February 2010

CARBON TRADING: a murky future

There may be huge potential in the emissions trading markets, but investors are uncertain about their direction post-Kyoto, writes Angèle Spiteri Paris smokestacks.jpgEven if there is enormous potential in carbon trading markets, the future of these nascent investments hangs in the balance as politicians struggle to come to a binding conclusion on what is to be done after the Kyoto agreement expires in 2012.

The global effort to reduce carbon emissions has led to opportunities for investors through the creation of a secondary market for carbon credits.

Firms operating within countries signed up to the Kyoto agreement have had their CO2 emissions capped. For example, in Europe, each member state gets an annual emissions allocation that it then divvies up among its worst emission-producing firms. Each company in turn is then obliged to produce no more emissions than its allocation allows.

If it produces less CO2 then it can sell its excess allowance as carbon credits to other firms who overshot their targets. If any firm comes in over target it has to pay a penalty and buy credits on the secondary market to make up the difference.
It is in these secondary markets that fund managers can look to make a return.

One aim at the United Nations Climate Change Conference in Copenhagen in December 2009 was to determine what would happen when the Kyoto agreement, which currently forms the basis of the emissions trading markets, expires in 2012.

But as the talks came and went without forging a legally binding arrangement, it looks now like carbon markets post-Kyoto will operate more and more independently.

At present the most active carbon markets are those in the US and in Europe. The European Climate Exchange (ECX) is the most liquid carbon marketplace in Europe. In December 2009 ECX trading volumes were up 81% over 2008. These were made up of 4.2bn tonnes of European Union allowances and 0.8bn tonnes of certified emission reductions.

In the US, futures and options on the Regional Greenhouse Gas Initiative (RGGI) contract, launched in August 2008, traded a record 20,012 contracts in March of 2009.

Investors in the existing carbon exchanges may have been concerned that they may be left out of pocket after the Kyoto agreement expires in 2012 and the markets they were trading on broke down.

Ian Simm, CEO of Impax Asset Management, an investment manager dedicated to the environmental and clean-tech sectors, says: “Annually, each emitter has to submit sufficient permits to cover their CO2 emissions, and if they don’t have enough permits they have to buy them on the open market.

“The EU has indicated that, post 2012, it will retain its carbon trading regime.  However, if it were to change its mind, the value of carbon permits from 1 January 2013 would collapse to zero.

“The value of carbon is at the whim of regulators, who can decide which carbon assets to include within each scheme. There’s a parallel with the money supply here – the more carbon permits are created, the lower the value of each permit.”

To 2020 and beyond
But the fear of the carbon markets disappearing completely may be abated. It looks as though, despite the lack of a global policy, regional markets will continue to operate independently, without much of an impact on investors within those markets.

Europe, for example, has agreed to continue trading carbon until 2020 and the regional systems in the US are being strengthened.

Neil Eckert, chairman of the Climate Exchange group, says: “Europe has already committed to keep the trading system going to 2020, so whatever happens, even if there is no post-Kyoto market-based solution, Europe will still trade until 2020.”

In the US there is the Regional Greenhouse Gas Initiative (RGGI), which includes ten states in the north-east of the country, as well as the California Climate Action Reserve (CCAR).

The future of these US markets depends on the country’s politicians. If the Senate takes vote on the issue, this will lead to the implementation of a nationwide trading system. If the Senate prevaricates, which is a possibility considering that it is election year, one could see a proliferation of regional schemes – an expansion of the RGGI or the Environment Protection Agency (EPA) may step in to regulate CO2 emissions.

According to Eckert: “There is about a 50-60% chance that the Senate will vote this year. In the absence of that, I do think there will probably be an EPA-regulated system coming in and before that you’ll see a growth in the regional systems.”

The EPA was set up in 1970 and given the mission to protect human health and the environment.

Although the future of the carbon markets in Europe and the US looks positive at first glance the answer may not be so simple.

Commitment to carbon markets, and other environmental exchanges, is ultimately dependent on investors’ outlook on the long-term prospects of an operational trading system.

According to David Harris, manager of responsible investment at the FTSE Group, the long-term path of green technology markets has been clarified. He says: “There is now an acceptance about trying to limit global average temperature increases to 2º Celsius and in order to do that it means a global reduction of emissions by 50% by 2050.

“There isn’t yet an agreement on specific emission reduction targets but if we accept the 2º limit then that is what it means.”

He adds that what we don’t know are the mechanisms that will be employed to hit this long-term objective.

So, although there may be a vague suggestion that action will be taken, investors in the carbon markets may have been left with a sour taste in their mouths following the Copenhagen talks. At the moment investor confidence in the future of the green markets is not exactly very high.

Experts said there was “too much talk and not enough action” during the Copenhagen discussions.

Eckert, at Climate Exchange, says: “If the market believes that there’s going to be a long-term system post-2020 then it gives people more confidence to engage and set themselves up. So the longer the projected life of the system is, the better.”

An industry player says that at the moment people are “pretty cross” about what went on in Copenhagen. “There were 47,000 people, hundreds and hundreds of countries, politicians talking about everything and, really, very little was actually achieved… the worst thing was that there was no commitment to a legally binding reduction [of CO2 emissions].”

Ben Dear, a partner at Osmosis Investment Management, says: “Expectations were a little bit talked up by the journalists because of all the heads of states in attendance. If you talk to the people at the conference on the ground, there wasn’t an expectation of a final binding deal. Everyone knew that was going to take a little bit longer.

“The reality is there has been progress with developing countries signing up for the first time to commit to reduce emissions and developed countries going some way towards allocating funds to a climate compensation pool. Nothing’s written in stone yet but as a step forward that is an important development.

“Also at the end of the day we must not forget that most national governments have their own national initiatives as well. Based around energy security, commodity price volatility and green collar job creation.”

In fact, the one thing that seems certain is that post-Copenhagen, carbon markets will most probably be more fragmented.

Harris, at FTSE, says: “One of the results from Copenhagen is that there is a slightly increased risk that different countries will go their own route. Also, the importance of carbon trading is slightly less certain now than it was before although it is still the most likely central mechanism, along with renewable energy tariffs and tougher energy efficiency standards.”
According to Eckert, regional developments should not strike fear in investors’ hearts. He says: “I don’t think historically there’s ever been an issue where the whole world got together and signed up to one protocol. Whether it was international trade or tax… So I believe that the world is eventually going to be forced to move with a series of different initiatives.”
Dear, at Osmosis, says: “I think there’s going to be an agreement in Mexico. It’s like Kyoto – you step away from it then renegotiate and you come up with an agreement. When you look at the institutional market, quick change is never a great thing anyway. Slow implementation is a much better way of getting things through and people will be more comfortable with that.”

Eckert says that the two countries that matter are China and America. “Once you’ve got those, then everything else will fall into place,” he says. “China uses two tonnes of CO2 per head and America uses 20. America wants absolute reduction because they can afford it, while China wants a per capita-type system. Until they can bridge this gap, we have a problem.

“With any luck, they have committed to re-engaging so I think we’ll see little bits of progress throughout 2010.”

So, bringing China on board may very well be one of the most important steps to be taken in the fight against climate change. But it would not just be a step forward for the global good, having China sign up to reduce its CO2 emissions will probably lead to a huge expansion of the carbon markets.

Harris, of FTSE, agrees that both China and the US are of great importance. He says: “China is crucial and the US carbon emission market is forecast to be two or three times the size of the Europe market.

Fragmented market
“One concern [about the increasingly regional markets] is to what extent different countries may go their own route and put more emphasis on other mechanisms such as tax rather than on cap and trade, but the uncertainty on the particular mechanism will encourage more diversified investment in environmental markets – for example, targeting larger companies with diversified low-carbon technologies rather than technology-specific companies.

“If we don’t get a strong global agreement then we will have a more broken-up, diversified market with different approaches in different regions and countries. Maybe outside of the UN framework you’ll have different coalitions of countries working together.”

Harris says that it is still difficult to say what the impact of this fragmentation will be on investors.

At present FTSE does not produce indices specific to carbon emissions trading. Harris says: “It’s a pretty small market when you compare it to other asset classes, but I wouldn’t rule it out. It’s certainly possible that if we get more interest from our clients we’d consider it.”

“It’s about how the different markets interlink – are they going to be free, standalone markets? Probably, hopefully, not. We need to see to what extent are they going to be transferable and interlinked.”

Simm, of Impax, says: “Post Copenhagen, even if carbon markets are confirmed as a key element of international global warming policy, investors must question whether they are willing to accept the substantial risk of adverse regulatory change.”

The potential growth of the carbon markets is huge, but the equally large number of uncertainties around their long-term future means the realisation of that potential all hangs on a ‘what if’ – it’s all a bit of a waiting game at the moment.
The carbon markets’ murky future means fund managers are not exactly fighting each other to get a piece of the action.
Some prefer to steer clear.

Simm, of Impax, says: “We are sceptical about the chances of carbon markets surviving in their current form, and prefer to sit on the fence until a detailed regulatory regime has been established that is able to underpin a robust marketplace.”

©2010 Funds Europe

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