The UN climate meeting in Cancun last December was widely viewed as being more productive than the 2009 event in Copenhagen, but many in the carbon trading markets came away feeling that too little had been achieved.

After all the grip-and-grin photographs had been taken at United Nations climate meeting in Cancun, Mexico, in December, the results seemed to be mixed. Despite what many called a major step in putting the UN climate negotiations back on track, most said the work required for a new agreement still needs to be completed.

The next major meeting is set for Durban, South Africa in December this year, and it is already drawing Copenhagen-like expectations as the breakthrough event. But before the hype gets out of control, it is worth exploring what was achieved in Cancun.

Minimal impact

The biggest question in the markets trading CERs (certified emission reductions), especially the UN's Clean Development Mechanism (CDM) and the EU Emissions Trading Scheme (EU ETS), is what impact the Cancun meeting had in these areas. In the short term, the answer is very little.

"Cancun had little impact on the EU and CDM markets because it did not enable anyone to better estimate post-2012 supplies of project credits to post-2012 buyers," says Olivia Hartridge, vice-president specialising in fixed income at Morgan Stanley. "To do this, you need answers to questions such as: will countries agree there is an adequate legal framework for continuing to issue CERs post-2012 under the Kyoto Protocol? Will the CDM, or an updated version of it, be replicated under a new UN agreement?"

Cancun's main value, adds Ms Hartridge, was keeping pressure on non-EU countries to reduce their emissions.

Trevor Sikorski, carbon analyst for Barclays in London, says the Cancun agreements provided some guidance on what is coming up for the global markets.

"It accomplished more than we expected," says Mr Sikorski. "It made progress in certain areas, such as monitoring, reporting and verification for developed and developing countries. We saw CDM reform, for example, the endorsement of standardised baselines."

Ronald Reagan was famous for his dealings with the Soviets, in which he remarked, "trust, but verify". The carbon world has been going through its own version of this as countries attempt to set carbon limits and verify them. In previous UN meetings, verification has been a key sticking point between the largest carbon emitters (China and the US). But in Cancun, China offered to codify its carbon commitment and allow external parties to verify it. This was arguably the most significant advance in Cancun. In other words, progress on verification could provide the foundations for the next UN agreement, or serve as a cornerstone for bilateral agreements on carbon.

Areas of progress

Another area of progress is in the streamlining of the rules for carbon offset projects, such as wind and solar power, that remove carbon emissions. The previous whimsical and meandering rule findings under the CDM have been frustrating for project developers and unsettling for banks and investors in these projects. Under the new agreement, "standardised baselines" will be set, making it easier for project developers to determine which projects are eligible for carbon credits.

Historically, projects have also been hurt by UN delays in the processing of various project applications. This caused a significant backlog of projects and, in some cases, the UN has reversed its approval of projects that were already granted. In January, the UN announced that it would rule on projects and check them within 30 days – down from about 90 days, although some took even longer. Groups such as the Carbon Markets & Investors Association (CMIA), which represents banks and investors in the carbon space, applauded the move, even though it missed the Cancun meeting's target of 15 days.

"We strongly encourage the [UN's CDM executive board] to carry on aggressively with its reforms," says Christiaan Vrolijk, vice-chair of the CMIA's financial mechanisms and international architecture working group, and principal carbon emissions specialist at Carbon Resource management. "In cutting down the average time between the receipt of a submission and the commencement of the completeness check to 30 days, the CDM executive board exceeded our expectations and we hope it will continue with this pace of reform."

Code Redd

Another contentious (and some say critical) issue to the global carbon markets is REDD (reduced emissions from deforestation and degradation), on which Cancun made some headway.

REDD will be implemented in a three-stage process: phase one involves countries building a national capacity plan; phase two is the implementation of the action plan; and phase three involves the monitoring, reporting and verification of emissions reductions.

However, the position of forestry offsets within the global carbon market remains uncertain. Long debated by UN participants, some want REDD rules and regulations to integrate forestry offsets within the CDM, which would enable offsets to be traded in the same carbon markets. Others are vehemently opposed to tying forestry offsets to carbon markets in this way.

As a result, the Cancun agreements dropped specific wording, at the behest of Bolivia, that explicitly allowed REDD offsets to be integrated into the carbon market. But as there is no explicit prohibition of tying REDD to market mechanisms either, it looks as if this is another issue that has been kicked down to Durban in December. Currently, the EU ETS does not plan to accept REDD offsets.

However, the lack of clarity over such issues is having a direct impact on investment. Meg Brown, climate and sustainability analyst at Citi, says the ongoing uncertainty surrounding REDD has made Citi generally wary about such forestry offset project investments.

"We've been quite sceptical of the investment opportunity in REDD because we don't really know how and where the permits are going to be sold," says Ms Brown. "Now that you have the market mechanism wording dropped, that basically means it is irrelevant for investors. I'm surprised by it, because ahead of the UN meeting, it seemed like we were nearly there and this was going to be a breakthrough at Cancun."

Kicking the can

Perhaps the biggest sticking point left from Cancun focuses on the post-Kyoto Protocol agreement and whether to carry it beyond the 2012 expiration. Countries such as Canada and Japan, which are not likely to meet their Kyoto emissions reduction targets, are adamantly opposed to extending the agreement. The US and Russia are in the same camp. Developing countries, however, would like an extension, because the agreement requires developed countries to take action before emerging economies.

Yet the final wording in the Cancun agreements supported continued market-based solutions for greenhouse gas emissions. For market participants, this is a positive signal of future intent.

"To most observers, that's about as strong a statement as we can get for the CDM, given the legal complexity," says Abyd Karmali, global head of carbon markets at Bank of America Merrill Lynch. "Coupled with the EU's very strong statement that compliance buyers and the EU ETS can continue to rely on CDM up until 2020, subject to quantitative and qualitative restrictions, there is enough comfort out there in the CER value chain."

All of this provides some support to the EU ETS, which continues to push forward into its planned phase three, beginning in January 2013 and running to the end of 2020.

This phase is the most crucial to the EU ETS, as it is designed to deliver two-thirds of the EU's 20% emission reduction target by 2020, from 1990 levels. This means that by 2020, the EU ETS will be saving 500 carbon dioxide-equivalent metric tonnes a year, making it the biggest single policy instrument for addressing climate change in the EU.

Under phase three, the EU will move to a centralised EU-wide cap (rather than a national limit) on emissions, and will begin to auction emission credits. At least half of the allowances will be auctioned from 2013, compared with 3% in the current phase. Across most of the EU, there will be 100% auctioning to the power sector.

Currently, polluting entities are allocated emission credits, or allowances, by their national government. To meet reduction caps, a company may purchase additional EU and international trading credits; but if it has met emission caps, a company can sell its credits in the open market. Having to buy credits, rather than be allocated them, is seen as crucial to improving the environmental effectiveness and economic efficiency of the EU ETS.

The aviation and shipping sectors will be folded into the EU ETS from January 1, 2012.

Phase three will also put a cap on use of CDM credits from outside the EU, which will be limited to no more than 50% of the reductions required in the EU ETS, reducing the role of the UN's CDM as an offset source. This is a massive reduction for participants, because the current phase allows companies to offset their emissions up to 226% elsewhere. So, the move to tighter and more centralised caps on emissions will mean a tighter market.

Long-term approach

Mr Karmali at Bank of America Merrill Lynch says his clients are taking a more holistic and long-term approach to carbon reductions.

"Most of the companies we deal with are looking at a whole suite of measures to reduce their own carbon footprint," he says, adding that one power plant in the EU is looking at accelerated maintenance of boilers, co-firing coal with biomass, securing and building its own long-term biomass plant and importing CERs. "So there are a whole range of measures companies are taking to reduce carbon intensity over time, recognising that this is not just a short-term challenge."

What it all points to is a maturation of the carbon markets in Europe. The EU ETS continues to lead the world in terms of trading and integration with other markets such as power, natural gas and coal.

Total transaction volumes in the global carbon market slipped to 7 billion tonnes (also known as gigtonnes) in 2010, down 12% from a year earlier, according to a January report by market analyst Point Carbon. The total value of the market for the year was almost flat with an estimated value of €92bn, reflecting the global economic slowdown.

The EU ETS remains the largest emissions market with 5.2 billion tonnes traded in 2010, down 4% from a year earlier. The total value for that market was €72bn in 2010, up 4% from 2009, at a weighted average price per tonne of CO2-equivalent of €13.99, according to Point Carbon. The CDM accounted for most of the remaining market activity, with 1.5 gigtonnes trading, down 5%. Notional value was worth €18bn, up 3%.

Appetite for change

As companies prepare for the coming EU ETS changes, and perhaps a new UN agreement, the markets look poised for not only higher carbon prices, but also more participation from companies looking to hedge their carbon price risk and more speculators looking for markets that complement their energy portfolios.

David Peniket, president and chief operating officer at futures exchange ICE Futures Europe, says this reflects a market that has embraced and integrated carbon trading like almost any other commodity. "The risk managers at utilities and companies are managing their risk every day on the basis of: what is the price of power, coal and carbon. It's part of the energy-related complex," says Mr Peniket, whose exchange acquired Climate Exchange (which included the European Climate Exchange) in July 2010.

Globally, the industry believes other carbon markets will likely emerge in the coming years. In the US, despite Congress shooting down a bill for a federal carbon market, states such as California are ushering in state and regional markets anyway.

"This is an interesting time for the carbon markets," says Morgan Stanley's Ms Hartridge. "On the one hand, we have no chance of a US carbon market [and] we have some questions about the long-term viability of the CDM. On the other, we have countries such as South Korea, Japan, Australia and a few others looking to create a market-based carbon price. California looks likely to launch a carbon market, as well as South Korea. China could well surprise everyone. So we are still heading towards growth, but a slowdown in the pace of growth was inevitable in the current economic climate."

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter