All eyes on Copenhagen

Amid the banking crisis, the carbon emissions market has emerged as one of the fastest growing and potentially the most lucrative financial market in the world. Among its major players is a list of the banking sector's survivors: Barclays Capital, Goldman Sachs, Morgan Stanley and JPMorgan.

With the world's biggest polluters now prepared to seriously address the issue of climate change - the US is close to passing legislation to create the biggest cap and trade system in the world - there is an air of optimism in the European carbon market. It is a market that US president Barack Obama says will act as a model to the US system, if not the world.

Last year, carbon trading volumes doubled to $128bn. While this is relatively small in the context of the wider energy market - with a similar volume in the oil futures market being swallowed up in less than two days - that will not be the case for long, according to some analysts. According to climate research group Carbon Finance, the market could be worth $3000bn in just a decade.

Critical juncture

Whether or not the carbon market reaches such heights depends on what is agreed in Copenhagen in December; this will be the stage at which the negotiations between 180 nations come to a head and a new framework will be drawn up to replace the 1997 Kyoto Protocol.

The success or failure of the Copenhagen round hinges on a meeting of minds between the world's two largest carbon emitters, the US and China, and the question of where the biggest emission cuts will come from. The US wants to supplement its proposed cap and trade system by generating carbon credits through developing clean energy projects in developing economies. China, meanwhile, wants the US to cut its emissions at home first.

"It is important to be realistic about what can be achieved in Copenhagen. At best, it will generate an agreement on targets, but certainly not a detailed text on implementation. Importantly, perhaps we can hope for some leadership from the US and China to break the impasse on a compromise between developed and developing world targets," says Camilla Taylor, an investment advisor at carbon trading fund Trading Emissions.

The carbon markets will also seek clarification on how an international carbon trading system will operate. An important question is what will be the common currency, says Ms Taylor.

Market participants want to include the US and eventually the developing world in the new scheme starting in 2013, which will use a common carbon credit that can be used to comply with emissions caps across Europe, the US, Australia, and, most importantly, China. That link might be something similar to the certified emission reduction credits (CERs) from the United Nation's Clean Development Mechanism (CDM); the CDM creates cross-border emissions credits for companies that develop clean energy alternatives. This may take several more years, forcing investors and bankers to be more patient.

Landmark act

In the meantime, much of the focus will be on the US Senate as it prepares to vote on the American Clean Energy and Security Act. The landmark legislation calls for the US to reduce its greenhouse gas emissions by 17% from 2005 levels by 2020, and 80% by 2050. The emissions caps begin in 2012, and some trades are already being made on the Chicago Climate Exchange.

"There can be no massive growth until we expand the marketplace, and the US will carry most of the responsibility of that happening," says Louis Redshaw, head of carbon trading at Barclays Capital, which has been voted as the top emissions trader for three out of the past four years by analyst Point Carbon.

Even if the bill is passed, timing is tight, says Michael Cosgrove, North American head of commodities and energy brokerage at GFI Group in New York. "While the legislation may pass at any time, I don't believe the programme can be designed and implemented in less than one year," he says. And if the bill is not passed by the Senate ahead of the Copenhagen summit, that may limit breadth of any agreement between the US and China.

That said, the wheels are in motion and there is much optimism that within six years most of the world's major economies will have legislated cap and trade systems.

"We hope that by 2013 the US, Australia, New Zealand and Canada will have emissions trading schemes. We have to hope that China, India and Brazil will have their own schemes somewhere around 2015, and certainly before 2020" says Patrick Birley, CEO of the European Climate Exchange (ECX). "What's important is that each system gets up and running before we start thinking about a single trading system.

"In terms of the why, nationalistic issues tend to make countries want their own scheme with their own peculiarities - if they feel that a global system is going to overpower their own scheme, it may make them more reticent to get going. Hence, let's get the schemes in place first and then worry about linkages later."

Growth path

While the global debate plays out, participants are focused on the EU Emission Trading System, which continues to grow apace, even amid what is the worst financial crisis since the 1930s.

Carbon markets have evolved both as an over-the-counter (OTC) and an exchange-traded product, with volumes historically split somewhere down the middle. However, as the credit crisis raised the spectre of counterparty risk, the willingness to trade bilaterally has diminished. The ECX has been the biggest beneficiary of this. "The OTC market has dried up a bit due to the credit crisis, so we've seen more volumes move onto the exchanges," says BarCap's Mr Redshaw.

In June, the number of carbon permit contracts traded on the ECX - whose trades are cleared by ICE Clear Europe - rose to 463,149, the third highest monthly total in its history, a 57% increase on the previous month. In June 2008, 187,413 contracts changed hands.

As a result, monthly average volumes in the OTC futures contract have fallen to less than one-third of overall futures market turnover, down from 45% in 2008, according to data from Thomson Reuters. Even though, according to the London Energy Brokers Association, in terms of tonnes of carbon traded, OTC volumes in both EU emission allowance and CER futures rose by 82% in the first five months of 2009 from the same period a year ago.

OTC's loss of market share can probably be explained by a surge in trading in the spot market as a result of tight credit markets. According to BarCap, spot trades for EU CO2 allowances jumped to 38% of the total market activity in May this year, up from 18% in March.

The key reason behind this surge is that spot trading is typically cheaper and requires less collateral as security than longer-term contracts - and companies want to free up cash in tight credit markets by selling spare carbon allowances. For example, company filings reveal that Cemex, the largest cement maker in the Americas, sold 9.1 million metric tonnes of 'surplus' EU CO2 allowances in the second half of 2008 for $274m.

Price slump

But as industrial companies have flooded the market with allowances in a bid to free up cash, carbon prices have crashed from about €30 a metric tonne last year, to about €8 a metric tonne in February.

There have been other contributory factors to the price slump, says Emmanuel Fages, a senior carbon analyst at Société Générale in Paris. "Prices also reflect the current economic fundamentals and, to an extent, trends in oil markets," he says.

The global recession has caused industrial production to plunge. In the eurozone, production fell by 21.6% in April from a year earlier - the biggest drop since records began in 1986.

Whatever the reasons behind the price slump, it could not come at a worse time for climate policy-makers, who are trying to drive through a new global carbon market framework: lower prices do not create an effective incentive for industry participants - whether utilities, industrial or financial players - to develop and finance clean energy alternatives or commit to making markets.

"At what price point is the market effective in creating that incentive?" asks Paul Newman, managing director at ICAP Energy. "Thirty to forty euros seems to 'matter' to people. It needs to be inbetween that before participants start making real, behaviour-changing decisions."

SocGen's Mr Fages suggests that, in the current economic environment, emissions targets and national quotas may need to be set much lower in order to push the market forward. "What the present price level does suggest is that constraints aren't high enough; quotas have to be set lower to cope with actual climate risk. If quotas are set lower, you will very rapidly see prices high again - and then people might complain it is too high," he says.

Others argue that the low price is merely an aberration and claim the price is set to rise dramatically in the coming years, regardless of emissions quotas.

Tom Frost, equity capital markets advisor at AKUR, says that a complex set of converging factors could create a significant supply squeeze that may significantly impact upon the EU market before the end of the current phase.

Due to extreme criticism for the handling of the first phase of the EU trading scheme, during which excess supply drove the carbon price close to zero, policy-makers have responded by moving to the other extreme, which could lead to a spike in carbon prices.

Mr Frost says that credit crunch-induced selling of carbon permits will create distressed buyers from 2011 because new restrictions on borrowing permits, and the fact that most permits will have to be paid for, will incentivise emitters to 'bank' their allowances from the second phase rather than sell them, thereby creating a supply shortage.

Credit shortage

The squeeze may be further exacerbated by the shortage of carbon credits or offsets, which are generated through the UN's CDM. To date, supply has been limited to 308 million tonnes in the past four years, and EU factories and power stations have the capacity to use 1.4 billion tonnes by 2012.

As the Copenhagen round nears, regardless of price, the market makers will be listening very closely to the dialogue between the US and China, which holds the key to how fast the carbon market develops - and the prize is big.

Carbon market pioneer Richard Sandor, who helped to create the financial futures market, which dwarfs all other listed futures markets at $17,800bn, and is now chairman and CEO of Climate Exchange Plc, said recently: "We're going to see a worldwide market and carbon will unambiguously be the largest non-financial commodity in the world."