THE CARBON MARKET is growing in size and sophistication but regulators are in danger of causing serious damage to the thriving market they have created. The European Commission’s threat to limit emission credits in the EU Emissions Trading Scheme (ETS) after 2012 threatens the billions being invested in Clean Development Mechanism (CDM) projects, and repeated delays to the creation of central elements of the market’s infrastructure raise the spectre that traded contracts could fail to settle in December, exposing counterparties to a settlement risk of hundreds of millions of euros.
At a carbon markets conference organized by consultancy Point Carbon in Copenhagen in March, speakers included a Nobel Prize laureate, a prime minister, a minister of the environment and some chief executives, but for the delegates the speaker with the most sought after views was without a doubt Yvon Slingenberg, head of the C2 directorate of the European Commission (which covers market-based instruments including greenhouse gas trading), sent at the last minute to speak on behalf of her boss, who couldn’t make it.
Although Eurocrats generally do not enjoy a reputation for show-stealing charisma, in the carbon markets, where regulation is everything, their every word and indeed their every silence are enough to move the market.
On this occasion, the most burning issue for the conference delegates was how the EU’s position on potential limits to the amount of carbon credits that it will allow to be used in the ETS threatens to jeopardize billions of dollars-worth of investments in CDM projects.
In January this year, the EC proposed a revised ETS directive that threatened to limit the total amount of credits allowed into the scheme up to 2020 to the amount it had originally proposed to accept for the 2008–12 period, if no satisfactory international agreement was reached to succeed the Kyoto Protocol. The proposed limits are a signal to other countries that the EU is not prepared to shoulder the cost of CDM to the extent that it is at present, which is understandable given the fact that the EU is the only big polluter with a cap and trade system today, making it by far the largest buyer of credits generated by CDM. The limit is also to encourage companies to make real reductions within the EU itself.
The problem, however, is that given the continuing absence of a successor to the Kyoto Protocol, the EU’s position means that investors in CDM projects today face the risk that demand for Certified Emission Reductions (CERs) might evaporate after 2012.
“The risk is that there could be a slowdown in project development,” says Benedikt von Butler, vice-president of European environmental markets at CantorCO2e, a leading CDM project developer. “Many projects have a lifetime of seven to 10 or even 21 years, so long-dated forward sales of credits are needed in order to use the value from carbon finance, particularly for those that generate fewer credits per year. Without certainty, post-2012 people may hold back from entering into long-term contracts, which means that projects in the planning stage now that might only start in 2010 may get only two to three years in which to sell their carbon credits.”
According to project developers, the problem is compounded by the fact that there are fewer opportunities for projects with a high leverage to global warming potential – that is, those that produce lots of credits relative to the amount invested.
“I think you will probably see a gradual change in the types of projects being done,” says von Butler. “The ones based only on CO2 reductions will get squeezed out because of their lower leverage, which means that they need a longer off-take period to be worthwhile. However, projects such as landfill methane still have a lot of potential because of their decent leverage, which comes from the fact that each avoided tonne of methane generates 21 carbon credits compared with just one from avoiding one tonne of carbon dioxide.”
“The post-2012 risks have always been very much present. The problem is that the market expected those post-2012 risks to have reduced by now, through policy progress at both EU and international level,” says Olivia Hartridge, vice-president at Morgan Stanley. “The big picture is that the EU ETS has been the engine for the CDM to date and now the European Commission is indicating that if demand doesn’t pick up from other parts of the world the EU is not prepared to support it single-handedly into the future, despite its positive environmental results across many parts of the world. This result is that the timescale during which CDM projects must be profitable is reduced down to just two to three years, which is very challenging, because it takes about that long to get many projects going.”
For those involved in another corner of the carbon market, meanwhile, there looms a worrying grey cloud over the coming Christmas holiday season that is the result of things the European Commission hasn’t done. Banks, utilities and other traders expecting to see the contracts they have been trading settle physically for the first time this December are worried that their holidays and indeed their profits could be wiped out if crucial bits of market infrastructure are still not yet in place by then.
Crucial infrastructure
The crucial piece of infrastructure in question is a connection between the EU’s national registries and the International Transaction Log (ITL), which verifies transactions proposed by national registries to make sure that they comply with the Kyoto Protocol. The ITL has been delayed numerous times with little explanation. Without it, trades in EU allowances (EUAs) and CERs cannot settle physically.
“There is no certainty that the many EUA and CER trades expected to settle physically in December will be able to do so,” says Louis Redshaw, head of environmental markets at Barclays Capital. “The market has made contracts expecting everything to work but if the infrastructure is not up and running by then, market participants are potentially on the hook for hundreds of millions of euros and if that happens no one will want to trade again. We need guidance from the Commission or at least recognition of the problem.”
Another problem looming over the market is the fact that the allowance allocations, which determine the emission reduction targets for individual countries in the EU, have yet to be made for large countries such as Poland. Without these allocations, market participants cannot know whether they are long or short allowances and do not know what they need to do.
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Volumes rise but price is range-bound |
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European Climate exchange carbon financial instruments futures contracts: price and volume |
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Source: European Climate Exchange |
In an artificial market created by regulation like the ETS, good communication between the regulators and the market is essential for the market’s smooth functioning. Many market participants, however, are less than happy with the EC’s current efforts. The criticisms go beyond the problems with the ITL and national allowances, in which political bargaining between member states, an area outside of the EC’s control, has played a role. The commission has also been criticized for its failure to properly manage such mundane communication issues as the timely and predictable release of data such as the verified emissions data, which track actual levels of greenhouse gas emissions from sites covered under the scheme, a key pricing signal for the market.
Traders complain about not being told sufficiently in advance when the data are to be released and that the data come with no summary information. The result has been that the release of the verified emissions data over the past three years has resulted in huge price fluctuations on the day as analysts and newswires race to be the first to mine the data and come out with an early interpretation, which often turns out to be wrong, sending the market dramatically in one direction in the morning only to reverse completely by the afternoon. A combination of politics and the credit crunch has, however, helped to get a growing number of corporates involved in the carbon markets.
“Most corporates outside the power sector really didn’t have too much to do in phase one of the ETS because the vast majority were long allowances,” says Gavin Tait, head of carbon trading at ABN Amro. “Some early adopters who realized what their net positions were likely to be, hedged or sold early while a number of others tried, largely unsuccessfully, to time the market. But most have just allowed their excess allowances from phase one to expire in the accounts, which is a huge missed opportunity. Under phase two, however, fewer allocations have been made all round so the majority of companies are now likely to be short, which means they can’t afford to just sit still.”
According to Tait, companies are increasingly coming to view the carbon market not as a commodity market but as an environmental interest rate market. “In phase one we were dealing mainly with factory managers; now our relationship with these clients is more and more with their treasury teams. For sophisticated corporates already used to dealing with currency and interest-rate issues, adding CO2 to that list is relatively easy.”
Some companies are also exploiting the one-year overlap between the time allocations are made in advance and the time they have to be surrendered to do repo-style transactions in which EUAs are used as collateral to lower their cost of funding, a deal that has become more attractive as credit costs have increased.
For the majority of companies however, the high degree of uncertainty surrounding the carbon market stops them from trying anything too adventurous. Political risk is largely responsible for holding most corporates back from doing one of the easiest and potentially most profitable trades in the carbon market today: swapping as many EUAs as possible for CERs. Although the two instruments have the same compliance value, the political uncertainty surrounding CER delivery and the delivery risks associated with CDM projects mean that they trade at a hefty discount to EUAs of about 30% in the secondary market. Even though some banks are willing to structure deals to remove the political risks, the number of corporates willing to do such deals remains small.
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Steady rises and sudden falls |
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Société Générale World Alternative Energy Index |
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Source: Société Générale |
For those with enough confidence in the world’s politicians to support the market approach to tackling climate change, the trade is an attractive one that attracts such investors as hedge funds. A growing number of pension funds have also started to show an interest in the carbon markets. Although the decision to invest for some is motivated by socially responsible investing principles, the interest for others is diversification. The fact that the EUA price has increased more than 20% since the start of the year doesn’t hurt either.
Uncertainty initiative
In the voluntary market, by contrast, uncertainty about regulations is proving no barrier and even seems to be an incentive for some.
The market for voluntary emission reductions, although relatively small, is also growing quickly thanks to strong interest from US companies eager to familiarize themselves with carbon markets before proposed mandatory schemes become a reality.
Point Carbon estimates that some 75 million tonnes of CO2 equivalents were traded in the voluntary market in 2007, up from just 20 million tonnes in 2006, and that there are more than 140 million tonnes of emission reductions from US projects in the pipeline.
Interest from US companies is particularly strong because the market expects that mandatory schemes in the US will recognize credits generated domestically. The EU ETS and Kyoto protocol, by contrast, only recognize CDM credits, which are emission reductions made in countries without agreed reduction targets.
By getting involved in the voluntary market, US companies are also hoping to exercise influence over the shape of mandatory cap-and-trade schemes. Participants in the voluntary market have been influential over the type and quality of offsets being considered by the 10-state Regional Greenhouse Gas Initiative and can be expected to be similarly influential in any eventual federal cap-and-trade scheme.
“There are a lot of companies looking at voluntary offsetting as part of their overall sustainability strategy,” says Bruce Tozer, global head of environmental markets at JPMorgan. “For those that get involved early, however, there is the additional benefit that participation in the voluntary market will be valuable preparation for coming mandatory schemes. There is also the possibility that regulators will allow companies to benefit from voluntary credits generated in mandatory schemes once they are a reality.”
Despite the political uncertainties inevitable in a market of its kind, the carbon market is growing in size and sophistication.
Point Carbon estimates the value of the carbon market worldwide at €40 billion in 2007, up 80% from 2006. In terms of the volume of CO2 and equivalents traded, the market traded 2.7 billion tonnes in 2007, up 64% from the 1.6 billion tonnes traded in 2006.
The EU ETS represents 70% of the global financial market for carbon and 62% of the global physical market. Volumes in the ETS in 2007 rose 62% to 1.6 billion tonnes and the value traded rose 55% to €28 billion.
Growth in the CDM market has been even more impressive. The value of the CDM market reached €12 billion in 2007, up 200% from 2006, representing 947 million tonnes of CO2, a 68% increase. Point Carbon estimates that the CDM market now represents 35% of the physical market for CO2 and 29% of the financial market.
The number of CDM projects in the pipeline at the UN surpassed 2,800 in 2007 compared with 1,500 the year before, although notably the average size of projects continues to decline as more small-scale renewable energy projects take the place of highly leveraged ones. Renewable energy was the largest transacted project category in 2007, accounting for 29% of total confirmed transaction volume. Energy-efficiency schemes almost tripled their market share to 20%.
The market for secondary trading of CDM credits, which received a boost in 2007 with the launch of exchange-traded secondary CERs, starting with the NordPool exchange in June 2007, is now the fastest-growing segment of the carbon market. From limited activity at the start of the year, the market grew to about 350 million tonnes of sCER trades, up from just 40 million tones in 2006, much of this related to EUA-sCER swaps.
The pace of growth is such that Point Carbon predicts that the total CER market could well overtake the EUA market in terms of traded volume by 2009 or 2010.
Options trading has also increased rapidly in the EUA market in the past few months. The volume of EUA options traded on the European Climate Exchange in January 2008 reached a notional 45 million on the exchange, compared with 58 million traded in the whole of 2007.
