Trading of greenhouse gas emission allowances has become standard activity on European energy desks, with European Climate Exchange (ECX) products acting as the benchmark for prices around the world. It was a market established exchanges such as the New York Mercantile Exchange (Nymex) and Eurex seemed willing to cede to the upstart, but now both are pulling out all the stops to gain a foothold in this rapidly expanding market — and threatening the dominant position of ECX and its parent, Climate Exchange Plc, which also owns the Chicago Climate Exchange (CCX).
Nymex is in the process of launching its “Green Exchange” in the United States, while the European Energy Exchange (EEX) is expanding its range of carbon products just as ECX finds itself unable to expand its product range thanks to a dispute with its clearinghouse, LCH.Clearnet (see “LCH, ICE dispute leaves ECX cold,” January 2008).
But while exchanges are scrambling to offer carbon-based products, most traders have little understanding of what these instruments are or what drives price moves.
Both ECX and CCX offer so-called “Carbon Financial Instruments” (CFIs), which are trading at about $35 per ton of “CO2e” (carbon dioxide equivalents, representing a basket of greenhouse gasses) on ECX, while CFIs on CCX are to be had for less than $2.50 per ton.
The price differential between CFI futures in Chicago and CFI futures in London flows from the fact that these are completely different instruments unlikely to converge in price. If you want to make money in the new carbon markets, you’ll have to learn a few acronyms and be prepared to learn the subtle differences among emerging cap-and-trade regimes.
VOLUNTARY VS.COMPLIANCE
The most obvious difference between ECX and CCX is that London CFIs are based on compliance allowances, while Chicago CFIs are based on voluntary allowances.
Compliance allowances are those that companies purchase to comply with the law, and until now that has meant European Union Allowances (EUAs) trading under the European Union Emissions Trading Scheme (EU ETS), which is run under EU laws flowing from the 1997 Kyoto Protocol.
That protocol obligates developed nations that signed it to reduce their emissions of greenhouse gases to a level 5% below their 1990 emissions by the end of 2012. The United States famously signed the protocol, but didn’t ratify it — and now the focus among traders has shifted to the negotiations over what will replace Kyoto once it expires.
“Between now and 2009, negotiators will be hammering out the details of what is to follow Kyoto,” says Patrick Weber, who heads the environmental trading books at Dresdner Kleinwort Investment Bank in London. “This debate offers plenty of trading opportunities as views are aired and expanded. We could see a trading range of €20 to even €40 per ton, depending on which way the talks go.”
The voluntary market is a different animal altogether, comprised as it is of companies that agree to voluntarily limit their emissions to one benchmark or another. Companies that aren’t able to reduce their emissions outright can offset their emissions by purchasing allowances, credits or offsets, the latter being projects that reduce emissions elsewhere.
The prices for voluntary allowances don’t fluctuate as much in response to the utterances of negotiators as do compliance allowances, but they do offer plenty of trading opportunities, with more than a $1 trading range on CCX CFI futures in October of 2007 alone.
There are plenty of motives for entering a voluntary trading scheme — from doing the right thing, to winning some green credibility, to gaining proficiency in emissions trading for when the United States implements a compliance regime.
The factors impacting the prices of voluntary allowances range from the public’s confidence in the integrity of the allowances, to the price of new technologies, to debate over whether voluntary allowances purchased now could ever be sold into a compliance scheme down the road (the consensus: don’t bet on it).
REDUCING ON THE CHEAP
The offsets mentioned above add complexity to the market, especially in the compliance area, where the Kyoto Protocol’s Clean Development Mechanism (CDM) makes it possible for companies in Kyoto-compliant countries to offset their own dirty activities at home by spending money on clean development abroad.
To avoid greenwash, such projects have to meet so-called “additionality” requirements, meaning you have to prove that the money actually caused the reduction in order to get a credit. That’s easy when you’re installing solar cookers in Indonesia, where the alternative is to burn wood — such projects would clearly never take place if someone weren’t paying for them. But what about projects that reduce emissions by increasing energy efficiency, and thus reducing costs?
Then comes the sticky issue of “leakage,” proving that a clean project in one part of a country doesn’t lead to a dirty project somewhere else.
An entire cottage industry has sprung up to verify and validate CDM projects, and leading investment banks and carbon funds have invested billions of euros in projects from Brazil to China in the belief that they will one day be able to cash in by selling Certified Emission Reduction certificates (CERs) into recognized trading schemes such as EU ETS, which currently lets companies cover up to half of their allowances with CERs.
Speculation over the future role of CERs in EU ETS is expected to be a key driver in market moves over the next two years (see “Beyond Kyoto”), and for at least the next six months, both EEX and Nordpool will be able to offer CER futures, while ECX is frozen out of the game.
CERs trade at a discount to EUAs, reflecting both the risk of the projects not delivering and the lower cost of abatement in the developing world. It’s simply cheaper to build a clean energy plant in China than it is to try and reduce emissions in Europe, but developers don’t get to swap CERs for EUAs until the projects have actually delivered the anticipated environmental benefits.
An active spread market exists between EUAs and CERs, with the differential between the two markets narrowing to as little as €2 and expanding to as much as €8 (see “EAUs vs. CERs,” above).
For traders, it has paid in the past to keep an eye on the CDM pipeline, which you can do at the Web site of the United Nations Framework Convention on Climate Change (UNFCCC). Going forward, however, it will pay to keep up to speed on negotiations affecting the post-Kyoto framework.
PLANTING TREES
That's because everything is on the table: from the nature of a global framework to replace the protocol to the structure of national regimes to ensure compliance. Mainstream media has focused on the posturing between the United States and the European Union over who's going to sign on to the deepest cuts, but a greater impact for markets could be lurking in how the world deals with trees.
Deforestation in the developing world accounts for anywhere from 15% to 25% of greenhouse gas emissions worldwide, because chopping down (and burning) trees releases billions of tons of carbon into the atmosphere. That places Indonesia in the same league as the United States and China, but it's been nearly impossible to get CER credits for planting trees, let alone preventing them from being chopped down. One key stumbling point on granting CERs on projects that save endangered forests has been determining whether a forest was in danger. The favored method, reduction in the rate of deforestation, can potentially reward countries that have been chopping down their forests willy-nilly, like Indonesia, and punish countries that have voluntarily tried to halt the process, like Brazil. That's led to a movement to value all standing forests the same, which increases the supply of carbon credits that might be delivered into cap-and-trade schemes, and forces a redefinition of what constitutes a reduction. Scores of proposals are on the table for dealing with this, and traders are well-advised to keep abreast of the debate.
