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Emissions derivatives (1)

01 December 2005

Satyajit Das explores the complex market of emissions trading

Emissions trading is focused on the trading of credits
designed to control and ultimately reduce pollutants produced from business activities. The central driver of emissions trading is the impact on global climate and the degradation of environmental resources from emissions of various gases. Principal targeted pollutants include sulphur dioxide (SO2)/nitrogen oxides (NOx) (causes of acid rain) and carbon dioxide (CO2) (cause of global warming)2. The principal causes of emissions include economic/industrial development, demographic pressure and use of polluting technologies.

The concept of emissions trading is driven by market failure on a significant scale. Emissions trading is directed at intervening in the operation of market economies. It primarily operates economically to specifically internalise the costs borne by parties external to the production process.The system is designed to deal with the problem of 'externalities'. An externality refers to the position where one party
(such as a power plant) generates a product (as a by-product of its production process, for example emissions of toxic gases) that harms others, but the producer is not held responsible for the damage caused or the cost. The problem of externalities can also be considered as the result of undefined property rights. In this example, the ownership rights to clean air are not adequately defined. This means that
the right to clean air cannot be monitored or enforced. In economic theory, there are various ways in which the
problem of externalities is dealt with.  Emissions rights and trading in those rights is one way of seeking to control those externalities. Exhibit 1 sets out the types of emissions programmes and tradeable commodities that are generally used.

In practice, there are two primary emissions markets that have evolved. The first is a domestic US market focused on sulphur dioxide/nitrogen oxide emissions. The second is the potential greenhouse gas (GHG) emissions market deriving from the
Kyoto Protocol.The US market is relatively well established. The GHG market is currently in the initial phase of development.

The primary market is trading in the quotas or permits in a spot market.Emissions derivatives (forwards or options on the price of the quota/permit) are a logical extension of trading. In practice, emissions derivatives are in the early stage of

The major users of emissions trading are likely to be producers of emissions such as utilities (particularly power generators and other polluting industries).

The emissions trading market has a number of interesting characteristics:

  • The underlying is artificial and reflects the fact that the emission quota is an artificial creation of government/regulatory policy


  • The concept of trading in property rights creates an interesting opportunity to trade in various other analogous property rights.

US emissions trading

There are a number of emissions markets in the US. The major markets are the SO2 and NOx (referred to as SOx
and NOx).

The markets have their origins in the US Clean Air Act Amendments of 1990 that required electric utility plant
emissions of SO2 to be reduced by 50% by 2010. The central element of this regulation was a market based allowance system.The market structure is that of a cap and trade system. Each utility was provided as an annual emissions allowance. Each allowance allows the owner to emit one ton of SO2. Allowances can be bought, sold or banked for future use.All emitters must have allowances covering the amount of
emitted gases. If emissions for a given year exceed a utility's available allowances, then the firm has 30 days to acquire additional allowances. Failure to comply is subject to penalties. Allocations are based on a phased reduction from historical emissions levels consistent with government policy.

Many of the other US markets are based on a similar structure. The SO2 allowance market affects all major utilities in the US. The NOx allowance market affects utilities, independent power producers and industrial sources in the North East US.

The US emissions market allows utilities to comply with the requirement to reduce emissions in a number of ways:

  • Use of pollution control techniques such as scrubbers (fluidised gas desulphurisation or selective catalytic
    reduction technology)
  • Change to cleaner fuel sources (low sulphur coal or natural gas)
  • Purchase of emission allowances.

The allowance market creates a natural relatively homogenous
commodity (allowance of a specified vintage (that is, year). The allowances are registered in a central database maintained by the regulatory agency. Compliance is monitored by a documented verification process. This allows ready trading in the allowances.

There are several levels of trading

  • Annual auctions - since 1993, Chicago Board of Trade has, on behalf of the Environmental Protection
    Agency (EPA), conducted an auction of allowances. The EPA withholds a portion of allowances to be offered for auction and direct sale. The auction provides price information on the allowance market
  • OTC market trading - there is an active non regulated
    market in emission credits3.Allowances are traded in a
    variety of structures including:

    1. Cash structures - these are immediate settlement (three days) contracts entailing delivery against payment
    2. Forwards/options - this entails forwards (traded out to ten years) and options (primarily European options
    with maturities out to 18 months) on emission allowances
    3. Structured trading - this includes swaps of allowance vintages (exchanging allowances for a year for allowances for another year) and inter-pollutant exchanges (exchanging SO2 allowances for NOx
    allowances). Integrated trades (a sale of high sulphur coal packaged with emission allowances to counter higher emissions from this fuel source) are also feasible.

The market is well established and relatively successful. Prices for allowances are volatile, reflecting the availability of and demand for emission rights. Several other countries have domestic initiatives to develop similar markets.

Greenhouse gas market

A market for GHG emissions trading has emerged in recent years.The market is driven by ongoing negotiations for an
international climate control treaty.

The genesis of GHG trading is the Kyoto Protocol of December 1997. The Kyoto Protocol derives from the
United Nations Framework Convention On Climate Change
(UNFCCC) in Rio de Janeiro, Brazil in 1992. The UNFCCC established the goal that industrialised countries return GHG emissions levels to 1990 levels by 2000 and stabilise concentrations of greenhouse gases in the long-term "at a level that would prevent anthropogenic interference with the climate system".The process of developing the Kyoto Protocol to enable implementation is ongoing. However, the Protocol has not entered into force and few national governments have implemented restrictions on domestic emission levels or developed rules for trading allowances. The development of the framework of GHG has been slow and ad hoc. The major component of development is project based emissions trading programmes and national initiatives. The longer term prospects for GHG trading is uncertain. This reflects the
opposition by key participants (most notably the US) to the programme.

Despite the absence of a definitive regulatory framework, a nascent market in GHG emissions trading has emerged. GHG trading does not entail (for the most part) trading in emissions
allowances and credits.This reflects the absence of a defined regulatory framework. The major type of trading is focused on the following:

  • VERs - this entails trading in VERs involving a commodity defined by the parties, with the future
    prospect that the emission reductions will be allowed to be applied against future emission reduction requirements. Exhibit 2 sets out examples of VER trading transactions
  • National programmes - this entails national programmes placing limits on emissions on domestic firms under a cap and trade or baseline and credit system.These regimes are in the process of development. There is interest in these programmes because of the risk that VERs will not be recognised in future regulatory regimes.

The current GHG market is characterised by the following features:

  • Participants in GHG trading are motivated by corporate citizenship/governance concerns about future regulation and risk management concerns
  • Actual transactions completed are highly customised. The primary commodity traded is VERs. Most trades
    involve CO2 or methane. The vintage and geographic location are key attributes of trading. Forward stream transactions involving consecutive vintages are feasible. Trading has involved both VERs and derivatives (primarily call options) on the VERs
  • There is parallel interest in emission reduction activity. This covers activity such as sequestration projects
    (known as carbon sinks). This entails investment in or protection of forests to absorb CO2 from the atmosphere. Uncertainty regarding the status of
    sequestration in a future regulatory framework has reduced commercial interest. Reduction activity also
    includes investment in renewable energy sources such as wind or solar power
  • The market infrastructure for GHG trading is developing. There are proposals for exchange-traded markets in GHG emissions. A number of brokers
    are active in the market providing price discovery and structuring transactions. Financial institutions are
    increasingly interested in trading GHG emission allowances. A number of carbon investment funds have been established
  • The infrastructure of verification of emissions is also developing. A number of engineering, accounting,
    certification, consulting firms and environmental non-government organisations have developed capabilities to provide assurances regarding level of emissions and emission reductions.


The prospects of GHG emissions trading are uncertain. The multilateral nature of the treaty negotiations and entrenched
opposition of a number of countries is likely to impede rapid
implementation. In the short-term, project based programmes and national initiatives are likely to be the major components of the market.

Exhibit 1 -Emissions trading structure

  • Cap and trade system - this is also known as allowance based trading. The maximum level (cap) of
    emissions from a source is prescribed by a regulator.
    This is in the form of a permit or allowance. All sources must have permits up to the required amount to produce the emission. The permits are tradeable. The
    aggregate of issued permits is set at a level that limits emissions at the level desired by the regulator
  • Baseline and credit system - this is also known as a credit or project based trading. Each source of emissions is provided with a baseline level of emissions. If the source reduces its actual emissions below the baseline, then the difference is credited to the source. These credits can be traded. The baseline can be struc-
    tured as a fixed amount or a changing amount (decreasing over time). The adjustment in the baseline can be used to control the aggregate level of emissions.
    Tradeable commodities:
  • Allowance - this refers to a government or regulator sanctioned right to produce emissions in a cap and trade system
  • Credit - this is a government or regulator sanctioned right to produce emissions in a baseline and credit system
  • Permit - this refers to both allowances and credits
  • Verified emission reductions (VERs) - this refers to credits that are generated by project based activities defined by the purchaser and seller. The credit is
    verified by a third party. VERs are usually created and traded where there are no government rules.

    Source: See Rosenzweig, Richard and Janssen, Josef (March 2002) The EmergingInternational Greenhouse Gas Market; Pew Centre on Global Climate Change

Exhibit 2 - GHG trading examples

TransAlta and Hamburgische Electricitats-Werke (HEW)

In June 2000, TransAlta agreed to purchase 24,000 metric tons of CO2 VERs (3,000 tons/year from 2000 to 2007) from HEW.

TransAlta plans to reduce net emissions of GHG from its Canadian operations to zero by 2004.  This is despite
the fact that TransAlta plans to continue to use fossil fuels. TransAlta plans to reduce emissions by a combination of efficiency improvements, technology developments and emissions offset trading. The transaction with HEW is a component of the emissions offset trading.

HEW is planning installation of wind turbines near Hamburg. This investment in emissions reduction through renewable energy sources generates marketable GHG reductions. The electricity generated by wind allows HEW to maintain output at a lower level of emissions.

The transaction enabled TransAlta to reduce its net emissions. The transaction enabled HEW to monetise its reduction in GHG emissions. This provides a subsidy to its investment in renewable energy sources. The transaction is not formally
recognised by any government or regulator.

PG&E - Ontario Power Generation (OPG)
OPG purchased 1 million metric tons of CO2 VERs from US Gen New England (a subsidiary of PG&E).

OPG has internal voluntary targets for the reduction of emissions. This is achieved by improvements in internal energy efficiency, investment in renewable power initiatives and purchase of emissions allowances. The transaction with
PG&E is part of the programme of emissions purchases.

PG&E's emission reductions were generated from the capture and destruction of methane that would be emitted from the Johnston Landfill in Rhode Island in the period 1998 to 2000.
The transaction enabled OPG to reduce its net emissions. The transaction enabled PG&E to monetise its reduction in GHG emissions. This provides a subsidy to its investment in prevention of methane emissions. The transaction is not
formally recognised by any government or regulator. 

Source: See Rosenzweig, Richard and Janssen, Josef (March 2002) The EmergingInternational Greenhouse Gas Market; Pew Centre on Global Climate Change.


1 This paper draw on material from Das, Satyajit (2004) Swaps/Financial Derivatives - 3rd Edition; John Wiley &
Sons; Singapore. Please see the book for detailed sources and references.
2 Other targeted gases include methane, hydro fluorocarbons, perfluorocarbons and sulphur hexafluoride.
3 See Zaborowsky, Peter "Emissions: Possible" (November 1998) Power & Energy.

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