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.
“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.
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.
If companies in a capped sector generate more emissions than they have allowances for, they must purchase additional allowances from one of three sources: from companies that have extra allowances, from government auctions, or by investing in clean development projects in the developing world.
EUAs are associated with the first two types of offset, and CERs are the last type. European companies can only use CERs to meet their obligations under certain circumstances. CERs generated by planting trees that capture carbon, for example, cannot be used for compliance purposes in the European Union, even though they are recognized by the UN. Furthermore, individual EU member states place limits on how many CERs can be admitted into the system for compliance purposes in an effort to promote the reduction of industrial emissions at home.
The relationship between CERs and EUAs is a complex one, but futures are listed on both, and there is active spread trading between the two contracts. CERs trade at a discount to EUAs, but the market is in backwardation because the companies that verify and validate CDM projects are finding it difficult to attract people with the skills necessary to do the job. This, in theory, offers an opportunity for traders who are able to tell when the logjam might break -- but that’s an insider’s game.
“The pipeline is a matter of public record, but it’s difficult to gauge how long individual projects take to get verified, let alone the whole sector,” says Heiko Siemann, a carbon trader with UniCredit Corporate Investment Banking in Munich. “Also, it’s difficult to say which countries are close to their limits.”
The European challenge
Traders also should keep an eye on climate change talks as negotiators from all United Nations Framework Convention on Climate Change (UNFCCC) countries meet throughout the year to hammer out a successor to the Kyoto Protocol. This year’s talks culminate in December in Cancun, Mexico, but few observers believe such an agreement will be reached this year under current UNFCCC rules. There is, however, speculation that the U.S.-led Copenhagen Accord will evolve into a multilateral agreement backed by the largest emitting nations, with financial carrots and sticks for developing nations to take on obligations of their own.
A global deal would be bullish for both EUAs and CERs, but the spread between the two would depend on which types of offsets the European Union recognizes, as well as how it adjusts its overall caps. The European Union has already obligated itself to reduce emissions to a level 8% below 1990 levels by the end of 2012, and their next-phase commitments are even more impressive.
In 2008, the European Commission set a target of 20% below 1990 levels by 2020, even if there is no global accord, but it has also offered to increase this reduction to 30% if a global agreement is reached. The commission recently circulated a draft working paper advocating a reduction to 30% below 1990 levels regardless of how talks play out this year. The argument in part reflects that achieving such a reduction is now cheaper than had been before, but also reflects a growing willingness to recognize offsets generated by capturing carbon in trees.
If those ideas gain traction, the market for EUAs could receive an added boost, because for now, trade is focusing on the status quo. “The market is operating on the assumption that nothing will happen in Cancun,” says Sanjoy Dutta, also of UniCredit. “Any hint of a deal before then would be a positive surprise.”
He says that traders also should keep an eye on quarterly carbon auctions carried out by individual member states, as well as the number of allowances that countries distribute in 2011 and 2012.
Although the European Union has an overall reduction target for itself, it gives individual member states wide leeway on their individual reductions under the so-called burden sharing agreement (BSA).
Under the BSA, the countries that were the most industrially advanced (Luxembourg, Germany and Denmark) have the deepest reduction targets (28%, 21%, and 21%, respectively), while countries that lag in terms of development (Spain, Greece, and Portugal) are allowed to let their emissions grow (15%, 25%, and 27%). Individual countries also determine how many allowances they are going to give away, although the EU then either signs off on this amount or reduces it.
In addition, countries can auction off allowances on a quarterly basis. Each country follows its own schedule, and auctions are a key indicator of price.
Follow the energy markets
For now, traders are focusing on the price of power, the price of natural gas and the relationship between the two, as well as crude oil, though that is seen as a proxy for global economic health.
Phrased another way, they’re keeping an eye both on long-term electricity contracts and the near-term price of energy inputs.
“Utilities follow a pattern that all traders should be aware of,” Dutta says. “At the end of the first and second quarters, they make their long-term sales of electricity to industry, and because they have to start buying their carbon allowances after 2012, that leaves them short carbon, so they have to buy.”
Dutta says that’s led to fairly reliable surges in the price of carbon this time of year over the past five years, and helped the recent run-up from below €13 at the end of March to nearly €16 as we go to press.
“The contracts they’re making now are for 2013, but companies can bank carbon allowances for the future, so they are buying today as a hedge,” Dutta says. “We’re seeing added signs of support from the economy, which has become a key proxy for carbon.”
If the economy slips back into recession, or the Greek contagion becomes a drag on the developed parts of Europe’s economy, the price of carbon could begin to drift downward. Barring that, traders we contacted expect an expansion of the trading range to test the €18 level.
“I don’t really see it going down for now,” says Bob Kapp, the top carbon trader at Macquarie Bank in London (see Trader Profile). “The factors are already in place to make the price go up -- impending tighter requirements, more demand from a resurgent economy, etc. -- and we just have to wait for the numbers that people have in their heads [to] change.”
At different times, the market will fixate on different criteria, but for the next few months, it will remain focused on the price of power.
“In general, if you’re watching the pricing switch between different fuel types, you can pretend you’re a utility and assume you have gas plants and coal plants,” Kapp says. “As the prices of the gas change relative to the coal, one plant becomes more economical than the other, and that changes your demand for emissions, because natural gas is cleaner than coal.”
