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Issues in the international carbon market, 2008-2012 and beyond

Executive Summary

1. Introduction

2. Price range in international emissions trading market

3. Price risk management tools

4. Relationship between transaction costs and size of participants

5. Annex I – further reading

6. Annex II – CDM project cycle

7. Annex III – glossary of terms

2. Price range in international emissions trading market

2.1. Introduction

There is no single price for carbon the world over. The international carbon market is in fact a system with different ‘commodities’, or types of carbon credits, that are linked to varying degrees. This section of the report explains how these different markets inter-relate.

2.2. What is the price of carbon?

The Kyoto Protocol was signed in 1997 and entered into force in 2005. Since then, several markets have emerged either directly from the Kyoto Protocol’s flexible mechanisms, or as countries implement policies to meet their targets.

The Kyoto Protocol sets out three flexible mechanisms:

• Clean Development Mechanism – where tradable carbon credits are awarded to projects to reduce greenhouse gas emissions that are hosted in developing countries and that complete a formal approval process. These credits are known as Certified Emissions Reductions (CERs);

• Joint Implementation – where the credits are awarded to similar projects, only they are hosted in developed countries or those with economies in transition. These credits are known as Emission Reduction Units (ERUs);

• Emissions Trading – intended as a government-to-government market where the sovereign states can buy or sell credits they are issued as part of their cap under the Kyoto Protocol, known as Assigned Amount Units (AAUs).

The four flexible mechanisms have different currencies, being CERs, ERUs and AAUs. In addition, governments can log their emissions sinks from land use, land use change and forestry efforts as removal units RMUs, which are then convertible to AAUs. Also, the EU emissions scheme has its own currency, EUAs, which from 2008 are each shadowed by an AAU.

All of these currencies represent one tonne of CO₂, or equivalent where for example a project reduces the emissions of a different greenhouse gas. While they share this characteristic, they are not fully fungible and pricing depends on their use against targets, the risk inherent in their delivery to the final customer and many other contractual issues.

As a result, there is no single price for carbon. Each carbon commodity responds to different factors, but there are correlations between some of them. In the case of the market for ERUs is still in its infancy and firm pricing patterns have yet to emerge.

In the AAU market, no firm transaction involving AAUs has been concluded. A further complication is that only intergovernmental trading was foreseen in the case of AAUs, so there is no provision in the Kyoto Protocol and subsequent regulations to allow for private sector ownership of AAUs. It is not expressly outlawed, but unless a country provides for private sector ownership of AAUs there is disagreement over whether it can be permitted. This is primarily the case in the EU.

Japan, for example, does allow for private sector companies to submit AAUs against their national targets. It has resolved this issue by providing for private sector companies to own AAUs on the national registry. It is possible that this issue is overcome on a technical level as the various national registries and the over-arching UN registry, the international transaction log (ITL), become operational. In the meantime, the AAU market has not yet started. As a result there is no evidence of pricing in the AAU market.

This report focuses on what forms the price in the two main carbon market segments, the EU emissions trading scheme and the Clean Development Mechanism. This section sets out the price drivers in the EU ETS, then the price drivers in the Clean Development Mechanism, and finally the extent of the impact of EU ETS prices on the international carbon market.

2.3. Pricing in the EU emissions trading scheme

In the European Union (EU), member governments and the European institutions in Brussels agreed to create a regional emissions trading scheme. It is mandatory and caps the carbon dioxide emissions of factories, power plants, refineries and offshore installations in all 27 member countries.

The EU ETS began with a trial phase running from 2005 to 2007, the second trading phase is to run from 2008 to 2012 in line with the Kyoto Protocol’s commitment period.

In the context of the EU ETS, The two main areas of price formation in the EU ETS are:

• policy decisions, and

• fundamentals, being the energy complex (weather, energy and economic activity).

2.3.1. Policy decisions

Like other environmental markets, the EU ETS is created through political decisions and has to be framed in law. It must then be implemented through a series of regulatory decisions and operating guidelines, which could potentially have an impact on market price and developments.

As a result, the market responds to occasional price signals from issues such as the number of EUAs that are issued, the EU ‘linking’ directive which allows for the use of Kyoto credits in the EU scheme, rules on banking EUAs from one trading phase to the next as well as what happens when the Kyoto Protocol’s first commitment period ends on 31 December 2012.

For example, as the scheme’s watchdog, the European Commission must approve the decision by each government on how many EUAs that government can issue to its industry and energy companies. If the European Commission demands cuts to the government’s original plans, the price history suggests that the market reacts to the prospect of supply being restricted beyond expectations and the price for EUAs will rise accordingly.

However, these political price signals occur only occasionally. On a daily basis, it is the broader energy complex that provides price drivers.

2.3.2. The energy complex

The power generation sector accounts for 60% of the emissions covered in the scheme. As a result it is the most important sector in the scheme and the relationship between the price of EUAs and the prices for oil, natural gas, coal, freight for coal and electricity itself has been established.

While the initial supply in the EU ETS was a political/regulatory decision, demand for EUAs is set by emissions; as companies emit more than their limit, they must buy EUAs to cover their extra emissions.

In general, CO₂ emissions depend on a number of factors, such as weather data (temperature, rainfall, and wind speed), fuel prices and economic growth. Among these factors, weather has a double effect; firstly, cold weather increases energy consumption and corresponding CO₂ emissions through power and heat generation.

Secondly, rainfall and wind speeds will affect the share of power generated by non-emitting sources, which indicates greater use of fossil-fuelled power generation and thus emission levels rise. This is particularly important for countries and regions relying on hydropower and/or wind power to any significant extent.

In many countries, power generators are able to switch their overall fuel use from coal to gas and back, depending on which leaves them with a better return given current power prices. With the EU emissions trading scheme now in place, they must now also consider the cost of EUAs to cover the emissions associated with that fuel burn. Typically, burning coal to generate electricity results in the emission of twice as much carbon dioxide – approximately one tonne per Mega-Watt hour – than natural-gas fired power stations. The cleaner fuel faces a lower cost in buying EUAs to cover its emissions.

So, since the EU ETS was introduced, power generators are able to calculate each day whether they would be more profitable generating from coal plants (including the cost of emissions resulting from the generation), or natural gas. This decision determines the intra-day demand for EUAs and is the major price driver in the EU carbon market on a daily basis.

2.4. Pricing in the Clean Development Mechanism

The Clean Development Mechanism is a term that covers different market segments. The project approval process is regulated by a UN body, the CDM Executive Board and offshoot panels and committees. However, the commercial side has grown organically and is in a constant state of evolution.

Typically, participants in the market talk of two market segments, the primary market and the secondary market.

2.4.1. The primary CER market

The primary market refers to the initial transaction between the project developer and the investor. It is the transaction that carries the CER, the commodity in question, from the project in the developing country to the international market.

The contract to transfer ownership of a CER from seller to buyer is known as an Emissions Reduction Purchase Agreement (ERPA). As the initial CDM contract is much like project finance, ERPAs vary from case to case. Typically, however, the price agreed in most primary ERPAs is a function of the apportionment of the various risks inherent in generating a CER and delivering it to the buyer, as well as contractual issues.

The risks are grouped as follows:

• Performance risk (financial, technical, counterparty related)

• Registration and revision risk (project approval, baseline and methodology from the UN)

• Host country risk (general and carbon related).

Performance risk

The performance risk relates to how the project performs in relation to expectations:

• whether the developer will gain finance to build the plant;
• whether the plant will operate as foreseen in the project plans and the expected number of CERs are issued to it; and
• the creditworthiness of the counterparty.

Registration risk

Registration and revision risk relate to whether the project is registered as approved by the CDM Executive Board. The emissions reductions, which determine the number of CERs the project is issued, depend on what ‘business as usual’ scenario the CDM authorities decide is appropriate to judge the project (baseline risk). The project must be executed according to a ‘methodology’ which in turn must be approved by the CDM methodology panel.

Country risk

Once these challenges are overcome, there remains the investment climate in the country hosting the project. Consider the example of Thailand, which counts 70 projects in various stages of development [According to Point Carbon’s project database and portfolio manager, the Carbon Project Manager, as at 14 September 2007.]. In September 2006 the government was overthrown by the military, casting great uncertainty on all economic activity, including CDM projects. Since then, however, the host country approval of projects has continued and the country now has three projects that are registered as approved. They expect to be issued around 2.5 million CERs by 2012.

Point Carbon categorises ERPAs according to the risk that the seller assumes. This is expressed usually as a sanction on the seller if it fails to deliver as agreed (see box).

Due to the low risk involved in categories 3 and 4, they overlap in their price ranges. The secondary CER transaction also falls somewhere in these price ranges.

Contractual issues

It is also noteworthy that each ERPA contract may have different provisions that affect the price. For example, where the buyer is willing to commit to upfront payment they will command a lower price than payment on delivery. Similarly, a higher price will be paid by one company seeking to be the preferred claimant if a project with several buyers under-performs. That company will pay more to be the first in line to receive CERs if there are not enough for the seller to meet all of its obligations.

Each CER in the primary market is therefore worth a different amount reflecting the risk profile of each individual project, depending on various factors, including:

1. the risk inherent in each project, how that risk is apportioned between buyer and seller;

2. At what stage of development the project has reached when the ERPA is agreed;
3. the risk profile that project type, host country etc offer;
4. other contractual details of each individual ERPA, eg whether it covers the first 30% of the CERs to be generated or the last 30%.

2.4.2. The secondary CER market

The secondary market refers to any further transaction after the primary transaction: the onward sale of the CER until eventually it is bought by the final consumer who will submit it to meet their target. Typically, the buyer in the secondary market (secondary CERs) carries much less risk as the CER is either already in existence, or its delivery is guaranteed in some way with replacement or compensation for non-delivery written into the contract. As a result, the buyer pays much more for the secondary CER.

The buyers for this more expensive, low-risk secondary CER tend to be European companies that face their specific target under the EU ETS. The secondary CER market has grown up as an offshoot of the EU emissions trading scheme and prices are often quoted as a percentage of the price of EUAs.

2.5. The effect of the EU emissions trading scheme on international carbon prices

The companies that face targets in the EU emissions trading scheme may use the European carbon commodity, EUAs, and that of the Kyoto Protocol’s Clean Development Mechanism, CERs, to meet their compliance needs. The strong demand for CERs from European companies marks the interface between the EU emissions trading scheme and the global market.

As set out in this report, the weather and the energy markets determine to a great extent the price of carbon in the EU. Volatility on the energy markets or indeed abnormal weather events in turn create volatility in the EU carbon market. This is passed through to the secondary CER market.

However, there is little evidence in the carbon markets to date that the volatility is carried much further than that on a short time scale. The primary market constitutes the lion’s share of the CDM, where European companies compete with European governments, Japanese entities and international financial institutions, all of whom have different price and contractual expectations and a different stimulus for being in the market. The primary market does not respond to short term price signals from the EU ETS.

Nevertheless, the EU emissions trading scheme does provide a constant, long-term source of demand for Kyoto credits such as the CERs from the CDM and eventually ERUs from JI. Over the longer term, a greater shortfall in the EU market therefore implies demand for CERs and upward pressure on CER prices generally. It is reasonable to expect the supply of CERs to increase in response to such price signals, stabilising international prices.

The primary CDM market is a multifarious, opaque market where contracts can take months to negotiate, where price discovery is a complicated and difficult process and volatility is therefore much reduced. The following table sets out prevailing prices in various market segments.

Figure 2.4 Comparison of prevailing market prices as at 17 September 2007, according to Point Carbon database of transactions in the EU emissions trading scheme and the Clean Development Mechanism.

While the EU allowance and secondary CER markets are relatively dynamic (see figure 2.3), the prices in the primary CER and ERU markets have not shown much volatility over the years, but rather reflect how developed each individual project is. In the early years (2003 and 2004, for example) projects were at an early stage in the approval process, forward contracts were being signed at €4 per tonne of CO₂ equivalent (NZ$7/tCO₂e). Now some have been registered and emissions reductions have been validated and CERs issued, they can be acquired at over €16/tCO₂e (NZ$31/tCO₂e)

2.6. Summary

Like any emissions trading scheme, the main price drivers in the EU emissions trading scheme are political and regulatory decisions, and emissions levels which are determined by weather, the wider energy complex and economic growth. The EU market is particularly responsive to the energy complex due to the dominance of the power generation sector.

The Kyoto flexible mechanisms, notably the Clean Development Mechanism, provide carbon credits which European companies can use to comply with their targets. As a result, CDM credits (CERs) with guaranteed delivery are traded at a rate discounted to the EU price and respond to volatility in the EU market.

However, the short term volatility does not impact the primary CDM market. Contracts are negotiated according to the apportioning of risk between buyer and seller, as well as the specifics of each contract. Price ranges there respond to demand signals from various sources including the EU emissions trading scheme, but on a longer time scale.

The market for ERUs, the carbon reduction project credit under the Joint Implementation mechanism, is expected to respond to some of the same price signals as the CDM market as it develops.

The market for AAUs has not yet started. Even when it does, it may be limited to government-to-government emissions trades in the EU, as there is still uncertainty over the private sector having legal ownership of the credit. It is possible that this hurdle is easily overcome when the various national and international registries are operational.

The surplus of AAUs held by economies in transition, particularly Russia and Ukraine, is enough to offset the targets set by the Kyoto Protocol on all other countries. The governments of many developed countries have indicated they are not willing to buy the surplus AAUs unless the host country invests the revenue in domestic projects that cut greenhouse gas emissions or have some other environmental benefit.

These so-called green investment schemes have yet to emerge in their final form. The first confirmed intergovernmental transaction is expected in 2008. The AAU market is expected to continue developing with occasional, large volume intergovernmental transactions, rather than a more liquid market with many private sector participants.

In the international carbon markets created by the Kyoto Protocol, the price range currently is €5 to €17 per tonne of carbon dioxide equivalent (NZ$10 to NZ$32/tCO₂e). The EU ETS, which is derived from the Kyoto Protocol, lifts the top end of the range to €21 (NZ$40/tCO₂e).

Participants in the emissions markets have developed strategies and tools to manage the risk associated with their emissions in the complex emissions trading markets. A new area in financial services has evolved, offering companies exposed to the price of carbon with a range of carbon risk management tools to enable emitters to mitigate the risk and seek out opportunities in the carbon market. These price risk management tools are explained in the following section.

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