Jam tomorrow?

Progress towards a global market in greenhouse gas emissions has been frustratingly slow. But, says Graham Cooper, the foundations are now in place for international trading in carbon

It will be the largest commodity market in the world…”

“The carbon market could be worth $100 billion a year.”

Such were the bold predictions of pioneers of the market in greenhouse gas (GHG) emission reductions. To spare their blushes, we will draw a veil over who said what and when.

Sadly for them, and the many others eager to see market-based solutions to climate change, progress has been frustratingly slow. It may eventually live up to such great expectations, but few markets can have had such a difficult birth.

Where it all began: 180 nations gathered in Kyoto to negotiate a global climate change agreement

Dozens, if not hundreds, of companies were created in the hope of winning a share of this market. Already, however, many have had to scale back their ambitions or radically reset their targets.

Now, with the world’s first mandatory multinational carbon market – the EU Emissions Trading Scheme (ETS) – about to begin, a new wave of business plans are being written up – or dusted down – incorporating, no doubt, some heroic assumptions about trading volumes.

A glance at the first issue of Environmental Finance, published in October 1999, reveals just how slow progress has been. London’s International Petroleum Exchange (IPE) was then talking confidently about launching carbon contracts in 2001, while the Sydney Futures Exchange had bold plans to list similar contracts by mid-2000.

The Australian plans have long since been abandoned but contracts on the IPE finally look set to see the light of day in December this year, under a link-up with the voluntary Chicago Climate Exchange. Several other exchanges are also firming up plans to launch contracts based on the EU ETS, which will begin in January next year.

That first issue of the magazine was published less than two years after the Kyoto Protocol was agreed as the basis for international action to combat climate change. One of the key features of this landmark agreement was the creation of an international emissions trading scheme (see box 1).

But the hopes and expectations of the politicians and environmentalists who helped structure this ambitious accord remain unmet, as it has yet to come into force. It is the failure of this agreement to win ratification in the intervening five years that explains the slow progress towards an international market in carbon.

A turning point in the fortunes of the Protocol came in November 2000, at the sixth annual meeting of the UN Framework Convention on Climate Change when the EU refused to concede to US proposals to count carbon absorbed by domestic forestry and agriculture towards its Kyoto targets.

Given the proximity of that meeting to the tightly-fought US presidential election, our December editorial accused the EU’s Green environment ministers of “shocking political naivety” in blocking a compromise deal. We stand by that charge. Surely a flawed but binding agreement with the US on board would have been better than no agreement at all. After all, no one ever pretended that Kyoto was anything other than a tentative first step on the way to major reductions in global GHG emissions.

By the time COP 6 was reconvened in July 2001, the Clinton administration had left the White House and President George Bush had made it clear the US would not ratify the treaty. He claimed it threatened to damage the US economy and unfairly exempted developing countries from emission caps, and argued that it was based on uncertain science.

The Australian government followed Bush’s lead and, ever since Japan ratified in 2002, the Protocol has been waiting for Russia to bring it into force. It has been the subject of well-known differences of opinion within the Moscow elite.

“Little did I realise when I entered this market that I would be betting my career on Russian politics,” said one leading emissions broker wryly.

As this issue of Environmental Finance goes to press, it seems this wait may soon be over. On 30 September, the Russian cabinet finally sent the Protocol to the parliament for ratification.

Well before the Kremlin’s decision, however, many countries, particularly in Europe, made it clear that their national climate change policies would be determined by their Kyoto commitments. Indeed, the EU ETS is an attempt by the 25 member states to ensure that European industry plays its part in helping the EU meet its collective Kyoto target of reducing its overall GHG emissions to 8% below the 1990 level by 2008–12.

While it is limited in terms of the gases it includes – only carbon dioxide (CO₂) for the first three years – and the industrial sectors it covers, the EU ETS is the first international mandatory cap-and-trade market for GHGs. And many observers expect it to be enlarged in terms of both gases and sectors after the 2005–07 first phase.

Optimists expect the EU market to follow a similar evolution to the US sulphur dioxide (SO₂) market, with early emissions targets being met comfortably, environmental benefits exceeding expectations and allowance prices much lower than many forecasts. Pessimists, however, point to surging oil prices and rising interest rates and say that putting a price on carbon could be the straw that breaks the camel’s back for some major emitters, and could wreak lasting damage on Europe’s industrial competitiveness.

While the EU programme is the only international mandatory carbon trading scheme in place, numerous voluntary initiatives to reduce industrial GHG emissions have been launched since the Kyoto pact was agreed.

Among the most significant, because of its government backing, was the UK Emissions Trading Scheme, launched in April 2002. Its aims were to deliver cost-effective reductions, help give UK companies a head start in emissions trading expertise, and establish London as a centre for an international market in carbon.

Key features of the scheme were that: participation was voluntary; all six major greenhouse gases were included; and government money was used to incentivise companies to commit to absolute cuts in their emissions. A preliminary report on its effectiveness, published in April by the National Audit Office (NAO), was overwhelmingly positive. The NAO, which scrutinises public spending on behalf of the UK’s parliament, says the scheme “has brought about a reduction in greenhouse gases and … has benefited the UK economy”.

In the first year of trading, the report noted, emissions were reduced by 4.64 Mt of CO₂, compared to targets totalling 0.79 Mt, although it concedes that a substantial amount of these savings would have happened even without the trading scheme.

Although the UK government argues that the incentive money was essential to persuade companies to commit themselves to binding emissions cuts, other voluntary programmes have been set up with no financial incentives. The biggest of these – the Chicago Climate Exchange (CCX) – began trading in December 2003 and now has more than 60 members, ranging from industrial giants such as Ford and American Electric Power to universities, municipalities and agricultural offset providers. Emitters have pledged to reduce their GHG emissions by 4% below their 1998–2001 baseline emissions by 2006.

Despite the lack of incentive money, CCX participants expect the exercise will bring them numerous other benefits. They include favourable publicity, ‘learning by doing’, potential gains if future legislation rewards early action and, in some cases, valuable energy efficiency improvements. In the first nine months of CCX trading, more than 1 million tonnes of carbon dioxide changed hands.

Many other companies have also set themselves voluntary GHG targets. One of the pioneers was oil giant BP, whose chief executive John Browne announced in 1997 that the company aimed to reduce its GHG emissions to 10% below 1990 levels by 2010. To help it reach this goal, the company created an internal market in which different operating units could buy and sell emissions reductions from each other. Given BP’s far-flung operations, this made it effectively the world’s first global trading system for greenhouse gases.

In March 2002, Browne announced that BP had already achieved its target, and the internal trading programme, though not the reduction efforts, was halted when certain UK operations joined the UK ETS. A striking feature of the BP programme is that the reductions were achieved at a substantial net profit to the company, as a result of energy efficiency savings, sales of methane that previously escaped to the atmosphere, and improvements in technology.

This win-win situation has received far less attention than it deserves and could well be the experience of many of those about to enter the brave new world of the EU ETS.

Since then, many other private sector companies – particularly major emitters in industries such as energy, cement and chemicals – have set themselves voluntary targets, either in isolation or as part of a regional programme. Japanese companies are particularly heavy buyers of project-based emission reductions and have collectively become the single biggest source of demand for carbon credits. At present, the only other large-scale buyers are the World Bank and the Dutch government. Together, these three groups now account for almost 90% of demand.

The supply side of the market is also highly concentrated, with Asia by far the major source of carbon credits and just five countries – India, Brazil, Chile, Indonesia and Romania – providing two-thirds of the supply volume.

Project-based emission reductions, generated under the terms of the Clean Development Mechanism or Joint Implementation (see box 2) are the source of almost all the credits in the present market. Most of these trades are intended to help the buyers comply with their Kyoto obligations. Others are bought for compliance with voluntary programmes or by organisations wishing to offset emissions in order to claim ‘carbon neutral’ status for a particular activity or product (see figure 1).

The second type of asset in the carbon market –

emission allowances allocated under national or regional cap-and-trade programmes – represents less than 5% of the total volume of reductions exchanged, although it represents the majority of transactions. Activity in this market is growing fast as the EU ETS approaches.

According to the World Bank’s State and Trends of the Carbon Market, published in June, the total volume of transactions this year is likely to be more than double the 78 million tonnes of CO₂ equivalent traded in 2003. The market is “fast approaching maturity”, concludes Franck Lecocq of the Bank’s Development Economics Research Group.

However, a more detailed analysis reveals serious growing pains. Just two projects – both based on the decomposition of HFC23, a highly potent GHG used in refrigeration – accounted for almost one third of the volume supplied in the period January 2003–May 2004.

As this issue goes to press, these projects are poised to be the first formally registered as CDM projects. However, at this last hurdle in the lengthy approval process, fresh questions have been raised about the methodology on which these projects are based. The CDM Executive Board has requested a review which, some believe, could lead to these projects being granted far fewer credits than had been expected.

A key agreement known as the Linking Directive, formally approved in September, promises to establish a link between the market in project-based credits and the EU allowance market. In theory, this is a key development in building a unified carbon market and it underlines the EU’s commitment to the Kyoto agreement and its mechanisms.

In the short term, however, the influx of CDM and JI credits into the EU ETS could trigger a sharp fall in the price of EU allowances. At present, the market price for credits from CDM projects is considerably lower than the forward price for EU allowances, which is around €8.50/tonne, having been above €13 early this year (see figure 2).

With continuing demand from the World Bank and Japanese companies, and several EU member states making it clear they intend to rely on JI and CDM credits to help them meet their Kyoto targets, demand for such credits looks certain to grow. But, as the World Bank is keen to stress,the CDM market could essentially close in 2006 or 2007. Unless projects are in operation by then, many will be unable to deliver carbon credits before 2012 – the end of the Kyoto Protocol’s first commitment period. There is currently no guarantee that project-based credits will have any value after 2012.

Some certainty about a post-2012 market for project-based credits is clearly a pressing need if the carbon market is to maintain its hard-won momentum. Proposals for what might replace the present Kyoto structure are expected to form a major topic of discussions at COP 10 in Buenos Aires in December. One of the key tasks will be to consider how the US can be brought within the next international agreement.

Such negotiations are likely to be no less fraught and complex than the original talks that gave birth to the Kyoto accord. And, once again, the outcome could be profoundly affected by a US presidential election.

But, in the meantime, there are signs that the regional markets – notably the EU ETS and the CCX – could evolve significantly and these developments could help shape a post-2012 global agreement.

In less than 18 months from now, the European Commission will have to prepare for the second phase of the EU scheme, which will begin in 2008. Given the scale of the European market and its broad compatibility with Kyoto, it is expected that Canada, Japan and other countries that set up domestic emissions markets will try to ensure they are consistent with the EU ETS, thus potentially opening the door to global trading. Indeed, there is already a potential link as both Japan and Canada are eligible to buy CDM credits which, thanks to the Linking Directive, can be traded in the EU ETS.

Such integration will not be easy. As the past five years have shown, attempts to reach international agreement in this area face enormous political risk. Nonetheless, climate change is much more widely recognised as a critical global issue than it was in 1999 and much has already been achieved. It seems reasonable to expect that progress in the next five years will be faster than in the past five. EF

BOX 1 - The Kyoto Protocol – condensed

The Kyoto Protocol is an international political commitment to reduce emissions of greenhouse gases in an attempt to slow global warming. It was agreed at the December 1997 meeting of the United Nations Framework Convention on Climate Change and commits developed countries to reduce their collective emissions of greenhouse gases by an average of just over 5% compared to 1990 levels by the period 2008–12.

After signing the agreement, each government has to ratify it, often with the approval of its parliament or legislature. It will become legally binding when it has been ratified by at least 55 countries that account for at least 55% of developed country emissions. In the absence of the US, this 55% threshold cannot be reached until Russia ratifies. Although the Protocol is an agreement between national governments, business will be expected to deliver the bulk of the emissions savings.

The Protocol does not prescribe how the reduction targets should be met, but proposes three mechanisms which are designed to help developed countries reduce the cost of meeting their emissions goals:

- The Clean Development Mechanism will grant these countries credits (certified emission reductions) for financing developing country projects that avoid emissions and promote sustainable development.

- A Joint Implementation programme will offer allowances (emission reduction units) for contributions to projects in other developed countries (including the countries of Central/Eastern Europe and the former Soviet Union).

- An International Emissions Trading scheme will allow developed countries to buy and sell emissions credits among themselves.

BOX 2 – Banking on carbon

While the story of the carbon market to date is a litany of disappointments and delays, at least one participant – the World Bank – has seen far more activity than it envisaged five years ago. The Bank launched its Prototype Carbon Fund in November 1999 with the aim of channeling public and private capital into projects in developing countries that reduce greenhouse gas emissions.

It faced criticisms, particularly from US energy companies, that its money would be better spent financing clean energy projects directly rather than in running a fund, and that it risked distorting a market that would be better developed by the private sector. It countered that this fund was merely intended to act as a catalyst to pave the way for private sector investments and that no more Bank funds were planned.

Five years on, however, and the Bank is involved in six funds, with more on the way. Together, these currently account for almost 25% of all purchases of project-based carbon credits. While some say the Bank’s involvement is distorting the market for potential private sector players, it is undeniable that, along with the International Emissions Trading Association, it has done a great deal to raise awareness of the possibilities of carbon finance and help lay the foundations for global trade to tackle this global problem.