The rewards of early action

This year has seen carbon trading take off and, for many veterans of the market, their foresight and investments begin to pay off. Mark Nicholls talks to the winners of Environmental Finance’s sixth annual market survey

For most of the winners in the Greenhouse Gas (GHG) Emissions categories of Environmental Finance’s sixth annual market survey, the successes of the previous 12 months have been a long time coming. Almost all of this year’s winners are carbon trading veterans, whose early investments in this emerging – and often precarious – market are, at last, beginning to pay off.

Louis Redshaw, Barclays Capital: seeing increasing interest in trading beyond 2008

They’ve seen the early enthusiasm for the Kyoto Protocol’s market mechanisms undermined by US withdrawal from the climate change agreement in 2000; they’ve been roiled by Enron’s implosion the following year, and the collapse in confidence that caused in energy trading markets; and they’ve been frustrated by the often glacial progress of the Clean Development Mechanism (CDM).

But this past year has finally seen carbon trading take off – with the launch in January of the EU Emissions Trading Scheme (ETS), the entry into force of the Kyoto Protocol in February, and in October the long-overdue award under the CDM of the first carbon credits to emissions-reducing projects in developing countries.

The EU ETS has, at a stroke, transformed carbon trading from a largely theoretical concept to day-to-day reality for thousands of companies across Europe which, since January, now face carbon emissions targets – backed by meaningful penalties for non-compliance.

Environmentalists have criticised EU governments for failing to set significantly testing reduction targets for the first phase of the scheme, which runs to the end of 2007. Nonetheless, allowance prices raced up, from €7/tonne of carbon dioxide in January, to hit €30/t in July. Despite the price falling back to around €20/t by November, these price levels have led to calls from some in industry for the scheme to be scrapped.

Significant supply of allowances will soon reach the market, relieving some pressure on prices – and on political opposition to the scheme, says Garth Edward. He heads the now 10-strong environmental products desk which he set up back in 2001 at Shell, which has again been voted Best Trading Company in the EU ETS.

“It’s still early days. As in any compliance market, buyers come to market first to ensure compliance, and sellers have the option to sit back and do nothing,” he says. Indeed, large volumes of allowances – such as those held by Eastern European companies – are being held back from the market by a combination of incomplete market infrastructure (such as the national registries that allow trading) and a lack of knowledge about the opportunities the scheme provides to monetise emissions savings, say brokers.

Also, Edward points to Bulgaria and Romania which, while not currently part of the EU, are due to join in 2007. With membership also involving entry into the EU ETS, those two countries could become major exporters of allowances, he believes.

But the market is already developing rapidly, says John Molloy, London-based head of environmental products at broker TFS, which was voted Best Broker, EU ETS, beating last year’s winner, Evolution Markets, into second place. “Volumes are now averaging 1.5 million tonnes a day – with some days seeing a lot more,” he says.

“The next stage in the maturing of the market will be a move towards structured products, and derivatives,” Molloy adds, “and we’re already seeing an influx of financial players, such as hedge funds.”

Barclays Capital – one of those financial players, but one that has been active in the market since 2004 – plans to roll out EU allowance (EUA) option contracts next year, says Louis Redshaw, the bank’s head of environmental markets. These would add a vital tool to companies’ risk management armoury, but while one or two option contracts have been transacted, no options market as such currently exists, he says.

Barclays – which was voted runner-up in EU ETS Trading – is also increasingly seeing customer interest in transactions for the second, 2008–12, phase of the scheme, despite the fact that governments have yet to finalise emissions targets beyond 2007. “Power companies may not know their allocations, but they’re trading electricity that far out, and want to hedge their emissions,” he says. “On the other side, you’ve got CDM developers that want to hedge credit prices.”

The relative speed at which the EU ETS was introduced, and the novelty of its market-based approach, means that there is an enormous range in the level of understanding about the scheme, says Per-Otto Wold, chairman of Norwegian consultancy Point Carbon – which has been analysing the carbon market since 2000 – and which was voted Best Advisory, EU ETS.

“The level of expertise varies enormously, both within sectors and across them, and especially regionally,” he says. “But, increasingly, companies are recognising that this is a risk management issue – it’s getting up to CEO level for pretty much everyone.”

The one newcomer in the GHG categories this year is the European Climate Exchange (ECX) which, in a crowded field, scooped Best Exchange, EU ETS. The launch of the EU ETS has prompted no fewer than nine exchanges to launch EUA contracts and, with the launch of its carbon futures via London’s International Petroleum Exchange (IPE) in April, the ECX was one of the first off the blocks.

But while the ECX may be a relative newcomer, its parent, the Chicago Climate Exchange, has been ploughing the environmental markets furrow for some years. This US voluntary market was spawned in 2003 by futures and environmental markets pioneer Richard Sandor’s Environmental Finance Products, and provided much of the basis for the ECX’s contracts.

Peter Koster, ECX: emissions now trade “as an integral part of the energy portfolio”

A clear advantage for the ECX is its tie-up with the IPE, Europe’s premier energy exchange. “Emissions are not traded as a unique product,” says Peter Koster, ECX’s Amsterdam-based chief executive. “They’re traded as an integral part of the energy portfolio.”

In October, the ECX claimed around 80% of exchange-traded EUAs – or more than 20 million tonnes – of which around 70% are so-called exchange-for-physicals. These allow bilaterally agreed deals to be transferred on to the exchange, whose clearing house effectively eliminates credit risk.

The ECX is now also working with French power bourse Powernext to offer spot and futures contracts jointly, and in November launched ‘calendar spreads’, allowing traders to more easily roll contracts from December 2005 into next year, Koster says. The exchange is also considering cash-settled index products and options contracts, he adds.

The ETS is designed to prepare the 25-nation bloc for the 2008–12 Kyoto Protocol GHG target period and, given that it is open to credits generated under the Protocol’s CDM, links between the two systems already exist.

The hope for the CDM – which allows GHG reduction projects in developing countries to generate Kyoto-compliant carbon credits – was that it would finance sustainable development and provide a stream of low-cost credits to industrialised world buyers.

The reality is that the mechanism has been slow to get started, and buyers and developers complain of an under-resourced, overly bureaucratic process that simply can’t generate credits in the volumes required. While the CDM was, originally, expected to begin operating in 2000, it has taken until this year for the first projects to be registered: and, to great fanfare, the first ‘certified emission reductions’ (CERs) were awarded to three projects in October.

One of those projects – a small hydro plant in Honduras – was developed by EcoSecurities, an erstwhile carbon finance consultancy, which has been voted the Best Advisory firm by Environmental Finance readers each year since 2001. Along the way, however, the company has morphed into a project developer and carbon credit originator.

While its founder, president and chief operating officer Pedro Moura Costa may share some frustrations about the slow development of the CDM, the evolution of the carbon market – and the growing regulatory certainty that underpins it – is clear from the valuation of his company.

In November, EcoSecurities announced its intention to float on London’s Alternative Investment Market, with a tentative valuation of more than $200 million. “We have a portfolio of 71 million tonnes of credits,” he says “with a pipeline of 300 million. While the consultancy is an important part of the business, that’s where the value is.”

He is also confident that the CDM can deliver: he disagrees with the World Bank, which has been warning that there may simply not be enough time to develop sufficient projects to meet expected credit demand to 2012. “High volumes can be generated by projects initiated and registered by the end of the EU ETS first phase” in December 2007, he says.

Another complication in the CDM rulebook – that projects must be registered by December 2005 to be eligible to earn ‘retroactive’ credits generated before that date – has brought a rush of business to DNV, says the company’s Norway-based technical director, Einar Telnes.

“There is a hope that the [government] negotiators [at the UN climate meeting in Montreal] might extend this, but I don’t think you can put your faith in negotiations,” he says. DNV – which was voted Best Verification Company in both the EU ETS and Kyoto Project categories – has been working on the Kyoto mechanisms since the Protocol was signed in 1997, Telnes says. This year, it has doubled its staff covering carbon, now dedicating at least 40 full time to the market.

Steve Drummond, managing director of CO2e – winner once more of Best Broker in the Kyoto Project Credits category – has also seen a dramatic increase in business this year. And, unlike many in the market, he never believed the arguments that the CDM was starved of supply.

Steve Drummond, CO2e: “there are hundreds of millions of tonnes of CERs out there”

“I’ve always been more bullish, and I think if you look at the projects queuing up, I’ve been vindicated – there are hundreds of millions of tonnes of CERs out there,” he says. “But the whole point is that it should be environmentally thorough,” he adds, referring to the careful assessment that each project undergoes by the regulators.

How quickly those projects can generate CERs, and how quickly those CERs can be used for compliance, is still worrying some. The UN’s International Transaction Log (ITL) – which will track Kyoto Protocol credit trades – is not expected to be operating until 2007 and any delays could make it impossible for European companies to use CERs in the first phase of the EU ETS.

But despite these uncertainties – or possibly because of them – speculators see possibilities in trading both CERs and EUAs, and arbitraging between them, says Chris Norton, UK-based head of the environmental and climate practice at Baker & McKenzie. The international law firm was the first of its peers to establish a team specialising in carbon trading, back in 1999, and its depth of experience has helped it again win Best Law Firm, this time in both the EU ETS and Kyoto Credits categories.

“We’re seeing a number of entrepreneurs coming into the market, wealthy individuals who see that there are arbitrage opportunities in the CDM,” he says. Baker & McKenzie has also been advising some of the growing number of carbon funds that have been launched – either to provide their investors with credits for compliance, or with cash returns from successfully trading in the market.

But even outside Kyoto Protocol-related markets, carbon trading schemes have either been launched, or are contemplated. In Australia, the Labour-run state governments are considering banding together to introduce a cap-and-trade scheme over the head of the Liberal federal government. Indeed, New South Wales is in the third year of its GHG Abatement Scheme, which caps carbon emissions from its power sector.

“The scheme has been a huge success. The states are essentially looking to expand it into a national system,” says Ken Edwards, director of Next Generation Energy Solutions. His firm, which was voted both Best Broker in NSW GHGs, and won the Australian green certificates category, was set up in 2000, and has been broking environmental products since 2001.

Trading in the GHG market, which covers around 15 participants, can be sporadic – although he says that it traded every day in October. Since the scheme was launched in January 2003, around 12 million allowances have been created, and around 5.5 million tonnes have been traded, he says.

“Lots of people have been working with the NSW government to learn about trading – it’s the first scheme to include carbon sequestration,” he says. “But we need to get a national scheme going,” he adds.

Similarly, in the US, state-level schemes on both coasts are under development in the face of opposition from the White House to binding GHG caps. David Oppenheimer, managing director of long-established environmental broker Natsource – which pipped rival Evolution Markets to the Best Broker, North America prize – says that “our US clients are looking to be environmentally proactive by investing in the GHG market.

“We’re advising some clients on making purchases or evaluating opportunities internally that will stand them in good stead when regulations exist,” he continues. But, in comparison with Canada, where “people are finally able to look at the obligations they will have in coming years”, it’s still very days for a US carbon markets. “I’d rather there were more US companies doing transactions,” Oppenheimer adds.

BOX - How the survey was conducted

More than 1,500 companies were approached in October and November and asked to nominate the leading brokers, dealers, and advisors in emissions allowances, weather derivatives and renewable energy certificates, via an online survey. Voters were asked to vote only in those categories in which they had direct experience and to make their judgements on the basis of: efficiency and speed of transaction; reliability; innovation; quality of information and service provided and influence on the market, not just the volume of transactions handled. More than 700 completed responses were received.

Only one vote per company was allowed and those firms that nominated themselves had their votes disregarded.