Much was expected but little emerged from the climate talks in Copenhagen late last year. Moreover, with debate in the US focused on financial regulatory reform, discussion about the cap and trade system got pushed back. In Europe, market participants are worried about the move from government-allocated carbon credits to market auctions. The carbon world is not where it wanted to be. Writer Jim Kharouf
Twelve days and five pages. That's the sum total of the UN climate meeting in December and the resulting Copenhagen Accord. The failings of the UN meeting and the inability to forge a comprehensive agreement is not a surprise to banking executives. The much-hyped event in Copenhagen had little real political momentum from the US and China. As such, despite all the speeches and political jostling, the meeting ended with a five-page non-legally binding accord that barely inched the ball forward.
"It was obvious that the UN system was really running out of steam, even in the months before Copenhagen," says Laurent Segalen, global head of carbon emissions trading at Nomura International in London. "Any international agreement should first stem from a US-China deal, which together emit 45% of the world's total emissions, but both countries were pretty reluctant from the beginning to really commit and adhere to the UN process."
Still, some bank executives and long-time climate industry veterans see the process moving in the right direction.
"It's very clear countries such as China and India are feeling pressure they hadn't before," says Olivia Hartridge, a former EU carbon market regulator, who now oversees client business on Morgan Stanley's carbon trading desk. "Even though progress is slow, now that climate negotiations have finally reached the head-of-state level where conflicts between climate, energy and trade issues can be resolved, there is a lot of political momentum going into 2010."
No hope for Mexico?
The next major UN meeting will be held in November in Mexico City and there is a fair degree of pessimism about a global agreement there as well.
What is clear now is that the market is turning its sights towards two things: the current EU Emissions Trading Scheme (ETS) and the potential creation of a US carbon market. A look at both markets will illustrate how 2010 is shaping up to be a critical year for carbon markets.
Patrick Birley, CEO of the European Climate Exchange
The EU market
The good news for the ETS is that the structure of the market is pretty well set until 2020, although there are some issues that could impact the market.
The European Climate Exchange, which handled about 95% of exchange-traded European Union Allowance (EUAs) futures and UN Certified Emission Reduction (CERs) contracts in 2009, posted a strong year with volumes growing 80% from 2008. Volumes remained strong despite the EUA futures prices showing little movement. The EUA futures hit a high of €15.87 in May 2009 and ended the year at €14.37. CER prices also muddled along from a high of €13.82 in October to about €12.97 by the end of the year.
Prices are expected to hold at €11 to €12 for EUAs in the first half of this year, rising to €15 to €18 in the second half, according to various bank analyst estimates. Some of that rather wide price range is due to the ongoing economic problems across the globe and lack of demand for carbon.
Despite the lukewarm outlook in 2010, industry executives say the ETS is fulfilling its mandate of creating price discovery for carbon.
"The market, and the price in the market, reacted in exactly the way you'd expect in a product where we have a known supply and the variable factor which affects price," says Patrick Birley, CEO of the European Climate Exchange. "Demand is the absolute driver for price in the ETS. So as demand for power in the EU was dropping due to the recession, the price decreases matched the decreases in power. So during the recession I think the ETS reacted exactly the way it was designed to."
CDM under pressure
The Clean Development Mechanism (CDM), from which CERs are derived, is also under some price pressures in the wake of Copenhagen. The meeting was supposed to address bottlenecks in the CDM project pipeline as well as provide some more standardisation regarding CDM projects. However, without a comprehensive UN agreement none of the suggested changes by market participants were approved, a frustrating situation for some in the market and project finance space.
"It's not just holding up compliance strategies, it's also holding up a lot of investor strategies," says Ms Hartridge. "At the moment, it's very difficult for investors in emission reduction technologies to put money at risk and scale up because they are only able to work with certainty within a very short time horizon."
Ironically, the CER market is in a bit of a quagmire because, if the UN did improve the approval process for the CDM, it could unleash a large amount of CERs onto the market at a time when prices are historically low.
Louis Redshaw, head of environmental markets at Barclays Capital in London
Auction shift
The focus is also turning to auctions of carbon allowances. Under the EU's ETS, carbon allowances will be shifting from free allocations to auctions for participants. Utilities, such as electricity producers, will be required to purchase their permits via auction from 2013. To prepare for the change, small carbon auctions have been tested by Germany, which began a weekly auction schedule this year, and the UK, which began its periodic auctions in 2009.
More countries are expected to begin testing in the coming months to ensure a smooth transition to the auctioning of credits as phase three of the ETS gets under way in 2012.
"From the trading side, the introduction of auctioning is going to create a shift in the level of activity involved in the ETS," says Mr Birley. "People will move from managing their risks around the marginal difference between what they are allocated and what they will actually use, to a situation where they have to risk-manage the whole position; and that's a huge shift in the level of activity we'll see in the market."
Louis Redshaw, head of environmental markets at Barclays Capital in London, says the frequency of the auctions will be critical to the market - not least because there is a massive amount of EUAs to be auctioned and cash flows that will need to be adjusted to them. If auctions are spaced out too far apart, and large allotments auctioned, markets could be in for price shocks as huge quantities of carbon credits flood into the market.
"Our view is that the market is an auction all day long, every day," says Mr Redshaw. "Yes, the authorities think they should prescribe how they auction volumes. The consensus now is for weekly auctions. The danger with auctions that are [specific] events is that liquidity suffers during the interim period and then trading is based on the new price that has been set. So it makes sense to us to filter auctions into the day-to-day running of the markets."
Mr Redshaw pointed to Germany's January auction which sold carbon credits for €12.37 while the established daily market was trading slightly higher, at €12.44. So event auctions may not prove to be the most efficient or profitable mechanism for EU ETS countries.
Laurent Segalen, global head of carbon-emissions trading at Nomura International, London
Looking to the US
As the EU ETS continues to mature, the US market is still waiting for Congress to move on its climate legislation. Last year began well enough, when the US House of Representatives passed the American Clean Energy and Security Act (ACE) in June.
But promises of fast action by the US Senate were bogged down by two major legislative battles in Congress - health care and financial markets reform. As battles between Democrats and Republicans raged into late 2009, the Clean Energy Jobs and American Power Act, from senators John Kerry and Barbara Boxer, was pushed back to 2010.
Now Washington experts say the clock is ticking on climate legislation, which is largely divided along party lines.
Gary Hart, a consultant to ICAP Energy and long-time emissions market expert in the US, says the vote will be decided by a handful of senators from middle America, who are looking to protect jobs, coal production or coal burning utilities in their states. Making the legislation more tenuous is the upcoming election for various senators and congressmen in November. "If this doesn't happen in the first quarter, we're looking at 2011, after the election," says Mr Hart.
He and others give the current Kerry-Boxer bill about a 30% chance of being passed in the first quarter.
Regional potential?
Some industry participants say that if federal legislation is not passed, regional groups of states may push ahead with their own regional cap-and-trade programmes in the west and midwest. But Mr Hart says those have little chance of getting started if federal legislation is still a possibility.
Others point to the US Environmental Protection Agency, which theoretically could create its own cap-and-trade market without Congressional approval. But that option would likely be delayed as well by a host of lawsuits by business interests opposed to the EPA's authority on carbon.
So why is the US legislation so important? For one thing, without it there appears to be little chance of an international agreement. And questions over possible linkages to the EU's ETS and approved offset projects will remain unanswered. Even with an expected weak carbon target for a US cap-and-trade market, with such a market in place, other nations such as China and India would likely move ahead as well and the global patchwork of emissions markets would begin.
An unmissable opportunity
"I think Congress will step up to the federal legislation," says Tom Lewis, CEO of Green Exchange, which is owned by the CME Group and a consortium of large banks, brokers and market participants. "The US has an opportunity to lead in this global capital market for carbon. In Europe, we have a $300bn market. If we add $1000bn to that, it becomes a significant asset class. Even nominal participation by China and India could add another $1000bn of liquidity to that."
Whether Congress can get it done early this year is still unknown, but market participants are hoping they address it as if the fate of the world rests upon it.
