Measured sustainability…a calculated, deliberate approach to sustainability.

Carbon markets



The carbon market was developed to address the reduction of GHG emissions, and originates from the Kyoto Protocol that consists of three flexible market mechanisms, namely: the international Emissions Trading Scheme (ETS), the Clean Development Mechanism (CDM) and Joint Implementation (JI). These project-based mechanisms yield certified emission reductions (CERs) and emission reduction units (ERUs) to be traded in the regulatory market as credits and allowances respectively. Verified emission reductions (VERs) are traded in the voluntary market.



The prices of the three market segments vary widely.



Under CDM projects, Annex B developed nations of the Kyoto protocol are allowed to receive CERs generated through GHG emission reductions in developing non-Annex B nations that have not taken on emission reduction commitments. CDM projects can have a seven-year crediting period that may be renewed twice, making a total of 21 years or a once-off 10-year period.



Due to the lack of international reduction commitments after 2012, a large majority of CERs are contracted only until 2012.



GHG emission reduction projects carried out under JI are between two or more Annex 1 nations, where one country acts as the investor/buyer and the other as the host/seller. The host country will issue ERUs, which may then be deducted from the other country’s emissions.



These certificates can be used for compliance by countries and companies.



The European Union Emissions Trading Scheme (EU ETS) and the global Kyoto compliance market are the most liquid markets currently. To regulate emissions, the European Union has adopted a carbon market as its core strategy, thus creating the largest emissions market in the world and hence, the global benchmark carbon price.



Most EU countries and Japan have CER/ERU Purchase Agreements to comply with Kyoto where installations (entities with emission quotas) have sector-specific GHG emission limitations, but make use of CER and ERU trading schemes.



EU Allowances (EUAs) are traded along with CERs and ERUs on the EU ETS.



Carbon prices create incentives for installations to reduce their emissions in two ways: (1) by encouraging low-carbon and more energy-efficient technologies; and (2) by substituting high-carbon input products and services with less carbon-intensive alternatives.



Assessing the carbon market fundamentals is challenging, considering the multiple variables involved, many of which hinge on policy decisions. A general understanding of the global carbon market – its underlying structure, dynamics and evolution – is required, as well as a sense of how various market forces shape demand and supply, and hence influence prices.



Demand



CER and ERU demand is primarily driven by three factors: the willingness of Annex B nations to cap their emissions; the limits these nations set on admitting Kyoto credits into their compliance regimes; and the requirements imposed on firms via the EU National Allocation Plans (NAPs).



Actual demand is influenced by several other factors including economic growth, weather patterns, fuel prices, availability of low-emission electricity and the extent to which Annex B countries can implement additional policies and measures such as energy efficiency measures.



Supply



The supply of credits is affected by policy as well as the availability of credits from large, low-cost sources and the availability of financing.



The slow approval process and complexity of CDM projects hampers their delivery and dissuades potential project sponsors from pursuing CDM status.



CERs and ERUs have long gestation periods, and project sponsors run the risk of either generating the credits too late to gain much revenue before 2012 or never receiving credits.



The price that project sponsors can achieve is dependent on the market segment in which they compete – the attributes of the credits they are selling and the risks that they are prepared to assume in the sale. Lowering the delivery risk and increasing the compliance quality increases the price, so it would be prudent for the sponsor to maximise the quality of its CERs without assuming unreasonable levels of risk.



Carbon prices in the short and long term will be driven by the interplay of Annex 1 governmental purchasing programmes and trading schemes, overall GHG quota allocations, non-market policies such as voluntary GHG mitigation, as well as the global supply of CDM and JI projects.



Macro drivers



Political



The political and administrative processes are the main drivers of the carbon market, as they shape the implementation procedures for global climate change treaties.



Governments introduce a price for carbon by implementing either a cap-and-trade scheme or by imposing a tax on carbon emissions.



Under cap-and-trade schemes, governments set a cap on the total volume of emissions of a given pollutant and allocate the corresponding volume of allowances. These allowances may be freely traded between firms that face high costs to reduce their emissions, with purchase allowances from firms with lower costs, thereby reducing the total costs of emission reductions.



Market forces set carbon prices within a cap-and-trade scheme, whereas in the case of a carbon tax, the government decides the price at a national level.



Annex B governments with a demand for allowances under Kyoto forward a portion of their compliance obligation onto installations through emission trading schemes, for example the EU ETS. These installations meet their emission reduction commitments through trading EUAs.



If the price of carbon is higher than the internal abatement cost, companies will reduce their emissions internally to meet their commitments and sell any unused allowances in the market.



Countries listed under Annex B have been issued with emission quotas known as assigned amount units (AAUs), which may be transacted on a large, bilateral political basis through International Emissions Trading (IET) – one of the three flexible mechanisms of the Kyoto Protocol.



Surplus AAUs are purchased by countries or companies to avoid Kyoto non-compliance.



To sell surplus AAUs, countries need to fulfil several criteria under IET such as having a national registry and GHG inventory.



Long-term demand for CERs can be influenced by governmental demand for AAUs and the volume of AAU surplus that comes to market.



The EU ETS prohibits the use of AAUs by installations. Therefore, private sector demand is very limited.



The National Allocation Plans approved by the European Commission (EC), outline the level of allowances to be issued and how these are allocated to sectors and individual installations within each state, which vary widely from countr to country.



CER demand is influenced by the NAPs set for each country, and hence prices.



The Conference of Parties (COP), which is an annual meeting of all the signatory countries to the climate change treaties, influences the CER price through its various decisions and provides both positive and negative signals to the market.



The CDM Executive Board decides on whether a project qualifies for CDM, and therefore the total supply is dependent on project volume approval which influences market development. When developers assess the price potential of their CERs, they should be aware of the multilevel global climate change decisions and pay close attention to the optimisation of contract terms and cash flow requirements, as the lengthy duration of CDM projects increases the importance of proper risk management.



Economic



The global economic status will impact the carbon price. Positive economic growth implies an increase in production and the amount of emissions which will ramp up the demand of CERs, resulting in the price gaining momentum upward.



Recently, a large volume of compliance buyers have been active in the market, affecting the price positively. It suggests that the carbon price movements may be a barometer of economic growth.



A large increase in the share of allowances implies a decline in industrial output, and the carbon price will trend downward as a result of less emissions.



Commodity prices (coal, oil and gas) determine the relative attractiveness of the choice of fuels for power generation and the amount of carbon dioxide emitted.



Short-term abatement options include fuel-switching to lower emitting fuels or energy-efficiency measures.



An important factor is the coal and gas price differential, as it influences the direction of fuel-switching. To deliver emission reductions, switching from coal power stations to gas power stations would be required.



If natural gas prices trend upward, the carbon price at which it is economical to replace production of coal powered stations by gas power stations also increases.



Market participants will trade allowances at higher prices. As natural gas prices move higher, the carbon price required to switch would have to be even higher.



Environmental



The level of CO2 in our atmosphere currently is approximately 385 parts per million. Before the Industrial Revolution, the figure was 280ppm. The stabilisation target of 450ppm of CO2 in the atmosphere yields higher carbon prices than less ambitious stabilisation targets of 550ppm.



The present CO2 concentration level, suggests that a high carbon price is required to attract investments and induce technological change sufficient to keep concentrations below 450ppm.



The greater the number of countries committed to reducing emissions will lead to a lower carbon price.



The type of weather can be a critical driver of the carbon price. Extreme temperatures, hot or cold, require an increase in power generation, which will generate more emissions and increase the price.



Power generation in Europe represents the large majority of EUA allowances and therefore affects the supply and demand of EUAs.



Technological



Implementing alternative sources of energy technology such as renewable energy generation, biofuels, nuclear power and fossil-fuel based power generation with carbon capture and storage (CCS) will reduce emissions and the demand for emission reductions, affecting the carbon price negatively. However, the environmental costs of nuclear power and CCS are externalised and would need to be seriously considered.



Technological advancements in the improvement of energy efficiency will have a favourable impact on emission reductions, which will push down the carbon price. Innovation in this area is crucial in reducing carbon emissions, and is improving daily.



Conclusion



The global carbon market is a system of fragmented markets and differing carbon credit prices that are linked to varying degrees.



A system of interlinked, policy-led financial markets is emerging very similar to the present-day currency markets.

This market is a fully operational commodity market with large trading volumes and room for growth. However, it remains characterised by a low degree of both liquidity and transparency.