From the June 01, 2010 issue of Futures Magazine • Subscribe!

Carbon allowances: Tomorrow’s game today

When U.S. climate legislation went off track in late April, the pressure to get it rolling again came not only from environmental non-governmental organizations (NGOs), but from companies like General Electric, Shell, and Rio Tinto.

All three belong to the United States Climate Action Partnership (USCAP), an amalgamation of leading corporations and NGOs lobbying for the creation of a credible nationwide greenhouse gas reduction scheme for the entire United States.

Some USCAP members, like Applied Energy Services (AES), have long partnered with NGOs to promote green development, while others have track records that are decidedly climate unfriendly. For these companies, the argument in favor of a consensus on greenhouse-gas reduction is often strategic: they need to make long-term capital investments, so they need to know the long-term regulatory framework within which they operate.

The U.S. plan will likely involve cap-and-trade, a scheme pioneered in the United States to reduce sulfur dioxide emissions and more recently adopted as the key “flexibility mechanism” of the Kyoto Protocol. This is the mechanism that allows companies that reduce their greenhouse gas emissions efficiently to sell credits to companies that aren’t able to do so, thus incentivizing the most efficient practices. It’s now the driver behind a global carbon market that the World Bank says is worth more $100 billion, and many analysts expect it to grow to $1 trillion within a decade.

Cap-and-trade schemes have been implemented across the United States, Europe, Japan, and New Zealand, but just one offers the kind of liquidity and transparency that most futures traders need: namely futures on European Union Allowances (EUAs), which are allowances (see “Contract specs”) issued by EU member states under the European Union Emissions Trading Scheme.

Specs

“You have to remember that the system is cap-and-trade, and without a cap, there is no trade,” says Patrick Birley, head of the European Climate Exchange (ECX). “Most of the trading volume is in Europe because we have caps. That’s what drives the need for accurate and constant pricing.”

EUAs are primarily traded on the ECX, which is a subsidiary of Climate Exchange Plc, which itself was recently taken over by ICE (see Trendlines). Climate Exchange Plc also owns the Chicago Climate Exchange and the Chicago Climate Futures Exchange, which lists futures and options based on its own “Carbon Financial Instrument,” as well as on offsets from two regional U.S. schemes (the East Coast’s Regional Greenhouse Gas Initiative and the West Coast’s Climate Action Reserve), as well as on Certified Emission Reduction certificates (CERs), which are created under the Kyoto Protocol’s Clean Development Mechanism (CDM).

CME Group’s Green Exchange lists futures on CERs and EUAs as well, but almost all volume is concentrated on the ECX.

Prices for EUAs have been locked into a range between €12 and €16 for the past year (see “Locked in a range”), with the floor coming from the European Commission’s reiteration of its support for reducing emissions and the ceiling coming largely from concerns over the future of the European economy.

Chart

Current EU laws place caps on the energy sector, while other industrial sectors will be capped over time. Carbon prices, as a result, tend to reflect three factors: perceived future supply driven by EU legislation, perceived current demand from the energy sector, and perceived future demand from the economy on the whole.

The framework

To trade EUAs and CERs, you need at least a rudimentary understanding of the United Nations Framework Convention on Climate Change, which was signed in the early 1990s by nearly all the world’s countries, including the United States. It’s a legally binding agreement to reduce greenhouse gas emissions, but it doesn’t set any targets and it doesn’t say how these reductions will be achieved.

Under UN procedures, such specifics are left to protocols, such as the Kyoto Protocol, which came into force in 2005 and expires at the end of 2012. It divides the world into developed countries, which are obligated to reduce their greenhouse-gas emissions to a level 5.2% below 1990 levels on average by the end of 2012, and developing countries, which have no obligations to reduce their emissions. Through the carbon market, however, companies in the developed world can earn credits by paying for clean development projects such as wind farms in India or tree-planting projects in Brazil.

The European Union pledged to reduce its emissions to a level 8% below those of 1990 by the end of 2012, and is slowly imposing emission caps on all of its industrial sectors in a phased approach that will continue to expand regardless of what happens in the United States. In the current phase, only a few sectors are regulated, and companies in these sectors receive emission allowances from their national governments. Over time, more sectors will be capped, and all allowances will be auctioned off instead of given away.

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