The political stalemate at the Copenhagen climate change conference in December has thrown a cold bucket of doubt over the carbon market.

Up to a few months before the UN Framework Convention on Climate Change summit, many believed that a global agreement could be reached, containing measures significant enough to change the outlook for carbon markets.

But as the summit approached the mood became more sober, and the eventual outcome was worse than many had expected.

Many questions are impossible to answer definitively: will a global agreement be reached? If so, when? Is it now less likely that individual nations will introduce legislation mandating cap-and-trade schemes?

Though carbon was never expected to be a highly volatile commodity, the price has not only been changed by fundamentals and by macroeconomic factors; it has also ended up being affected by uncertainty.

The daily futures price for EU Emissions Allowances at the European Climate Exchange in London rose during the summit and reached €14.39 for a tonne of CO2 equivalent on December 15, but then fell to €12.16 on December 21, the first trading day after the summit ended.

Though many agree that this will suppress growth in futures volumes to some extent, it is widely believed that growth will continue nonetheless – just at a slower rate than if there had been a more concrete conclusion from the summit.

The consensus is that the volume of trading under the EU Emissions Trading System will continue to rise steadily and that eventually there will be cap-and-trade legislation in the US. There is also a strong possibility of schemes in other nations.

The weak outcome of the summit will not be good for business in the short term. But in the long term, carbon market participants may see this as a temporary hitch in a long and exciting process.

“Realistically, we got what the market expected deep down that it would get,” says Andrew Ager, head of carbon and emissions trading at Bache Commodities in London. He thinks there will be a global carbon market in the future and that “in history this will be a blip in the proceedings”.

National and global

Lack of confidence surrounds two main issues: national targets and a global agreement. The doubt as to whether there will be a global agreement means the idea of an international market with fungible credits has been pushed forward into the distant future in people’s minds.

Even before Copenhagen no one thought a global market could be put in place until after 2020; now, it seems further away.

Market participants are also concerned that they do not know what national targets will be set. As this article was being written, governments were preparing to announce what cuts in emissions they would make by 2020, for a deadline of January 31, set at Copenhagen.

The EU has pledged cuts of 20% from 1990 levels by 2020, but has an option to raise that to 30%. If it fails to decide on 30% by January 31, this will upset the carbon market, as it had been widely believed that the EU would eventually adopt the higher target.

And even if targets are put in place, they will not be legally binding.

“It’s difficult to know whether targets will be set in stone,” says Trevor Sikorski, director of carbon markets and environmental products research at Barclays Capital in London.

All is not lost, though. “All markets live with uncertainty and the carbon market is no different,” he says.

Hopes for Mexico

Though Copenhagen was a flop, it is likely that further commitments will be made in the months and years to come. The UNFCCC will meet in Bonn in May and in Mexico City in December, with the hope of brokering further deals – and the debate about climate change will never go away.

“I don’t think Bonn is going to be that pivotal,” says Abyd Karmali, global head of carbon emissions at Bank of America Merrill Lynch in London. “More serious action will be taking place in Mexico City.”

Grattan MacGiffin, head of voluntary carbon markets at MF Global in London, believes that a binding post-Kyoto UN agreement will happen at Mexico and not before.

Some believe decisions will be made in forums other than the UN. Karmali argues: “The current UN rules of procedure are unworkable” to produce anything meaningful.

In his view, gatherings such as the G20 and the Major Economies Forum may become more relevant. Both include all major emitters and representatives from all regions.

Though the prospects for broadening cap-and-trade markets may not now be as good as they might have been, the experience traders are gaining now should pay dividends when the market eventually grows and more participants enter.

EU waits for key decision

The result of Copenhagen may delay the emergence of new mandatory markets, but it will also affect existing markets.

“Generally speaking, carbon markets are now in a period of heightened uncertainty,” says Karmali. He thinks that over the next year “market developments are more likely to be driven by domestic political developments in countries looking to enact new emission trading programmes”.

The EU Emissions Trading Scheme is independent of the UN process and is unlikely to be altered by what happened at Copenhagen – though the pattern of its growth and pricing may.

“In Europe [the Copenhagen outcome] is probably not going to have a massive impact,” says Sikorski. “[The outcome] makes it less likely that the EU will go to 30%.”

Patrick Birley, chief executive of the European Climate Exchange, agrees. “In terms of our core business, the impact [of Copenhagen] is small,” he says. “I think the growth trajectory is likely to continue.”

“We have to maintain perspective,” Birley argues, pointing out that the market will be around for quite some time.

On the other hand, lack of clarity as to whether the EU will move from its current target of a 20% reduction in emissions by 2020 to one of 30% is not good for the market.

“The EU position on timing for exercising its option to move from a reduction of 20% to one of 30% is difficult to read,” says Karmali. As a result there is “huge uncertainty hanging over the EU market”.

Tim Greenwood, head of customer relations at the European Energy Exchange in Leipzig, is also longing for that clarity: “Once you’ve got a firm [EU] decision, you have a background you can rely on and everyone knows what the roadmap is.”

Markets in training

The EU ETS is not the only show in Carbonville, however. Trading has begun in the US, even before the imposition of any federal cap-and-trade law.

In 10 northeastern and mid-Atlantic states, a Regional Greenhouse Gas Initiative (RGGI) is operating, which has capped emissions from the power sector, and aims to reduce them by 2018.

Then, there are pre-compliance and voluntary markets, in which firms are trading in advance of a mandatory national scheme. These – especially pre-compliance markets – are likely to be hurt more than the markets founded on rules.

MacGiffin says: “Voluntary markets are pretty well insulated” from what happened at Copenhagen. Companies that engage in trading carbon offsets and credits of various kinds voluntarily are doing so as an act of conscience, not because they have to.

That said, this activity has been hurt by other factors. “2009 was a very bad year for voluntary markets — mainly due to corporate diminished corporate social responsibility demand,” MacGiffin says.

Pre-compliance markets – trading in preparation for enforced caps – are inevitably affected by the prospects for a mandatory US cap-and-trade scheme. Those appear weaker because of the lack of a binding agreement at Copenhagen.

An example is the Western Climate Initiative, set up by a group of western US states and Canadian provinces, which aims to introduce a cap-and-trade scheme by 2012. Some trading is already going on in advance of this.

“Prior to US cap-and-trade, there’s an interest for people to get their feet wet with pre-compliance markets,” says Michael Cosgrove, head of commodities and energy brokerage for North America at interdealer broker GFI Group in New York.

Asked what will happen to pre-compliance volumes, Jubin Pejman, a senior broker at GFI in New York, says everyone is looking at the RGGI as a guide to what cap-and-trade will be like in the US. But he warns: “It’s debatable whether RGGI will be the de facto standard; I don’t think it will.”

The RGGI market should gain volume from players using it as a training ground for the federal scheme that many expect to materialise eventually.

But Pejman expects that US-based traders will also increasingly trade in the EU ETS. “It’s better to trade on the European market to practise for US cap-and-trade… There’s no substitute for trading on a liquid market,” he says. “I think Europe is an excellent test fit on what the US will be like in the next five to 10 years.”

Redd alert

Alongside carbon permits, designed to limit emissions, the other side of the carbon markets is offsets, supposed to cancel them out.

So far the main international programme for recognising offsets is the UN Clean Development Mechanism (CDM), which allows developed world companies to claim they have reduced their emissions if they sponsor projects in the developing world that are deemed low carbon.

A newer strand is Redd, the UN programme on Reducing Emissions from Deforestation and Forest Degradation in Developing Countries. The aim is to find a way for wealthy countries and firms to finance the preservation of forests, whose destruction is a huge contributor to climate change.

Carbon trading specialists have their eyes on Redd as a possible new source of tradable instruments.

But the mechanism by which Redd will be delivered is still unclear. It could be connected to the CDM, but this has not yet been mooted at a high level.

Sikorski says that at Copenhagen there was a “recognition we should do something about Redd” but that “the Copenhagen accord didn’t take it forward at all”. He describes the accord as “very weak on Redd”.

More opportunities are likely to come with Redd when more cap-and-trade schemes are introduced, creating demand for offset credits.

“Redd will pay a big part in the US voluntary market. It’s very popular with Americans,” says MacGiffin. The main reason is that American policy is likely to favour money being spent domestically.

“I would have thought the maintenance of forests that could be logged should logically be a feature of US cap-and-trade,” says Cosgrove.

Could Do More

Another disappointment at Copenhagen was the failure to reform the Clean Development Mechanism, which many market participants argued had serious flaws.

Chief of these for project backers and traders was unpredictability: they could not be sure enough in advance how many Carbon Emission Reduction credits (CERs) a project would earn. Obtaining these credits is the main attraction for them of sponsoring these projects, since they can be sold to companies in the EU ETS to enable them to exceed their normal emission limits.

In Copenhagen, talks on CDM reform were one of the areas where encouraging progress seemed to be happening, but the lack of an overall agreement stymied any real change.

International leaders did, however, make a commitment to streamline the process by which projects can be accepted for the CDM. This should raise investors’ confidence somewhat.

Karmali says that “while it’s good that there have been decisions” regarding the CDM, “the underlying drivers are going to come from demand; but demand is paralysed due to concerns about 2012 credits”.

If companies covered by the ETS do not know how many EUA permits are going to be issued after 2012, they can have no idea how much to pay for CER credits.

Because of this, Karmali believes CER trading will be driven by hedgers rather than speculators.

Sikorski thinks the CDM reform was “fairly weak” and says people were hoping for more. In his view, the CDM would ideally be broader-based, less political, and its executive board would work on more of a guidance and advisory role.

Greenwood believes that changes to the CDM process “should have an indirect effect” on CER trading. “Anything that brings long term security and harmonisation is good for the markets,” he said.

Business as usual

The clouds obscuring the carbon market’s future may not be ideal, but they are by no means disastrous.

Birley believes that, sooner or later, more and more countries are bound to impose cap-and-trade schemes. Though several countries have proposed a carbon tax as an alternative to emissions trading, he says the two can work together: “I don’t see [the carbon tax idea] as a replacement for cap-and-trade. There’s a combination of policy measures that need to be applied.”

Meanwhile, on Birley’s own exchange and elsewhere, carbon trading is an expanding industry.

“I don’t think we’re going to see the growth we might have seen,” says Ager. But he believes this is not necessarily bad for the markets: “We will see some of the euphoria stripped from the market — it will be more like business as usual.”

The carbon market is still allowing companies to expand their customer bases and make new relationships with hedgers. On the speculative side, financial institutions are becoming increasingly interested in carbon as an asset class.

“There’s a lot of education going on right now… I’m not really talking to utilities but mainly to financial entities,” says Gary Hart, a senior energy analyst at Icap in Birmingham, Alabama. He suggests firms such as banks and hedge funds have shown the most interest early on.

Of course, all the confusion about the future means the carbon market is perceived as quite risky at the moment. But there is always risk in financial dealing.

“The carbon market is risky — you have to size your bet accordingly,” says Cosgrove. But he adds: “I think it’s less risky to buy pre-compliance credits in California for $4 per tonne than $95 oil.”