“It puts you in a great mood,” he says. “And it keeps you there all day.”

Running a booming business can also put you in a good mood, and Birley has nailed that down as well. He runs the European Climate Exchange (ECX), which leads the world in futures and options on carbon credits: financial instruments that measure the degree to which emitters of greenhouse gasses reduce their emissions. There are plenty of gasses that contribute to the greenhouse effect, but carbon dioxide is the most common, so emissions tend to be measured in “tons of carbon dioxide equivalent,” or “tCO2e,” but we’ll stick with “carbon.”

The volume of global carbon trading doubled in 2008, and nearly all the growth came in the secondary markets, which provide the liquidity that helps make the primary market more efficient. As secondary trading grows, the carbon markets are beginning to behave more like markets for corn, wheat, or currencies — with identifiable trends and deep, if spotty liquidity. As liquidity increases, exchanges like Bluenext (a subsidiary of NYSE.Euronext) are teaming up with information providers like Markit (a joint venture backed by several investment banks) to develop indexes based on different sub-sectors of the carbon market. Many of these will one day form the basis for futures and options themselves.

CAP & TRADE 101

The United States invented cap-and-trade, and it’s proven effective when done right. 

It begins with two basic premises: one, that we can only continue to harvest our natural resources as long as our rate of renewing them exceeds our rate of harvest; and two, that our current economic system doesn’t factor the cost of environmental degradation into the cost of production. The logic flowing from these premises ultimately boils down to the conclusion that we have to embed the cost of environmental degradation into the cost of production.

That means first determining what constitutes a safe level of degradation, and then coming up with a way to keep the rest of us within that limit. Cap-and-trade gives government the task of determining that amount by setting one limit for the entire economy, but it lets companies decide among themselves how they can hit those targets most efficiently by issuing or selling pollution allowances that can be bought and sold. 

In theory, this means that government’s role in cap-and-trade is to set and enforce the limits, while the private sector’s role is to figure out the most effective way of achieving them. In reality, the government ends up playing the role of market overseer — and, critics would say, also market manipulator.

The market mechanism in cap-and-trade schemes is designed to funnel money into efficient environment-friendly technologies, especially those that aren’t yet market-viable, and to reduce the costs of compliance for companies that can’t reduce emissions by giving them the option of paying others to reduce emissions
more cheaply.

The government can either give allowances away or it can sell them through an auction, and the global trend is towards a hybrid of issuing and auctioning. This means some allowances are given away, and others are auctioned, with the proceeds from auctions going to specific environmental programs (it’s this aspect that some critics have derided as “cap-and-tax”). Waxman-Markey follows the hybrid model, and carbon traders will have to learn the intricacies of the auctioning process the way bond traders have learned the intricacies of how the Federal Reserve Board operates, especially since, unlike bonds, the carbon markets are not yet deep or liquid enough to support purely technical strategies.

Creating the tapestry of global cap-and-trade regimes that will replace the Kyoto Protocol is a daunting task, but cap-and-trade itself is hardly an untested method. In fact, it forms the cornerstone of the Environmental Protection Agency’s Acid Rain Program (ARP), which aims to reduce acid rain by placing a cap on emissions of sulfur dioxide and then auctioning off those allowances every year.

Environmentally and economically, the program has been an unequivocal success: emissions of sulfur dioxide have plunged more than 40% since the program’s launch, and at a cost of less than $3 billion per year. Benefits, measured in terms of lower health costs, reduced damage to crops, and other economic goodies that flow from a healthy environment, now top $100 billion per year.

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.

Adding agriculture to deforestation, you find that nearly 40% of global greenhouse gas emissions come from changes in land-use, and the REDD sector is likely to be absorbed into a larger sector called Land Use, Land-Use Change, and Forestry (LULUCF), which promises to be a massive influence on prices.

U.S. SCHEMES & EXCHANGES

Chicago Climate Exchange (CCX) was the first U.S. platform to trade greenhouse gas reduction certificates. It was conceived in the 1990s, when it looked as though the United States might sign the Kyoto Protocol. When this failed to happen, CCX became a voluntary exchange, one that offers an opportunity for companies to show off their green cred by signing a binding agreement to reduce their carbon footprint and then using a voluntary cap-and-trade scheme to help them achieve that. It got off the ground in 2003.

Its volumes, however, are nothing compared to those of the ECX, which it is affiliated with through parent company Climate Exchange LLC.

CCX has a subsidiary, called the Chicago Climate Futures Exchange, which offers futures and options on its CFIs. In June, CCX’s cross-town rival, CME Group, launched futures and options on Certified Emission Reduction certificates (CERs) and European Union Allowances (EUAs). These are offsets recognized under the Kyoto Protocol and EU ETS, respectively. In a nutshell, CERs are international offsets generated by clean development projects in the developing world. Some types of CERs can be converted into EUAs, but the European Union does not recognize all types. As a result, CERs trade at a discount to EUAs, and individual CERs trade at a premium or discount to the quoted CER price. Active hedging is taking place between the two types on the big three European exchanges (ECS, Bluenext, and the European Energy Exchange (EEX), which is affiliated
with Eurex).

European exchanges have a clear advantage over the CCX: namely, their products are part of a recognized and regulated scheme. The United States has just two schemes whose offsets and allowances will be recognized under Waxman-Markey as it currently stands: namely, the Regional Greenhouse Gas Initiative (RGGI) and the Climate Action Reserve (The Reserve).

RGGI involves 10 northeastern U.S. states, and has failed to attract much attention, largely because legislators were afraid that cheap offsets would upset the environmental community and expensive ones would upset the business community. As a result, they created a system that allows the supply of offsets to increase as prices rise and limits the supply of offsets as prices fall, leaving little incentive for investing in costly offset projects. This leaves developers of offset projects no incentive to take the risk of investing in clean development projects, and also offers little incentive for traders to enter in hopes of capitalizing on
price moves.

The Reserve (formerly known as the California Climate Action Registry) is a voluntary carbon standard and a credit accounting registry that has been endorsed by state legislation to supply offsets into California’s regulated cap-and-trade scheme, known in policy circles as AB 32.

STANDARDS & REGISTRIES

The derivatives and securities worlds have their clearinghouses, and the carbon offsets world has its registries, which keep track of projects that reduce emissions and make sure that offsets from the same project aren’t sold twice or thrice. The United Nations has its own registry for projects that generate offsets under the CDM, and the Kyoto Protocol describes the standards to which offset projects must conform. Likewise, an entire cottage industry of project verifiers has emerged, dominated by groups like Germany’s TÜV SÜD, which inspects and certifies factories around the world.

In the voluntary world, a handful of standards also have emerged, and the one preferred by companies looking to voluntarily reduce their carbon footprint is the Voluntary Carbon Standard, which in turn has selected four registries to track offsets generated under
the standard.

In June, Markit finalized the purchase of one of these registries: TZ1.  This gives them access to unprecedented amounts of information and signals the arrival of an entity that has long been ahead of the curve.

Predicting the next huge derivatives market is a tricky game but it is apparent that the carbon market is building the underlying infrastructure that must occur for larger success to follow.