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January 2008

The Carbon Market - a Primer

The developed countries (25 in Europe, Japan and Canada) that have signed the Kyoto protocol have agreed to reduce their carbon emissions to 5.2% below their 1990 levels by 2012. To track and implement this protocol, each of these countries have been issued Assigned Amount Units (AAUs) which cap the total emissions that will be permitted by these countries. In turn, the countries assign these units to companies (as EUAs in Europe) within their countries in line with their nationally approved emission limits.

[Apologies for the alphabet soup, which will get more intense as the report progresses – a glossary is provided at the end of this report.]

If a company in one of the developed countries is unable to reduce its emissions to the required level, it has to buy credits to make up the difference. It can either buy EUAs from companies in developed countries that are surplus – i.e., have reduced emissions to below their assigned levels – or buy carbon credits from companies who have registered projects under the Clean Development Mechanism (CDM) or Joint Implementation (JI), which are different mechanisms defined under the Kyoto protocol. Credits issued under the CDM (or JI), called CERs (or ERUs), while identical to EUAs in terms of their carbon savings – incidentally, one carbon credit (CC) is defined as 1 Metric Ton of carbon dioxide emitted by burning of fossil fuels or from emissions of HFCs or methane – are not priced the same as EUAs, nor is there a straightforward relationship between the price of CERs (or ERUs) and that of EUAs [see below].

Buyers of credits are mostly EU, Japan and Canada. Australia, which has recently joined the protocol during the Bali conference in 2007, may soon be a new buyer.

Sellers of credits would be mostly East European countries, particularly Russia and Ukraine, who have reduced their emissions substantially (30% in Russia), and companies in developing economies that have Implemented (or are implementing) projects under CDM (or JI).

Market Size

Market volume for these tradable credits has grown dramatically over the past three years, from around 100 million tonnes of CO2 equivalent in 2004 to nearly 2,400 million tonnes in 2007, with nearly two-thirds of the 2007 volume begin traded in the second half. The chart shows that the bulk of the growth in volume was in the EU-ETS segment (i.e., traded between different EU governments and companies), with the volume of developed country credits holding largely steady at around 500 million tonnes.

At the start, all the carbon trading was OTC, with bilateral transactions between governments and/or companies. Commercial banks entered the market in early 2005, which also saw the evolution of carbon exchanges. The exchanges, which are rapidly gaining market share, include European Carbon Exchange (ECX), which has a market share of 75.6%, PowerNext (13.3%), Nord Pool (7.4%), and EEX (3.6%). The market is strongly broker-driven, with over 70% of total volumes (exchange plus OTC) handled by brokers. While the OTC market is shrinking in importance – today, it handles just about 40% of volumes – it remains critical in the CDM segment, with virtually all developing country credits being traded bilaterally.

What affects the price of EUAs?

The chart shows that, despite the fact that the market is in its infancy, total volumes transacted have reached a healthy EUR 25 billion in 2007. With strong global growth and more and more CDM projects going onstream in developing countries, the traded volume is expected to continue to grow dramatically, even from these levels.

However, understanding the pricing of credits is more complicated than in most commodity markets. This is because (a) the market is in a very nascent stage, (b) the perennial uncertainty of supply and demand, and (c) importantly, because there is huge difference in the perceived value of EUAs (credits traded within Europe) and that of CERs (credits sold by CDM projects in developing countries, which require regular audit and verification), despite the fact that they both represent the same commodity.

Supply of credits is determined by the allowances issued to the market (EUAs) through the National Allocation Plans of Member States, and, of course, carbon credits generated by new and existing projects that are certified as “carbon positive” (CERs and ERUs). While the former is determined at the start of each phase, the latter depends on a whole host of unforecastable factors, including the speed with which projects in emerging economies get off the ground, the regulatory time frame, the perceived quality of the certification, etc.

Demand is determined by the actual amount of emissions relative to the permitted amount (the allocations). Actual emissions are influenced by economic growth, climatic conditions and fuel prices.

Obviously, higher global growth leads to higher emissions and increased demand for credits.

Cold weather increases power and heat demand while low rainfall and wind speeds reduce production of non-polluting hydro- and wind-power. Weather effects have been seen to have a strong correlation with EUA prices (as high as 89% in 2005), although the correlation did seem to break down during the market meltdown at the end of 2006. However, the correlation appears to have returned and it's impact can be hugely significant, with weather-related effects estimated to increase emissions by as much as 60 million tonnes per year (around 3% of the annual cap) in a particularly bad weather year.

Fuel prices work in a secondary manner. For instance, relatively higher prices of natural gas vis-à-vis coal will increase GHG emissions as more coal is used to generate power. In 2005, fuel prices had a 48% correlation with EUA prices; nonetheless, fuel prices can swing emissions by upto 45 million tonnes per year, and can have a significant impact on the volatility and trend of the market.

Policy and regulatory factors can also play a dramatic role in the market as was seen in the second quarter of 2005, when the publication of verified emissions data in Europe showed that EUAs were found to be over-allocated to the extent of 65 million tonnes for phase 1. The huge – and sudden – excess supply led to a sharp crash in prices of the Dec 2007 EUA contract from $32 to $9 in three weeks. This prompted the European Commission to warn governments to cut down allocations for Phase 2 so that the supply/demand balance moved sufficiently in favor of sellers to stimulate more “green” projects - to create scarcity and allow the market to work.

It is, perhaps, significant the December 2008 contract was less unaffected by this technical factor, which suggests that, at least at that time, the underlying medium-term trend was bullish.

There are other factors suggesting firm prices in the future. For instance, the European Union has recently raised the penalty for defaulting on emission targets under the EU- ETS, from EUR 40 for phase 1 (2005-07) to EUR 100 for Phase 2 (2008-12). Clearly, this penalty level would cap the market price of credits since a defaulter would simply pay the penalty rather than buy credits at a higher price. The sharply higher cap suggests that there is considerably more room for the market to rise – note, it does not mean the market WILL rise; it merely means the cap on prices is higher.

On the other hand, the developing country projects (CDM), while currently about 20% of the market, are likely to grow, increasing supply. One of the problems with this source, however, is that information on CDM projects is, at this stage, a bit obscure. While Point Carbon, a consultancy, reported 2050 CDM / JI projects with estimated emission reductions of 2000 million tonnes registered as of March 2007, the UN website shows only 885 registered CDM projects with 187 million tonnes of carbon reductions at the end of 2007. Further, not all the estimated projects may come through and many of them may not deliver reductions as rated.

This would suggest that at least in the early part of Phase 2, growth in supply would lag that in demand, and, in any case, will be uncertain. This may explain why EUA prices are well bid right now.

CER pricing

We note that the price for CERs (credits generated by developing country projects) averaged just EUR 6.40 per credit (as compared to the average EUR 17.84 accorded to EUAs); of course, since the crash in the price of EUAs in 2006, the markets are now closer together (2007 averages: EUA 10.57; CER 7.15).

Some of the reasons given for the variation is that while EUAs are assigned and represent a definite CO2 reduction, the value (in terms of CO2 reduction) of the CERs are less certain and depend on

a) the credit rating and standing of project promoters

b) the country rating in terms of country risk and credibility

c) the status of the project, since projects are in various stages of completion

d) the size of the project and expected CER volume

e) the history of the project in honoring its commitments, if it is a continuing project

f) the number and reputation of project participants

g) the work done by the project promoters in sustainable development, since the entire Kyoto protocol is intended to push companies in this direction

Added to these project-specific factors, CER prices are also discounted because of nervousness about audit quality, and, it must be said, the weaker negotiating power of developing countries.

However, over time, the increase in volume of CERs generated and the price gap between the two credits could exert a downdraft on EUA prices. As developing countries – particularly the leaders, like China and India – begin to exert more influence on world affairs (and markets), which process is already under way and should be very well developed by the end of Phase 2 (2011-12), we would expect that the spread between EUAs and CERs would be very thin. Already, China, which dominates the sell side with a 70% share, is already using its clout to set a floor of EUR 8-9 per CER.

Beyond 2012

To ensure significant investment in low carbon projects, there needs to be considerable certainty of the economic incentive to ensure acceptability by global markets. Despite the fact that the Kyoto Protocol's targets are legally binding, the fact that the current scheme has a 5-year horizon creates a disconnect with this requirement.Significantly, the KP framework is also defined for an infinite period of time with its signatories required to negotiate targets for blocks of 5-years – commitment periods – beyond 2012. While there is general support for reducing global emissions, talks are deadlocked due to the divide between developed and developing countries on how to distribute the costs.

New sectors such as aviation, road and marine transport, and aluminium are also expected to be included and developing countries are likely to take on emission caps as they reach advanced stages of development. The EU-ETS is set to continue as the EU has sketched a path towards emissions reductions of 20% by 2020, or 30% if other industrialized countries - especially the US – agree to take on targets.

US participation

The US has been the major obstacle to achieving progress on climate change with its emissions running 16% above the 1990 levels. It withdrew from the Kyoto Protocol after committing to a 7% reduction over 1990 levels and, under President Bush, has refused to engage meaningfully in international or domestic GHG reduction efforts. With the country responsible for 25% of global emissions, and total emissions being 25% higher than those of either China or the EU, its participation is critical to the success of the global climate change initiative.

However, while the federal government has taken little interest in reducing emissions, pressure has been building from public opinion, corporate America, and regional trading initiatives to come up with a market based mechanism. After Hurricane Katrina wreaked devastation in Louisiana, over 75% of Americans agree that the effects of global warming are already manifesting themselves and will become even more serious in the future.

Corporations, realizing the inevitability of carbon constraints, are also taking leadership in pushing for federal legislation with moderate targets and long-term certainty. 720 mayors have also signed on to the “US Mayor’s Climate Protection Agreement” to try and meet or exceed the US' original Kyoto target by taking local actions in their communities. Certain states have taken the lead in establishing mandatory regional GHG cap and trade programs (RGGI and California Plan).

The Regional Greenhouse Gas Initiative (RGGI): is a cap-and-trade program – lasting through 2019 – for CO2 emissions of power plants in 10 Northeast and Mid-Atlantic States. It spells out a stabilization target for the electricity sector of 180 million short tons (163 million metric tons), a few percent above the 2000-02 baseline. Each state has authority over the allocation process, and reserves at least 25% of the allowances for consumer benefit or strategic energy purposes. These may be sold through state or regional auctions, or directly into the market. Unlimited banking of allowances is permitted and there is also an offset program which provides a link to the Kyoto CDM and JI projects – and hence to the EU ETS. International credits may be used to cover upto 10% of emissions above a price of $10/ton adjusted for inflation plus a 2% per year increment, while domestic credits must be used below this threshold.

California Plan: In September 2006, the California legislature passed a bill to reduce GHG emissions 25% to 1990 levels by 2020. The law also provides for a statewide market-based system to trade emission “credits”. Contrary to the RGGI and EU-ETS, which have generation-based caps, the plan proposes a load-based cap which would cover all power purchases, including imports which are at 15%, to avoid emissions leakage. The plan also allows for linkages to other systems and the state has expressed a desire to join the RGGI.

With all the Presidential contenders in favor of taking some action – although campaign rhetoric and action are not necessarily well correlated – the US is expected to return to the negotiating table and participate in reduction efforts after the new administration takes charge in January 2009.

Of course, it would be expected to try and ensure that its entry into this market didn't send prices skyrocketing, since US corporations would have to bear the bulk of the cost, since US emissions are generally much higher than anywhere else in the world. Thus, it is possible that the entire structure may end up being redefined, or, in the world of market choice, we may end up with more than one carbon trading program.

In other words, the entry of the US may turn out to be a mixed blessing for carbon credit holders. It would certainly introduce considerable volatility into the market.