In May, Laurent Segalen declared, “We have a market!” Segalen is investment manager for the European Carbon Fund. His declaration came after the price of carbon allowances trading under the European Union Emissions Trading Scheme (EU ETS) on the European Climate Exchange (ECX) had plunged from €30 per metric ton to just €8.50 in a matter of days before bouncing back to the current range of between €15 and €20.
With outright margin of just €3.50 per ton, or €3,500 per thousand-ton contract, it was a wild ride indeed —and one that critics trumpeted as the demise of carbon trading as a viable component of greenhouse gas reduction efforts.
Segalen, unlike those writing the obituaries, knows a thing or two about financial markets. He’s one of a core group of perhaps 300 green-minded financiers who have managed the leap into carbon trading, and he has little sympathy for the thousands of others who bought in as prices soared.
“You had a lot of people who understood nothing about anything and they tried to come in and make some quick gains,” he says. “They got bashed.”
Dirk Forrister, managing director of emissions consultancy Natsource, agrees. “If you believed those prices as they were climbing and climbing, you had to believe there was nothing anyone could do anywhere in Europe for under €25 per metric ton,” he says. “That simply was never the case.”
The good news: traders who got bashed did so in an orderly fashion, with no interruptions and with several margin calls issued and met.
Open interest on the ECX actually rose to 42,649 in the midst of the May turmoil, more than double the 21,000 after the March expiry. Albert de Haan, ECX’s commercial director, says 30 companies that had never before traded directly became active the day after the crash. “These were companies who had prepared themselves ahead of time and were just waiting for the right time to buy,” he says.
And the composition of the market is also encouraging. On the day the slide began, 4.2 million metric tons (4,200 contracts) were traded in 467 individual transactions, 394 of which were traded through the screen as opposed to Exchange for Physicals (EFPs), indicating a large number of small transactions rather than a small number of large ones. “The bulk of trading is coming from utilities, with banks becoming more and more active as carbon becomes part of the energy complex,” de Haan says.
“This is a functioning, mature market,” echoes Peter Kreuzberg, managing director of German energy giant RWE’s trading division. “But it’s not the sort of thing you can trade by looking at charts.”
Indeed, market participants almost universally laid blame for the volatility on the lack of transparency regarding emissions numbers and the lack of regulatory certainty regarding the long term structure of the markets.
“There should, at the very least, be a code of conduct on how the individual member states as well as the EU releases sensitive information,” says ECX CEO Peter Koster. “It’s very important that it is done in a structured and a professional way, as if it is a publicly-quoted company releasing earnings information.”
Andrei Marcu, president and CEO of the International Emissions Trading Association (IETA), says business has done its part by creating a workable market. “But markets are driven by supply and demand, and demand in this market is driven by government policy,” Marcu says.
Voluntary vs. mandatory
Global politics has divided the world into two spheres of carbon emissions influence: the voluntary world, where companies, organizations and even individuals choose to reduce their net emissions by purchasing allowances, and the mandatory compliance world, where companies meet limits imposed by law.
The granddaddy of all voluntary exchanges is the ECX’s parent company, the Chicago Climate Exchange (CCX), where prices on so-called Carbon Financial Instruments (CFIs) have remained below $5.00 per ton — largely because the United States, along with China and India, is not part of the United Nations Framework Convention on Climate Change’s (UNFCCC) Kyoto Protocol (see “Mandatory beats voluntary,”).
CCX has attracted respectable volume, but the World Bank report “State and trends of the Carbon Market 2006” makes it clear mandatory reductions like those in Europe and Japan are generating the greatest incentive to reduce, and thus stimulating the greatest demand for emission allowances.
The ECX’s EU ETS program offers trading in European Union Allowances (EUAs), which are either issued by governments or earned by companies through validated reductions. Prices for EUAs can be generally divided into two categories: those that expire before 2008 and those that expire afterwards. That’s because the current “pilot” phase of EU ETS runs out at the end of 2007. Phase two runs from 2008 through 2012, and E.U. governments are currently debating the caps to be imposed and the means of enforcing them.
Companies can bank credits from one year to the next, but not from one phase to the next — except for a few exceptions granted in Poland and France. Spread trading between the two phases has already begun to take place as companies try to create virtual banked credits.
The Kyoto Protocol sets a baseline of 1990, a sticking point for the United States as that was the year its economy and emissions diverged from that of Europe and the Soviet Union.
Mandatory reduction programs don’t have to follow Kyoto, as Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont can attest. Those states have formed the Regional Greenhouse Gas Initiative (RGGI), which will impose a mandatory cap on carbon emissions from power plants beginning in 2009, and targets a 10% reduction by 2019. The baseline for that reduction is tentatively set as 2008, and CCX hopes to set up platforms to service RGGI.
With global warming skeptics converting en masse and new groups turning green, including a group of 86 evangelical Christian leaders, it’s not difficult to imagine some sort of mandatory federal cap for the United States before 2012. The Supreme Court has already agreed to hear arguments from 12 states that want to force the federal Environmental Protection Agency to regulate auto emissions.
However, exchange-traded allow-ances are just the tip of the iceberg; and traders looking to play them are well-advised to learn the whole cycle of carbon allowances.
When Worlds Intersect
The Clean Development Mechanism (CDM) is a cornerstone of the Kyoto Protocol and a template for voluntary programs. It allows companies to fund clean development projects to “offset” their emissions and lays out a detailed set of criteria for doing so. According to the World Bank, the developing world, and especially developing countries that have not signed the Kyoto Protocol, have been cashing in on so-called Certified Emission Reduction (CER) contracts under the CDM to fund the growth of their green energy sectors.
From a trading perspective, CER contracts are something like seedlings — they represent projects that are out there somewhere in the world, being planted and nurtured, but no one really knows what they’ll deliver until harvest time. They are wind parks in Mongolia, renewable energy projects in India and soon high-tech clean coal-burning power plants in China. The value of CER contracts depends on how much carbon emissions the projects have certifiably reduced and that won’t be known for years.
“This is high-risk business,” Segalen says. “The technology is unproven,
and there are plenty of other risks, such as weather.”
The ECX plans to offer a platform for trading CER contracts but that
is still a ways off. Meanwhile, an entire cottage industry has sprung up to
find, fund and most important, audit CER projects.
Anyone who uses CERs to offset emissions has to prove that the projects not only reduce emissions but pass the “additionality test,” meaning that the emission reductions wouldn’t have happened without the money investors used to “buy” the credits.
So-called Designated Operational Entities (DOEs) are accredited by the United Nations to certify and verify such projects under a rigorous set of criteria (see relatedc link below). One such DOE is the Switzerland-based non-profit MyClimate Foundation, run by Renat Heuberger and a group of other green-minded auditors.
“We basically look for projects that are run by reputable people who can show us they know how to implement them,” Heuberger says. “Then we quantify the amount of carbon they will prevent from getting into the atmosphere and try to sell the CER contracts at the best price.”
He recently brokered CER contracts on clean energy projects in India and South Africa, which he sold for €1,000,000 to Frankfurt-based 3C, which bought them on behalf of the Federation Internationale de Football Association (FIFA) to offset an estimated 100,000 tons of carbon emissions generated by surging traffic flows at Germany’s 2006 Soccer World Cup.
The World Bank says sales of CER projects helped developing countries raise billions for clean development projects and offset the equivalent of 374 million tons of carbon dioxide throughout the course of 2005 and the first six months of 2006, with Europe and Japan accounting for 90% of the buying and China accounting for a whopping 66% of the selling.
Many projects outside of China took pricing cues from exchange-traded EUAs. “More and more CER contracts are linked to the price of EUAs,” says Segalen. “Although the projects we are involved in tend to have long-term horizons, the kinds of moves we had in April and May often force short-term contracts to be renegotiated and they can be quite disruptive to negotiations.”
Heuberger agrees. “When market prices are down, it is easier to source projects because the people offering them are afraid of being undercut.”
Voluntary markets work by providing a central registry for offset projects that have been audited according to the registry’s own standards using approved third party verifiers, and then allowing the verified emission reduction credits to be offset against pollution. Several registries exist, most prominently the CCX and the California Climate Action Registry, but the IETA and several non governmental organizations are working on a global voluntary standard that will set rules for auditing and measuring emission standards across the board.
As the markets evolve, CCX and its subsidiaries hope to use the Intercontinental Exchange’s (ICE’s) trading platform to embed their products ever more firmly in the energy complex, providing spread vehicles for coal, electricity, crude oil, and other energy products. ICE is launching coal futures in July, and ECX is launching options on carbon, while CCX lists several other greenhouse gasses.
Yes, we have a market — and it is just beginning to arrive.
