Carbon defies commodity pricing

As prices in the carbon market are largely determined by public policy decisions, conventional commodity price forecasts have little value. But careful market analysis can still aid corporate planning, argues Mark Trexler

The greenhouse gas (GHG) market has been the subject of enthusiastic speculation ever since the Financial Times predicted a $100 billion annual market by as early as 2010, far eclipsing any other environmental commodity market.

But, although many trades in GHG emissions have already been seen, with more taking place every week, it is not yet a true commodity market: the ‘commodity’ being bought and sold is simply not yet sufficiently defined. Moreover, there may not be just one market, as prices vary considerably for different types of GHG reductions. For example:

- the Chicago Climate Exchange touts a market-clearing price of $0.84 per ton of carbon dioxide (CO₂) in its latest auction;

- the current price of ‘Kyoto compliant’ reductions from projects in developing countries is $3–5/tonne;

- some companies in Europe have been paying $10–13/tonne for credits that will help them meet their obligations under the EU Emissions Trading System (EU ETS);

- many market participants or potential participants (including the Russians) have assumed that credits would be worth $10–20/tonne by 2010; and

- modelling by the Stanford Energy Forum of what it would take to stabilise atmospheric concentrations of CO₂ suggests a market value of at least $75/ton.

Some observers, trying to apply ‘typical’ commodity thinking, have concluded that the GHG market is too chaotic, that one forecast of future GHG credit or allowance prices may be just as good as another, and that there is nothing to be gained from analysing GHG prices more seriously. This attitude tends to hide how important GHG price anticipation is to the development of climate change policy, both governmental and corporate, and leads to corporate decision-making that is suboptimal. This is because many companies end up either ignoring the future cost or value of GHG emissions reductions or valuing them in ways that may not support sound corporate decision-making.

It is natural to assume that there must be a ‘good forecast’ of future GHG credit prices, if only we knew where to look. Unfortunately, the uniqueness of the GHG commodity prevents this from being true. This uniqueness results from the influence that future public policy decisions will have on both the supply and demand sides of the GHG market equation, and hence on market prices.

Public policy and the GHG market

It is easy to see that demand in the GHG market will depend largely on policy decisions that force governments and corporations to constrain their GHG emissions. Some important variables include:

- whether countries comply with their Kyoto obligations;

- global economic growth and associated emissions growth;

- the nature of future US climate change policies and commitments;

- the timing and severity of any post-2012 reduction targets; and

- whether and how developing countries participate in global targets.

The differences in global demand for GHG reductions between the scenarios can be huge – whether the US is in or out of Kyoto is already a swing of some 2 billion tons of demand per year. Agreement on future targets could multiply GHG credit demand by more than tenfold over the next 10 to 15 years and lead to much higher credit prices than we see today.

Any view one takes regarding the future market and GHG credit prices means making important assumptions about these and other variables. But they are not market fundamentals per se, and are not amenable to the same kinds of demand forecasting one might do for other commodities.

What is far less intuitive than for the demand side of the GHG market is the impact of public policy decisions on the supply side. A variety of policy decisions will affect the supply of GHG reductions available to meet demand at any given time, including:

- policy treatment of ‘hot air’ ¹;

- the definition of ‘additionality’ for projects in developing countries ²;

- regulations on the treatment and accounting of forestry projects; and

- rules governing the banking of credits for future use.

As with demand, any view one takes regarding the future market and GHG credit prices requires making assumptions about these and other supply-side variables. Given the variety of emission reduction opportunities available across the six GHGs covered by the Kyoto Protocol, policy decisions in these and other areas will have dramatic impacts on supply and on credit prices.This is clearly seen in Figure 1, where current supply curves illustrate how much higher prices are likely to be with stricter additionality decisions, given set level of demand. Again, the variables discussed here are not typical commodity supply variables, and most likely are not amenable to the same kinds of supply forecasting that one might conduct for other commodities.

And, of course, policy variables are not the only factors that will affect supply and demand, and ultimately the price of GHG credits. Other key variables include:

- technical barriers to bringing reductions to market;

- the responsiveness of credit sellers to market developments;

- the availability of GHG project financing;

- market psychology among buyers and sellers, based on their view of future politics and the market itself; and

- energy prices and their implications for the cost of achieving CO₂ reductions. Table 1 illustrates how natural gas prices can dramatically affect the cost per ton of CO₂ for four representative GHG reduction technologies.

What this discussion of market variables makes clear is that:

- very different GHG price forecasts should accompany alternative policy scenarios;

- GHG prices will change dramatically over time in response to evolving public policy; and

- market psychology will be a key factor in the near term.

Corporate planning amid uncertainty

For companies where GHG emissions reduction mandates and the associated price of GHG credits are in no way material to their financial outlook, it makes sense to walk away from this issue at the current time. There are significant uncertainties, and there is no ‘off the shelf’ solution they can use. If the issue is simply not potentially material to them, it probably makes sense for them to ignore it.

For more and more companies, however, the complexity of the climate change issue does not justify ignoring the issue of the future market value (or cost) of GHG reductions. The issue may be obviously material to them, as in the case of large energy companies, or key stakeholders may see the issue as material to the company (in the context of Sarbanes-Oxley Act disclosure requirements, for example).

Those most affected by emerging CO₂ reduction regimes (the energy industry, sectors with high energy intensity or those particularly vulnerable on this issue when compared to competitors) are making business decisions that will determine their future environmental liabilities and assets. Expectations of future GHG prices (implicit or explicit) are central to ensuring that these decisions are the best they can be, even in the face of today’s policy uncertainties. These companies must forecast the financial liabilities (or assets) associated with business decisions they will take in the near to medium term.

Forecasting under conditions of uncertainty is nothing new. Energy companies forecast oil and gas prices all the time, knowing that these forecasts will not be ‘correct’ given all the physical and market variables that guide oil pricing. Nevertheless, these forecasts provide critical policy and strategic guidance to the companies.

What is different about forecasting the GHG market is the extent to which future policy decisions will determine GHG prices. Tax incentives and other policy decisions certainly affect oil and gas markets over time, but the situation facing the GHG market, in which policy decisions are creating the entire demand for the commodity, raise this issue to a totally new level.

The reality is that many potential policy outcomes exist, and the price forecasts associated with those outcomes may be appropriate for companies in different situations with respect to the materiality of the issue. But we have to ask different questions than we might with other commodities. Rather than asking what future prices will be, based on anticipated supply and demand and historic price trends and volatility, companies need to reframe the question:

- what is the company’s economic exposure under different policy and market scenarios?

- can we usefully anticipate shifts in policy and market trends and outcomes, and thus develop an adaptive strategy?

- what does it make sense for the company to build into its strategic planning for future GHG prices based on its view of the future and sensitivity to alternative policy outcomes?

A company looking at the GHG market from the standpoint of covering a major potential regulatory liability may want to assume a relatively aggressive policy scenario, for example, and an associated forward price forecast that has the ‘downside’ covered. This differs significantly from the situation facing a company looking to the GHG market as an upside for credits it plans to produce and then sell, where a relatively lax policy scenario (and conservative price curve) might be a more prudent business assumption.

Recognising this distinguishing feature of the GHG market, and re-orienting one’s forecasting focus from ‘the right forecast’ to ‘future GHG policy and associated GHG prices’, is a crucial breakthrough many companies need to make to be able to grapple effectively with this issue and respond to growing stakeholder and regulatory directives.

A ‘best available corporate forecast’

But recognising that companies need to ask what the appropriate assumption is about future GHG policy and associated GHG prices does not necessarily carry forward to the conclusion that companies can come up with useful price forecasts.

What is key, in our experience, is that companies should end up with a GHG forward price curve they will be comfortable using for business decision-making purposes. Accomplishing this goal requires a transparent and interactive approach to price curve forecasting in which the client’s policy and market expectations are identified and incorporated. We have developed and used this approach with a number of clients and refer to the result as the best available corporate forecast (BACF).

Developing a BACF for GHG market prices relies heavily on a company’s own situation and thinking, since it ideally incorporates:

- the materiality of the GHG issue to the company;

- the value at risk;

- timing of irreversible business decisions, investments, mergers, and acquisitions for which GHG prices are material;

- a company’s perceptions of climate change policy risk; and

- whether a company is managing risk or looking for upside.

Individual companies may choose to use radically different future policy scenarios and end up with very different price forecasts. This simply recognises that the materiality of this issue varies dramatically from one company to another and that the implications of ‘missing the mark’ with a forecast will differ as well.

While developing a BACF has the obvious advantage of incorporating the best available policy and market information into a company’s strategic planning and investment decision making, it can have other benefits as well. It also:

- forces systematic thinking about corporate risk and benefits;

- helps avoid policy and price complacency that could hurt the company in the future;

- encourages innovative thinking by business units that otherwise might not be engaged;

- can substantially inform corporate decision-makers; and

- positions companies for the market and creates a foundation for a prepositioned response strategy with significant financial benefits.

This approach should be more successful in guiding corporate strategy than almost any third-party forecast used in isolation. EF

Mark Trexler is founder and president of Trexler Climate + Energy Services. E-mail: mtrexler@climateservices.com. This article is drawn from: Trexler, M C, ‘Of Crystal Balls and Market Fundamentals: Anticipating GHG Prices,’ in Green Trading Markets: Developing the Second Wave, ed P Fusaro and M Yuen (Elsevier Publications, forthcoming 2005).

1 ‘Hot air’ refers to the gap between certain countries’ emissions quotas and projected actual emissions in the Protocol’s first commitment period. The collapse of the Russian and Eastern European economies since 1990 means that their GHG emissions will be nearly 30% below their targets. This will allow these countries to sell unused quotas for a profit, even though no actual emissions reductions have taken place relative to business as usual.

2 In a nutshell, additionality is a test designed to ensure that projects seeking to generate GHG credits are not already ‘business as usual’.

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