Revive derivatives in carbon credit

Carbon credit derivatives (futures) trading was introduced on the Indian commodity markets in January 2008, but the market failed to develop. Slowly, over time, the carbon derivatives market died naturally.

What was the reason? Once we know the reasons, can we create enabling conditions for such a market to flourish in India? As such, the corporates in the developed world or the Annex-I nations are supposed to meet the carbon emission targets set by their respective governments.

The carbon market creates the opportunities for companies, which are unable to meet their emission targets, to purchase these carbon credits from the market i.e. from some other institution/individual who conform to the targets by emitting below the ceiling levels, and therefore, has surplus of credits.

A developing nation such as India, therefore, turns out to be a seller of such credits, which eventually provides them with monetary gains.

UNFCCC signatory “Emission reduction”, eventually, was being treated as a commodity all across the world, and received greater sanctity with the Kyoto Protocol.

India comes under the third category of signatories to United Nations Framework Convention on Climate Change. India became a signatory to the Kyoto Protocol in August 2002. The next few years witnessed watershed events with India emerging a world leader in reduction of greenhouse gases by adopting Clean Development Mechanisms (CDMs).

Certain estimates even stated that if India would have been able to capture a 10 per cent share of the global CDM market, annual CER revenues to the country could range from $10 million to $300 million.

No doubt, the carbon market created a solid foundation for sustainable development financing through the market mechanism.

The concern, however, arises from the perspective of the derivatives market. Let us look at the present statutes, and the type of participation.

First of all, the commodity derivatives markets are regulated by the Forward Contracts (Regulation) Act, 1952, which allows for trading only in plain vanilla futures. Secondly, institutional and foreign participations are not allowed.

Now, let us look at the nature of the international carbon market. Indian industries are essentially sellers of the credit, while corporates in the developed world are the buyers. From that perspective, these buyers would have been taking a short position in the carbon futures market, to hedge against the risk involved in the carbon price fluctuations in the physical carbon market.

The problem arises from the fact that this segment of players cannot participate in the Indian commodity derivatives markets. Hence, the derivatives market, from the hedgers’ perspectives, becomes one-sided, and a buyers’ market (a market with too many short positions, compared to the long positions), considering the equal and opposite position of the physical market buyer.

Speculators, while taking hedger’s risks, have to take only buying positions. Theoretically, therefore, it is very difficult for such a market to finally result in any type of delivery, which can result in the divergence between the physical and futures prices, thereby resulting in a high basis risk on the one hand, and low hedging efficiency, on the other hand.

Derivatives market Further even, what might be the incentive of a speculator to participate in a low liquidity derivatives market? As such, ever since the process of global de-growth started post-2008 financial crisis, the global demand for carbon credits had been on a decline, with a fall in prices.

As a result, the demand for a derivatives segment (or a risk management instrument) for such a “commodity” should also be on decline, . This naturally would result in low liquidity in the carbon derivatives markets in a phase of de-growth.

It is now pretty clear that why carbon credit futures did not work in the Indian derivatives markets.

First is that foreign participation is not allowed in the Indian commodity futures market. Second is that the timing of the launch of the carbon derivative somehow did not fit well with the global growth scenario.

The remedy lies essentially in the problem. If carbon derivatives are to be traded, then ideally it should either be traded after the passage of the Forward Contracts Act Amendment, which would help foreign participation in the Indian commodity exchanges, or they should be traded in dedicated climate exchanges that should allow genuine foreign hedgers to participate.

The timing is also important here. A global de-growth situation is essentially associated with less of economic activity resulting in low carbon emissions, thereby constraining the carbon credit demand, limiting the growth of derivatives markets.

Hence, probably a better global economic situation should be looked at while launching a derivative product like this.

The writer is Chief Economist at MCX India Limited. Views are personal

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