This may be the year when carbon trading enters center stage. Growing interest in emissions trading is emerging not just in Europe, but also in the United States and globally. This still young market could see a shake-up as experienced exchange operators, such as Climate Exchange plc and Nord Pool, are challenged by a host of newcomers.
Today, NYMEX Holdings, in partnership with several investment banks and brokers, launched carbon derivatives trading on a new "Green Exchange" in New York. This is the first real challenge to U.S.-based Chicago Climate Exchange, owned by Climate Exchange plc, and is bound to spark new interest in potential growth for the U.S. carbon market. Last month, New Carbon Finance, a research firm, predicted that the U.S. carbon market could be valued at $1 trillion by 2020 if Congress passes a federal "cap-and-trade" system after the next presidential election.
Emissions trading markets allow polluting companies in countries regulated by the Kyoto Protocol to pay others to cut greenhouse gas (GHG) emissions on their behalf to meet emissions reduction targets. Companies in unregulated markets can also make voluntary commitments to reduce their emissions and trade on exchanges such as the Chicago Climate Exchange.
As pressure mounts for negotiators to agree on a post-2012 successor agreement to the Kyoto Protocol, exchange operators and banks are quickly seizing new opportunities. The value of global carbon markets grew by 80 percent from 2006 to 2007, reaching $60 billion in 2007, according to consulting group Point Carbon. This market is expected to continue to grow rapidly, and extend from Europe to the United States.
Several factors are driving this trend. For one, the likely presidential nominees in each party are backers of cap-and-trade legislation. After Sen. John McCain emerged as the Republican candidate for president on the Feb. 5 "Super Tuesday" primary, the price of carbon dioxide traded on the Chicago Climate Exchange jumped from $2.70 for $4.50 per ton. Like his Democratic counterpart, Sens. Clinton and Obama, McCain has pledged to make passage of climate change legislation a hallmark of his presidency. In addition, this bolsters the chance that the United States will be an active participant in the "Bali Roadmap" for a new global climate agreement, and open the door to new carbon trading markets at home and abroad.
Europe vs. the United States
Even without an international post-2012 agreement, Europe is committed to moving ahead on its own. In January, the European Commission announced its proposal for emissions reduction targets to 2020 as well as an update to the European Union Emissions Trading Scheme (EU-ETS). Given that carbon prices for the first phase of trading (2005-2007) collapsed in 2006 due to an oversupply of emissions allowances to affected entities, Europe is now focused on tightening targets, reducing the free allocation of permits and expanding coverage to new industries, including airlines, in the next round (2008 2012), which coincides with the first binding limits under the Kyoto Protocol. The Commission's proposal still needs approval from national governments and the European Parliament, and extensive debate is likely to continue.
Meanwhile, as the United States awaits adoption of its own federal climate legislation, the focus is on voluntary markets, including the Chicago Climate Exchange and a market in Renewable Energy Certificates (RECs) that is meant to spur alternative energy investment. Twenty-seven states plus the District of Columbia have Renewable Portfolio Standards in place that drive the REC market. Additionally, 10 states in the Northeast and Mid-Atlantic region have agreed to a cap-and-trade program to control power generation emissions starting in 2009 under the Regional Greenhouse Gas Initiative (RGGI). And finally, the Chicago Climate Exchange also announced plans in May 2007 to launch the California Climate Exchange, which will support that state's mandatory reductions under the California Global Warming Solutions Act, or AB32. At the same time, several states, including participants from Canada and Mexico, have moved towards standardized corporate emissions reporting through The Climate Registry, a non-profit agency that aims to provide transparency in emissions accounting.
This range of trading options has created a wide variance in carbon prices. A ton of carbon dioxide traded voluntarily on the Chicago Climate Exchange now trades for just over $5, for example, while an equivalent contract on the European Climate Exchange, also managed by parent company Climate Exchange plc, fetches around $35. The main reason for the disparity is that the European trades count toward emissions reductions under the Kyoto Protocol, whereas the U.S. trades do not.
But this all could change after this fall's national elections, and several U.S. banks are already preparing for the future. As one the world's two largest GHG emitters (along with China), the United States is expected to quickly surpass Europe in carbon trades as its key industries become regulated. Banks are eager to step in as intermediaries, and many are buying up carbon credits to sell to industry and national governments later on. Morgan Stanley, for one, has announced plans to commit approximately $3 billion over the next five years to buying carbon credits and developing emissions reduction projects. Several other U.S. and international banks are also building carbon credit portfolios and offering brokerage services for clients, including Barclays plc, Citigroup, Credit Suisse, Deutsche Bank, Merrill Lynch and Morgan Stanley.
Here Come the Exchanges
The most recent trend, however, is for the world's leading commodities and securities exchanges to carve out a piece of the carbon-trading pie for themselves. These players realize that along with standard carbon credit allowances will come numerous derivative products as carbon begins to trade like any other commodity. The first announcement came in October 2007 when NYSE Euronext said it will join with Caisse des Dépôts, the state-owned French financial institution, to launch BLUENEXT, an international carbon credit exchange. BLUENEXT launched in January 2008 with spot market offerings and aims to add futures contracts in the second quarter of 2008. BLUENEXT is likely to benefit from the global reach of NYSE Euronext, and will probably look to expand to both North America and Asia.
NYMEX Holdings, owner of the New York Mercantile Exchange, followed in December 2007 by teaming up with Morgan Stanley, Credit Suisse, JPMorgan Chase, Merrill Lynch and three other firms to set up The Green Exchange–launched today. Futures contracts are available for trading on the CME Globex electronic trading platform, while options contracts trade on the NYMEX trading floor. Initial contracts will focus on United Nations-approved and voluntary carbon credits, while future offerings could include bio-fuel and reforestation credits. Such liquidity will allow even more investors to take a position in climate change-based markets.
Climate Exchange plc, which owns the main European and U.S. exchanges, says it expected such competition, but also has to be wary of this new competition. NYMEX, for example, will offer energy traders seamless access to oil, gas and carbon trades, as well as its own clearing platform for exchange and over-the-counter (OTC) transactions. This is an important consideration, as the European Climate Exchange is just now offering Certified Emission Reduction (CER) futures through ICE Futures' platform after a prolonged conflict with clearinghouse LCH Clearnet was settled in late February. Meanwhile, European Energy Exchange is set to launch CER futures trading on March 26.
On the other hand, Climate Exchange has unique experience with voluntary credits, a lead in the U.S. SO2 and NOx markets with the Chicago Climate Futures Exchange (CCFE), and the ability to link regional markets. The firm also plans to start the Climate Spot Exchange (CSX) to capture expected growth in spot trades. Meanwhile, these environmental exchanges may not be able to avoid continuing consolidation among financial exchanges. CME Group, the parent of the Chicago Mercantile Exchange, announced an $11 billion buyout proposal for NYMEX in the last week of January. The companies are expected to vote on a potential merger today.
Developing Markets Also Have a Role to Play
None of this will stop developing countries from also trying to participate in this burgeoning market. India's largest commodity exchange, Multi Commodity Exchange of India, announced in January that it will offer European Climate Exchange (ECX)-based futures contracts. This will allow local emissions reduction project developers, who generate credits under the Clean Development Mechanism (CDM) of the Kyoto Protocol, to hedge against price risk. For example, if an Indian firm reduces emissions through a landfill methane gas capture project and enters into a futures contract to deliver the resulting carbon credits, the firm can ensure that there is no loss in credit revenues by purchasing European allowance futures contracts.
In fact, with China and India currently dominating the market for CDM project development, it is possible that Asia will emerge as a major carbon trading center. The Hong Kong Stock Exchange has announced plans to partner with an international exchange in emissions trading. New Zealand already has a regulated scheme that mirrors the EU-ETS, and Australia expects to start trading in 2011. Most recently, the Tokyo Stock Exchange and the Tokyo Commodity Exchange have agreed to jointly study the possibility of creating a domestic trading market.
However, it remains to be seen how demand for credits in Asia will grow if many companies there are not faced with emissions caps. Moreover, the European Commission is keen to cut back on developing world credits used for Kyoto compliance so that more utilities and industrial firms shift their technologies at home. Accordingly, many issues still need to be resolved before the future of global emissions trading becomes clear.
What is certain is that these markets, and their growth potential, are ultimately dependant on government regulation. If there is enough continuing support from exchange operators and brokers to spur such market-based solutions to climate change, it may just be the financial sector that acts as the catalyst for a new "green" revolution in our increasingly carbon-constrained world.
*This article represents the views of the author solely and does not purport to represent the views of RiskMetrics Group or its clients.