Under a cloud

Carbon-trading schemes now function from Europe to California, but abundant deficiencies are evident. Any global market will look rather different, write Fiona Harvey and Ed Crooks.

Rows of traders sit staring at their banks of computers, hand on mouse, eyes restlessly scanning the numbers that stutter across the screens. From time to time, one will stand and bark out an obscure question – “I’m talking EUA 09 contracts anyone?” – to be answered from another corner of the room.

They may not look it, but these men and women are on the front line in the battle against climate change. Carbon trading, carried out at desks like this in brokerages and investment banks across the world but chiefly in London, has grown from nothing five years ago to a US$125-billion business last year, even with the recession and a low carbon price damping growth.

If, as US president Barack Obama recently suggested, the upcoming climate talks in Copenhagen can reach an agreement that will lead to a legally binding treaty next year, these traders can look forward to a bonanza: the volumes they handle are likely to soar. The “cap-and-trade” scheme for carbon-dioxide (CO2) emissions in the United States that is at the heart of energy legislation now in the US congress would, if enacted, increase the value of the market to several hundred billion dollars, rising to as much as US$3 trillion by 2020, according to Point Carbon, an analyst group.

But behind the seeming success of these trading rooms is a more complicated picture. For its supporters, this is the market that will save the world: the best if not the only practical way to cut carbon output. For its critics, which range from ExxonMobil, the biggest US oil company, to Friends of the Earth, the environmental campaign group, the market is much too unstable a foundation on which to build the world’s effort to tackle the threat of climate change. Friends of the Earth denounces what is being traded as “the new subprime”.

The European Union’s Emission Trading System (ETS), the world’s biggest cap-and-trade carbon market, works by allocating to companies that create greenhouse gas emissions – typically power generators and heavy industries – a quota of permits to produce a certain quantity of carbon dioxide. If they want to emit more, they must buy more permits in the market; if they have too many permits because they have cut their emissions, they can sell the surplus.

“It’s about creating a price and doing so in a transparent way,” says Paul Newman, managing director of Icap, a brokerage. “Until you could put a real number on the value of a tonne of carbon, you had no means of allocating resources in a rational way. A transparent carbon price lets you do that.”

Supporters argue that carbon markets offer the cheapest way of encouraging emissions reductions. The companies that can most easily reduce their noxious output will have an incentive to do so in order to generate cash by selling permits. A market is also easier to implement than other mechanisms such as a global tax on carbon or emissions regulations.

However, problems have dogged these operations from the outset. Critics complain that difficulties in administering the system, price volatility and the market’s exposure to political risk mean carbon trading simply cannot be relied on as a means to make companies invest in emissions reduction.

The separate United Nations-backed system for generating carbon credits that can be traded, called the Clean Development Mechanism (CDM), has been dogged by delays. The rules have allowed some companies to reap enormous returns for a very small outlay by making low-cost changes that yielded large volumes of credits, which they can then sell. Experts suggest that other means of financing emissions reduction, or just straight regulation, might have been better.

Another concern is that the carbon market exists only because of political fiat, and politics can change. That was shown up with cruel clarity in 2006, when the EU market collapsed just a year after its start. Traders discovered that companies had been issued with far more permits than they needed, a full-blown panic ensued and the carbon price fell through the floor.

Though confidence has since been restored, by imposing a tighter cap on quotas, permit prices remain volatile. This year the recession felled prices from 2008 highs of about €30 (US$45) a tonne of CO2 to only €8. They now hover around €13, a level companies say is too low to stimulate investment in cutting carbon emissions.

According to the International Energy Agency (IEA), the rich countries’ think-tank on fuels, the price of carbon permits will need to be about US$50 in 2020 and $110 in 2030 to create an incentive for large-scale investment in costly technologies such as electric cars and coal-fired power stations that capture and store their emissions.

Europe’s energy executives and policymakers are becoming increasingly concerned that the volatile prices in the EU’s trading scheme may never provide a reliable enough price signal to invest in long-life assets such as nuclear power stations. “The carbon price is too low to support any accelerated investment in carbon abatement,” Wulf Bernotat, chief executive of E.ON, the German energy group, warned recently. “Every investment must deliver an acceptable return.”

Renewable energy sources such as wind and solar power have their own dedicated subsidy systems, and investment in renewables has been growing fast, although it has taken a hit in the recession. But where the carbon market alone is supposed to be enough to encourage investment, it is exposed as inadequate.

For example, Britain announced in November the most ambitious nuclear expansion in Europe, with a plan for a first wave of up to 12 new reactors. However, analysts warn that the economics of nuclear power, which expose investors to significant risks in the construction costs of the reactors and the price of the electricity they will produce, remain unattractive.

Vincent de Rivaz, chief executive of EDF Energy, the UK arm of the French group that aims to build at least four new reactors in Britain, argues: “The carbon price is now recognised as the biggest issue for low-carbon investment. It should create the right incentive for investors; not in two years’ time but in the next year.” He adds that relying on the European ETS to set the right price for carbon to encourage investment that governments want “is like the tail wagging the dog”.

Moves are under way to address the weaknesses of today’s carbon markets. An overhaul of the UN system will be discussed at Copenhagen, although it is unlikely to be resolved there. The United Nations has acknowledged that the meeting will produce only a political agreement on the main points of discussion, not a full legally binding treaty. That will have to wait until next year, and only then can reforms to carbon trading be decided in detail.

In the European Union, the cap on emissions is to be made more stringent after 2012, in line with the bloc’s commitment to cut its emissions by 20% compared with 1990 levels by 2020 and to up this to 30% if other countries reach a similar agreement at Copenhagen. The hope is that this will raise carbon prices to a level that gives companies a clear investment signal. Yet the British government’s advisory committee on climate change has predicted that by 2020 the price is likely to be only about US$30: well short of what the IEA believes is needed to stimulate investment.

In the United States, meanwhile, it seems impossible for the energy bill now in committee in the Senate to pass in time for Copenhagen. Emilie Mazzacurati of Point Carbon says a bill will not be approved before January, and puts the chances of its eventual passage at about 50:50.

Any bill that does pass, she adds, probably would be significantly watered down. It would have less stringent emissions targets than the 20% cut on 2005 levels currently envisaged. A “collar” setting a ceiling and possibly a floor on carbon prices is also likely to be included, preventing the worst of the volatility that has dogged the EU scheme. But Mazzacurati estimates that on current trends the ceiling would also be set at around the US$30 mark.

Given all these complications, if a global carbon market does emerge from the fog of Senate wrangling and post-Copenhagen negotiations, it is likely to look rather different from today’s systems. “The carbon markets in the US will survive and thrive but they will not necessarily replicate the EU ETS,” predicts Mitchell Feierstein, chief executive of Glacier Environmental Funds, a London-based investment company. “There will be a functional and tradable global carbon market, but the carbon market as we know it today it is not necessarily the way to achieving globally co-ordinated low-carbon economies.”

Neil Eckert, chief executive of Climate Exchange, which operates a carbon trading platform, suggests that if the US energy bill fails to pass, “plan B is the proliferation of regional initiatives”. Regional carbon trading systems already operate in several of the US eastern seaboard states and California, with Florida and Texas also tipped to join in. If efforts to craft a national system fail, more of these piecemeal initiatives are expected.

The resulting patchwork of regulation – already a vexing issue for investors – could actually drive efforts for a federal solution, according to Eckert, as businesses lobby for a level playing field. “That would create a huge head of steam.”

The United States, Feierstein says, has the opportunity to learn from the mistakes of the European Union and the United Nations and draw up a means of carbon trading that will achieve its environmental objectives without risking the uncertainty, doubt and volatility that have made the EU system so unsatisfactory to green campaigners and businesses alike. Traders can only hope he is right. For them, the next few months will be spent looking beyond their screens and into their crystal balls.

“Clearly we are at a crossroads,” says Simon Shaw, investment adviser to Trading Emissions, a carbon-trading specialist. “We hope that we are on a platform to take a great leap forward. But the next month or so will be crucial.”

Trade or tax?

Carbon trading was first mooted as a way of reducing emissions in the run-up to the 1997 adoption of the Kyoto Protocol. Back then the United States already operated a cap-and-trade system for emissions – not of greenhouse gases but of sulphur dioxide and nitrogen oxide. But the proposal to make trading the main mechanism by which to bring down emissions led to a fierce debate; some countries argued that a carbon tax would provide a simpler solution.

That debate continues unabated, with economists and some companies arguing that a tax offers greater certainty and is easier to administer. They also say trading is vulnerable to shocks that could send prices shooting up – thus damaging companies’ competitiveness – or down, as in the wake of the financial crisis.

Those in favour of emissions trading argue that it gives business greater freedom and lets the market set the price – and that, by setting an absolute cap on carbon, such systems satisfy scientific demands to ensure the concentration does not rise above a certain level.

Perhaps the most persuasive arguments for governments, however, are those of political expediency. Unlike a tax, a trading system is largely invisible to the public. It is also easier to repeal a tax than dismantle the machinery of a cap-and-trade system.

A new asset class

Although there are still many unanswered questions about the direction carbon trading will take in the United States, the existence of a mandatory cap-and-trade system in Europe has already been propelling the expansion of trading desks.

Banks and brokerages have been investing in what they see as a promising new asset class. Emissions are now being treated as an integral part of the banks’ larger energy trading portfolios, which started with oil and coal.

While operations such as Barclays Capital have beefed up their existing emissions trading operations, others are building them from scratch. In June, Bache Commodities, the commodities and derivatives trading unit of Prudential Financial, set up a carbon and emissions trading desk in London to “prepare for the rapidly growing European Union Emission Trading Scheme and … for the introduction of a carbon cap-and-trade scheme in the US”.

Specialist exchanges, too, have sprung up in Europe, offering anything from spot trading in carbon credits – such as contracts offered by BlueNext, controlled by US-based NYSE Euronext – to futures contracts on them, a market much larger than the spot market.

Exchanges in this business include the European Climate Exchange (ECX), a unit of the UK-listed Climate Exchange group – also the owner of the Chicago Climate Exchange, which has pioneered emissions permit trading in the United States. ECX has grown fast. Average daily trading volume in European emissions allowances is a little more than 20 million tonnes, up roughly 100% on a year ago. In the whole of 2005, ECX traded 95 million contracts.

But Europe is already feeling crowded. The mood of carbon traders is one of “cautious optimism”, says Trevor Sikorski of Barclays Capital. He believes banks are looking for growth in new markets, chiefly the United States but also Australia and Japan, rather than in the established EU trading system.

“The European market is mature,” he says. “There is a lot of competition for market share.” As long as the possibility of a US carbon trading system hangs in the balance, few companies are hiring in any numbers. “There is nothing for them to trade yet,” he adds.

Nonetheless, Trayport, a trading technology company that provides the electronic connections to emissions exchanges and pricing feeds needed to trade on energy markets, says it has been “educating” would-be market participants, “making them aware of how they would access the carbon credit market as soon as it’s established in the US”.

–By Jeremy Grant and Fiona Harvey

Copyright The Financial Times Limited 2009


Homepage image by Cristóbal Alvarado Minic