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Executive Summary

In this study, Point Carbon examines the price patters in the various carbon markets established under the Kyoto Protocol and the routes to market available to companies with exposure to carbon price risk.

There is not one single price in the global carbon markets, but many. The reason for this is that the tradable instruments each have different risks and usability which has led to a fragmented price. In addition to this, there has been a large price and volume volatility, especially in the EU emissions trading scheme, while transparency of the market has been low in the CDM and JI market.

The CDM awards carbon credits, known as certified emissions reductions (CERs), to projects that reduce greenhouse gas emissions in developing countries. Those credits can be used by governments to meet their targets under the Kyoto Protocol.

Trades in CERs are described as the primary market, being the initial transaction between the project developer and the buyer. Often the transaction is agreed in a forward trade before the CERs are issued to the project developer. Currently the price range for CERs in the primary market is €6 to €17 per tonne of carbon dioxide (tCO2). The range is set by several factors from project-specific and host-country risk to the creditworthiness of the counterparties and particular contractual issues. Ultimately, the CDM market as a whole responds to demand for credits.

The secondary market covers the resale of CERs once they have been issued to the project developer. Much of the project-related risk is therefore removed and these low-risk credits appeal to participants in the EU ETS. Such CERs tend to be sold at a price benchmarked to the EU emissions trading scheme, but at a discount, currently around €16 per tonne of carbon dioxide equivalent (tCO2e).

In the second phase of the EU emissions trading scheme, running from 2008 to 2012, the market is short about 1 gigatonnes of CO2 which will be covered primarily with imports of the Kyoto Protocol’s project credits, CERs and ERUs, as relatively cheaper abatement measures can be found outside the EU. There is a limited quota of credit imports into the EU ETS, but it is set at a high level and allows for more credit imports than required to cover the aggregate short position. Some swapping of EUAs against CERs and ERUs will be necessary to utilise the credit import capacity more fully, which helps explain the price difference between CERs and EUAs.

The EU ETS experiences volatility on a daily basis. The effect of the volatility is felt in the pricing of secondary CERs, but the bulk of the CDM market, the primary market, does not respond to the EU emissions trading scheme on a daily basis.

However, there is double causality between the Kyoto Protocol project markets (CDM & JI) and the EU emissions trading scheme, where the price of one affects the other and vice versa. Project credit supply is one of the main factors behind the EU allowance price, while the CER/ERU price in turn is affected by demand from the businesses in the EU emissions trading scheme.

Other than companies in the EU ETS, sources of demand for CERs include private and public sector carbon funds, aggregators and intermediaries, international financial institutions, the Japanese government, Japanese corporations and other participants in the international carbon market.

There are few price signals for the nascent market in governmental credits, AAUs. They are expected to come next year and in the form of a green investment scheme, where the seller undertakes to invest the proceeds in projects with environmental benefit. There are no reliable price signals yet regarding the AAU market and the period after 2012.

In response to the varied and size and needs of the participants in the global carbon market, a financial services sector has emerged to offer price risk management tools, with different structures to suit the target client, whether they be a minor emitter, major emitter or speculator.

Figure 1.1 summarises the price dynamics for various carbon credits under the different market mechanisms: EUAs, CER/ERUs and AAUs up to 2012 and beyond.

Figure 1.1 Price dynamics in the carbon markets

Phase I

2005-2007

Phase II

2008-2012

Phase III?

2013-

EUAs

  • Market is long
  • Low price
  • No quantitative restrictions on use of CERs
  • Incentives to bank CERs into Phase II
  • Market is short
  • Forward price determined by CER/ERU supply and relative fuel prices for power generation
  • Quota limit allows for more credits that the aggregate short position, provided industrial sectors and the power sector swap EUAs and CERs.
  • Supply limitations are likely to be more relevant than restrictions due to the initial allocation of credits.
  • CERs might be banked forward again, once NAP 3 and post 2012 UNFCCC framework is in place.
  • No supply/demand signals but ambitious political targets set.
  • Linking of trading schemes, with Kyoto project credits forming the price link, is a possible scenario.
  • Allocation process is likely to be further harmonized

CERs

ERUs

  • Forward CER prices reflect delivery risks and phase II allowance price in EU ETS
  • Spot CERs will probably trade at a small discount to spot EUAs to reflect differences in usability
  • There is a two-way price causality between CERs and EUAs
  • Price should be equal to marginal abatement cost.
  • US participation could boost demand

AAUs

  • No AAU market
  • Market is long
  • Limited private sector participation (except possibly in Japan)
  • Bilateral government-to-government trades expected
  • Supply from Russia and Ukraine will be important
  • Few price signals
  • Price will be dependent on whether there is a market and how ambitious the commitments are made from the Annex-1 countries (including new ones)
  • Banking from Russia and Ukraine and US participation will have major impacts on supply and demand
  • Chinese and Indian participation unlikely but possible

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