Why Carbon?
We owe our presence on Earth to carbon dioxide (CO2) and other greenhouse gases. It helped stabilize temperatures to levels suitable for organic life. It did this – and continues to do it – by what is known as the greenhouse effect. This occurs when heat energy from the sun passes unimpeded through the atmosphere and warms up the Earth. In turn, the Earth radiates this energy back towards space. The greenhouse gases – water vapor (the main greenhouse gas), methane, ozone, carbon monoxide, nitrous oxide and CO2 – absorb some of this energy and emit it in all directions, including back towards Earth. As a result the Earth’s surface is about 34ºC warmer.
Over millions of years, the Earth has managed to regulate concentrations of greenhouse gases through a system of sources and sinks. Carbon (in the form of CO2 and methane) is emitted by volcanoes, by rotting vegetation and other organic matter. But CO2 is sequestered, or absorbed, by trees (their roots, branches, trunks and leaves are about 50 per cent carbon), plankton, soils and water bodies. Indeed, scientists have become aware that increased concentrations of CO2 actually stimulate the growth of many different types of plant, including trees – this is called the CO2 fertilization effect. For example, a doubling of atmospheric CO2 has been shown to stimulate leaf photosynthesis rate by up to 50 per cent depending on temperature. Although some of this CO2 will be released back into the atmosphere by increased respiration, more carbon should be sequestered.
Where did the solution lie?
The adoption of the UN Framework Convention on Climate Change (UNFCCC) in 1994 was a major step forward in finding an innovative solution to the problem of global warming. Yet as greenhouse gas (GHG) emission levels continued to rise around the world, it became increasingly evident that the member firms needed an independent international agreement that could be linked to the existing treaty.
This gave rise to the Kyoto Protocol that was adopted at the 3rd Conference of the Parties to the UNFCCC in Kyoto, Japan, on 11 December 1997. Most of the countries ratified this treaty except USA and Australia. Post the ratification by Russia, the Kyoto Protocol entered into force on 16 February 2005. As of December 2006, a total of 169 countries and other governmental entities have ratified the agreement.
The Protocol requires developed countries to reduce their GHG emissions by nearly 8% below the baseline of 1990 and these targets must be met within a five-year time frame between 2008 and 2012.
In order to help the members achieve their targets, the protocol offered the following innovative mechanisms :
1. Emission Trading
2. Joint Implementation
3. Clean Development Mechanism (CDM)
These mechanisms allow developed parties to earn and trade emissions credits through projects implemented either in other developed countries or in developing countries, which they can use towards meeting their commitments.
Emission Trading/Carbon Trading
Carbon trading essentially means exchanging points earned by reducing emissions of certain harmful gases for money, has emerged as a huge opportunity for developing countries like India and China. 1 tone of carbon dioxide is equivalent to 1 carbon emission reduction (CER) unit and its price ranges from Rs 458 for early stage projects to Rs 973 for issued units.
The emission trading program can be conducted in two ways i.e. The “Cap” & “Trade” approach in which a cap on all sources is established and then these sources are allowed to trade among themselves to determine which source emits the excessive pollution load.
The second approach is called the “Baseline” approach. In this a set of polluters that are not under an aggregate cap can create credits by reducing their emissions below a baseline level of emissions.
Recent Trends in Carbon Trading/CDMs/JIs
The carbon market grew in value to an estimated US$30 billion in 2006. Project-based activities primarily through the Clean Development Mechanism (CDM) and Joint Implementation (JI) grew sharply to a value of about US$5 billion in 2006. The voluntary market for reductions by corporations and individuals also grew strongly to an estimated US$100 million in 2006.
The carbon market and associated emerging markets for clean technology and commodities have
attracted a significant support from the capital markets and from experienced investors, including those in the United States. Analysts estimated that US$11.8 billion have been invested in 58 carbon funds as of March 2007 compared to US$4.6 billion in 40 funds as of May 2006. 50% of all capital driven to the carbon value chain is managed from the UK. Most of the newly raised money, of private origin, came to the sell-side (project development and carbon asset creation) which currently represents 58% of the capitalization. A key indicator of interest in aligned and closely related fields is the record US$70.9 billion in clean technology investments in 2006 with major investments from well-known investment banks.
Till now, only the energy and the manufacturing sectors were included in the EU tading program but transportation-aviation & shipping may also join the band wagon.
FUNCTIONALITIES OF THE EMISSION TRADING SCHEME
EU Emission trading scheme is the largest multi-national, greenhouse gas emissions trading scheme in the world. Today’s EU European Trading Scheme (ETS) accounts for about two-thirds of global carbon trading, with each country allocating carbon credits for free to various industries such as utilities and manufacturers. It is divided into two phases. First phase from 2005-2007 which includes around 12,000 installations, representing approximately 40% of EU CO2 emissions. The second phase which is from 2008-2012, has some significant addition over the first phase. In this phase Clean Development Mechanism and Joint implementation would be introduced. This will significantly enhance the market of emission trading. Also, large and rapidly growing aviation sector would be included. This in addition is expected to increase the demand of allowances by about 10-12 million tones of CO2 per year. This in turn is expected to lead to an increased in the use of JI credits from projects in Russia and Ukraine, which would offset the increase in prices. This whole process would result in lesser visible impact on average annual CO2 prices and hence fluctuation in the carbon prices would be reduced.
The goal, by the year 2012, is to lower emissions to a level 8% below those in 1990. This market-based approach to reducing emissions is built on a sliding scale so that fewer credits will be issued in coming years, thus making it more expensive for those companies to buy carbon credits. If carbon prices continue to rise and become a major drain on profits, companies will invest in the technology or offset projects to reduce their emissions.
INCREASING THE EFFICIENCY OF EMISSION TRADING
“Climate change risks are an important challenge for the international financial markets – Emissions Trading is an efficient way to manage these risks.” – Anonymous
I believe that the following factors may contribute to the increase in efficiency of Emission trading and increase in liquidity in the market:
Scope and size- The successful development of emissions trading market depends on the liquidity of the market. An international emissions trading regime requires not only a broad range of sectors but also sufficient volume to ensure an adequate diversity of contracts.
Market access -Traders and financial intermediaries increase market liquidity and reduce volatility and are therefore a necessary component in an emissions trading scheme.
Market compatibility-Transferability of certificates across regional and national markets, and between flexible mechanisms for example, is an important condition for market liquidity and cost efficient emissions reduction.
Emission reduction targets- Within such an international trading scheme, absolute emission reduction targets, as called for by the Kyoto Protocol, are an important prerequisite for credible, efficient and effective emissions trading
LIQUIDITY IN THE MARKET.
The carbon emission market offers a wide spectrum of instruments, and the pricing is closely related to a country’s economic situation, the price of energy commodities, and the weather. Therefore, despite regulatory uncertainty, carbon emission instruments should be included in the investment strategy of any traders targeting these markets.
Lack of liquidity as a plague to the carbon emission exchanges; the carbon market is still mainly an OTC market. The fact that many exchanges provide reporting capacity to market participants that conduct OTC transactions inflates the transaction volume of carbon emission exchanges. In reality, 72% of the trades in the carbon market are conducted OTC, with a significant share of bilateral trading.
To increase the liquidity the following measures could be taken:
1. Currently, future/forward trades account for 90% of the transactions conducted on carbon emission markets. This situation is mainly due to lose reduction targets in the past year and is likely to change in the near future as more restrictive schemes are implemented.
2. Today, the market is dominated by OTC transactions that accounts for 72% of trades. Nevertheless, there are discrepancies among regions and some exchanges such as the ECX are able to capture some significant market share (400 transactions are conducted daily on the ECX). The concentration of the market among a few leading players and the lack of transparency does not play in favor of electronic trading at this time. However, expects electronic trading to gain market share as the scope of emission reduction schemes expands and new participants enter the market.
3. To avoid the forecasted cataclysm of global warming, numerous countries have agreed to the Kyoto protocol to reduce their carbon emissions. Of course, the most concerned countries are OECD members, which currently account for 50% of the global emissions.
There is a concern with rising gas prices. It becomes cheaper to shift from gas to coal-fired power plants that will need to buy additional allowances to cover their increased carbon emissions. Electricity generators thus become short of allowances and demand more allowances in the market. This drives the price of carbon up, other things being equal. As we are witnessing the fastest rise in the prices of the oil and gas today , it would be more profitable to shift from gas to the coal fired power plants.but the coal fired power plants have more carbon emissions than the gas fired plants and hence additional allowances would be required by the power plants to fall under the ambit of standards. Due to all this, they would become short of allowances and hence there would be more demand of allowances in the market. This would then drive the carbon prices up keep several other things constant.
Another school of thought for crunching liquidity is that the surplus allowances lie with the small players in the market. These small players are not willing to sell off the allowances in the hope of expanding their business and consuming these credits.
FUTURE OF CARBON TRADING
The current scenario portrays an optimistic picture of carbon trading. The need of the hour is to develop efficient markets like the EU ETS. Already, we have the Canadian Climate Exchange(CCX), The Australian Climate Exchange (ACX), Chicago Climate Exchange etc. One of the most important CDMs that are emerging in the system of carbon trading, which allows the development of a market wherein carbon dioxide as well as carbon equivalents, ie, other greenhouse gases like methane, can be traded between participants. The participants could be countries or Companies. Though the political and institutional framework for carbon trading is yet to develop, it is generally believed that a potentially large and lucrative global market for carbon trading could develop by the end of the decade. The potential for inter-state trade has been estimated at around $2 trillion over the next 10 years.
Aviation sector is one sector which has increased its contribution in Co2 emission worldwide , but still it has managed to escape the eye of EU policy makers. Though cognizance of its effect has been taken into account , but still the practical difficulties have prevented its full implementation. Various difficulties include whether to include international fights in the scheme , determining the cap to be put and various allowances to be allotted and how to take other greenhouse gases into account.
There are three divisions as to where the policy should be applied differently. The first is for intra EU flights which cover emissions from flights from one locale to another within EU. Second one is for flights departing from EU which cover any flight departing from EU to any destination and the third one is for emission from any flight that are release over EU airspace. So in order to decide on various policy scenes we have to take into consideration the effect of prices on the above mentioned three categories. This becomes critically important as EU is committed to reduce the CO2 level by 20% by 2020 and this cannot be achieved if aviation, which is the major contributor to the CO2 emission, is not taken into consideration.
Gaurav Malhotra, FMS Delhi