An open market system of well regulated, organized exchanges helps businesses reduce the effects of global warming.

To combat global warming, companies and countries want to reduce their carbon footprint, thus driving an emerging growth market in carbon trading. While penetrating any immature market can be risky, there are strong opportunities for both marketplaces and financial players in global carbon trading. 

Carbon trading enables organizations to buy and sell carbon credits, helping to regulate carbon emissions. According to industry analyst Celent, the carbon exchange market has grown from under €9 billion in 2005 to about €25 billion in 2007 and, depending on the future regulatory framework, could reach €40 billion by 2012 and over €100 billion by 2020.

Currently, there is both a regulated compliance segment of the carbon market and a voluntary, unregulated one. Two such regulated markets are the UN-sponsored regulated Clean Development Mechanism (CDM) and the largest regulated market, the European Union Emission Trading Scheme (EU ETS) which was created in conjunction with the Kyoto Protocol. Kyoto binds many developed countries to a cap and trade system with the goal of reducing overall emissions. Because the US did not ratify Kyoto, it is not bound.

In the regulated compliance segment, the EU allocates carbon credits to countries. These credits are then divided among industries within that country. Each industry is assigned a cap on the amount of carbon it may emit, and individual companies can trade the allowances amongst themselves. Niche power marketplaces, like the European Climate Exchange (ECX), Nord Pool and Powernext, list contracts in CO2 certificate contracts, European Union Allowances (EUAs) and Certified Emissions Reductions (CERs).

The European scheme recently completed Phase I of its Kyoto program, establishing a solid baseline price for allowances and setting the stage for a more settled market. During the first six months of the full Kyoto period, EUA contracts traded at about €20-25 per metric ton.

“This may not be a perfect system, but it is an excellent start,” says Torger Lien, CEO of Nord Pool. “The carbon market has significantly increased awareness of global warming and the role played by CO2 emissions. For the first time, we can put a price on polluting the environment – a powerful incentive for change.”

The regulated compliance segment of the market should evolve. Once industries develop a reliable method for counting emissions, they will reduce caps annually. Then, the EU will progressively lower the target for allowable emissions and expand the regulation to include more industries. Eventually caps will be applied and auctioned instead of allocated.

“It will create a very different pricing model,” says Patricia McGinnis, Research Director at IDC Financial Insights. “It’s hard to imagine another financial market that could grow as quickly as this one can, assuming that all the dimensions of the European requirements continue to roll out.”

The regulated compliance segment will likely grow throughout Europe and worldwide. The CDM allows EU-based firms to earn or spend credits elsewhere in the world, so new markets will emerge. One is being launched in New South Wales, Australia, for instance.

If the US signed the Kyoto Protocol, the regulated segment would be boosted. A bill introduced in the Senate in June 2008 failed. Over time, it will become increasingly difficult for the US to justify its position on lowering carbon emissions when 182 countries have pledged to act.

In October 2008, NASDAQ OMX completed its acquisition of the clearing, consulting and international derivatives products of Nord Pool and formed the NASDAQ OMX Commodities division. Recently the US Commodity Futures Trading Commission (CFTC) granted permission to Nord Pool to allow US companies to trade and clear carbon products, enabling US companies to trade on a regulated compliance marketplace, and setting the stage for a NASDAQ OMX global commodity offering.

Voluntary markets for carbon trading exist in the US. The Chicago Climate Exchange, formed in 2003, was the first North American marketplace geared to reducing greenhouse emissions. In March 2008, a group of 11 financial and energy industry players launched the Green Exchange to trade environmental futures and options contracts. Currently trading through the New York Mercantile Exchange (NYMEX), the Green Exchange expects approval to become a separate designated market in 2009.

The voluntary markets lack the infrastructure present in the regulated compliance markets. “Like the Wild West, there’s no good sense of what the rules are,” says McGinnis. “There’s no registry for carbon credits or debits in the US in the voluntary markets, and there’s no place to park them.”

For example, carbon credits could be issued to plant trees in Africa, or to protect the Amazon Rainforest. But who counted the trees and what was the amount of carbon allocated per tree? Was it done correctly, or done at all? Are the allowances divided into the right number of units? With no registration or depository, it is impossible to confirm that the same units were not sold multiple times.

Such a scenario does not bode well for attracting investors. “The industry infrastructure is missing in the voluntary markets, so it isn’t going to be attractive to anybody,” says McGinnis. “There has to be accountability and transparency to know what you’re buying.”

Voluntary markets have significant growth potential, but their fate will be determined by the willingness of the players to establish a self-monitoring and self-supporting infrastructure. Standardization is the key. To this end, the carbon market needs auditors – like Den Norske Veritas and Bureau Veritas – to verify emissions accounting.

Once the infrastructure is in place and the market is standardized, organizations including the World Wildlife Fund, Rainforest Action Network or Sierra Club, may be interested in issuing carbon credits and their products could be listed on exchanges that serve as the central counterparty for trading, netting, clearing and settlement.

Opportunities abound in the carbon market. Business is realizing that an open market system of well regulated, organized exchanges is an excellent way to help control pollution worldwide. Such exchanges can deliver a transparent, fair and efficient marketplace and a level playing field.
 

BY SHERREE DECOVNY   PHOTO ROB TANNENBAUM   ILLUSTRATION ANNA SVANFELDT

MarketView 2008:2