When the EU’s Emissions Trading System
– the cap-and-trade
system by which a limited
number of carbon permits are traded by companies in
participating industries – was launched six years ago,
no one was under any illusion that it would completely solve
the problem of controlling and ultimately reducing carbon
It was, however, seen as a good
start – a system that could be grown and built upon.
Eventually, some believed, with further global cooperation and
the buy-in of both industry and politicians, it would form the
foundation on which a more robust carbon emission control
mechanism could grow.
The ETS had obvious problems.
Clearly, any scheme confined to the EU could not solve a global
problem. In addition, it was limited to certain industries,
albeit those that produced the highest carbon emissions.
However, there was optimism that, following the
EU’s lead, global leaders could reach agreement on
tackling climate change.
Another weakness at first was
that in the early years allowances were dished out free. This
rendered them essentially valueless in conception; they only
gained value in the secondary markets when traded. Companies
with more permits than they needed would sell them; those with
too few were forced to buy. This also meant the number given
out was critical – to their value and to any hopes of
the scheme encouraging companies to cut emissions.
In the view of many critics, the
system was woefully inadequate. Even for companies regularly
forced to buy additional certificates, the cost was too small
and too variable to justify any long term capital investment in
new carbon-reducing technologies.
Even the complementary
Certified Emissions Reductions
scheme – credits issued under the Kyoto Protocol to
projects in the developing world that theoretically cut
greenhouse gases – came with inherent flaws.
The idea was that companies could
invest in carbon-reducing or lower carbon technologies in poor
countries, where the potential efficiency gains were greater,
and be rewarded with carbon permits equivalent in almost every
way to the ordinary EU Allowance certificates issued under the
Yet how to define the type of
technology that qualified was confusing. It also muddied the
pricing of certificates in the secondary markets.
For all its flaws, however, this
was a market founded on good intentions and optimism. So
despite its drawbacks, when the ETS was introduced in Europe in
2005 it was greeted with gusto by professional advisers and
banks, which saw it as a growth market offering lucrative
"This was the big market for
banks to get into six years ago," says Tim Greenwood, head of
customer relations at the European Energy Exchange in Leipzig.
"It was regarded as a sexy product with ecological aspects
– something the banks wanted to be seen to be involved
"It was very competitive between the different exchanges,
and brokers and banks were vying for market share. The margins
were, however, lower than many other sectors but it was seen as
having big potential for growth."
A vibrant and competitive spot
market developed, as did several futures and options trading
platforms – both for full exchange trading and in an
OTC market linked to clearing houses.
Since those heady early days,
however, a combination of the economic downturn, banking crisis
and some teething problems for the carbon trading market have
heralded an era of greater caution. Some players have
retreated. "Many companies have left because of internal
reasons but the market has lost some credibility," Greenwood
Criminals have used the market to
carry out a number of high
profile VAT frauds as well as thefts of certificates through
cyber attacks. The certificates were quickly sold on through the spot market before the
breach was detected.
This scandal, which struck in
January this year, highlighted the lax computer security of
some of the national registries which administer the ETS in
each country. Parts of the trading market were shut for days
and in some cases weeks while the mess was sorted
How much these cases have harmed
the market’s credibility, however, is
disputed. "This was a major
issue last year and it certainly affected the spot markets,"
says Greenwood. "It was no surprise in a way. We have all had
strange phone calls from individuals looking to access these
markets. But it still undermined it. Steps are being taken to
stop these things happening again but the situation is still
far from perfect. The market is young but these things mean it
is also seen as somewhat exotic as a result."
Others warn against exaggerating
the problems. "These incidents do not help the
market’s credibility, of course," says Julian
Richardson, chief executive of Parhelion, an insurance
underwriter in London that specialises in emissions and green
energy. "But true credibility in a market can only stem from a
stable regulatory environment.
"In that sense, the glitches in
this market have been overblown. It is like saying that people
are selling dodgy goods on eBay so it should shut down. All
markets have glitches, even the LSE. And, equally, VAT fraud is
found in many sectors – it occurs wherever tax
irregularities exist. Carbon trading is a small and relatively
new market and teething troubles are bound to occur. In a
perverse way, these things show the value in it. I suppose it
is like a coming of age."
Georgie Messent, head partner of
the emissions and carbon team at law firm Burges Salmon in
Bristol, agrees. "Credibility is still an issue," she says.
"Some registries are only now coming back on line after
closing. It has certainly made investors very aware of the
dangers, although equally it has illustrated the value of the
market. If criminals are interested, it shows it is a market
where money can be made."
Messent says the biggest problem
is on the spot side and that there is no easy solution. "That
is where these [stolen] deals have been cashed. But this market
moves so quickly it is very difficult to certify a certificate
at the point of exchange."
Henrik Hasselknippe, managing director of global product
development at the Green Exchange, a joint venture
between CME Group and 12 energy trading firms, says most of
the problems happen in the spot
market because it is relatively unregulated.
"As a highly regulated exchange,
we do not face these problems," he claims, "but the market has
suffered some reputational damage. There have been some lessons
Yet these blows to the
market’s reputation come at a time when other
important changes are being made – designed to enhance
both the market’s credibility and its value in
very tangible ways.
The most important concerns the
way certificates are allocated to companies. For some
industries, they can now be auctioned, so that emitting
companies have to bid for them.
Under EU rules, member states can
now sell up to 10% of their allocations of permits. The UK, for
example, has decided to sell 7% of its allocation, enough to
cover the power-generating sector, which will now have to buy
all its EUAs. From 2013, about half the permits available are
expected to be sold.
The only companies expected to
receive their permits free are those in industries particularly
vulnerable to competition from overseas businesses that are not
subject to the same strict environmental regulations –
the cement sector, for example.
This is a big change for the
market. "The main point is that the new auction system will
impose more costs on the relevant sectors; the
lion’s share will be borne by the power sector,"
"The theory is that if you
increase the cost, more companies will divert resources and
capital to carbon emissions reduction technology. While the
power companies are broadly supportive of the idea of carbon
trading, they do complain about the costs involved. And this
will probably drive up the costs in the secondary
But Messent adds that the auction
system would still fail to influence the market’s
most fundamental dynamic: the ratio of the total number of
certificates in circulation to the number actually needed by
companies. Only by squeezing the supply of permits can the cost
of emitting carbon be raised, sharpening the incentive
for companies to reduce their
Especially as the consumption of some sectors such as
manufacturing has fallen due to the recession, this dynamic
needs monitoring, she adds.
Hasselknippe highlights some of the benefits of the
new system, such as the revenue countries can earn by
auctioning certificates. He is not sure what effect it will
have on secondary trading but believes it could encourage more
players to get involved.
But there are even more
fundamental issues that require solving in the industry before
it can gain true credibility. Many of these concern the role of
Richardson says Parhelion has recently partnered with Kiln,
a unit of Japanese insurer
Marine and an underwriter in
Lloyd’s of London, to offer an insurance product to overcome
one of these problems. But he also has bolder thoughts on how
the industry could change.
The insurance product Kiln and Parhelion have conceived is
designed to protect companies investing in projects they hope
will qualify for Certified Emissions Reductions. Firms can use
the insurance to offload the risk that the CERs from their
particular project are ruled ineligible for compliance use in
the ETS because of regulatory changes.
This risk has been a big factor deterring companies from
investing heavily in such projects.
Richardson hopes the policy will encourage fresh investment
in CER projects and stimulate secondary trading of the
The policy was designed for a
specific bank in response to a decision by the
EU’s Climate Change Committee to ban trading in
credits earned from plants that destroyed two sources of
greenhouse gases – HFC-23, a byproduct of refrigerant
manufacturing, and adipic acid.
Richardson says that while policy development
under the Kyoto Clean Development Mechanism has settled down,
EU policy on the ETS is a movable feast, which discourages
"Because this market exists
purely through regulation, banks are faced with a lot of
regulatory risk," he says. "The EU decided only late last year
that these two types of project no longer
Banks are important to the carbon
credits market because their purchase of options on future CERs
helps to fund projects, while their trading in carbon futures
adds liquidity and helps companies and governments hedge their
emissions reduction costs.
Richardson says the banned
credits, issued to projects destroying the two types of gases,
accounted for about half of all CERs yet issued and about a
quarter of credits due to be delivered in 2012 and
The Parhelion-Kiln insurance
product addresses a specific problem in the market and goes
some way to offering certainty to investors.
But it only solves one problem.
Richardson advocates a more radical approach. He believes the
EU should itself insure against the risk of regulatory
"There is a disconnect at the moment between
the regulator and the investors who bear the risk," says Richardson.
"This risk needs to be aligned better. The government should set in place its own
guarantees against future regime change. This does happen in
other circumstances, such as in the world of political risk
insurance in emerging markets, where governments guarantee
against the consequences of future illegitimate regime changes.
If they did that more companies would
He believes that alongside the
European Investment Bank, the EU should create an insurance
company with similar scope. "They would be better off with an
insurance company that could step in and give certainty on some
of these regulatory issues," he says.
Richardson also advocates a different approach for the EUA
permits. He believes a European central carbon bank should be
created that would seek to manage carbon prices, keeping them
inside a broad price band – as ordinary central banks
do with inflation and employment.
The carbon bank’s tools would be actively
managing the number of certificates available, with a view to
stabilising their prices.
"This would completely change the dynamic of the market
because you create long term price stability," Richardson says.
"That would encourage capital investment by allowing companies
to better understand future savings they would make by
investing in green technology. At the moment, investment
committees are working in the dark."
Another approach, favoured by some advocates of tougher
controls, would be to publish clearer information about how the
number of available permits is expected to reduce, year by
year, into the future. That would force companies to plan ahead
to make efficiencies.
New schemes on the way
The carbon market is developing and moving forward in other
ways. From January 2012, airlines which operate international
flights to, from or between EU airports will have to surrender
EUAs against their carbon emissions.
Lufthansa has announced that it will join the European Energy Exchange to trade carbon
in its spot and derivatives markets. "A lot of the airlines are
getting geared up for this," says Greenwood.
Hasselknippe expects the
airlines’ entry to increase liquidity, though it
is hard to say how much.
And although the global community
has so far failed to agree any deal on reducing carbon
emissions, several countries outside the EU are moving towards
introducing schemes of their own.
In the US, California is set to
launch its own cap-and-trade system in 2012, similar to the EU
one. The state passed the
nation’s most comprehensive climate law in
2006, mandating a cut in carbon pollution by 2020
to 1990 levels — about 10% below today’s
Although the US Congress balked at similar legislation in
2009, California will cap greenhouse gases at 600 industrial
plants and allow companies to buy and sell emissions
"California is coming online soon and we expect other
US states to follow suit, even though there is still no push at
a federal level," Hasselknippe says. "Ultimately, we
believe that the US market could end
up being half the size of the EU, which is not insignificant.
We are excited about what is happening in the US and we believe
that it could develop into a highly liquid and credible
At the other corner of the country,
ten northeastern states, including New York, New Jersey and
Massachusetts, have set up a Regional Greenhouse Gas Initiative
with tradable permits, aiming to cut 10% from power station
emissions by 2018.
In the developing world,
the World Bank’s
Partnership for Market Readiness, formed late last year, aims
to help countries cut their emissions through trading systems.
The UK government recently pledged £7m to help 15
developing nations set up schemes. Ultimately, the World Bank
aims to raise a total of $100m for such investment.
Its International Climate Fund
will aim to test and pilot carbon trading schemes in at least
five developing nations by 2015. As part of this, China will launch pilot emissions trading
schemes in six areas before 2013 and set up a nationwide
trading platform by 2015. China has pledged to reduce the
carbon intensity of its economy by 40%-45% by the end of 2020,
against a 2005 benchmark.
While headway such as this is
important for the market, a full global deal remains the ideal.
"Other countries doing it will give it credibility but it can
only be a genuine success if all countries sign up," Greenwood
says. Richardson agrees: "A global solution can be the only
long term aim."
For the moment, market
participants must live in hope.