The outlook for carbon markets post-Copenhagen
Global media attention was firmly focused on the Danish capital for two weeks in December last year as world leaders gathered in an attempt to come up with solutions to probably the greatest challenge yet faced by mankind: How to reverse the damage that we are doing to our planet as a result of our thirst for energy.
Expectations for the conference had been overhyped, and for some time those close to the process had been warning that prospects of a conclusive deal were unrealistic. Still, we remained optimistic that, with the new American administration in place, a binding agreement may have been forthcoming.
In the end it appeared that political tensions, beyond the climate issues that were on the table, made an agreement impossible. It ended with plenty of good words and a series of new deadlines set for pragmatic steps forward, but there was no finalised agreement.
Whilst this is clearly disappointing and must be seen as an opportunity lost, in reality many believe that it is only a small stumble in the inevitable march towards broad adoption of mandatory caps on emissions by all nations.
Cap and trade
When trying to understand cap and trade mechanisms, there tends to be a disproportionate amount of attention paid to the “trade” part of the equation. With volatile prices and high-flying dealers making and losing large sums of money, it may be inevitable that organizations such as ECX become the focus of protests by those concerned that not enough is being done to combat climate change.
But the protests are somewhat misguided – the important (and difficult) part of cap and trade is the “cap”. It has been shown that it takes great political leadership to put caps in place and therefore to assume additional costs. So far, it has only the 27 members of the European Union which have been brave enough to apply such measures. The mandatory caps on the amount of carbon that can be emitted by certain industrial sectors are set by politicians in consultation with scientists. It is these caps that reduce the overall amount of carbon going into the atmosphere, and their existence creates a price risk which is managed through a market mechanism, in exactly the same way as other commodities.
European Emissions Trading Scheme (ETS)
The EU introduced an experimental version of their ETS in 2005. Whilst it had numerous problems and was heavily criticized, the so called phase 1 scheme highlighted many problems that were then avoided when the current phase 2 scheme was introduced to correspond with the Kyoto period (2008 – 2012). The European mechanism only covers the biggest 5 polluting industries (accounting for 46% of European emissions) but will be extended to other industries over time – airlines are next on the list and will be eased into the scheme from 2012.
There is an absolute cap on the total amount of “permits” (known as EUA’s or European Union Allowances) that are issued each year and the number is reduced each year to meet the required reduction target. But within the overall limit, industries can trade between themselves and via intermediaries. This means that those who are able to find cleaner ways of producing electricity (and therefore require less permits) can sell their excess to industries which have been slower to transition to new operating methods. The efficient get incentivized, the inefficient are penalized – through this simple mechanism the process of change is encouraged and the evolution to cleaner power sources is speeded up.
This trading activity encourages other parties who are attracted by the arbitrage, investment or speculative opportunities. Their involvement makes the market liquid, allowing industry to effectively manage the carbon risks.
As can be seen on the volume graph below, the trading activity on ECX (where the vast majority of activity takes place) has grown dramatically since the first trade took place in early 2005, with over 5 billion tonnes changing hands in 2009.
Rest of the World
Although international agreement was not achieved in Copenhagen, there is nothing to stop individual countries from imposing mandatory caps. Several countries are in advanced stages of design and have drawn from the European experiences.
The US administration is pushing ahead with trying to impose Federal level caps despite the best efforts of the powerful energy lobby. Canada and Australia seem to lack the political bravery required to go it alone, but there seem to be more encouraging signs from Asia.
The change in the Japanese administration in the middle of 2009 has resulted in a new commitment to carbon reduction measures, and it may be first Asian country to impose a full cap and trade scheme. More recently South Korea, which has been elevated into developed nation status, appears to be moving swiftly to develop its own scheme. Korean industrials have been quick to apply their minds to how they can use such a scheme to help them with long-term growth.
Also encouraging is that China is increasingly engaged on climate change issues. Whilst the Chinese have been portrayed as the “bad guys” at Copenhagen, on the ground they are in fact taking the issues very seriously. Initial focus has been on the local level pollutants (sulphur and nitrous oxide) which have such an obvious impact on city air quality, but there is also growing thought being applied to the invisible, but much more damaging, carbon problem.
Climate change is not going away. The scientific community is united and has given us a clear message that the “good ship Earth” is heading for a cliff. Cap and trade mechanisms can help us change direction at a manageable speed and with the lowest economic impact. So, whilst the failure to reach agreement in Copenhagen is an opportunity lost, it should not stop the process of developing market-based mechanisms to help us avoid future catastrophe.
About Patrick Birley
Patrick Birley was appointed Chief Executive of ECX in July 2007. Patrick has previously CEO of LCH.Clearnet Limited, the London based multi-asset class clearing house. Prior to this he held senior management positions at the London Metal Exchange (Director of Strategy) and FTSE Group (Director of Operations). Patrick started his financial markets career as the second employee of the fledgeling South African Futures Exchange (SAFEX) in 1989, and was appointed as the youngest Chief Executive of any financial market in early 1999. Patrick was a key player in the SAFEX development into one of the most active derivatives exchanges in the world.