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Opalesque Exclusive: Carbon and emissions trading in Europe, Part One - How the Europeans do it

Posted on 29 June 2009

Benedicte Gravrand, Opalesque London:As public awareness of climate change issues is growing and market-based solutions are increasingly seen as the key to delivering pragmatic change, the trading business is booming.

The London-based European Climate Exchange (ECX) is seeing increased interest in emissions trading from the investment management and hedge fund community. Indeed, volumes on ECX are experiencing tremendous growth.

ECX, a marketplace for trading carbon dioxide (CO2) emissions in Europe and internationally, currently trades two types of carbon credits: European Union emissions allowances (EUAs), which are created and allocated; and Kyoto Certified Emission Reductions (CERs - aka ‘carbon credits’), which are earned from actual emissions reduction projects and which are issued by the UN.

Trading on ECX began in April 2005 with EUAs, and futures and options on CERs were introduced in 2008.

Capping and trading in pollutants Emissions trading, also known as cap-and-trade, is used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants, whereas a central authority sets a limit, or ‘cap,’ on the amount of a pollutant that can be emitted and issues emission permits to companies. Companies that need to increase their emission allowance must buy credits from those which pollute less. The transfer of allowances is referred to as a ‘trade.’

According to ECX’s CEO, Patrick Birley, talking from his offices in the City of London at a presentation last month, cap-and-trade is a system accepted as a mechanism to be used under the Kyoto Protocol - a 1997 international treaty which came into force in 2005 and which binds most developed nations to a cap and trade system for the six major greenhouse gases - and it is not well understood.

“It’s the ‘cap’ that’s the clever bit: it drives reduction in amount of emission, and it is incredibly complex to put in place,” he said. ECX is involved in the trade-side of the business. The emissions business introduces a way to limit emissions being pumped into the atmosphere, he explains.

The ‘cap‘ process consists of: 1. Measuring - thus creating a shortage in something that was always deemed to be limitless. That requires great political leadership as those covered will naturally resist (depending on local factors); 2. Licensing - like a license to pollute. These allowances will be slowly reduced over time, and industries will just have to adapt. 3. Limiting supply - which will never be truly fair.

Those that do well will end up with extra carbon permits they will be able to sell. Those that continue polluting at old levels will have to pay, and the charges will increase as the supply is squeezed. The overall improvement is the quantum of the reduced supply, Birley explains.

The ‘trade‘ part of the business brings buyers and sellers together, creating a price formatting mechanism. It provides transparency and liquidity, allows active financial risk management, and facilitates the monetisation of excess credits. It can be done on ECX, which is, in this respect, like any other exchange.

“Cap and trade is a U.S. invention,” explains Birley. “It came together with acid rain (sulphur) in the early 1990s. We don’t hear about acid rain anymore, which means major changes happened through the introduction of cap and trade.”

EU Emissions Trading Scheme The 27 Europeans member states put in a trial system between 2005 and 2007 - namely, Phase I of the EU Emissions Trading Scheme (ETS). It was an experimental phase but “phenomenally successful,” as emissions were reduced by an average of 8%, but it pointed at two major flaws: 1) too many permits were allowed and prices thereby declined; 2) permits with ends-date, if there is an over-supply, become worthless.

Phase II of the European experimentation takes place between 2008 and 2012 during the Kyoto Protocol’s given period (each participating country agreed at the Protocol to reduce overall emissions (cap) by 5.2% of their 1990 levels by the end of 2012.)

According to Birley, the European Union, which has since Phase I reduced its emissions allowance, has already been sued several times by some member states for under-allocation but has won each suit.

12% of allowances can come from the Clean Development Mechanism (CDM), the Kyoto mechanism which allows the creation of carbon credits. “95% of what is in the atmosphere now has been pumped by us in the last 200 years,” he explains. “We must empty it now before China and India start pumping it too. Thus in projects for carbon reduction in the developing world, participants gain credits too.”

Phase III sees the scheme finalising between 2013 and 2020. The European commitment is clear but there are no exact details of target and CDM quota.

“If only Europe participates,” Birley notes, “it will commit to a 20% cut by 2020. If the rest of the world participates, then total reduction could reach 30%.”

Climate exchanges The London-listed Climate Exchange Plc (CLE) heads the Chicago Climate Exchange (CCX), North America’s only cap and trade system for all six greenhouse gases launched in 2003 (see …………………………To view our full article: Click here

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