The Hindu Business Line : Carbon emissions market: A bubble in the boom?

A recent surge of investor interest in the global carbon credit market has created ripe conditions for risk management products. But the rush of money into the green arena has also raised fears of a bubble since share prices — as in the dotcom bubble — have risen in part on the back of future earnings growth rather than solid visible returns.

Sunil Kewalramani

A fundamental change appears to be under way in the world of carbon trading which could see the industry take off in a big way. Globally, companies have fixed emissions limits imposed on them and can offset their excesses by buying allowances in the market.

However, the levels of demand and supply are severely out of balance. This may lead to a radical re-pricing of carbon that will fundamentally alter the political, business and financial landscape forever.

The price of European carbon allowances (known as European unit allowances, or EUAs) has risen only modestly this year, to about Euros 27 a tonne. But market pressures could take the price to Euros 100 a tonne or higher.

The trigger for a rise to a more realistic level is the Euros 100 per tonne fine that comes into force this year, with phase two of the European Union’s Emissions Trading Scheme.

It will be imposed on companies breaching their emissions limits, who will also have to purchase enough allowances to bring them back into line. A possible short-term effect will be a scramble to cover EUAs, triggering the squeeze.

In his report “It takes CO{-2} to contango”, Mark Lewis of Deutsche Bank argues that carbon’s market clearing price with oil at $85 (Euros 55) a barrel and coal at $90 (Euros 58) a tonne is about Euros 40 a tonne.

However, with the actual oil price at about $135 (Euros 87) and coal at $140 (Euros 91), the market clearing price for carbon is Euros 75-80 a tonne — nearly three times its current level. The effects of a re-pricing of carbon will be profound. Carbon will take its place alongside oil, coal and gas as one of the most closely followed commodities in the world.

Governments, the US in particular, will have to join Europe to create a global market for pricing carbon and businesses around the world will have to accept the price the market sets.

This will mark the beginning of externalities being priced into the cost of production.

Surge of investor interest

G8 leaders, on July 8, 2008, set a goal to halve greenhouse gas emissions by 2050. The European Parliament has approved a measure that will be the biggest environmental constraint yet placed on an industry hit the most by increases in fuel costs.

Air travel is now included in the European Unions’ emissions trading scheme from 2012. Airlines, including non-EU carriers, will be issued with permits to produce carbon dioxide.

Carbon emissions trading has the potential to become the world’s leading derivatives product over the next four-five years as businesses in Asia and the US move to lower their greenhouse gas emissions and competition intensifies between exchanges.

In addition, energy security, resource conservation, reduction of pollution and protection of natural habitats are causing governments all around the world to set up carbon trading exchanges and enjoy a piece of the action.

A recent surge of investor interest in the emerging global carbon credit market has created ripe conditions for risk management products, ranging from insurance to derivatives. Traditional corporate buyers and newly created funds, alike, have rushed into the market in recent months.

Trading volume in the so-called Kyoto market rose from 351 million tonnes (mt) of carbon in 2005 to 897 mt in 2007, according to carbon analysts New Carbon Finance. US greenhouse gas emissions contracts grew 131 per cent in 2006, compared with a 31 per cent rise in worldwide futures contracts.

Part of the recent surge has been due to some hedge funds shifting allocation away from other asset classes into carbon credits after the recent credit turmoil. Consequently, investors are expected to pour $4.5 billion into the market for carbon credits in 2008.

A World Bank report issued recently puts the emissions-related trading market at $30 billion for 2006, roughly a day’s trading on the Hong Kong Stock exchange, but the figure was three times greater than a year before.

Critical mass is now available for insurers and other financial institutions to launch diverse products. Credit Suisse launched the first carbon structured product in December 2007 in a joint venture with Dublin-based Eco Securities — essentially a collateralised debt obligation (CDO) that allows investors to choose the level of risk they take on, by tranching the risk that projects will under-perform expectations. Munich Re, the re-insurer, last month teamed up with specialist insurer Carbon Re to offer policies covering the non-delivery of carbon credits, a pioneering move for the Kyoto carbon credit market.

Bubble trouble?

The rush of money into the green arena has raised fears of a bubble since share prices — as in the dotcom bubble — have risen in part on the back of future earnings growth rather than solid visible returns.

Most of the carbon trading so far has been carried out under the EU’s emissions trading scheme, and some under the United Nations system of emissions trading under the Kyoto protocol. The EU’s scheme has not worked quite as intended so far.

In the first phase of the scheme, from 2005 to the end of 2007, permits were over-allocated, meaning most companies had a surplus and thus no incentive to buy permits or to cut emissions. When the glut was discovered, the price of permits crashed from more than Euros 30 to less than Euros 10.

Bigger role for Asian exchanges

Currently, emissions-related trading is dominated by the European Climate Exchange, the world’s largest platform for carbon emissions trading, and the Chicago Climate Exchange.

The establishment of the EU ETS has led to London becoming the global carbon centre with all the major investment banks running carbon trading desks alongside traditional commodity desks.

On the UN’s Web site for the Framework Convention on Climate Change, there is an interactive map showing the location of all the emissions reduction projects under its CDM (Clean Development Mechanism).

China and India are speckled with dots — projects in the two countries account for 65 per cent of the reduction in greenhouse gas emissions achieved by the Kyoto protocol, and therefore, 65 per cent of all the carbon credits generated every year.

It is, therefore, natural that the market for trading in such credits should be brought to Asia from Europe, where most of it now occurs.

The ADB is setting up a $200-million fund, enough to finance about 40 carbon reduction projects, even after 2012, the cut-off date for the Kyoto protocol.

It hopes the move will also encourage other public and private investors to invest in carbon credits that may come on stream after 2012.

Carbon trading, until now subdued is ready to take off in a big way with the emergence of China and India as economic powers and competitors in carbon trading. The stage appears set for world carbon exchanges to enjoy their day in the sun.

The author is CEO, Sunil Kewalramani Global Capital Advisors.

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