Isra-Mart srl: Market focus: EU carbon market set for growth

www.isramart.com
Europe’s emissions trading scheme, the EU ETS, is the largest of its kind in the world. The scheme has experienced numerous teething difficulties since its launch in 2005 and as it moves into its third phase, expectations are reduced but lessons have been learned and the trading model could become a blueprint for other markets.

The European cap-and-trade emissions trading scheme (EU ETS), under which carbon emissions are capped through allowances that can be traded on spot and derivative markets, was launched to great fanfare in 2005. The scheme aimed to reduce carbon emissions within the European Union by 21% 2020.

The two most traded contracts are the Certified Emission Reduction (CER) credits and the European Allowance unit (EUA), one credit of each is equal to one tonne of CO2 emissions. Emission Reduction Units (ERUs) are also tradable under the EU ETS where emissions are made through what is termed a Joint Implementation project in another eligible country.

EUAs accounted for 84% of the total global carbon market in 2010, with related transactions under the EU ETS such as European CERs, taken into account that share rises to 97%. The majority of the derivative contracts are traded on ICE Futures, with the European Energy Exchange, GreenX and Nasdaq OMX also trading CERs, EAUs and ERUs futures and options contracts.

Teething problems

The EU ETS has had a tumultuous existence since its launch. The scheme faced ideological problems having been derided by the left for being ineffective against climate change and the right for hampering economic growth. The EU ETS, the largest of its kind, has also faced logistical problems plagued by criminality and price volatility.

The ideological problems won’t be solved any time soon. However, the two main logistical problems have their roots in the structure of the market when it was launched and are being addressed by regulators and the markets as it moves into the third and final of its launch phases.

Initially each member state within the EU was given responsibility for the handling of their depositories resulting in a number of successful pishing attacks on some locations and the electronic theft of the certificates. The EU is taking steps to create a single repository for certificates to mitigate the threat from hackers.

Another significant design flaw in the scheme was the allocation of allowances. In Phases I and II allowances were given to firms for free. Not only did this result in a windfall of profits for some companies, much to the chagrin of some elements of the press, but it also resulted in a situation where value was only realised in the secondary markets and only then in the event of demand.

However, due to an over-allocation of allowances, demand dropped significantly. Certificates were not tradable between phases with the unsurprising result that over-supply and approaching expiry dates led to a collapse in market prices, which reached zero towards the end of Phase I in 2007.

Reforming markets

The EU has set out to correct these flaws in the move into Phase III in 2013. Phase III will see the establishment of an overall EU cap (a move away from the current National Allocation Plan model), tighter limits on the use of offsets, unlimited banking of allowances between phases II and III, and a move from allowances to auctioning.

Phase II allowances will be carried over to Phase III and with the cap placed on emissions during Phase II predicted to be higher than total emissions, partly as a result of the recession, many market participants are expected to bank these allowances and take them into the next phase, something that they were not able to do over previous transitions.

In addition, the scheme is being expanded with the Inclusion of the aviation sector in the scheme from 2012, which is expected to lead to an increase in demand of around 10-12m tonnes of CO2 allowances per year. Some airlines have already begun participating in the market with Lufthansa joining the EEX to trade in the spot and derivatives markets this year.

Exchanges are currently registering their interest in the contract to be the auction platform for certificates in Phase III. EEX has been auctioning 10% of the German allowances during Phase II and is currently a favourite for the contract. However it will face opposition from ICE Futures and GreenX for the potentially lucrative contract.

During the third phase, at least 50% of the allowances will be auctioned, compared with just 3% in Phase II. 120m allowances will be auctioned by the EU in 2012 in anticipation of the start of Phase III.

The EU ETS looks set to become a hotbed for arbitrage opportunities. The UK, Poland and Germany have opted out of participation in the EU common auction platform meaning that there will be four primary markets for allowance auctions with the resulting opportunities for arbitrage of the fungible contracts.

Regulatory uncertainties abound going in to the third phase of the scheme. Not least is what form CERs will take in the third phase. To overcome this exchanges are innovating. For example, GreenX has launched a CERPlus, a contract that will automatically convert to whatever unit is mandated by the regulators.

Reduced expectations

The various challenges have led to a reduction in ambitions for the market. Carbon trading was predicted to be one of the fastest growing markets with volumes comparable to credit derivatives by Merrill Lynch in 2007 and “the biggest of any derivative products in the next four to five years” by Bart Chilton of the CFTC in the same year. Now, however, due in part to the problems experienced early on and changing political winds, expectations are lower.

Tom Lewis, chief executive of GreenX, the CME backed European emissions exchange, said: “Global ambitions have been scaled back. The shift in the political winds in the US that was driven by the stalled economy has stalled the expansion of the scheme. There is a misconception that there is a net loss for capping carbon but in fact it would improve the US’s ability to compete.”

One result of the scaling back of ambition has been the shift away from the creation of a common global market, a “carbon currency” that would have seen companies across the world trade fungible emission contracts. This now looks unrealistic.

However, Lewis has not given up on the idea. “Fungibiliy happens in small steps,” he said. “Large multi nationals will have international liabilities and firms with a large footprint will be motivated to trade futures and options contracts to manage liabilities across regions.

“It is possible for exchanges such as GreenX to manage multi-national liabilities and we could see the creation of contracts that address the multi-regional requirements of these firms.”

Global setbacks

It has been a bad year politically for carbon trading: the US did not pass federal cap-and-trade legislation, Australia froze its plans for a domestic scheme and a Japanese act on global warming did not pass through the upper house. These are all setbacks for the EU’s ultimate aim of linking its ETS with other compatible trading systems across the world.

In addition, existing schemes in the US are losing pace. There are currently two schemes in the US: the Western Climate Initiative, a group of West Coast US states and Canadian provinces committed to reducing emissions to 15% below 2005 levels by 2020 and the Regional Greenhouse Gas initiative, a scheme involving a number of US states.

Both schemes have fared poorly during the downturn. Most recently, the withdrawal of Arizona from the WCI and speculation that Utah will also drop out has thrown the scale of the scheme into doubt ahead of the proposed launch in January 2012.

The Regional Greenhouse Gas Initiative, is also flagging. Like the EU scheme, it has been plagued by overcapacity despite an initial auction of the credits. Credits now trade at the legal minimum of $1.89, 70% of credits went unsold at the last auction and New Jersey looks set to drop out of the scheme.

The World Bank describes the current state of the market as “fragmented but workable” and one that “could further evolve through linking and acceptance of similar levels of ambition [to the EU ETS]”.

However, it warned that “without fungible assets and open schemes, the fragmentation of the carbon market will persist and the hoped for longterm carbon pricing signal will not be achieved”.

Lights in the tunnel

However, there are signs of progress. New Zealand is phasing in an Emissions Trading Scheme and despite the setbacks to the WCI, California is forging ahead with its cap and trade scheme, which will go live in 2013 becoming the second largest ETS in the world after the EU ETS. Futures contracts on Californian emissions were launched last month on GreenX.

Despite the various false starts, few can doubt the merits of the EU ETS. The scheme is predicted to reduce emissions in the 30 European countries operating under the scheme (the 27 EU member states as well as Iceland, Lichtenstein and Norway), by 21% reduction on 2005 levels by 2020. Europe aims to reduce emissions by 80-95% by 2050, a hugely ambitious target.

Lewis said that there were a number of lessons that had been learned during the development of the EU ETS that can be applied elsewhere. In addition, he said that the Californian scheme will not be plagued by the complications that come with implementing the scheme across a number of different jurisdictions.