Carbon Trading - Show me the Gree$$n

Winston Churchill once said "A lie is halfway around the world before the truth has a chance to get its boots on." While this quote is too harsh to apply to the international emission markets, the following needs to take place at a minimum before a meaningful, liquid market evolves in emission credits:

- The extension of the Kyoto Protocol in 2013 for at least 10 years to include emission caps for the United States, China and India

- Meaningful reductions in greenhouse gases converted into one, fungible instrument known as the 'right to pollute one tonne of CO2'

- A tightening of emission caps in Europe to restore market confidence

- A U.S. Congress and Administration which has federal climate change policy in its platform; this will not happen under the Bush Administration even with the Democrats in control of Congress

- An internationally recognized body to certify emission reductions with the appropriate audit trails.

The European experience is a good case study in the teething pain of nascent, environmental markets.

About three years ago literally anyone with a pulse who could spell the word “Carbon” was able to raise large amounts of money in Europe on the news of the launch of the world’s first compliance market in Carbon Dioxide (CO2) credits. Carbon Dioxide and other greenhouse gases are believed by many scientists to contribute to global warming.

This new market is known as the European Union Emission Trading Scheme (EU-ETS). Now the United States might follow suit. First some background on the European experience:

• The EU-ETS is conceptually very simple. E.U. member states submit a national plan setting forth how the member state’s domestic industry will reduce its emissions of CO2. Permits, or ‘rights to pollute’ known as EUAs, are handed out to all industry players, and those that are ‘short’ [emit over their quota] pay a fine, increasing from €40 to €100, and must go out into the market place to buy a ‘right to pollute’ or EUA from someone else who is ‘long.’ [emit under their quota through emission reduction programs]. Alternatively, if the short player believes it might not meet its targets, it can buy EUAs ahead of time and avoid the fine.
• The European scheme is divided into two phases. Phase I started in 2005 and expires at the end of this year. Phase II starts on January 1, 2008 in sync with the Kyoto Protocol, and ends in 2012.
• Financial players, flush with liquidity from the Japan carry trade and other sources, rushed into Phase I seeking riskier assets. The expectation was that the entire EU system would be ‘short’ so the price of carbon credits, these EUAs, zoomed from about €6 in June of 2005 to €30 in Q1 2006.
• Then national governments started announcing the results of actual emission reductions in April of 2006, and the market was surprised to learn the whole system looked like it was going to be very ‘long’
• The price of an EUA for phase one has collapsed from €30 to a little over €1, leaving a lot of investors holding the bag. Many players simply couldn’t get out of the market during the crash, as the bid-ask spread widened and widened.
• Now Phase II is set to begin, but the ground rules have yet to be finalized. A forward contract for 2008 delivery of an EUA is priced at €15, but it remains to be seen if burned traders from Phase I will support that price.
• The key to a successful emission trading program is for EU governments to set meaningful reduction targets. So far, the jury is out on their willingness to reduce the allocation of EUAs at the expense of EU industry.
• The Kyoto Protocol starts in 2008. Yet Japan and Canada still haven’t finalized their domestic emission reduction legislation. The oil sands rich province of Alberta is seeking one system, at odds with Ottawa.

The United States

Certain states have legislation already in place to create a cap and trade system for CO2. California passed the Global Warming Solutions Act and various North Eastern states, including New York, New Jersey and others (known as the regional greenhouse gas initiative or RGGI) have passed similar legislation. The rules have yet to be finalized.

The passage of successful federal climate change legislation hinges on many factors, including

• That the mood of the nation won’t swing against questioning the science of global warming, and both the Congress and the new occupant of the White House in 2008 agree on a federal bill. On balance, it is probable that the political landscape will be in favor of climate change legislation.
• Any proposed laws must contemplate meaningful reductions in CO2 and other greenhouse gases. Otherwise, a credit that emission traders might believe to be worth $15 may end up with a value of $1
• The United States would probably insist on the inclusion of China, India and Australia, along with the EU, Russia, Ukraine and Japan, as countries with emission caps post-Kyoto. The E.U. is a certainty, the other countries are possibilities, but no deal has been struck with China and India. Why should the US pick up the bill for the fast growing, fast polluting nations of China and India?

Firms of the ilk like Morgan Stanley could put the daily volume of European EUAs on their credit cards. So despite the media glory, the international emission markets are still in their nascent stages.

What is encouraging is the structuring of special products, such as options on future emissions regulations, that can smooth out the conundrums of power generators and industry faced with an uncertain future. The banks will stand by to structure these products to provide liquidity. These products in turn smooth out the risks inherent in the vision of an international emissions trading market, encouraging further entrants.

But we still have a long way to go.