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MARKET SURVEY

Here comes Uncle Sam

19 December, 2008

The Clean Development Mechanism is a mess, uncertainty clouds the EU Emissions Trading Scheme, and the world’s on the brink of recession – but at least the Americans are getting on board. Mark Nicholls talks to the winners of Carbon Finance’s 2008 market survey

Only a few years ago, many carbon market proponents feared it might never happen. But 1 January 2008 ushered in the beginning of the Kyoto Protocol commitment period, marking the imposition of greenhouse gas reduction targets on much of the industrialised world.

January also marked the beginning of Phase II of the EU Emissions Trading Scheme (ETS), on a firmer footing than the first phase, which was plagued by an oversupply of carbon dioxide (CO₂) allowances. And the year ended with the election of a US president committed to reversing his predecessor’s foot-dragging on tackling climate change, and to introducing a federal cap-and-trade system.

But it wouldn’t be the carbon market if participants weren’t also fretting about difficulties in getting projects done, and looking forward anxiously. A growing number of project developers and investors are despairing of the Kyoto Protocol’s Clean Development Mechanism (CDM), with relations between regulators, auditors and developers at their worst.

Proposed reforms to the EU ETS are pitting member states against each other, as they squabble over the possible economic impacts of proposals to auction most allowances from 2013, rather than largely giving them away. And, while many hope that a successor to the Kyoto Protocol will be finalised in December 2009, sage voices are cautioning that agreement might be delayed.

All this is taking place against a backdrop of a recession and continuing distress in the financial markets, which has decimated the ranks of carbon traders and contributed to dramatic falls in prices for EU allowances (EUAs) and certified emission reductions (CERs).

Prices in the EU ETS did, for a time, defy gravity after the turmoil in the wider financial markets during September. However, by mid-October falling oil prices and announcements that major emitters were slashing production finally sent prices crashing, from almost €23/tonne ($33.25/t) for 2008 EUAs on 15 October to €15/t by 21 November. CERs fell from €20.20 to €13.87 over the same period.

“On the positive side, we’ve seen record volumes in 2008,” notes John Molloy, head of environmental products at Tradition in London, which was again voted Best Broker, EU ETS Spot and Futures. While some participants have left the market or dramatically scaled-back, they’ve been replaced, says Molloy, by “a new influx of players” from as far afield as California and the Far East.

The turmoil has also taken its toll on the EUA options market. The market grew rapidly in 2007, but growth has levelled out in 2008, according to Richard Wilson, head of emissions at Tullett Prebon in London, which was voted Best Broker, EU ETS Options. “It’s been a knock-on effect of the global crisis – we’ve seen people pulling out of the options market.”

But, perhaps as a positive indicator of the market’s growing maturity, volumes have remained steady as the typical deal size has increased, he says. In 2007, trades were typically for 100,000–200,000 EUAs, whereas 500,000 is now the standard size, with deals for 1 million–2 million “regularly going through”.

Rob Koltun, principal at New York-based investment manager RNK Capital, says that the departure of some speculative capital has been compensated for by increased use of options by project developers. “European project developers have become slightly more risk averse,” says Koltun, whose firm was voted Best Trading Company, EU ETS Options. “If they want to get bank financing on a CDM project in Asia, for example, they’re buying puts on CERs,” which give them the right to sell CERs at a fixed price.

Some traders believe that the market could be in for a long haul back to buoyancy, at least in price terms. “I think [EUA] prices next year will remain below €20/t and will be range-bound and difficult to predict unless something crazy happens to oil and gas prices,” says Louis Redshaw, head of environmental markets at Barclays Capital, which once again was voted Best Trading Company, EU ETS.

The drop in EUA prices has hit the CDM hard, given that buyers in the EU ETS account for the lion’s share of demand for CERs. This was particularly so when the spread between EUAs and CERs was wide, which made it attractive for utilities to sell EUAs and buy cheaper CERs, and pocket the difference. But, argues Simon Dent, London-based head of European power and gas sales and trading at French bank BNP Paribas, voted Best Trading Company, Kyoto Project Credits, the fall in prices has brought some reality to the market.

“The spread has contracted from as high as €10 – it drove a lot of swap business,” he says. “But some of the prices asked for in the primary market ... I felt were too high, and didn’t factor in [an appropriate] risk premium.”

“Arguably, the CDM market had seen people paying much more than primary CERs were worth,” adds Redshaw. “That was only possible because people had an evangelical view of carbon, and believed the price could only go up.”

However, falling prices are exacerbating problems for developers, as the ‘2012 cliff’ nears. “Unless we get some clarity on what happens after 2012, it’s possible that projects will stop being developed,” says Lucy Mortimer, global manager of CDM and Joint Implementation at TFS Green, part of Tradition, which was voted best broker in this category.

“A few buyers are contracting post-2012 [reductions], but not enough. And the number of buyers prepared to take risk has come down with the removal of some of the banking teams,” she adds.

“The legislative position regarding the post-2012 environment will be the driver of trading in the EU ETS next year,” says Peter Zaman, a partner at law firm Clifford Chance, voted Best Law Firm, EU ETS, for the second year running. Once the rules are in place for Phase III, which runs to 2020, “there will be a much longer investment window ... and it will encourage a lot of people to think about how to manage their volume.”

Meanwhile, frustration among project developers and investors at the speed of the CDM project approval process is threatening to boil over – with the latest bombshell being the temporary suspension of DNV as a ‘Designated Operational Entity’ (DOE), a verification company approved to carry out mandatory audits of CDM projects. In early December, accreditation was withdrawn after a CDM Executive Board spot check threw up a number of non-conformities with CDM rules, largely relating to internal audit procedures (see CDM market rocked by suspension of leading verifier).

DNV – which claims to have verified 50% of CDM projects, and which was voted Best EU ETS Verifier – stated that it was “taking action to regain accreditation”, which it hoped to do by February.

However, while the Board is under pressure to tighten up the environmental integrity of the CDM – amid claims that many projects would have gone ahead regardless of the mechanism – market participants are growing increasingly frustrated with how the system is operating.

“The Marrakech Accords foresaw a system with thousands of projects – but the Executive Board has reverted to a project-by-project approach. It doesn’t work,” says Robert Dornau, director of the climate change programme at SGS, which was voted Best Verifier, Kyoto Project Credits. “I’m not saying that every DOE does a good job, but the crux of the problem is that instead of fixing the system, they are trying to fix the wrong end.”

“It’s taking longer to get projects approved, so we’re seeing more disputes about deals,” says Martijn Wilder, a Sydney-based partner at Baker & McKenzie, which won a number of best law firm placings, including for Kyoto Project Credits. “It’s taking so long, the market price [for CERs] has changed.”

His London-based colleague Graham Stuart is also critical of the system. “The Executive Board are described as regulators, but they are one of the strangest regulators I’ve ever seen. There’s a lack of transparency in how they make their decisions, and there’s no come-back for project developers.”

However, while uncertainty clouds the outlook for the EUA and CER markets, the prospects for carbon trading in North America are unquestionably much brighter now than 12 months ago. Although both presidential candidates supported the introduction of a federal cap-and-trade programme – McCain co-sponsored one of the first legislative cap-and-trade proposals – many analysts considered an Obama win to be more likely to lead to speedy and rigorous action on cutting emissions.

And, despite fears that the economic crisis in the US would push climate change down the agenda, Obama has signalled that a cap-and-trade system could be an integral part of a recovery package.

“The administration is trying to connect climate change policy, energy security and the revitalisation of the economy,” says Ken Berlin, head of the environment and climate change practice at Skadden, Arps, Slate, Meagher & Flom, voted Best Law Firm, North American Mandatory Markets. “This augurs in favour of fairly quick action on cap-and-trade.”

Berlin predicts that a federal cap-and-trade system will cover as much of the economy as possible, and will have a significant role for offsets, both domestic and international. “The international community is looking for signals from the US ... and Obama is keen to engage. One way to do that is through [opening the door to] projects in developing countries,” he says.

No-one would welcome a significant role for domestic offsets more than Bill Townsend, whose Utah-based company Blue Source was voted Best Project Developer, North America. Its 200-300 million carbon credit portfolio ranges from carbon capture and storage – where the firm made its name – to biomass and alternative fuels. Townsend is expecting competition to hot up in the US offset market in 2009, as clues emerge about what credits are likely to qualify for a federal scheme.

But big questions remain as to when legislation might be passed, and when trading could begin.

“Next year would be aggressive,” argues Steve Fine, vice-president of energy resources at Virginia-based consultancy ICF International, which won Best Advisory places in a number of categories. “There will be a flurry in 2009, but 2010 would be more likely ... partly because of how big a job it will be.” And ICF’s view is that 2015 is a likely start date for caps to be introduced.

This makes regional programmes, which are more developed, of greater importance, he believes. From January, CO₂ emissions from power plants in 10 north-eastern states will be controlled under the Regional Greenhouse Gas Initiative (RGGI), and California’s AB32 legislation will see a cap-and-trade programme introduced in 2012. California is also part of the Western Climate Initiative, a coalition of US states and Canadian provinces aiming to reduce their collective emissions partly through carbon trading.

“In the past, we thought these would be quickly subsumed into a federal programme. Now, it’s clearer that they may be around for some years. That opens a whole flurry of questions – will there be federal exemption, will there be transfer of credits, what sort of offsets will be eligible, what will happen to auction revenues from existing schemes?” says Fine.

And RGGI trading is hotting up, says Lenny Hochschild, a managing director at Evolution Markets, voted Best Broker, North American Mandatory Markets. The first trades happened early in the year, but after the first allowance auction in September, volumes picked up, and average around 100,000 tonnes a day.

“Trading is still fairly illiquid, and the amount of risk is still very modest ... but it’s the fastest commoditisation of a market we’ve seen. It’s very quickly gone from an esoteric non-transparent market to one where two exchanges [the Chicago Climate Futures Exchange and the Green Exchange] are quoting prices,” he says.

“We’re extremely optimistic about the US market, more so than ever,” says Hochschild. However, he declines to hazard a guess when a federal system might start. “But the date of the start of the cap is less important than the message that the US is back,” he adds.

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