Carbon emissions trading is the buying of fungible carbon credit units. In much the same way as stocks and shares are traded on stock exchanges, carbon trading exchanges provide the platform for transactions in the carbon credit market. Also as with the commodity units we may be more familiar with, carbon trading can take place in a number of forms from over-the-counter trades to spot trades and futures as well as auctions.
Like the carbon market in general, carbon emissions trading can be split into two semi-distinct yet converging markets, the compliance market and the voluntary market. As such, we will look at both sides of the trading market separately, with the aim of providing an overview as to who is trading, what products they are trading, the platforms and registries facilitating this fledgling market and current and future trends.
The Carbon Emissions Trading Market
As with any financial transaction, carbon trading markets rest upon the dynamic between buyers and sellers of carbon credits and their derivative products which are compatible with the compliance market.
- Countries – As already covered, the compliance carbon market consists of industrialised nations, Annex 1, which have made commitments under the Kyoto protocol to reduce their greenhouse gas emissions. One of the mechanism for achieving these reductions are based upon Kyoto approved fungible carbon credit units, CERs and ERUs, representing one ton of carbon equivalent greenhouse gas emissions. If a country exceeds its emissions limit, it may compensate this by buying CER or ERU carbon credits equal to its excess emissions. So one of the major buyers on the carbon trading market is Annex 1 countries.
Polluting Industry – For a country or a region to keep its commitments under the Kyoto Protocol it must monitor and control the sources of pollution within its borders. Tying the sources of pollution to emissions caps is considered the most effective means of doing so. Countries taking this route choose industries which they consider to be the major polluters, especially profit making enterprises, and impose an emissions cap to them, allocated from the country’s overall emissions cap. Part of this allocation of carbon credit units, as has been the case until now, is usually free, and a smaller percentage of the allocation paid for. Also, if a company exceeds its cap it must compensate this by buying additional carbon credits on the open market, either from other companies in the same country or region who have a surplus, or from external sources selling Kyoto compliant carbon credit units. This is the essentials of a cap-and-trade system and the basis of global carbon trading.
On the buyers side we have countries and polluting industry. The most prominent example of this is the EU Emissions Trading System (EU ETS), which is by far the most developed cap-and-trade system under Kyoto’s flexibility mechanisms. In 2012 it will enter phase III, where the emissions cap will be lowered much more aggressively than in phases I and II and a much lower percentage of the carbon credits comprising of the initial cap allocation will be for free with a larger percentage being auctioned. On 2010′s figures, the EU ETS, including the internally allocated EUA carbon credits and compliant Kyoto carbon credits bought into the EU ETS, accounts for 97% of the global carbon trading market.
Other national or regional cap-and-trade markets are very much in a fledgling status. National governments find it difficult to overcome the vested interests of polluting industry influencing implementation of the cost of emissions being passed directly to them making legislation tricky to pass. Despite a mooted federal cap-and-trade system in the USA floundering, California is pressing ahead with its own state system which will come into force in mid-2012 after a slight delay. It is expected that within a few years the size of the Californian system may rival Europe in terms of carbon emissions trading volumes. Australia has also very recently, in October of 2011, passed legislation introducing a carbon tax on polluting industry, which is aimed at paving the way to a full cap-and-trade system within a few years.
Institutional and Private Investors – Although institutional investors are under no obligation to purchase carbon credits, for the sake of examining the carbon emissions trading markets, we will group all trade of carbon credits which are compatible with the compliance markets as part of the compliance carbon trading market. As fungible units on a free market, whoever engages in buying and selling of these carbon credits has an influence of the compliance carbon trading market, by effecting supply and demand, and so price.
The main institutional players trading and holding portfolios of carbon credits are the major investments banks and energy trading companies, examples of which are Barclays Capital, Bank of America Merill Lynch, Goldman Sachs, Shell, Gazprom, and the list goes on. Some of these companies also have major investments and part ownership of companies which invest in projects producing carbon credits. Société Génerale’s joint venture with Rhodia, the chemical’s giant, in Orbeo – a full-service origination to trading player in the carbon market is a prime example.
There is a growing number of funds also involved in the compliance carbon trading market, both as holders of portfolios of carbon credits and in investing in projects which produce them.
- Companies, Not-for-Profits and NGOs – There is a rapidly growing market of private companies out with the compliance markets buying carbon credits on the voluntary market in order to offset their carbon footprint partly or in its entirety. Notable examples of this are Google, UPS and General Motors with well publicised regular purchases of voluntary standard carbon credits. However, many companies of all sizes and descriptions are beginning to follow suite, either absorbing the cost of doing so themselves, or offering their clients the choice to voluntarily contribute, such as when buying train or plane tickets.
- Individuals – A growing number of private individuals are buying small quantities of carbon credits to offset their own personal carbon footprints usually via wholesalers or companies offering the option as a sideline to selling carbon credits to voluntary corporate clients.
- Countries & Regions – With Phase III of the EU ETS involving a much higher percentage of the EUA allowance being auctioned by the Member states rather than allocated for free, the member states will be by far the largest seller of carbon credits within the compliance market.
Project Developers – Offset projects producing compliance market compatible carbon credits, either CERs or ERUs, are, outwith national allowances, the primary source of carbon credits on the market. As the accreditation process for CERs and EUAs is both relatively difficult and expensive, CER and EUA projects under the Clean Development and Joint Implementation mechanisms tend to be the preserve of relatively large-scale investors.
- Carbon credits coming to market from project developers would be considered the primary market, credits going from issuance, directly to the final owner and subsequent retirement as an offset. The secondary market, under compliance systems, would consist of wholesalers and investors bringing their portfolios of carbon credits to the end buyers.
What Are They Trading?
Within the compliance carbon emissions trading market, the primary units traded are Kyoto approved CER and EUA carbon credits. In Europe, the primary compliance market, EU ETS units are also traded. Other regional specific units for the other, smaller regional compliance systems, such as the NZU, in New Zealand, account for the remainder of the market.
The Californian System, to be regulated by the Californian Air Resources Board, is expected to approve some carbon credit standards not compatible with current compliance markets. Forestry, especially REDD, carbon credits are expected to count amongst these.
The voluntary market has a much wider variety of types of carbon credits which are traded. There are a number of independent third party standards with slightly diverging classification criteria, some more common than others. Carbon trading within the voluntary market is made that bit more complicated in that all of these different standards have differing average prices and criteria.
Carbon trading transactions, fall principally into three categories; spot trades, futures and over-the-counter. Spot trades and futures contracts principally take place via specialist climate exchanges or major commodities exchanges with a facility for carbon emissions trading, such as InterContinental Exchange (ICE). Spot trades are the buying and selling of existing carbon credit units. This is either for retirement, in the case of industries which are a part of the compliance markets, or for resale, much the same way as forex or other commodities are spot traded.
Futures form a significant share of the carbon trading market, especially the compliance market. With prices of EU ETS compatible carbon credits expected to rise with Phase III’s auction system, many buyers are currently fixing themselves in to current prices via futures contracts.
Over-the-counter trades are also not uncommon especially in the voluntary market, where the majority of trading tends to be over-the-counter. In the compliance markets less so but there are still deals done directly between the end users and projects producing Kyoto compliant carbon credits.
Direct investment in projects is not exactly trading per se but is the other major transaction on the carbon market. The investment can be repaid in actual carbon credits in some cases, at a price presumably well below the current market value of the credits on the open market. Chemical giant Rhodia’s joint ownership of Orbeo, the carbon market project developer, was probably, at least initially, strongly influenced by its own carbon credit requirements under the compliance regime.
Over-the-counter trades, as already mentioned are much more frequent in the voluntary market, and are the lion’s share of transactions here. This is partly likely to be influenced by transactions generally being much smaller in monetary value than in the compliance market. Another reason is that for voluntary buyers, the project itself, as the source of the carbon credits and what their sale is financing, is much more important. Buyers on the compliance market are generally not interested in the source of the carbon credits that they buy but simply on the price and them carrying the correct accreditation to count towards their quota. Voluntary buyers on the other hand tend to more commonly have an interest in the source and a desire to feel an empathy with the particular project based on it answering to their own personal criteria. This may make over-the-counter trades more appealing than the mechanical anonymity of carbon emissions trading via exchanges where the only information connected to the individual units are facts of registration and accreditation.
Pre-payment contract types have also gained in popularity on the voluntary OTC market, accounting for 18% of all trades in 2010, compared to 7% the previous year. This perhaps shows greater faith in the market as well as the project developers themselves.
Exchanges and Registries
The exchanges used for carbon emissions trading on the compliance and voluntary markets also contrast. Although some of the major exchanges that compliance market carbon credits are traded on also offer a platform for the trade of certain voluntary standards, they tend to be relatively distinct from one another.
European Union Allowances (EUA) Transactions on the European Climate Exchange (ECX)
By far the biggest exchanges globally are those upon which the carbon credits compatible with the EU ETS are traded for the obvious reason that this trade accounts for the largest share of carbon trading. The European Climate Exchange, in conjunction with Intercontinental Exchange’s electronic future’s platform, Futures Europe, is said to account for 80% of the exchange traded volume on the European carbon market. As the European compliance carbon market accounts for over 95% of the global carbon trading market, 80% of this volume makes the ECX/ICE trading platform the major one on the market.
The other major exchanges upon which EU ETS compliant carbon credits and their derivatives are traded are the NASDAQ OMX Commodities Europe (formerly Nord Pool), BlueNext and the European Energy Exchange.
Various regional climate and energy exchanges around the world also offer trading platforms for Kyoto compliant carbon credit units, the Montreal Climate Exchange, the Chicago Climate Exchange and the China Beijing Environmental Exchange being notable examples. The recent trend is towards new regional and national climate or environmental exchanges opening up every few months.
The voluntary market still sees the majority of transactions taking place in over-the-counter deals directly between buyer and project in the primary market and buyer and wholesaler in the secondary. However, as the market develops it is likely that exchanges will begin to play a more prominent role. Particular voluntary standards being accepted as compatible with future compliance markets, as is expected to happen with the Californian Trading Scheme, will have a significant influence in this regard.
Registries track carbon credits from issuance to retirement via serial numbers. This is done to prevent fraud and duplication of individual carbon credits or duplication of sales etc. In the case of the compliance market, regional or national systems with their own issued units, such as the EU ETS, have their own registry. This registry both tracks the transactions of carbon credits issued by it, as well as the compatible Kyoto approved carbon credits which enter into the system. CER and ERU carbon credits from the CDM and JI Kyoto mechanisms also have their own registries tracking the lifespan of offset units.
As the carbon trading market grows, the function of strong and reliable registries to prevent fraud is becoming ever more crucial. As new national and regional cap-and-trade systems appear, integration of registries between different systems and involving different carbon credit standards will need to become ever more efficient and sophisticated.
Because of its more fractured nature in terms of standards and verification, the voluntary carbon market also has a more fractured system of registries. In mid-2011, 11 registries accounting for carbon credit standards within the voluntary market were present. Some of these registries are standard specific, which is to a degree logical in the case of the smaller more specific standards. Nonetheless, it would make sense for future trends in registries in the voluntary market to become more integrated and merge.