Volume and Liquidity Improving in the Carbon Markets

Implications: The PointCarbon estimates provide data on the size of the emission markets. Some of these data are approximately correct, whilst others are overstated.

The European Union has become the global center for emissions trading with London as its capital.

- Four exchanges with clearing facilities now operate in the E.U. These are the ICE-ECX joint venture (London), Nordpool (Scandinavia), Powernext (France) and EEX (Germany)

- The emissions market in Europe is still majority over-the-counter, although the exchanges are fast increasing their market share

- New products such as call and put options on European Emission Credits are still relatively illiquid but open interest is on the uptick

- The volume of emission credits traded was 6 million on March 27, 2007 with February 2007 seeing the first month of 3 million credits traded on the largest exchange (EEX)

- Monthly volumes will increase through the end of 2007 to on or about 150 million credits, or some 2 billion EUAs annually; a figure somewhat less than the 2.4 billion estimated by PointCarbon.

- Canada, Japan and the United States are all studying the E.U. model with a view to offering competing products. None of these countries have a domestic cap and trade system or emissions trading regime in place.

- The CER market, based on actual deliveries versus projected CER deliveries, is much less than forecasted by PointCarbon and the value of these CER credits is questionable until such time as the EU, Japanese and Canadian regulations are finalized for 2008-12.

Analysis: Europe is by far the leader in a developed market for emission credits. The European emission credit is the EUA, which stands for European Union Allowance. It is the right to pollute one metric tonne of Carbon Dioxide (CO2).

The most popular contracts are the EUA futures contracts for 2008-12 inclusive. Trading in the Dec-2007 contract is virtually moribund, due to the price collapse of this contract from a high of on or about €30 in March of 2006 to €1.05 today.

- Monthly volume of all EUAs traded in over-the-counter and exchange markets increased from 86.4 million in January of 2006 to 141.8 million in February of 2007

- Of the volume of 141.8 credits in February 2007 (rounded):

67.00   million were traded OTC
62.34   million were traded on the ECX
  5.93   million were traded on Powernext
  5.53   million were traded on Nordpool
  1.03   million were traded on the EEX

- The pricing and volatility on emissions and power options, and the bid offer spread too wide, to call the emissions market liquid enough for hedging and speculative purposes in 2007. This will change in 2008, subject to E.U. policy on emission reductions.

- The quota of CDM credits (known as CERS) from developing countries and their pricing into European markets will not be known for another month or so until all EU member states finalize their national plans for emission reductions for the period 2008-12.

- The number of CERs coming online will be on or about 100  million for 2007 from an estimated 22 million in 2006. These deliveries will be subject to the operation of the UN CITL system, which is still in final development stage.

- Internationally, the Japanese and Canadians have yet to launch an exchange or contract for their Kyoto compliance trading. Alberta and the Canadian federal government under PM Harper have yet to resolve their disparate, proposed climate change legislation.

- The state of California and other U.S. states (including the RGGI scheme) do not have a liquid market for trading in CO2 permits and will not do so to any significant degree in 2007. RGGI does not come into force until 2009. The California Energy Commission has sent out a notice of a public hearing set for April 25, 2007 to discuss the proposed rules for emissions trading in the state.

- No market for U.S. federal cap and trade permits for CO2 will take place, if at all, this year. Any substantive climate change legislation would likely meet with a Presidential veto. A distinct possibility exists for U.S. Carbon trading in 2010 after the next Presidential and Congressional elections. As such, investment funds and industrial hedgers need to model various optionalities in proposed, federal climate change legislation to structure financial products and price CAPEX.

Overall, the international emission markets have a long way to go to offer trading in CO2 permits on one platform with a universally recognized, fungible contract acceptable to financial institutions and hedgers alike.

However, Europe has taken the lead and volumes of 6 million EUAs per day are achievable in Q4 of 2007.

This volume gives enough capacity to structure products and models for both arbitrage trading and risk management for affected industry in the E.U. 

Internationally, the emission markets will develop much more slowly.

However, volumes and liquidity are definitely on the increase, such that pricing of exotic options on the risk of climate change legislation is not just a prudent exercise but a necessity.