THE LEGAL FRAMEWORK
Volume and open interest on ECX have been rising steadily since 2005, when the European Union launched the current pilot phase of EU ETS, the European Union Emissions Trading System, which to-date is the world’s largest cap-and-trade scheme for greenhouse gas emissions. That status, however, is expected to be eclipsed once the United States passes the American Clean Energy & Security Act (ACES), which is better known as “Waxman-Markey” for its sponsors, Henry A. Waxman (D-Calif.) and Edward J. Markey (D-Mass.).
Once signed into law, Waxman-Markey will lay out America’s targets for reducing greenhouse gas emissions and provide a framework for achieving those reductions most efficiently. It looks set to create demand for up to two million tons of carbon offsets annually, the price of which should rise if the American economy fails to meet emission-reduction targets and fall if those targets are met or beaten.
That will hinge on whether legislators really design it to reflect environmental benefits and there’s plenty of debate over how to achieve that. Everyone agrees that the price of carbon offsets has to be higher than the cost of implementing those green technologies that don’t pay for themselves if the offsets are really going to drive funding to those technologies. Policymakers, however, are divided over what those technologies might be.
The European Commission’s Environmental Directorate, for example, has made no secret of its belief that policy should aim to keep the price of offsets slightly above the cost of switching from coal to natural gas. Their most recent calculations translate into a carbon offset price of roughly €28 per ton of carbon dioxide or its equivalent.
U.S. legislators tend to have more faith in the carbon market’s ability to generate new low-cost solutions, and are thus less fixated on the idea of a target price. Successful traders will be those best able to identify both the reasoning behind evolving schemes and the political will for implementing them.
OFFSETS VS. ALLOWANCES
Carbon credits can broadly be divided into two categories: “allowances,” which are issued or auctioned by a given regulatory regime’s recognized oversight agency and are traded among companies within that agency’s scheme, and “offsets,” which are created by entities outside that scheme.
Some offsets will ultimately evolve into allowances, but most won’t. Therefore, it makes sense to keep tabs both on the number and type of clean development projects being undertaken around the world and the evolving regulatory landscape on which these offsets will ultimately find their home.
Astute traders have already been able to make money by following the Waxman-Markey process and trading markets that react to it. The Chicago Climate Exchange (CCX), for example, lists an instrument of its own creation: Carbon Financial Instruments (CFIs), which represent 100 metric tons of carbon dioxide or its equivalent. The price of CFIs rises when it appears the instruments will be recognized under Waxman-Markey and falls when it appears they won’t.
Traders who want to capitalize on moves in existing markets will have to understand the logic that drives the formation of the market – including current negotiations designed to culminate at the end of this year in Copenhagen, when a successor to the Kyoto Protocol is supposed to be hammered out. However, most experts expect only an agreement in principle with details to be worked out in 2010.
Offsets, for example, were designed a carrot to bring the developing world into climate-reduction talks, but can also be used to promote reductions in sectors within a developed economy that are not covered by trading schemes.
The debate over whether or not to recognize the CCX’s CFIs as offsets under Waxman-Markey, for example, flows from the debate over how to entice companies into reducing their emissions today rather than waiting for the law to take effect.
On the developing-world front, the Kyoto Protocol’s Clean Development Mechanism (CDM) makes it possible for companies in the developed world to earn offset credits for activities as diverse as building wind farms in India or planting trees in Mexico.
Indeed, the concept of offsets began in the late 1980s, when U.S. conservation organization Conservation International teamed up with green-minded industrial emitters after learning that deforestation in the tropics accounts for 20% of all greenhouse gas emissions. The emitters began offsetting emissions voluntarily by preserving patches of endangered rainforest, and the ease with which emissions could be reduced by avoiding deforestation led to the concept of generating offsets by Reducing Emissions from Deforestation and forest Degradation (REDD). That type of offset, however, was squeezed out of Kyoto by Greenpeace and other left-wing environmental organizations that felt it detracted from the focus on reducing industrial emissions.