Carbon markets warming

Sustainable development has risen to the top of 21st century priorities and market mechanisms are being deployed to reduce greenhouse gas emissions. Professor George Allayannis (University of Virginia, Darden School of Business) has produced a case which describes the carbon marketscape.

This technical note (see reference below) serves as a synthetic introduction to the market-driven efforts to control emissions. It covers six topics.

Emissions trading approaches
In a cap-and-trade approach, a regulator establishes an aggregate level of emissions, the cap, permitted in a jurisdiction. Firms receive credits or purchase credits at auctions which correspond to their allowed emission. Firms that exceed the cap must purchase credits while firms that come under the cap can sell theirs. In this way firms that can reduce emissions in a cost-effective way will benefit from selling their credits and firms that can’t reduce emissions as economically will pay less thanks to the purchase of credits. Two risks associated with the approach are fraud and lifespan. Organizations are therefore required to certify credits on the one hand, and to ensure that retired credits are not resold.

In the baseline-and credit approach, the regulator establishes an emissions baseline (business as usual) for all polluters. Firms are encouraged to reduce their emissions below the projected “business as usual” path of increasing emissions. If they increase their production and emissions increase proportionally they will be forced to buy credits. On the other hand, any reductions below that future path earn credits for the difference which can be sold to other emitters struggling to contain increases over baseline levels.

In the offset approach, projects are encouraged that prevent or offset actual emission. For example, a carbon offset is a commodity representing the reduction of one metric ton of CO2 equivalent by a a qualifying project. Typical offset projects would be renewable-power generation and forestation. Linked to carbon offsets are renewable energy certificates, RECs. A REC states that one MWh of electricity was produced using renewable sources. By proving that this renewable electricity offsets an equivalent amount of carbon-based electricity, RECs can be converted into offsets.

Kyoto Protocol mechanisms
The 1997 Kyoto Protocol provided on top of emissions trading, two other ways for its signees to achieve the greenhouse gas reduction goals: clean development mechanism (CDM) and joint implementation (JI). Through CDM, industrialized countries can meet reduction goals by implementing reduction projects in developing countries for which they earn carbon emission reduction credits (CERs). Under JI, a developed country (Annex I country in the Kyoto nomenclature) can meet part of its reduction goals by setting up a reduction project in another Annex I country.

The 2012 CDM pipeline contains some 4000 projects amounting to 2.5 billion of CO2e reduction. The three leading emerging countries, China, Brazil and India, have attracted 51%, 16% and 8% of the projects respectively. The process to approval takes 6-10 months, comprises a half dozen steps, involving several institutions.

Carbon funds
Carbon funds are pools of capital reserved to secure carbon credits through Kyoto Protocol mechanisms. For example, the carbon fund will provide equity for a renewable energy projects. That project generates carbon credits and electricity. The sales of electricity to consumers and of credits to high polluters, generates revenue for the investors. Carbon funds can use the carbon credits for compliance or for capital gains as part of a carbon credit trading strategy. Among important funds are the World Bank Fund and the European Carbon Fund. Overall in 2007 there were nearly 60 funds for a total capital pool of over 6 billion euros.

Carbon credit trading
To trade carbon credits, two mechanisms are in place. The first, over-the-counter trading (OTC) covers over 70% of the market. Organized exchanges are home to the remaining 30% of exchanges. The case highlights the Chicago Climate Exchange (CCX) which has nearly 300 members: GHG emitters, offset aggregators (who aggregate several offset projects in different parts of the world and trade them) and offset providers (who own offset projects). Finally liquidity providers are members are outside investors interested in trading the CCX’s contracts. Because the market is not a mature one, there is significant volatility in the contract prices as well as in the monthly trading volume.

Carbon indices
Indices are an attempt to provide a benchmark for the growing carbon emissions markets. Barclay’s led the way in 2007 with its Barclay’s Capital Global Carbon Index (BGCI) This tracks the performance of the carbon credits associated with the EU Emissions Trading Scheme (EUAs) and the Kyoto Clean Development Mechanism (CERs). Merrill Lynch (MLCX Global CO2) and Dow Jones (Dow Jones CCX European carbon Index and Dow Jones CCX Certified Emissions Reduction Index) followed suit in 2008. These recent indices point to the interest in carbon as an asset class.

The case comes to us out of the University of Virginia and therefore highlights some American initiatives (see box). But for the time being, Europe is leading the way in carbon-consciousness and carbon trading. This is clear from recent World Bank reports which can serve as useful supplements to the case (see box).

Reference:
UVA-F-1583
“Carbon Credit Markets”
Professor George Allayannis, Susheel Tenguria, Matthew Taylor
Darden School of Business, University of Virginia

Published February 2010