Isra-Mart srl: Carbon 101 - the carbon market explained

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While the ultimate aim of carbon trading is simple, the various trading schemes and how they fit together is fairly complex. Daniel Bloch explains the background to the major carbon trading schemes and various mechanisms currently in operation

Lowering greenhouse gas emission levels is high on the international agenda. Many countries have set targets to reduce emissions, particularly carbon emissions. To reach these targets, schemes have been devised that put a price on carbon.

While taxation is one of the simplest ways to price carbon, it is better suited to domestic rather than international policy because the marginal abatement cost curve (MAC) differs by country. More precisely, based on the MAC of a country, one can use a Lagrange optimisation framework to determine the lowest cost of achieving the total emissions reduction required in a year. An alternative approach is the cap-and-trade scheme where an upper limit is placed on emissions of greenhouse gases so that flows will go where the costs are lowest, allowing the required reduction in emissions to be achieved as cost effectively as possible.

Under such schemes, the government allots tradeable pollution permits, called allowances, to emitters of carbon dioxide (CO2) and other greenhouse gases (Mills, 2008, and Kassenaar, 2009). It gradually diminishes the number of allowances it issues to reduce pollution, pushing up the price of carbon.

A price is then put on carbon across sectors and countries, which results in emissions reductions occurring in whatever sector or country they are the least costly. The desire to generate high enough prices will depend on ambitious and binding national targets.

In principle, companies in developed countries have relatively high abatement costs and face high targets, so they could purchase permits on the international markets to meet these targets. Developing countries, with low-cost abatement opportunities and modest targets, would benefit from receiving net inflows of cash that can be used for low-carbon development.

Theoretically, it results in the marginal cost of abatement equalling the price of a permit within the scheme, which is equivalent to optimising the allocation of a greenhouse gas emissions tax among energy companies (Jones et al, 2008).

The Kyoto Protocol is a product of the United Nations Framework Convention on Climate Change aimed at fighting global warming. The Protocol was adopted on December 11, 1997 in Kyoto, Japan, and put into action on February 16, 2005. Under the Protocol, 37 Annex I countries committed to a reduction of four greenhouse gases – carbon dioxide, methane, nitrous oxide and sulphur hexafluoride – and two groups of gases – hydrofluorocarbons and perfluorocarbons. They agreed to reduce their collective greenhouse gas emissions by 5.2% of the 1990 levels by 2012. To facilitate compliance, the Kyoto Protocol proposed three mechanisms: emissions trading, the Clean Development Mechanism (CDM) and Joint Implementation (JI). Both JI and CDM allow Annex I countries and companies to generate certificates called emission allowances by financing emission reduction projects in other countries.

The JI has caused less concern than the CDM about spurious emissions reductions because it takes place in countries that have an emissions reduction requirement, also called economies in transition. The permits generated under CDM are called Certified Emission Reductions (CERs) and those generated under JI are called Emission Reduction Units (ERUs). The carbon emission allowance (EUA) is a right to pollute while the CER/ERU is backed by physical projects that stop or reduce the generation of CO2 emissions.

Allowances are traded in local markets that are governed by local cap-and-trade schemes, whereas primary CERs are traded on a global CDM market with potential links to several cap-and-trade schemes, and secondary CERs are traded on European exchanges such as the European Climate Exchange, Nord Pool and the European Energy Exchange.

European Union Emissions Trading Scheme (EU ETS)

Under the Kyoto Protocol, the EU has committed to reducing its greenhouse gas emissions by 8% compared to 1990 levels by 2012. The Kyoto Protocol says the trading of emissions allowances is one of the primary mechanisms through which CO2 emissions reduction should be achieved. Each allowance gives the holder the right to emit one tonne of greenhouse gases. This creates a limit on the amount of greenhouse gases that each polluter can emit without incurring direct costs. After the initial allocation, the allowances are considered to be a tradeable asset, with a price determined by the market forces of supply and demand.

The EU ETS was initiated in January 2005 and imposed mandatory participation of more than 12,000 installations responsible for about 45% of the EU's entire carbon emissions.

The EU ETS operates in two initial phases: the preliminary phase, or pilot period, lasted from 2005–2007, and the second phase, called the first Kyoto commitment period, covers the period from 2008–2012. For the post-2012 period, after the expiry of the Kyoto Protocol, the European Commission has decided to continue market operations as EU member states have agreed to reduce their greenhouse gas emissions by an additional 12% by 2020.

EUAs are allocated yearly by governments, according to the corresponding National Allocation Plan, which defines an emission limit for each compliance period. That is, each year at the end of February, companies with combustion installations exceeding 20 megawatts are allocated a certain number of EUAs. On April 30 of the following year, companies have to submit either EUAs – or, since 2008, CERs or ERUs restricted by an import limit – to the national surveillance authorities, according to their actual emission volumes.

In principle, if projected emissions exceed their allocated EUAs, companies have two possibilities: they may either abate some of their emissions or buy the EUAs they lack on the market. A lack of allowances requires a company to either make some plant-specific or process improvements, to cut or shutdown the emissions producing plant, or to purchase additional allowances. The emission credits may either be allocated free of charge, auctioned off or sold at a fixed price. If companies fail to comply, they have to pay a penalty and must also deliver the missing EUAs in the following year.

The EU set the penalty for the preliminary period 2005–2007 at €40 per tonne of CO2. The penalty was increased to €100 for the first commitment period of the Protocol from 2008-2012. The intended effect is that companies with cheap abatement opportunities will abate more CO2 and sell the EUAs in the market to companies for which abatement is more costly.

If any facility requires further allowances because it cannot - or chooses not to - abate emissions, it must seek environmental compliance through the market to avoid penalties. Hence, the new market forces companies to hold an adequate number of allowances in relation to their CO2 output. Failure to do so will result in sanction payments per missing tonne of CO2 allowances. Therefore, the emissions become either an asset or a liability due to the obligation to deliver allowances to cover those emissions.

The CER scheme

A CER is specified as a unit of greenhouse gas reductions that was initiated and created under the provisions of Article 12 of the Kyoto Protocol, which outlines the CDM. Article 12 states that CERs must be certified by operational entities to be designated by the Conference of the Parties, serving as the Meeting of the Parties. CER prices are determined by evaluating the diverse risk factors involved in a project and existing market forces by both the buyer and sellers. Any CER seller who is willing – and has financial capacity – to take on project risk will benefit if the CER prices are higher. On the other hand, a CER buyer who is willing to invest in any risky project will benefit in the event of lower prices.

At various stages in the process, and given the right conditions, a project owner may secure investment in the underlying project, or a reliable source of revenue through the forward sale of CERs in agreement with Annex I and non-Annex I parties. Agreements may combine many types of financing such as debt, where loans can be arranged with terms and conditions to reflect prevailing project finance interest rates – possibly at a preferential rate if an option to purchase CERs resulting from the project is included.

Alternatively, equity stakes can be agreed whereby the investor receives revenue from the proceeds of the project, including CER revenues or the CERs themselves. In principle, CERs can be sold to governments seeking to meet their Kyoto Protocol emissions reduction targets or to firms facing compliance rules under the EU ETS.

For years, the supply of CERs into the carbon markets was predictably slow, as project approval and CER issuance had difficulty navigating the CDM's bureaucracy. But reforms to the system and more manpower are now speeding things up faster than analysts had predicted.

Market size

Carbon markets have experienced tremendous growth, with transactions rising from $11 billion in 2005 to $64 billion in 2007, which is about 3 billion tonnes of CO2.

In 2009, the Kyoto market represented only 0.9 billion tonnes of CO2 while the EU ETS accounted for 2 billion tonnes of CO2. Hence, the EU ETS is by far the most developed and most active market for emissions trading. One of the reasons for this is that participants can get easy access to the market via the Community International Transaction Log (CITL), which provides ready-made access to the entire, pre-existing capital market infrastructure, and is a powerful trading platform. This is not the case for the Kyoto markets where the International Transaction Log, with infrastructure similar to the CITL, only became fully operational at the end of 2008.

The CER market has long remained essentially a primary market where prices are driven by the value of EUA contracts. However, a secondary market for CERs, with CER futures contracts, launched in 2008. Nowadays, several exchanges in Europe trade EUAs and CERs as spot and futures contracts with quarterly and yearly maturity, and with physical delivery of CERs and Phase II EUAs.

In the EU ETS market, even though EUAs and CERs are eligible to offset the same amount of CO2 emissions at the end of the compliance period, their prices are not equal due to the import limit on CERs (Barrieu et al, 2011).

Regulation

EUAs can be banked or borrowed. Banking is the act of storing EUAs for later usage – transferring surplus allowances of the previous year for use during the next year or the next compliance period – and borrowing describes the act of using future certificates for compliance in the present. EUAs issued in the first trading period (2005-2007) could not be banked in the Kyoto commitment period (2008–2012), and the spot price approached zero at the end of 2007.

However, in the second trading period, excess allowances from one year may be banked to the next year, and borrowing EUAs from a future year is permitted and could be used by companies to comply with the preceding year. Further, banking is allowed during a compliance period and also between compliance periods. Consequently, Uhrig-Homburg et al (2009) argued that after May 2006 there was no clear connection between the first period spot and the second period futures prices because futures for the second period were written on an underlying, not traded in the first period.

In Phase II, the market is in strong contango while it was in backwardation in Phase I. As emissions for a given year do not have to be converted until April of the subsequent year, the offset can be made by the subsequent year's allowances allocated in February. However, borrowing is only allowed within compliance periods and, as such, it is generally assumed that market players will not fail to comply within the third compliance period.

About CER pricing

The pricing structures

Primary CER prices are quoted in euros or US dollars for sale on the global market, and the pricing structures offered are typically fixed, floating or a combination of both. But other types of exotic structures do also exist.

The fixed price is an agreed price per CER that will not change if the EUA allowance market moves against the seller. This structure is often preferred by those requiring more certainty of the revenue stream for future budgeting plans, rather than being exposed to market fluctuations. A fixed price may also be preferable to lock in current market conditions if perceived to be advantageous to both parties. A fixed price will usually be lower than the equivalent floating price because the buyer is taking the delivery risk and the market risk. The floating price is a percentage of the average EUA price over an agreed number of days and gives sellers exposure to potential gains in the EUA market, but also to potential losses should the market fall.

This structure generally only works for European buyers who have an exposure to the EUA market. And finally, in the combination of fixed and floating price, buyers and sellers may choose to specify a price based on fixed and floating components in order to reduce exposure to either structure. For example, 50% of the agreed CERs may be at a fixed price, while the other 50% may be at a floating price, or a fixed minimum price may be agreed with an additional floating payment.

In general, CER prices are derived from the evaluation, by both buyer and seller, of the various risk factors involved in a project and prevailing market forces.

The factors affecting CER prices

There are several factors affecting the prices of CERs:

• For many buyers, the value of CERs is benchmarked to the EUA price – the most established trading system for emissions – and volatility in EUA prices is typically reflected in the CER market. Further, the credit availability also influences the prices of CERs as the distinctive long-term nature of the CER contract needs both the seller and buyer to reveal their credit details. Given that parties in developing countries best suited to developing CDM projects may not have the requisite credit rating, and that both parties are often reluctant to foot the additional expense of a letter of credit, price negotiations often depend on how this issue is approached and managed.

• The terms and conditions of the sale of CERs also determine their price. The CER price in a contract is dependent on several factors – for example, delivery guarantees offered by the seller, volumes likely to be generated, the use of an established methodology, who bears the costs of developing CDM documentation, project validation and registration, and any upfront payments that may be required.

• Various other types of risk affect the price of CERs such as sovereign risk, quality risk, technology risk, delivery risk and registration risk. Yield and delay risk are also important.

Sovereign risk is related to the development of political and legal infrastructure, currency volatility and perceived risk by investors. This also refers to the status of local infrastructure developed to encourage CDM activities, as this will determine how efficiently projects obtain national approval, and whether they are likely to meet the standards required for eventual project registration with the CDM Executive Board.

The most proactive countries – such as India, Brazil and China – have approved many projects, and have developed a streamlined and effective process for facilitating future projects. China, for example, has set up several provincial CDM centres to encourage progress, as well as developing an online facility listing all nationally approved projects and projects looking for investment or technology partners.

The more developed a project is – in terms of approvals, documentation and physical construction – the less likely it is, in theory, to fail in generating CERs. It is also likely to have overcome hurdles, such as obtaining the relevant licenses for operation and getting host government approval. Value-enhancing standards, such as the CDM Gold Standard, are gradually being adopted, leading the market in the direction of high-value, high-quality projects.

These standards address key issues early on in the project development cycle, highlighting and resolving potential problems that may otherwise have led to a review at the registration stage, for example, or a failure to register completely due to sustainability or additional concerns.

A project can fail to generate the expected volumes of CERs for many reasons - for example, the delayed commissioning of the project, lower than expected project efficiency or lower levels of greenhouse gas emissions than expected - which can result in an under-delivery of committed volumes. Despite best efforts, the CDM approval process can still lead to projects being rejected for approval, or not even passing the validation stage, regardless of the good intentions of the seller to access the market. For this reason, going through a CER broker might be attractive to both buyers and sellers - buyers for the convenience, quality, range and access to projects, and sellers for the broad network of buyers available and the expertise in negotiating contracts.