Global warming on cap-and-trade

IFR Derivatives 2009
10 min read

The success of the European carbon cap-and-trade market has encouraged other countries to use the same mechanism to regulate carbon production. But regulation and government mandates are crucial to the success of the market, and the failure to update the Kyoto Protocol beyond 2012 is undermining the progress Europe has already made. Owen Wild reports.

The European Union’s Emissions Trading Scheme (EU ETS) has established itself as the model for cap-and-trade schemes set to be introduced around the world. Australia, Japan and the US are set to be the next countries to adopt similar schemes. But these plans – and the existing European market – are being held back by uncertainty. Some market participants are looking hopefully towards the UN Climate Change Conference in Copenhagen this December. But for many, optimism is in short supply.

More than anything else, uncertainty is currently driving the carbon markets. What happens on January 1 2013 is the big unknown. The Kyoto protocol will have expired and no successor is yet in place. It is not in doubt that a replacement for Kyoto will be found, but uncertainty has decimated trading volumes for futures and options beyond 2012. The market is regressing for the first time since 2005.

Early stumbles

In the formative years of the EU ETS between 2005 and 2008 there were some difficulties as the structure of the market was agreed. Credits expired at the end of 2006, meaning they became worthless as they approached the new year. Banks lost money, but participants stressed those years were about building a market and introducing corporates to commodity trading. The losses of 2006, when market prices collapsed due to oversupply of European Union Emissions Allowances (EUAs), were forgotten as phase II of the scheme (2008-2012) saw the market move towards reduction of output.

Emmanuel Fages, senior carbon analyst at SG in Paris, said Phase I was more about establishing infrastructure than reducing emissions. “There is a lot of jargon to introduce to companies, from EUAs to CERs and now ERUs, and many of them are not natural traders,” he said. Several years into the project many small and medium-sized firms are trading just once or twice a year.

As the distribution of free credits, the EUAs, has fallen each year, the market has begun to achieve its aims. Firms exceeding their allocations are paying the price through the cost of additional credits. Yet the lack of depth in the emissions markets remains a problem.

Companies tend to trade one or two years ahead so large polluters, particularly utilities, build up substantial inventories. When financing pressure was at a peak in early 2009, companies looked to free up cash and sold their positions. The European Climate Exchange saw an all-time high in trading volumes during February 2009, with activity hitting 447m tonnes, while prices fell to below €10 for EUA front month settlement, down from nearly €30 in June 2008 and €20 in October 2008.

Prices have since recovered some ground to trade around €13. The impact of global recession has been a contraction in output, pushing down carbon production and with it the need to purchase additional EUAs or certified emissions reductions (CER). Therefore, any price recovery is likely to be modest.

During February there was also a narrowing of the spread between EUA and CER prices, yet a gap has persisted with EUAs trading at a premium. In part this reflects the challenges with the creation of CERs.

Hot air

CERs are created by the UN under the Kyoto Protocol. These contracts, which each cover one tonne of carbon (the same as government-awarded EUAs) result from projects which are shown to capture carbon. The spread reflects the difficulties in developing projects and their mixed success in delivering the projected benefits. The collapse in the share prices of AgCert and EcoSecurities illustrate this, after projects to create CERs offered disappointing returns. AgCert, a project operator, saw its stock price almost double before its shares became worthless. The firm was ultimately absorbed into one of its creditors.

In response index provider Markit in late September launched a new family of indices to track the ratio of realised CERs to planned target amount of CERs for individual projects around the world. The indices are broken down by geographical location and sector of activity, reflecting both the amount of credits created relative to target and the timeline for delivery.

“There certainly is a wide differential between success in type and geography of projects and that should be reflected in the price of credits,” said Niall Cameron, executive vice president of commodities, indices, equities and risk management at Markit.

There is much debate whether companies should purchase CERs or EUAs. SG’s Fages believes companies should purchase CERs, but not from projects directly. On this basis the seller is obliged to deliver a contract at settlement, which would have to be purchased in the market if the planned delivery cannot be made.

While the Markit effort focuses on the failure of projects to deliver the gains envisaged, Fages argued a greater issue facing the carbon markets today is the failure of the UN to keep up with the demands of assessing projects.

“Many projects thought that they would achieve more emission reductions than they can actually prove. The Clean Development Mechanism executive board is improving by trying to standardise processes, making them more transparent,” said SG’s Fages. “What is not improving is the pace of issuances. When a project is seen for the first time it is thoroughly reviewed. But later when the same project asks for more credits to be issued, it is already registered and has been issued credits, so analysts expected the issuance process to be faster. But instead the backlog in issuing credits is mounting.”

The repeat issuance of credits to existing projects and more from new projects meant early expectations were for 2.5bn tonnes of credits to be created in the 2008-2012 phase. This was then revised to 1.5bn, then 1.3bn. It has been argued that at the current rate, production will be just 800m tonnes.

Regulatory uncertainty is the other major issue for bankers. Louis Redshaw, head of environmental markets at Barclays Capital, said regulatory uncertainty is the biggest factor impacting on volatility, though he does not think uncertainty post-2012 is having too much negative impact, considering Europe has already agreed to continue with its current ETS efforts until 2020. In addition, countries like China and India have softened their opposition to introducing targets, while the terms for the entry of air carriers into the scheme have also been determined.

The big question mark hangs over post-2012 trading. Prices will be massively impacted if the US cap-and-trade scheme were to commence at that time – while more cap-and-trade markets will also create more competition for the supply of CERs.

The introduction of the US alone would triple the size of the global carbon market overnight. The EU scheme covers 40%-50% of output. The US scheme will include transport, meaning 85% of emissions will be covered.

The other issue with speculating on where prices will be in 2013 is that Phase III in Europe sees another step in the development of the market. Previously EUAs have been free, with a contraction in the total number issued each year, but by then will be conducted via auctions. This marks significant further progress in the move to a market that brings together environmental and economic issues.

It will have taken eight years for the European scheme to reach this point. Inevitably the US scheme will follow a similar step-by-step approach. However lobby groups are already complaining about this process, even if it is intended to provide more stable markets.

“Congress seems to be designing carbon markets in ways that make them even more unconventional, for example by allowing a large portion of offsets credits, allocating allowances for free, and establishing a strategic reserve and carbon trigger prices,” said Michelle Chan of Friends of the Earth US in a report published in September. “These design choices will compromise the environmental and financial integrity of the system and make governance inherently more difficult.”

All eyes are now focusing on Copenhagen and the UN Climate Change Conference, yet optimism for any update to Kyoto has diminished. It is an opportunity for countries to get a better understanding of what their peers are doing, but there is unlikely to be any major progress, said Redshaw. This view is underlined by the US hoping to have draft legislation in hand by early October, but playing down the importance of having it ready ahead of Copenhagen.

Fages is also doubtful of meaningful progress, but highlights the importance of agreeing a programme for the future during 2010. “Unfortunately we all depend on certainty of the post-2012 situation. How can we get people involved in climate change fight when we don’t know what happens post-2012?”