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Carbon Trading
The Carbon Market – The Essential Guide, Part 1
May 01, 2008
Tim Morris, wise-owl.com analyst

With the global carbon market bearing an estimated value of $30bn and rising, investors may be forgiven for questioning whether the old adage that ‘money doesn’t grow on trees’ still holds true. To bring you up to speed on such matters, we have put together this ‘essential guide’.

Fast Facts

The technical outlook for European carbon credit prices is bullish.

Background

Unlocked following the 19th century industrial revolution, the power of carbon has fuelled the wave of economic development which has delivered modern society’s greatest accomplishments, such as electric lighting, the automobile, and flight. However, in the later half of the last century we learned that these advances were not without cost, as the first clues began to surface about the toll which modern society’s habits were having on our planet.

Unlocking the power of carbon based fuel sources releases carbon gases into the air, trapping heat within the Earth’s atmosphere, creating what we all know as the global warming effect. For evidence of the effect we need only consider the increasing concentrations of carbon dioxide within the atmosphere. Before 1850 the Earth’s atmosphere contained about 280 parts per million (ppm) of carbon dioxide, however the figure is now 380ppm, and is forecast to reach 550ppm by 2050 according to the Intergovernmental Panel on Climate Change.

The potential impacts of global warming on sea levels, the weather, and the food chain are well documented, and the message is clear. Society needs to curb its addiction to carbon based energy to ameliorate global warming.


For many years global warming remained largely ignored as purely an environmental and academic issue. Only during the last few decades have world leaders begun to acknowledge the issue, as its potential economic, social and financial risks became more translucent.

As world governments unite to counteract the effects of global warming, a combination of regulatory and market based remedies are being adopted to essentially put a price on clean air. While this poses a threat to some old industries with unflattering environmental records, it has spawned an entirely new industry focused on the emerging carbon market, creating opportunities for investors.

The Kyoto Protocol – Creating a Market for Carbon

A market for carbon evolved as a direct consequence of the Kyoto Protocol, an international agreement signed in 1997 that became effective from 2005. The treaty requires developed countries, referred to as ‘Annex I’ nations, to reduce their greenhouse gas emissions by 5.2% over 1990 levels by 2012. Developing countries that have ratified the agreement are not required to do so.

Discussions about greenhouse gas emissions often focus on carbon dioxide (CO2), which is the most common, but not the only gaseous villain in the battle against global warming. In addition to CO2, the Kyoto Protocol also targets reductions of five other dangerous gases, which have even greater ‘global warming potential’. However to avoid confusion and provide an ‘industry standard’, all greenhouse gas emissions are referred to in terms of CO2 equivalents. With CO2 being the industry’s reference point and four of the six greenhouse gases targeted by Kyoto containing carbon, it is no surprise to see this evolving field coined the ‘carbon market’.




Kyoto Compliance

Rather than simply placing a blanket ban on greenhouse gas emissions beyond a certain threshold, the Kyoto agreement recognises the need for a flexible approach for achieving emission reductions, offering 3 ways for governments and corporates to achieve compliance.

1. Direct emission reductions This involves a company or government altering their existing activities to directly reduce their emissions. A simple example would be switching off the office lights overnight.

2. Invest in Emission Offset Projects In circumstances when it is not feasible to directly reduce one’s own emissions enough to meet legal requirements, companies and governments are able to invest in separate projects that remove carbon from the atmosphere, to essentially offset their own activities.

3. Financial Compliance
By either paying a penalty for emissions beyond the legal limit, or through buying carbon credits, which are emerging financial instruments that permit the holder to emit beyond their legal limit.

The Carbon Market

By introducing a legal incentive for companies and governments to spend money on reducing their emissions, Kyoto has ascribed a monetary value to clean air, causing environmental issues to enter the realm of corporate financial strategy. Economic logic suggests that companies and governments will pursue the lowest cost means of achieving compliance. For the largest polluters, such as power plants and industrial companies, meaningful direct emission reductions are often unfeasible and very costly. Therefore we have witnessed strong growth around the later two compliance mechanisms involving carbon credits, and offset projects, which benefits those whose emissions fall below their legal limit, and those whose activities actually reduce atmospheric CO2 levels.

Carbon Trading

Carbon credits are essentially licenses that enable the holder to emit one tonne of CO2 equivalent into the atmosphere within a certain period. Carbon credits are generated by parties that emit below their legal cap, and by those whose activities remove carbon from the atmosphere. These credits can then be sold to parties who need to offset their own emissions in order to achieve regulatory compliance. The cost of purchasing a carbon credit provides a price signal on the value of clean air.




Carbon trading was initially conducted through direct over the counter (OTC) transactions between governments and companies. The entry of commercial banks into the market in early 2005, as Kyoto came into effect, sparked the evolution of dedicated carbon exchanges whose sole purpose was to facilitate trade in carbon credits. The overall growth in trading volumes for carbon credits since this time has been nothing short of phenomenal. Trading volumes have increased 24-fold, from around 100 million tonnes of CO2 equivalent in 2004 to nearly 2.4 billion tonnes in 2007, 2/3rds of which was traded in the later half of the year. In 2006 the World Bank estimated the size of the market to be around $30bn.

The most advanced carbon market is hosted by the European Union, which established an Emissions Trading Scheme (EU ETS) built on the Kyoto mechanisms in 2005. The scheme covers around half of the regions emissions – regulating 11,000 installations and 6,500 entities across the energy, metal processing, mining, pulp, and paper industries. The scheme sets an emissions cap for each member entity over a specified time period, requiring those which have exceeded their emission limits to purchase spare ‘carbon credits’ or ‘allowances’ from those who beat their reduction target. In the case that no member of the scheme has any spare credits, polluters can pay a financial penalty for each tonne of CO2 equivalent emitted beyond their cap.

This financial penalty effectively sets an upper limit on the price of carbon in the European market, because if the cost of buying credits were to exceed the penalty rate, members would simply pay the penalty. During phase I of the scheme from 2005-07, the penalty rate was €40 per tonne of CO2 equivalent. However we have now entered phase II of the scheme, which sets a penalty rate of €100 per excess tonne from 2008-2012.

Most trading of European carbon credits or ‘allowances’ as they are known, takes place by way of futures contracts on the European Carbon Exchange (ECX), which has a market share of around 80%. Contracts are specified according to the year in which the underlying carbon credit is valid, and are traded for up to 2 years before the underlying credit expires. For example, the 2008 contract shown below shows the cost of offsetting emissions made during 2008, and provides the best indication as to the current value of a European carbon credit, which is currently just below €25.




Key Price Drivers

Factors influencing the price of carbon are much more complicated than traditional commodity markets, which are typically governed by supply and demand. These market forces certainly play an important role in carbon pricing, however forecasting future supply and demand for carbon is very difficult because of the market’s emerging nature and the intangible nature of emissions and clean air.

As the market for carbon emerged as the product of a new legal framework, the regulatory environment will remain one of the most important drivers of price. In our view, the level of regulatory emissions cap will be one of the key long term drivers of carbon credit prices. By altering the legal limits on emissions, governments and international regulators have the ultimate influence on demand for carbon credits. By lowering emission caps, regulators can increase demand and tighten supply by reducing the number of parties with credits available to trade. On the other hand providing caps that are too generous can dampen demand and result in an oversupply of credits that can depress prices. Regulators of the European Trading System learnt this lesson last year when carbon prices crashed.

The Carbon Crash

In order to set the caps for the first phase of the EU ETS, member entities were asked to estimate their annual greenhouse gas emissions. These estimates forged the basis of the caps imposed from 2005-07. However following the release of officially verified emissions data midway through 2006, it was evident that members had over estimated their emission profiles, causing the imposed caps to be too generous. The result was an over supply of carbon credits for the remainder of phase I of the EU ETS, which saw the prices of the 2006, 2007 and 2008 ECX carbon contracts crash. Prices for 2007 carbon credits suffered the most damage, falling from €31.50 per tonne in April to below €10 by May. Prices for the 2007 contract staged an initial recovery, trading around €15 for the next few months, but as the reality of the oversupply kicked in, their value began to fade again, becoming almost worthless during 2007.




Other Price Drivers

Penalty Rates/Carbon Tax

The value of carbon credits will also be influenced by the financial penalty imposed on parties that fail to comply with the cap. Fixed rate penalties for each tonne of emissions beyond the cap, such as the case in the EU ETS, effectively put a price ceiling on the price of carbon credits. Throughout 2005-07, when the EU ETS penalty was €40/t, carbon credit prices never surpassed this level, as expected. However now that the EU penalty rate has been lifted to €100/t, European carbon credit prices have much more room to appreciate.

The Weather

It has been suggested that favourable weather conditions for clean energy generators could influence carbon prices by increasing supply and reducing demand for credits. As clean energy providers have a positive impact on greenhouse gas emissions by reducing demand for electricity from ‘dirtier’ power sources, their activities generate carbon credits. So when excessively windy or sunny weather conditions allow them to generate more power, supply of carbon credits on the market could increase. At the same time increased output from clean energy providers could reduce demand from ‘dirtier’ forms of electricity, which could result in lower emissions and less demand for carbon credits. Therefore, although it may seem obscure, favourable conditions for clean energy providers such as sunnier and windier weather could have a negative impact on carbon credit prices.

Energy Prices

Demand for traditional forms of energy such as coal, oil and gas are expected to have an impact on demand for emission offset mechanisms such as carbon credits. Using price as a proxy for demand for these energy sources, we expect a positive relationship between their price and that for carbon credits. Therefore when coal use is strong, as indicated by higher prices, emissions would increase, increasing demand for carbon credits.

Market Penetration

The EU’s regional trading system only covers a select few industries – the largest greenhouse gas emitters. Over the long term we may see the supply and demand fundamentals change as more industries are included under emission regulations. The landscape could also change as more countries introduce or join emission cap and trade systems. The US is the only developed nation which has not ratified the Kyoto protocol; however there is speculation that this could change following Presidential elections later in the year, which could increase volatility within existing carbon markets.

More articles from this edition of CompareShares:

Investing: Measuring the return of your investment property
Exclusive Interview: Renowned Turtle Trader speaks to CompareShares
Carbon Trading: The Carbon Market – The Essential Guide, Part 1
Commodities: Crude oil the hottest commodity on the planet
US: Federal Reserve cuts US rates again
Exports: China exporters face harsh 2008: report
US Economy: US economic growth limps ahead in Q1
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