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MARKET SURVEY GHGs: Carbon trading comes of age
As the Kyoto Protocol target period begins, caps are tightened in the EU Emissions Trading Scheme and carbon controls loom over US industry, the winners of the Environmental Finance market survey give Mark Nicholls their predictions for 2008.
One doesn’t have to look too far to be reminded how much risk there is in the world’s emerging greenhouse gas (GHG) emissions markets. Last year, it was most apparent in the EU Emissions Trading Scheme (ETS), when allowance prices crashed in the first half of the year, as the market realised the system was massively oversupplied.
This year, the risk has been felt by investors in the handful of listed project developers, whose share prices have been hammered by a slowdown in the issuance of the carbon credits on which their future profitability depends.
The past 12 months have also been characterised by greater scrutiny of the system – with questions raised over standards in the voluntary carbon market, the environmental quality of many of the projects registered under the Kyoto Protocol’s Clean Development Mechanism (CDM) and the high returns made by some investors and companies from destroying industrial GHGs.
But, despite this growing scrutiny, emissions trading is becoming more entrenched as a key tool to tackle the problem of climate change. EU member states placed trading squarely at the centre of the integrated energy and climate package, signed in March this year, which commits the EU to a reduction of at least 20% in GHG emissions by 2020, compared to 1990 levels. Commission proposals to bring aviation into the EU ETS are proceeding apace, marking the first extension of the scheme to a new sector.
The European Commission also took a tough line this year with member states’ proposed targets for Phase II of the EU ETS ensuring, most analysts believe, that the scheme will escape the oversupply problems seen in Phase I. Indeed, while prices of Phase I allowances have declined from €6.70/tonne of carbon dioxide (CO2) on 2 January to €0.01 by the end of November, Phase II allowance prices have remained firm – trading in the second half of the year between €18/t and €23/t.
And, of course, 2008 marks the first year of the five-year Kyoto Protocol compliance period. For the first time, industrialised countries will have an obligation, under an international treaty, to control their emissions of GHGs. While, in most cases, the policy frameworks to achieve this have been in place for a few years, the start of the Kyoto ‘commitment period’ will likely bring efforts to reduce emissions into sharper focus.
In the US, cap-and-trade schemes are rising up the political agenda – particularly among the Democrat presidential candidates – and bills to cap US carbon emissions are advancing in Congress. Outside Washington, more states or groupings of states have pledged action on emissions, with three regional trading schemes now planned. And, in Australia, the Labor Party victory in the November election will speed the creation of a trading system there, as well as bring the country back into the Kyoto fold.
But, while interest in emissions trading picks up in the US and further afield, Europe remains the engine-room of the global carbon market. As trading in the first phase of the EU ETS (2005–07) draws to a close, traders and brokers expect activity to grow further.
“We’ve seen a rapid increase in volumes across the vintages, due in part to the ‘trueing up’ of positions for Phase I, the impending approach of Phase II, and the start-up of the Kyoto commitment period,” says John Molloy, head of European environmental products at broker TFS Energy, which was voted Best Broker, EU ETS – alongside a clutch of other placings in GHG markets.
“As we step into Phase II, things will really take off,” he adds, citing increasing involvement by financial players. “The airplay that the market has been given, from both a European and a global perspective, has dragged in even the slower groups. I’m seeing strong signals for a huge uptake in activity through Phase II.”
As might be expected, carbon risk management is becoming more sophisticated, and is spreading beyond the utility sector, which was the first to embrace emissions trading, says Louis Redshaw, head of environmental markets at Barclays Capital which, once again, was voted Best Trading Company, EU ETS: A year ahead of the start of Phase II, we were already seeing companies outside of the utility sector actively hedging – that didn’t happen before Phase I, or hardly even during it.
“Generally, it’s via forward sales and purchases, but we’re starting to seeing more appetite for options,” he says.
More sophisticated risk management expertise could prove to be vital as we head into Phase II. Guy Turner, director at UK based analysis company New Carbon Finance, voted Best Advisory, EU ETS, predicts EU allowance prices will peak in 2008. Although he declines to be more precise than suggesting the price will be “north of €30”, he believes buying by utilities to cover their forward positions will combine with an unwillingness by industrials to sell any surplus allowances they might have so early in Phase II.
This price spike is likely to be exacerbated by the difficulty of importing certified emission reduction (CER) credits from CDM projects in developing countries, adds Turner.
The EU ETS has been the main driver of demand for CERs. A secondary market in CERs – ie, a market in credits whose delivery is guaranteed, backed by penalties for default, as opposed to credits bought directly from the project developer before they are issued – has built over the year.
“This is despite the Commission’s best efforts,” says Redshaw, who is scathing about the EU’s failure to link on time the Community Independent Transaction Log (CITL) – the piece of IT infrastructure that tracks EU emissions trades – with its UN equivalent. This linkage will allow companies to deliver CERs into the EU ETS, and use them for compliance – but may not happen until April 2009.
Although this will allow companies to take delivery of CERs in time to use them to meet their year one targets (sufficient allowances must be delivered by the end of April to cover the previous year’s emissions), Redshaw is not impressed. “The Commission does not seem to be cognisant of how markets actually function,” he continues. “You can’t expect people to continue to take risk in the face of complete uncertainty. And, on the face of it, it seems such a simple task.”
The problem could have been much worse. Most contracts now contain language to take account of ITL risk, says Peter Zaman, a senior associate with Clifford Chance, voted Best Law Firm, EU ETS.“ We’ve been trying to lead the market in managing risks associated with the ITL and, over the last year, we’ve been helping to protect industry-level documents.”
Other aspects of the scheme, such as reporting and verification, are working more smoothly says Robert Dornau, Geneva-based global manager of the climate change programme at SGS which, as last year, was voted Best Verification Company, EU ETS. But, as always, there is room for improvement. “Local authorities should promote the benefits of a split verification approach,” he says, whereby a first assessment is undertaken some months before a follow-up visit. “This means clients would have more time to implement corrective actions,” he says.
Verification is not going quite so smoothly within the CDM, however. Although 2007 has seen solid growth in projects entering the pipeline, the rate of issuance of CERs has slowed – leading to EcoSecurities, one of the largest project developers, and winner of the Project Developer and Advisory categories for Kyoto Project Credits, to revise downwards its CER portfolio, sending its share price in the same direction.
Belinda Kinkead, head of implementation at the London-listed firm, says at least part of the blame lies with the inefficiency of the UN project approval process, and a lack of capacity among the ‘Designated Operational Entities’ (DOEs), the private sector verifiers charged with assessing each CDM project.
“There’s lots of layers of double-checking, instead of the [CDM] Executive Board trusting the DOEs. There’s a fundamental breakdown of trust,” she says, suggesting that, if DOEs aren’t providing sufficiently high-quality oversight, the UN should consider withdrawing their accreditation.
A particular problem, developers agree, is the number of projects which are subjected to a “request for review” – where developers are required to resubmit their projects because of some inconsistency in the documentation, even for small infractions, Kinkead says. “At the moment, everything is material – the Board needs to set thresholds” below which such reviews are unnecessary, she argues.
Werner Betzenbichler, head of carbon management services at TÜV SÜD in Munich – voted Best Verification Company for Kyoto Project Credits – agrees that requests for review risk clogging up the system. He says that relatively inexperienced staff at the UN climate change secretariat – who are screening projects before they reach the Executive Board, and recommending reviews – are partly responsible for the problem. However, as they gain experience with the system, such requests are likely to decrease, he says.
An additional problem is that, as the CDM market grows, new project developers are entering the market, “and they have to learn their lessons, and build experience. In many cases, their first project design documents are not optimal,” he says.
He also points to “problems with human resources capacity” at some DOEs, in the face of an “explosion in the workload”. Here, requests for review can create a vicious circle, by placing further burdens on staff.
Zaman at Clifford Chance predicts that problems with CER issuance will lead to consolidation in the sector. “I think we’ll see a lot of mergers and acquisitions emerging out of carbon, when people expecting certain rewards for their CERs find themselves in difficulty. They’ll need financing or M&A to survive.”
This story was first published in Environmental Finance.
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