Feature: Cleaning up carbon trading

Feature: Cleaning up carbon trading

When the EU’s Emissions Trading System – the cap-and-trade system by which a limited number of carbon permits are traded by companies in participating industries – was launched six years ago, no one was under any illusion that it would completely solve the problem of controlling and ultimately reducing carbon dioxide emissions.

It was, however, seen as a good start – a system that could be grown and built upon. Eventually, some believed, with further global cooperation and the buy-in of both industry and politicians, it would form the foundation on which a more robust carbon emission control mechanism could grow.

The ETS had obvious problems. Clearly, any scheme confined to the EU could not solve a global problem. In addition, it was limited to certain industries, albeit those that produced the highest carbon emissions. However, there was optimism that, following the EU’s lead, global leaders could reach agreement on tackling climate change.

Another weakness at first was that in the early years allowances were dished out free. This rendered them essentially valueless in conception; they only gained value in the secondary markets when traded. Companies with more permits than they needed would sell them; those with too few were forced to buy. This also meant the number given out was critical – to their value and to any hopes of the scheme encouraging companies to cut emissions.

In the view of many critics, the system was woefully inadequate. Even for companies regularly forced to buy additional certificates, the cost was too small and too variable to justify any long term capital investment in new carbon-reducing technologies.

Even the complementary Certified Emissions Reductions scheme – credits issued under the Kyoto Protocol to projects in the developing world that theoretically cut greenhouse gases – came with inherent flaws.

The idea was that companies could invest in carbon-reducing or lower carbon technologies in poor countries, where the potential efficiency gains were greater, and be rewarded with carbon permits equivalent in almost every way to the ordinary EU Allowance certificates issued under the ETS.

Yet how to define the type of technology that qualified was confusing. It also muddied the pricing of certificates in the secondary markets.

Good intentions

For all its flaws, however, this was a market founded on good intentions and optimism. So despite its drawbacks, when the ETS was introduced in Europe in 2005 it was greeted with gusto by professional advisers and banks, which saw it as a growth market offering lucrative margins.

“This was the big market for banks to get into six years ago,” says Tim Greenwood, head of customer relations at the European Energy Exchange in Leipzig. “It was regarded as a sexy product with ecological aspects – something the banks wanted to be seen to be involved in.

“It was very competitive between the different exchanges, and brokers and banks were vying for market share. The margins were, however, lower than many other sectors but it was seen as having big potential for growth.”

A vibrant and competitive spot market developed, as did several futures and options trading platforms – both for full exchange trading and in an OTC market linked to clearing houses.

Taking some punches

Since those heady early days, however, a combination of the economic downturn, banking crisis and some teething problems for the carbon trading market have heralded an era of greater caution. Some players have retreated. “Many companies have left because of internal reasons but the market has lost some credibility,” Greenwood admits.

Criminals have used the market to carry out a number of high profile VAT frauds as well as thefts of certificates through cyber attacks. The certificates were quickly sold on through the spot market before the breach was detected.

This scandal, which struck in January this year, highlighted the lax computer security of some of the national registries which administer the ETS in each country. Parts of the trading market were shut for days and in some cases weeks while the mess was sorted out.

How much these cases have harmed the market’s credibility, however, is disputed. “This was a major issue last year and it certainly affected the spot markets,” says Greenwood. “It was no surprise in a way. We have all had strange phone calls from individuals looking to access these markets. But it still undermined it. Steps are being taken to stop these things happening again but the situation is still far from perfect. The market is young but these things mean it is also seen as somewhat exotic as a result.”

Others warn against exaggerating the problems. “These incidents do not help the market’s credibility, of course,” says Julian Richardson, chief executive of Parhelion, an insurance underwriter in London that specialises in emissions and green energy. “But true credibility in a market can only stem from a stable regulatory environment.

“In that sense, the glitches in this market have been overblown. It is like saying that people are selling dodgy goods on eBay so it should shut down. All markets have glitches, even the LSE. And, equally, VAT fraud is found in many sectors – it occurs wherever tax irregularities exist. Carbon trading is a small and relatively new market and teething troubles are bound to occur. In a perverse way, these things show the value in it. I suppose it is like a coming of age.”

Georgie Messent, head partner of the emissions and carbon team at law firm Burges Salmon in Bristol, agrees. “Credibility is still an issue,” she says. “Some registries are only now coming back on line after closing. It has certainly made investors very aware of the dangers, although equally it has illustrated the value of the market. If criminals are interested, it shows it is a market where money can be made.”

Spot the error

Messent says the biggest problem is on the spot side and that there is no easy solution. “That is where these deals have been cashed. But this market moves so quickly it is very difficult to certify a certificate at the point of exchange.”

Henrik Hasselknippe, managing director of global product development at the Green Exchange, a joint venture between CME Group and 12 energy trading firms, says most of the problems happen in the spot market because it is relatively unregulated.

“As a highly regulated exchange, we do not face these problems,” he claims, “but the market has suffered some reputational damage. There have been some lessons learned though.”

Phasing in auctions

Yet these blows to the market’s reputation come at a time when other important changes are being made – designed to enhance both the market’s credibility and its value in very tangible ways.

The most important concerns the way certificates are allocated to companies. For some industries, they can now be auctioned, so that emitting companies have to bid for them.

Under EU rules, member states can now sell up to 10% of their allocations of permits. The UK, for example, has decided to sell 7% of its allocation, enough to cover the power-generating sector, which will now have to buy all its EUAs. From 2013, about half the permits available are expected to be sold.

The only companies expected to receive their permits free are those in industries particularly vulnerable to competition from overseas businesses that are not subject to the same strict environmental regulations – the cement sector, for example.

This is a big change for the market. “The main point is that the new auction system will impose more costs on the relevant sectors; the lion’s share will be borne by the power sector,” says Messent.

“The theory is that if you increase the cost, more companies will divert resources and capital to carbon emissions reduction technology. While the power companies are broadly supportive of the idea of carbon trading, they do complain about the costs involved. And this will probably drive up the costs in the secondary markets.”

But Messent adds that the auction system would still fail to influence the market’s most fundamental dynamic: the ratio of the total number of certificates in circulation to the number actually needed by companies. Only by squeezing the supply of permits can the cost of emitting carbon be raised, sharpening the incentive for companies to reduce their emissions.

Especially as the consumption of some sectors such as manufacturing has fallen due to the recession, this dynamic needs monitoring, she adds.

Hasselknippe highlights some of the benefits of the new system, such as the revenue countries can earn by auctioning certificates. He is not sure what effect it will have on secondary trading but believes it could encourage more players to get involved.

Tackling regulatory threats

But there are even more fundamental issues that require solving in the industry before it can gain true credibility. Many of these concern the role of the regulator.

Richardson says Parhelion has recently partnered with Kiln, a unit of Japanese insurer Tokio Marine and an underwriter in Lloyd’s of London, to offer an insurance product to overcome one of these problems. But he also has bolder thoughts on how the industry could change.

The insurance product Kiln and Parhelion have conceived is designed to protect companies investing in projects they hope will qualify for Certified Emissions Reductions. Firms can use the insurance to offload the risk that the CERs from their particular project are ruled ineligible for compliance use in the ETS because of regulatory changes.

This risk has been a big factor deterring companies from investing heavily in such projects.

Richardson hopes the policy will encourage fresh investment in CER projects and stimulate secondary trading of the credits.

The policy was designed for a specific bank in response to a decision by the EU’s Climate Change Committee to ban trading in credits earned from plants that destroyed two sources of greenhouse gases – HFC-23, a byproduct of refrigerant manufacturing, and adipic acid.

Richardson says that while policy development under the Kyoto Clean Development Mechanism has settled down, EU policy on the ETS is a movable feast, which discourages investors.

“Because this market exists purely through regulation, banks are faced with a lot of regulatory risk,” he says. “The EU decided only late last year that these two types of project no longer qualified.”

Banks are important to the carbon credits market because their purchase of options on future CERs helps to fund projects, while their trading in carbon futures adds liquidity and helps companies and governments hedge their emissions reduction costs.

Richardson says the banned credits, issued to projects destroying the two types of gases, accounted for about half of all CERs yet issued and about a quarter of credits due to be delivered in 2012 and 2013.

Radical ideas

The Parhelion-Kiln insurance product addresses a specific problem in the market and goes some way to offering certainty to investors.

But it only solves one problem. Richardson advocates a more radical approach. He believes the EU should itself insure against the risk of regulatory change.

There is a disconnect at the moment between the regulator and the investors who bear the risk,” says Richardson. “This risk needs to be aligned better. The government should set in place its own guarantees against future regime change. This does happen in other circumstances, such as in the world of political risk insurance in emerging markets, where governments guarantee against the consequences of future illegitimate regime changes. If they did that more companies would respond.”

He believes that alongside the European Investment Bank, the EU should create an insurance company with similar scope. “They would be better off with an insurance company that could step in and give certainty on some of these regulatory issues,” he says.

Richardson also advocates a different approach for the EUA permits. He believes a European central carbon bank should be created that would seek to manage carbon prices, keeping them inside a broad price band – as ordinary central banks do with inflation and employment.

The carbon bank’s tools would be actively managing the number of certificates available, with a view to stabilising their prices.

“This would completely change the dynamic of the market because you create long term price stability,” Richardson says. “That would encourage capital investment by allowing companies to better understand future savings they would make by investing in green technology. At the moment, investment committees are working in the dark.”

Another approach, favoured by some advocates of tougher controls, would be to publish clearer information about how the number of available permits is expected to reduce, year by year, into the future. That would force companies to plan ahead to make efficiencies.

New schemes on the way

The carbon market is developing and moving forward in other ways. From January 2012, airlines which operate international flights to, from or between EU airports will have to surrender EUAs against their carbon emissions.

Lufthansa has announced that it will join the European Energy Exchange to trade carbon in its spot and derivatives markets. “A lot of the airlines are getting geared up for this,” says Greenwood.

Hasselknippe expects the airlines’ entry to increase liquidity, though it is hard to say how much.

And although the global community has so far failed to agree any deal on reducing carbon emissions, several countries outside the EU are moving towards introducing schemes of their own.

In the US, California is set to launch its own cap-and-trade system in 2012, similar to the EU one. The state passed the nation’s most comprehensive climate law in 2006, mandating a cut in carbon pollution by 2020 to 1990 levels — about 10% below today’s emissions.

Although the US Congress balked at similar legislation in 2009, California will cap greenhouse gases at 600 industrial plants and allow companies to buy and sell emissions permits.
California is coming online soon and we expect other US states to follow suit, even though there is still no push at a federal level,” Hasselknippe says. “Ultimately, we believe that the US market could end up being half the size of the EU, which is not insignificant. We are excited about what is happening in the US and we believe that it could develop into a highly liquid and credible market.”

At the other corner of the country, ten northeastern states, including New York, New Jersey and Massachusetts, have set up a Regional Greenhouse Gas Initiative with tradable permits, aiming to cut 10% from power station emissions by 2018.

In the developing world, the World Bank’s Partnership for Market Readiness, formed late last year, aims to help countries cut their emissions through trading systems. The UK government recently pledged £7m to help 15 developing nations set up schemes. Ultimately, the World Bank aims to raise a total of $100m for such investment.

Its International Climate Fund will aim to test and pilot carbon trading schemes in at least five developing nations by 2015. As part of this, China will launch pilot emissions trading schemes in six areas before 2013 and set up a nationwide trading platform by 2015. China has pledged to reduce the carbon intensity of its economy by 40%-45% by the end of 2020, against a 2005 benchmark.

While headway such as this is important for the market, a full global deal remains the ideal. “Other countries doing it will give it credibility but it can only be a genuine success if all countries sign up,” Greenwood says. Richardson agrees: “A global solution can be the only long term aim.”

For the moment, market participants must live in hope.