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Carbon Trading
The Carbon Market – The Essential Guide Part 2
May 05, 2008
Tim Morris, wise-owl.com analyst
Australia's position in the Global Carbon Market
The US has been left on its lonesome following Australia’s decision to sign the Kyoto Protocol late last year as the Rudd government came into power. Despite being late in recognising Kyoto, the emergence of a local carbon market is well under way. A national carbon trading system is currently being developed with a target for commencement in 2010. However trading is already under way at the state level, with NSW hosting the world’s second largest trading scheme in terms of volumes and value of carbon credits transacted.
Local carbon markets have been evolving for several years because Australia’s reluctance to ratify Kyoto reflected an unwillingness to be legally bound to emission targets rather than reluctance to curb emissions. The NSW state government’s ‘cap and trade’ scheme has been in operation since 2003. Known as the ‘NSW Benchmark Scheme’, it regulates annual emissions of participants in the electricity market. The ACT government joined the scheme in 2005.Carbon credits generated under the NSW system are known as New South Wales Greenhouse Gas Abatement Certificates (NGAC). Spot prices have recently traded around $6.80 to $7.20 according locally listed provider, CO2 Group (ASX code: COZ). Being the equivalent to less than €5, local carbon credit prices are much lower than their European counterparts because of differences in the type of activities permitted to generate excess credits, and the level of the penalty rate for non compliance.
The local penalty rate is only $12/t of CO2 equivalent, compared to €100/t under the EU ETS. So as long as this level is maintained, NSW carbon credits should not trade above $12. The EU ETS is also more restrictive in the types of activities that can generate credits, which serves to keep supplies tight. Unlike the NSW scheme, the EU ETS does not allow excess credits to be generated through forestry activities. The rationale behind this ruling is a source of contention within the industry, especially as the market for offset projects has ballooned in recent years.
Carbon Credit Creation
‘Offset projects’ are a way of generating carbon credits in addition to directly curbing emissions below the legal cap. They are recognised by Kyoto because they remove greenhouse gases from the atmosphere, which is a process known as carbon sequestering. Carbon can be sequestered from the atmosphere through natural activities such as planting new trees which absorb it, or by artificial processes which ‘capture’ carbon and store it underground. Activities that replace others which would have otherwise resulted in greenhouse gas emissions, such as renewable energy, also generate carbon credits.
Investment in projects whose sole purpose is to generate carbon credits by offsetting emissions has ballooned. The Kyoto protocol differentiates between projects undertaken in developing and developed nations. Projects undertaken in developing nations are known as ‘Clean Development Mechanism’ (CDM) projects, while those undertaken in developed nations are known as ‘Joint Implementation’ (JI) projects. Developing nations have attracted the bulk of investment in carbon offset projects, with the total value of CDM project investment being over US$5.25bn during 2006, which is 37 times greater than the $US141m invested in JI projects over the same period.
China has attracted the bulk of carbon offset project investment, hosting 70% of all CDM projects in 2006, with the next largest player, India, hosting 12%. The fact that developing nations are being used by industrialised corporate to offset emissions has stirred much debate. This trend makes sense from a financial point of view because administering projects in developing nation carries a lower cost. However the critics argue that this system ignores the actual source of emissions taking place, which is typically on the other side of the world.
Carbon Credits and Forestry Projects
The emergence of the carbon offset industry has the potential to create an illusion that, contrary to what our mothers always told us, money does in fact grow on trees. However after taking a closer look at the fine print governing the EU ETS and Kyoto, we do not suggest that members start counting on that large Eucalyptus tree in the back yard for their retirement income.
The Kyoto protocol imposes several restrictions on how forestry projects can be used to generate carbon credits and offset emissions. Only plantings on areas that did not previously host a forest are eligible to qualify for credit generation. These areas must not have hosted a forest on 31st December 1989, and only new plantings made after the year 2000 are eligible. Therefore in layman’s terms, only new trees on previously unplanted areas can qualify for carbon credit creation.
As there remain issues over how to measure the amount of carbon ‘sequestered’ from the atmosphere by new plantings, these kinds of projects are excluded altogether from the EU ETS. This exclusion also helps to mitigate the problem of companies ignoring their own emissions by pursuing the low cost option of planting a new forest in a developing country. This strict ruling on forestry activities is an area of contention, as critics argue that it does not incentivise developing countries to preserve existing forests.
Implications for the Local Forestry Sector
The NSW Benchmark system is more flexible than the EU ETS, as it permits the use of forestry projects, as long as they comply with the Kyoto rulings. This has the potential to generate new opportunities for locally listed forestry companies, which in a general sense have struggled in recent years following changes to tax laws. In light of the growth in carbon trading it can be easy to envisage the sector receiving a fresh wave of investor sentiment. Although we see opportunities for these companies to use their forestry plantations to generate carbon credits and extra revenues, the upside would be limited.
The NSW system’s current restrictions mean that areas where forestry companies cut down and replant areas of forest would not be able to generate credits. However what the current rules do suggest is that when forestry companies plant a new area of land for harvest sometime in the future, that area is able to generate carbon credits, but only once. When these new areas are ultimately harvested and replanted, more carbon credits would not be awarded, as the replanting is thought to simply maintain the sequestering role of the previous trees.
Carbon Market Opportunities
With the growth drivers behind the global carbon market set to remain strong over the years ahead we anticipate that some interesting opportunities will arise for investors. However with the market still in its emerging stages in most areas of the world, investors should adopt the same cautious approach as they would to any other opportunity. Domestic and international regulatory frameworks will play a vital role, but as the Europeans learned from last year’s carbon crash, there are likely to be ‘kinks’ that will need ‘ironing out’.
There are opportunities to directly invest in carbon credits via a number of global climate exchanges, but given uncertainties over factors driving carbon prices, successfully operating a carbon futures account could be out of reach for most investors. However for those who may be interested, we have provided a simple technical outlook on the price of the ‘2008 ECX CFI futures’ contract, which is essentially the futures price on European carbon credits valid to offset emissions during 2008.
Based solely on historical price patterns, the outlook has turned bullish after prices recovered following the 2007 crash. Strong support has been established near €18.50 after prices ‘triple bottomed’ around this level. Prices are currently trading just below €25, which is a significant resistance level. A break above this level would be bullish. The emergence of an ascending triangle, a typically bullish pattern, supports the case for a break above €25.
In terms of other opportunities, the choice of listed companies that participate directly in the carbon market is currently very limited. However we would not be surprised to see more IPO’s emerge along this theme during the next few years. Therefore while the market remains in its emerging stages we see the best opportunities in companies that are positioned to benefit from the rise of carbon trading, but whose business models are strong enough to survive, with or without carbon trading. With this in mind, we view the renewable energy and forestry sectors as ones to watch, but reiterate our stock specific focus.
Tim Morris is an analyst at wise-owl.com, one of Australia's leading independent stockmarket research houses. Click here for your complimentary report.
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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Carbon Trading: The Carbon Market – The Essential Guide Part 2
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Companies: Optus, Telstra bicker over broadband bid
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