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Executive summary
In a year that the need for future action to reduce the risks of climate change has figured prominently on the international agenda, a variety of approaches are being implemented to reduce carbon emissions. These range from efforts by individuals and firms to reduce their climate footprints to initiatives at city, state, regional and global levels. Among these are the commitments of governments to reduce emissions through the 1992 UN Framework Convention on Climate Change and its 1997 Kyoto Protocol, and Europe’s carbon constraint for electricity generators and industry under the European Union Emissions Trading Scheme (EU ETS). The carbon markets are a prominent part of the response to climate change and have an opportunity to demonstrate that they can be a credible and central tool for future climate mitigation.
The carbon market grew in value to an estimated US$30 billion in 2006 (Ђ23 billion), three times greater than the previous year (see Table 1). The market was dominated by the sale and re-sale of European Union Allowances (EUAs) at a value of nearly $25 billion under the EU ETS (Ђ19 billion). 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 (Ђ3.8 billion). The
voluntary market for reductions by corporations and individuals also grew strongly to an estimated US$100 million in 2006 (Ђ80 million). Both, the Chicago Climate Exchange (CCX) and the New South Wales Market (NSW) saw record volumes and values traded in 2006.
EU ETS Phase I demonstrated that a carbon price signal in Europe succeeded in stimulating emissions abatement both within Europe and especially in developing countries. Following the release of verified 2005 emissions data, it became clear, however, that the 2005-07 emissions cap had not been set at an appropriate level relative to what actual emissions were in that period. As a result, market expectations and the Phase I price signal were based on incorrect assumptions of the carbon
constraint, leading to high volatility in the EUA market. The EU Commission stated that Phase I was a “learning phase” and assured the market that it would assess second period plans “in a manner that ensures a correct and consistent application of the criteria in the Directive and sufficient scarcity of allowances in the EU ETS.”1 Market interest in the second half of 2006 shifted out of Phase I, and began to focus on Phase II based on expectations that those caps would be much more stringent.
In contrast to a highly volatile 2006 EUA market, project-based assets showed greater price stability, while transacted volumes also grew steadily. Developing countries supplied nearly 450 MtCO2e of primary CDM credits in 2006 for a total market value of US$5 billion (Ђ3.8 billion). Average prices for Certified Emission Reductions (CERs) from developing countries were up marginally in 2006 at US$10.90 or Ђ8.40 (with the vast majority of transactions in the range of US$8-14 or Ђ6-11). China continued to have a dominant market-share of the CDM with 61% and set a relatively stable price floor for global supply of CERs.
In 2006, Joint Implementation (JI) projects from economies in transition saw increasing interest from buyers, with 16.3 MtCO2e transacted (up 45% over 2005 levels) – with Russia, Ukraine and Bulgaria providing more than 60% of transacted volumes so far – at an average price of US$8.70 (Ђ6.70). Preliminary data for the first quarter of 2007 indicate at least the same volumes had already transacted in the first three months alone.
Buyers found it easier to close transactions than six months earlier, while sellers managed carbon price risk by favoring fixed price forward contracts. CER assets traded considerably higher in secondary markets (in a range of US$14.30-19.50 or Ђ11-15) than in primary transactions, although accurate volume data were difficult to confirm for secondary transactions.
Since 2002, a cumulative 920 MtCO2e (equivalent to 20% of EU-15 emissions in 2004) have been transacted through primary CDM transactions for a value of about US$8 billion (Ђ6 billion). Hydrofluorocarbon (HFC-23) reduction and nitrous oxide (N2O) destruction projects accounted for approximately half of the market volumes, while renewable energy and energy efficiency transactions together accounted for nearly 21% of the CDM market over the same period.
European buyers dominated the primary CDM & JI market with 86% market share (versus 50% in 2005) with Japanese purchases sharply down at only 7% of the primary market in 2006. The U.K., where the City of London is home to a number of global financial institutions, led the market for a second consecutive year with nearly 50% of project-based volumes, followed by Italy with 10%. Private sector buyers, especially banks and carbon funds, continued to buy large volumes of CDM assets, while public sector buyers continued to dominate JI purchases. A large number of international financial institutions and funds engaged in secondary transactions of carbon portfolios with other banks (primarily in Europe) or companies facing compliance obligations (in both Europe and Japan).
European buyers reported that they increasingly asked for and obtained zero-premium call options to purchase emission reductions beyond 2012. For the most part, the strike price in these contracts was the same as the contract for pre-2012 assets. Others reported a right of first refusal for post-2012 vintages at a future time for an unspecified “market price.”
Outlook
Most market players stated that considerable price risk – and likely volatility – remained in the market for both CERs and EUAs. There is a consensus emerging2 among market analysts that the expected shortfall in the EU ETS Phase II is likely to be in the range of 0.9 billion to 1.5 billion tCO2e. Estimates for not-yet-contracted volumes from JI/CDM and projected EU shortfalls are very similar to each other in these projections (unless additional demand before 2012 and the promise of higher prices stimulates additional JI/CDM supply).
The current projected demand-supply balance excluding Canada (and residual demand from Japan) implies that the price of CERs/ERUs is likely to help set the market equilibrium price for EUAs in Phase II. EU ETS companies would be the prime beneficiary of this balance provided that: no significant Japanese or Canadian competition appears for these assets; and provided that there are no surprises from higher than expected under-delivery of CERs/ERUs; as well as no consistent anomalies
over the five years from weather or from fuel prices; or any major technological inflection points in that time period. The prospect of EU ETS Phase III – and the ability to bank allowances across the second and third periods – gives a longer time planning horizon to market players considering new investments for abatement from both the CDM/JI and marginal abatement within the EU.
The April 26, 2007 climate change announcement by the Government of Canada calls for improvements in carbon intensity leading to an emission target of 20% below 2006 levels by 2020 (assumed to be 150 MtCO2e by Canada). The approach incorporates emissions trading and also includes the idea of early action and banking and allows CERs for up to 10% of the projected shortfall. If these assumptions are true, then some demand from Canada could enter the CER market relatively soon.
Developments in California, the eastern United States and Australia hold some promise of market continuity beyond 2012. There is continued debate, especially in California, regarding whether emissions trading, including offsets from overseas will be allowed. Precise rules to be developed will clarify to what extent these emerging carbon markets will seek to maximize value from high quality offsets no matter where they are sourced from. At least two pending pieces of draft federal legislation before the U.S. Senate include provisions that would welcome overseas credits.
The carbon market and associated emerging markets for clean technology and commodities have attracted a significant response from the capital markets and from experienced investors, including those in the United States. Analysts estimated that US$11.8 billion (Ђ9 billion) had been invested in 58 carbon funds as of March 20073 compared to US$4.6 billion (Ђ3.7 billion) in 40 funds as of May 2006.4 50% of all capital driven to the carbon value chain is managed from the UK.5 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 2006,6 with major investments (and announcements) from well-known investment banks.7
Most public companies in the carbon space are in a fast-growth mode and are yet to show a profit. One public company delayed its public disclosure in the wake of an unfavorable analyst report. Some companies cited the delay in the operations of the International Transaction Log (ITL) as a risk that would made it more difficult to earn and book revenues from CER spot sales this year.
There was increased consolidation in the sector and evidence of growing interest in the U.S. markets. A prominent investment bank bought a sizeable stake in a leading project development and asset management company. Another company acquired a boutique analyst firm in the United States, while a third acquired a smaller company in Washington DC specializing in developing Project Design Documents (PDDs). Several European entities opened offices in the United States citing the need to
develop a presence in this potentially large market. Reports of early offset transactions in North America filtered in with prices reported in a very wide price range starting at around US$1.50, e.g. from pre-compliance buyers for emission reductions from enhanced recovery from oil and gas fields.
The most promising impact of carbon markets has been its impact on innovation as smart capital takes an early, long-term bet on the quickly growing emerging market for environmentally-oriented investment. A key indicator of interest in aligned and closely related fields is the record US$70.9 billion in clean technology investments in 2006,8 with major investments (and announcements) from well-known investment banks.9
In the emerging fragmented carbon marketplace, efforts to mitigate carbon are multiplying in both the regulated and the unregulated sectors. For regulated markets, emissions trading can help achieve a given level of emission caps efficiently by setting an appropriate price, but this requires that policymakers set the caps consistent with the desired – and scientifically credible – level of environmental performance. Regulated carbon markets can only achieve environmental goals when policymakers set scientifically-credible emission reduction targets while giving companies maximum flexibility to achieve those goals. They also require clarity on the assumptions for economic growth and baseline carbon intensity improvements, orderly and transparent release of periodic marketrelevant emissions data and the imposition of strict penalties for fraud or non-compliance. The key elements for well-functioning carbon markets include: competitive energy markets; common, fungible
units of measure10; standardized reporting protocols of emissions data; and transferability of assets across boundaries.
Markets can, to a certain extent, accommodate the appetite that individuals and companies in Europe, Japan, North America, Australia and beyond have for carbon emission reductions that go well beyond what their law makers require of them. This high-potential voluntary segment, however, lacks a generally acceptable standard, which remains a significant reputation risk not only to its own prospects, but also to the rest of the market, including the segments of regulated emissions trading and project offsets.
The enormity of the climate challenge, however, will require a profound transformation, including in those sectors that ‘cap-and-trade’ markets cannot easily reach. These include making public and private investments in research and development for new technology development and diffusion, economic and fiscal policy changes, programmatic approaches to decouple economic growth from emissions development as well as the removal of distortionary subsidies for high-carbon fuels and
technologies.
Footnotes:
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See “Communication from the Commission to the Council and to the European Parliament on the assessment of national allocation plans for the allocation of greenhouse gas emission allowances in the second period of the EU Emissions Trading Scheme”, COM(2006) 725, 29 Nov. 2006, Brussels.
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Based on estimates from average of (central) estimates from Fortis, Merrill Lynch, New Carbon Finance, Point Carbon, Sociйtй Gйnйrale and UBS for EU-ETS shortfall and demand for CDM and JI.
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New Carbon Finance, “UK in Pole Position as Carbon Funds Surge – but More Funds required”. Press release 4 April 2007, www.newcarbonfinance.com.
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See R. Bulleid, “The capital begins to flow”, Environmental Finance, April 2006.
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See New Carbon Finance, op. cit.
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New Energy Finance, “Clean Energy Deal Volume Hits $100bn”. Press release 19 December 2006, www.newenergyfinance.com.
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Among the most recent ones, see announcement of Goldman Sachs of further investment in the clean and renewable power generation sector, with a large equity stake in an IGCC project, which will include a significant amount of carbon capture and sequestration.
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New Energy Finance, “Clean Energy Deal Volume Hits $100bn”. Press release 19 December 2006, www.newenergyfinance.com
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Among the most recent ones, see announcement of Goldman Sachs of further investment in the clean and renewable power generation sector, with a large equity stake in an IGCC project, which will include a significant amount of carbon capture and sequestration.
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One proposed regional scheme in the United States uses “short tons” while most other programs use metric tonnes to measure reductions.
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