

The first damaging event was the recent global economic crisis. Starting in late 2008, carbon prices fell sharply as investors and industrial emitters went into survival mode and redirected funds. Prices soon fell to record lows in the first quarter of 2009 as EU companies sold carbon credits heavily in order to generate much needed cash. The Clean Development Mechanism program (CDM), which allows emission reduction projects in developing countries to earn CER credits, struggled to secure funding. High numbers of project applications caused the program to experience approval delays. Then, just when prices were stabilizing, the Copenhagen Climate Conference (in December 2009) failed to produce any binding agreements. Thus, support for future global emissions reductions waned. The market continued to sell off carbon credits, further reducing the price.

 

 

Fraud accusations also eroded confidence in the system. According to Climate Action and United Nations Environment Programme (UNEP), some Chinese projects were accused of purposely overproducing HFC-23, which is 14,800 times more potent than carbon dioxide, in order to earn valuable carbon credits. If this is indeed the case, it's been estimated that Chinese companies will earn US$1.6 billion by 2012 from the overproduction of HFC-23. The United Nations considered withholding compensation for the destruction of HFC-23, but the UN was forced to pay when Chinese companies threatened to emit supplies into the atmosphere.

In 2009, the UK and EU governments confronted criminal gangs engaged in a 5 billion Euros VAT fraud. Investigators pointed to carbon trading as a conduit for this scheme. In 2010, computer hackers obtained unauthorized access to online carbon credits accounts, stealing millions of credits and reselling them into the markets. The EU suspended trading on the Paris-based carbon exchange BlueNext, Europe’s largest and busiest spot trading exchange at the time. Once trading resumed, fearful traders and investors quickly exited the market, causing the price to collapse and the liquidity to dry up. Since then, spot trading has mostly occurred over the counter and below quoted prices.

Globally, the adoption of carbon trading has been patchy. In November 2009, New Zealand’s parliament passed the Climate Change Response (Moderated Emissions Trading), making it the first mandatory, economy-wide scheme outside Europe. They have stated that full implementation could be delayed without adequate progress by other developed countries.

Australia’s Prime Minister Julia Gillard announced this month that the country is planning an emissions trading system that will rival Europe’s Carbon Trading Scheme. Full implementation is still uncertain, however, because opposition party members and powerful industry lobbies are pushing back. Those opposing the system argue that industries can’t afford to implement such measures at a time when economic recovery still faces challenges.

China, the largest recipient of credits under the Clean Development Mechanism (CDM) program, is experiencing mounting pressure to commit to GHG emissions reductions. The country has announced a plan to launch an internal emissions trading system in six regions by 2013 and nationwide by 2015. This has encouraged proponents of GHG agreements. Unfortunately, the current lack of support among developed countries for the Kyoto agreement may push the EU to adopt more protective measures on outside credits coming into their market. A shift in policy by the EU, the largest buyer of CDM produced credits, would most likely delay China's commitment to any binding global agreements.

India is a small participant, considering the size of its economy. The country is one of the largest emitters of CO2 in the world. It is eligible to receive large quantities of credits to subsidize projects under the CDM program, but to date India has relatively few projects. India’s lack of participation can be partially attributed to an undeveloped carbon reduction finance support structure and its inexperience in the global carbon market. Growth will largely depend on the country's ability to fully realize how beneficial the CDM financial incentive program can be for achieving GHG emissions reductions.

The situation in North America is tenuous at best. The United States was the second largest emitter of CO2 in 2009, producing 17.8 percent of the world's total. The U.S. has no cap-and-trade system or tax levies on carbon emissions. American lawmakers attempted to enact a climate bill in 2010 that included a cap-and-trade market in greenhouse gases, but the effort was defeated in the House of Representatives. If President Obama wins a second term, it is widely expected that he will push through a carbon emissions compliance system. Meanwhile, the Chicago Climate Exchange, which operates the voluntary carbon exchange program in the U.S., recently shut its doors, stating that there was no point in trading carbon credits without a legal requirement to do so. California enacted its own statewide cap-and-trade system in December 2010. Many carbon-trading advocates hope that individual states will continue to develop initiatives designed to control GHG emissions. Canada’s government has shown little support for a cap-and-trade system. Some progress has been made by individual provinces, but they have been left to implement their own initiatives.

The EU ETS is not perfect, but it provides the best carbon trading environment to date. The EU ETS was originally organized in three phases. Phase one was a pilot period between 2005 to 2007. Phase two coincided with the Kyoto Protocol commitment period of 2008 to 2012. Finally, phase three starts in January 2013 and will last until December 2020. Phase one and two had a number of positive results. There was a yearly reduction in carbon emissions. Power companies integrated the costs of carbon reduction strategies into their budget decisions. There was increased liquidity for CDM credits. Improvements in the infrastructure of registries, accounting methods and reporting and verification systems also occurred.

Improvements during the period between 2012 to 2014 may be slow as the European Commission (EC) finalizes the new carbon market regulations, mechanisms and operations planned for phase three. Announced changes include a single EU-wide cap to increase harmonization, tighter limits on the use of offsets, and a move from allowances to auctioning. The scope of the program will be extended to other sectors, such as airlines. The plan is also to include additional greenhouse gases within the regulatory scope. Tighter emissions caps will be implemented and there will be an increase in auctioning allowances. The EC understands that in order for phase three to be effective the price of credits needs to stay high enough so as to encourage industries to make investments in carbon cutting technologies, but not so high that it damages the health of a particular industry.

Critics of the program believe that an over supply of credits has caused volatility in the markets. Since phase one and two credits will be carried over into phase three, some experts state that at least 1.7 billion carbon allowances must be taken out of the EU carbon market in order to increase low carbon investment and halt emissions growth. One proposed solution is to increase the targeted cut in emissions for the EU to 30 percent by 2020 rather than the current 20 percent, which would help shore up the over supply. Parliament has resisted the idea, but the EC says it’s monitoring the market and will decide on measures to tighten up the market if necessary.

Due to the complex allocation and auction process, predicting the supply and demand of credits is a challenge. Different sectors are treated differently. Some are required to purchase all their allowances through government auctions or off the market. Other sectors perceived to be at risk of relocating production outside the EU will receive 100 percent of the benchmark allocation free of charge. The allocation amount for new entrants, such as aluminum producers and airlines, will be calculated separately in order to shield them from any rise in demand.

However the European Union decides to allocate, auction and reduce carbon credits, the market is large, active and growing. Out of the $136 billion carbon market in 2009, EU transactions accounted for $118.5 billion (€88.7 billion). Data published recently by Bloomberg New Energy Finance shows that the value of carbon emissions credits traded in 2010 reached $120 billion and indicates that the global carbon market will grow by 15 percent in 2011, the most in three years. Global financial support for emissions reduction projects is also increasing. An agreement in Cancun increased the $30 billion a year allocated for CDM projects to $100 billion a year, starting in 2020.

Another significant sign of growth is the Clean Development Mechanism program (CDM). This is the only international structure that provides incentives to reduce CO2 emissions in developing countries. The program creates a billion dollar industry that is supported by the World Bank and the United Nations. Powerful financial institutions profit by providing services to the emissions control industry. These services include asset management, project financing, and brokerage assistance. Insurance agencies insure CDM projects, professional managers oversee CDM projects, law firms navigate regulatory requirements, and accounting firms audit to ensure compliance. Major investment bankers, including Goldman Sachs, Barclays and Citibank are already heavily involved, with new players continually entering the market.

Furthermore, evidence strongly indicates that U.S. players represented 10 to 15 percent of the trading volume on London’s European Climate Exchange (ECX) in 2009. The Green Exchange, based in the U.S., announced in April 2010 that it intends to open an office in London. Hedge funds are well-positioned to profit from the carbon market, with its wild price swings and broad spreads caused by an illiquid market. Signs of a maturing market are appearing as a number of financial products have shown up such as futures, calendar spreads, options and swaps. As analysts see a tighter correlation between the carbon market and the powerful price drivers in the market, we should begin to see complex hedging strategies and structured cross-commodity products.

Some have bought into the perception that the carbon market has been a failure due to the decline in the price of carbon credits, or because the U.S. has not signed up. However, this thinking misses the big picture. Critics of cap-and-trade or emissions taxes claim it is economically harmful, while others don’t believe it is the best solution to fix the problem. Many just refuse to accept the science of global warming or just don’t want to pay to clean up the mess.

The facts are that the majority of people are concerned about carbon emissions and want their governments to do something. Greenhouse gas is a global problem, which requires a global solution. The idea that 192 governments will attempt to coordinate tax policy is unlikely. Cap-and-trade may not be the best solution, but when governments around the world sign up they are at least seen as doing something.

The cap-and-trade model continues to be the most proposed and implemented option by governments today. Viewed collectively, it won’t take much to see a sudden acceleration in market growth and technology integration. As for as the late players, they may come kicking and screaming, but eventually they’ll be in the game.