Other derivative markets have faltered in 2009, but carbon trading has gone right on booming. Participants are enthusiastic about the EU market, which is set to flourish. But the real challenge is to implement these ideas elsewhere – first in the US and then the wider world. As Siân Williams reports, the specialist firms are eager to start, but there will be no market until politicians, industry and the public overcome their fears.
In the city of Leshan in China’s Sichuan province, a hydroelectricity project is under way. One of the aims is to earn Carbon Emission Reduction certificates, which can be sold in Europe to companies wanting to exceed their carbon dioxide pollution limits.
Yet the future of projects such as this depends not just on what is happening in Europe, but on political debates from Washington to Ouagadougou.
This coming December, world leaders will meet in Copenhagen for a summit under the UN Framework Convention on Climate Change. Riding on that meeting are the prospects for achieving real progress in the fight against global warming.
For the derivative markets, whose intended role is to help allocate the cost of emissions cuts as efficiently as possible, Copenhagen will give the first clues to how carbon trading is likely to evolve in the next decade.
The derivatives industry has grown enormously in the past 30 years, in large part because of a proliferation in the kinds of risk that can be traded. Carbon emissions are one of the big opportunities for the market to make a further leap forward in size.
But carbon dioxide is not just another commodity. It differs from the others because of the extent to which its commoditisation is dictated by governments and its price subject to scrutiny by politicians, environmentalists, scientists, economists and utility companies.
Manmade supply, manmade demand
The particularities of carbon do not stop there. Unlike most commodities, a metric tonne of carbon dioxide does not have roughly the same value anywhere in the world. Because its price is determined by regulations designed to make it scarcer – gently – value will depend on supply and demand only within a particular legal area.
If, at some point, regional schemes are merged, or permits are allowed under some circumstances to be transferred from one trading region to another, the effects on pricing in the affected markets could be sudden and turbulent.
That problem may be a way off, however. At present the only fully functioning, nationally applied carbon trading regime is the European Union’s Emissions Trading Scheme (ETS). This has grown enormously over the past few years, and shows no signs of being constrained by the lack of a world market for the EU permits.
According to Thomson Reuters, trading in EU Allowances – the carbon permits issued to EU firms in six industries – has accelerated from 562m tonnes of CO2 in 2006 to 2.697bn in 2008.
The speed of this growth is not unusual for a nascent derivatives market. But this may be nothing to what is about to happen. In Europe, more industries will be obliged to join the scheme in the next few years, notably airlines, and the next phase, which begins in 2012, is likely to reduce the number of allowances given out. That should raise the stakes for polluting firms and may increase their need to trade.
Though trading volumes in the ETS are healthy, they may eventually be overtaken by a federal scheme in the US. The American Clean Energy and Security Act of 2009, also known as the Waxman-Markey bill, was voted through the House of Representatives on June 26 2009 and is now being considered by the Senate.
The political weight of the bill is enormous and it is being attacked from critics on both sides of the debate. The environmentally minded complain that the bill has been diluted from earlier, more ambitious proposals. They lament the fact that permits are likely to be given away free at first rather than auctioned and that the annual reduction targets are insufficient.
Indeed, Watermark Economics notes that in its present form, the bill allows emissions to increase almost 20% until 2016, from 4.6bn tonnes a year to 5.5bn. They would only fall back to the 2012 starting point in 2023.
Conservatives protest that with the economy in such dire straits, and with an expensive reform of the US healthcare system high on the political agenda, a cap-and-trade system for carbon would be one more enormous expense that could reduce consumer purchasing power and kick the economy while it’s down.
Springing into action
The manmade nature of the carbon permit market means that rather than having to grow organically from the outset, it automatically began life with a substantial number of potential market participants and a large notional value.
“People are increasingly understanding the uniqueness of carbon as a commodity,” says Patrick Birley, chief executive of the European Climate Exchange in London.
As the market expands, institutional investors are being attracted to an ever more liquid trading activity.
“The speed at which carbon changed in sophistication was much quicker than power,” observes Tim Greenwood, head of customer relations at the European Energy Exchange in Leipzig.
A US system, as well as other regional systems, could eventually amalgamate with the ETS and carbon dioxide allowances could be standardised and traded globally.
There are differing views on the growth potential for carbon. Some believe that, if the market were globalised, the amount of trading could eventually match the oil market, or even foreign exchange.
“It should be as big as the FX market,” says Greenwood. “There’s no reason that carbon shouldn’t reach the same level of trading as oil.”
Paul Goodhew, head of European energy exchange-traded derivatives at UBS, concurs. “It could be the size of crude… Why not?” he says.
Others say that is wildly optimistic and the carbon market will grow modestly but never reach such levels.
Further growth and more participation in the carbon market could also help make it more efficient. “Information dissemination is still imperfect… You see other markets respond quickly to negative information in the wider economy, yet the carbon market takes longer to react,” says Amit Oza, a senior emissions broker at TFS Green, a specialist brokerage in London.
Setbacks in Europe have dampened volumes, such as recent cases of VAT fraud in carbon markets. “Issues with fraud have affected volumes… but volumes are sure to increase. You can tell by the number of new companies joining the markets,” says Greenwood.
“Intra-Europe, there is still huge potential for growth… In the next five to 10 years I still see phenomenal growth opportunities,” says Birley.
Volume feeds volume
At the moment, around half the participants in the EU carbon market are there for compliance reasons and the rest are investors.
“At first it was almost only compliance,” recalls Nicky Chalkley of the ETD power and emissions group at UBS. The proportion of speculative trading is expected to grow as the market becomes more sophisticated.
“We have seen more speculators as the market has become more liquid,” Chalkley adds.
Nathan Amery, sales manager for trading systems business at Trayport, the software firm, reckons that of the speculative volume, about 75% is intraday.
But Oza at TFS Green identifies another reason why the number of investors is so far limited. “There are not many commodity-based speculative hedge funds in the market,” he says. “These funds look for anomalies and breakages in correlations to exploit inefficiencies. There is not enough history in the carbon market to come up with long term trends for these funds to trade on.”
Fear of the state
To put it another way, prices are just too unpredictable. One problem that worries institutional investors is the potential for political intervention. Since the assets are created by government, the state could intervene again to change the supply, and hence the pricing.
Another way that regulators could make things harder for investors is by imposing position limits, as the US Commodity Futures Trading Commission is now considering doing for traditional commodity markets. The aim of this would be to control speculation so as to prevent investors driving up the carbon price.
Regulators and politicians will also dictate whether or not there is ever a global system.
The consensus among market participants is that the initial US cap-and-trade scheme is not being designed with the goal of future global integration in mind.
This is probably because a global scheme seems a distant dream when it is difficult enough for politicians to convince voters that the mildest form of domestic cap-and-trade is a good idea at a time of economic upheaval.
Whether the Waxman-Markey bill is passed, rejected or amended is now in the hands of the Senate, and at this stage nothing is certain. There is a chance that it may be finalised before the Copenhagen summit this December, which could embolden other countries or regions thinking of setting up their own schemes.
But what market participants and environmentalists are really hoping for is a commitment to cap their emissions by non-Annex 1 countries — those that are parties to the Framework Convention but have so far not been asked to make any cuts.
If this does not happen, proposed compensatory measures such as imposing a carbon tax on imports from countries without a scheme risk undermining the principles of cap-and-trade.
Senate holds the keys
Though cap-and-trade was proposed by both candidates at last year’s US presidential elections, concerns about the economy mean the idea is now unpopular with the public.
This has been exacerbated by the healthcare debate. A reform of the healthcare system is likely to be very expensive and with America’s enormous debts, a cap-and-trade bill is seen by many as just another expense that will drive Americans further into debt.
“In the US there’s still a lot of scepticism [about cap and trade],” says John Wadsworth, a partner at law firm Brown Rudnick’s energy practice group in Boston. “Before the healthcare mess, I would have said [the Waxman-Markey bill] would get through in more or less the same form… I’m not as optimistic as I was.”
Gary Hart, a market analyst at interdealer broker Icap, based in Birmingham, Alabama, believes there will have to be big changes for Waxman-Markey to pass the Senate. “There is probably a group of 15-20 undecided votes in the Senate, from the states that use a lot of coal,” he says. “There’ll have to be a lot of concessions for moderate Democratic Senators to vote it through. I really don’t think the Senate version of Waxman-Markey will go through before the Copenhagen summit. It might not happen until the beginning of 2010.”
Surprising as it may seem, cap-and-trade already exists in the US. Schemes for sulphur dioxide and nitrogen oxides have existed since the 1990s and there is already a regional scheme in place for CO2, the Regional Greenhouse Gas Initiative. This involves the power sector in 10 northeastern and mid-Atlantic states.
“We expect the players who are in the RGGI, SO2 and NOx markets to participate in a potential US cap-and-trade programme,” says Richard Sandor, chairman and founder of the Chicago Climate Exchange. Hart says: “It’s slightly different from the SO2 market in that there’s the concept of offsets.”
“[In the Waxman-Markey bill] it looks like they’ll be able to use Carbon Emissions Reductions. They might even allow limited use of EU ETS allowances,” says Hart.
The RGGI is likely to be integrated into a federal system. “The current bill has [the RGGI] going up to 2012 then put on hold for five years,” says Wadsworth.
Asked what will happen to volume in the RGGI scheme if a federal scheme is put in place Sandor says: “I expect it would stay in place for a bit and then would migrate to a federal system.”
One of the problems with RGGI is that permits were overallocated and the price of carbon is very low. It is therefore likely that if it is integrated into a federal scheme, there will be a conversion ratio of several RGGI permits for every federal compliance unit.
Despite all the objections, the US system is expected to grow more quickly than the ETS, when it finally comes into being, chiefly because the US will be able to learn from mistakes made in Europe. Also, the availability of a few years’ data from the ETS will mean institutional investors will be better informed and can make more accurate predictions as to future prices than they could in the early days of the ETS.
“Once people gain confidence in the markets they will start to use carbon to hedge against electricity or fossil fuels,” says Hart. “But initially in the SO2 market there was very little of that – it took the market a while to recognise they could do that.”
The American way
It is widely believed that US carbon allowances will at first trade much more cheaply than their European equivalents. “There are very different appetites for carbon pricing on both sides of the Atlantic,” says Trevor Sikorski, director of carbon markets and environmental products research at Barclays Capital in London.
“Initially carbon will be just above $10 per metric tonne,” says Wadsworth at Brown Rudnick. Many others agree that it will be around that price – some even suggest it could be lower.
The initial price will depend on the number of allowances allocated, which at the moment is expected to be 4.6bn tonnes a year.
The scheme is also likely to allow firms to pollute more than their holding of permits would allow if they buy domestic offsets – credits indicating that they have sponsored a project deemed low carbon. This would put downward pressure on the permit price.
There may even be special escape clauses to keep the price low. “It might be that if prices get too high you can bring in EU Allowances,” says Wadsworth.
As regards exchange venue, there are two main contenders at the moment: the Nymex Green Exchange and the Chicago Climate Futures Exchange.
Despite the popularity of the centrally cleared model at the moment, Sandor does not think that the bill will insist on exchange trading.
Asked which would be the main exchange for carbon contracts in the US, Chalkley at UBS says: “It will be difficult to see initially. I think it’ll be a while before a pattern emerges.”
Wadsworth believes carbon contracts could survive on more than one exchange.
On your marks…
The approach of US carbon trading is already stimulating a flurry of activity by firms eager to prepare for the new opportunity.
“In the last six months we’ve seen a huge uptake in US companies trading in the EU system,” says Amery at Trayport. Several US companies have recently started to trade on the European Energy Exchange (EEX), for example.
Multinationals have set up separate teams to cope with the likely different systems in the regions where they operate.
Meanwhile, Chalkley at UBS has noticed growing interest from institutions in US carbon contracts at the Chicago Climate Futures Exchange.
Within the fast-growing carbon market, the segment occupied by exchange-traded and exchange-cleared sales and contracts has grown impressively in the past year.
Part of this is just the growth of carbon trading as a whole, but there is also a widespread move towards central counterparty clearing across many financial asset classes, spurred by a keener awareness of default risk.
The balance between futures and spot trades fluctuates monthly but most of the liquidity has been in the futures market. “I expect that this will continue,” says Oza.
However, carbon futures are still mainly traded OTC and there are more cleared OTC futures than trades in listed futures.
One brake on the exchange-traded futures in the ETS is that there have been two main delivery dates. This has caused difficulties and the market looks set to move towards just one date.
The European Climate Exchange (ECX) standard, in which contracts expire around December 15, has proven more popular since the credit crisis. The other standard of December 1 expiry, used in the OTC market and on EEX futures, has lost popularity and 99% of EEX’s clients want to move to the ECX date.
The price conundrum
Carbon pricing over the next few years will be influenced by several factors. In Europe, the most important will be the level of caps set for the years after 2012; the proportion of permits that are auctioned; and the impact of new industries joining the ETS.
These outcomes are hard to predict and depend to a large extent on political choices. But analysts wanting to forecast carbon prices can also look at pricing for fossil fuels and electricity, as these commodities are correlated with carbon.
The price of carbon fell steeply as a result of the economic downturn, which suppressed demand for power and fossil fuels, and hence for carbon permits and credits allowing firms to consume them.
As consumer demand and industrial output recover, demand for carbon credits should follow, pushing up the price again.
Yet at the moment the cost of permits is well below the cost of marginal abatement and it is likely to continue to stay at that level for some time. This means that the ETS is not incentivising firms to reduce emissions – they can more cheaply buy permits and keep emitting CO2 than change their operations to lower emissions.
With permit markets, there is always some degree of risk that governments could intervene to change pricing.
Some market participants do not seem concerned that politicians might meddle with the system. “Pricing follows a lot of fundamentals. It’s not as controlled by politics as people make it out to be… [The price] will track the economic recovery,” says Chalkley.
Others disagree. “The legislative and political risk cannot be understated,” says Oza at TFS Green. “[Political intervention] is often a concern for institutional investors.”
Another issue that market participants are grappling with is that the price of carbon might turn out to be more susceptible to volatility than that of other commodities because of the lack of elasticity in the supply.
Companies cannot produce more permits just because the price goes up. However, if the price went up too steeply, there would probably be strong political pressure to print more allowances.
Carbon Emission Reduction certificates can be produced by private sector activity, stimulated by attractive pricing, but under the present ETS rules, companies can only cover up to a certain percentage of their emissions using CERs, rather than EU Allowances (EUAs).
“It will take quite a while for the true market price to be determined,” says Amery. “A lot will come down to information that won’t necessarily be made public, such as investment in carbon-reducing technologies.”
Pricing and volumes after 2012 are uncertain but both are likely to rise. “Within Europe the next major structural change will be full-scale auctioning,” says Birley. “In phase three 65%-70% of the credits will be auctioned. This will add a new dynamic to the market.”
Hopes of arbitrage
Although most of the volume in European carbon futures is in EUAs, CERs may offer the best growth potential in the near future. This is because they may be incorporated into systems in the US and elsewhere.
“Amalgamation is a long way off but CERs should help harmonise the carbon market,” says Chalkley. “It’ll be interesting to see whether the US system has a linking directive. If so, we’ll see CER volumes rise. But if the US has a cap on CERs, there’s always going to be limited interest.”
CER pricing would inevitably be affected if the contracts could be used to comply with various schemes. “Indirect linking through international offsets would drive a degree of convergence,” says Sikorski.
Chris Villiers, commercialisation manager of EcoSecurities, an Irish-registered company that specialises in the CER market. “[A US system] could produce a price floor for CERs… If they were usable in other schemes, the price could be higher,” he says.
If partial links are established between schemes in different places, it could be a windfall for specialist carbon traders and investors, because there would be scope for arbitrage.
Whenever there is demand for the same thing from groups of entities who have different abilities to get hold of it, opportunities are created for savvy market players to buy cheap and sell dear.
In carbon this could happen, for example, if CERs were admissible in both the US and EU schemes. Depending on the rules governing their use in each market, they could be worth more in the market where the basic price of a carbon permit was higher. Firms with facilities and legal rights to trade in both markets could profit.
Another such situation would arise if EUAs were accepted in the US. This would not defeat the aim of the European ETS, though it would make it easier for US firms to pollute – so there is no immediate reason to think the EU authorities would object to it, even if they were able to stop it. However, it would push up the price of carbon in the EU, so European industries might protest.
“Right now, ECX and CCX operate as separate entities, but we always look at opportunities for further efficiencies and collaboration between our markets,” says Sandor.
Most people in the carbon markets believe that one day there will be a global marketplace. This is likely to take many years to develop—most think that it won’t happen in the next 10 years.
“In the very long term I think there will be one global market. Similar to power, it will start as a regional market and as the players get bigger it will begin to merge and intertwine,” says Greenwood.
“I think there will be a global solution in the future, but a long way in the future… not in the next 5-10 years… maybe in my grandchildren’s generation,” says Birley.
“A global solution is a long way off. We might have to take baby steps,” Hart believes. Sikorski predicts that markets will not be more aligned until after 2020.
Certain conditions of the US scheme may make it difficult to reconcile with the ETS. For example, it looks like firms will be allowed to offset carbon emissions through forestry and farming in the US. In Europe, offsets cannot be bought from within, but only through CER projects in the developing world.
Realism about Copenhagen
Nevertheless, the market is waiting eagerly for the Copenhagen summit in December. During the meeting there will be talks on the ETS after 2012 and on different countries’ action plans for combating climate change.
“There is huge pricing uncertainty post-2012 and there will continue to be until a post-Kyoto agreement is ironed out, hopefully in Copenhagen,” says Villiers.
“We’ve seen a lot of positive signs in Australia. There are certain issues but hopefully they’ll be overcome by Copenhagen,” says Amery.
Many believe that progress will be made at the summit but that it is over-ambitious to expect a global scheme to be created. “We want to come away with a clear international agreement and commitment from non-Annex 1 countries… But I don’t think there’ll be an agreement between different schemes,” says Birley.
Carbon is indisputably one of the most exciting commodities at the moment. Some see it as having enormous potential, others believe it is over-hyped. Its unique status and the unprecedented nature of the market make it subject to argument, discussion and disagreement.
But the progress made in the last 10 years – even if not as fast as our future security required – is undeniable. Even in the most reluctant countries, most informed people now accept that CO2 emissions will eventually have to be controlled through international agreement.
How quickly and well a solution is implemented rests first and foremost with politicians – but therefore also with industry specialists who can advise them, and with each of us as fragments of public opinion.