13 December 2016

Carbon markets face fresh uncertainty

Political changes in the UK and US have reversed recent progress towards greater clarity in the world's largest carbon markets, says Graham Cooper.

What a difference a year makes! This time last year, politicians and environmentalists, along with many businesses and investors, were celebrating the signing of the Paris Agreement on climate change and the increased certainty it provided about global and national targets for curbing greenhouse gas emissions.

12 months on, and the same people are bemoaning fresh uncertainties arising from the UK's vote to leave the European Union and the victory of a climate change sceptic in the US presidential election.

The Paris Agreement boosted confidence in the future of carbon markets, with an international PwC survey of large companies – members of the International Emissions Trading Association (IETA) –revealing that 82% expected existing carbon markets would expand as a result of the ground-breaking deal.

EU Allowance (EUA) prices stood at about 8 in December 2015 but, a year later, they are languishing around €5, representing a fall of almost 40%.

Optimism was also prevalent in the North American markets, this time last year, thanks to the election of a more climate-friendly government in Canada and president Obama's progress on his climate change strategy for the US.

Louis Redshaw, Redshaw AdvisorsA central plank of that strategy – the Clean Power Plan (CPP) – was expected to encourage more states to introduce carbon trading and possibly join one of the existing regional carbon markets – in California and the northeast (the Regional Greenhouse Gas Initiative (RGGI)).

"It really feels like we are in growth mode again around greenhouse gas credits in North America," said one of last year's winners in December 2015.

A year later, however, both the CPP and the California market are beset by legal challenges, while the Brexit decision, low EUA prices, and a lack of clarity over forthcoming market reforms, have cast a cloud of uncertainty over the EU market.

"It's been a very interesting 12 months," says a rueful Louis Redshaw, founding director of Redshaw Advisors, that retained the title of Best Advisory/Consultancy (EU ETS) in this year's poll.

Despite some "pretty serious" nuclear plant outages in France and the approach of winter, the fact that EUA prices remain far below last year's highs "tells us there is oversupply in the market – even in a year with backloading," he says, referring to the mechanism to withhold 900 million EUAs from auctions in 2014-2016 until 2019-2020 in an attempt to temporarily reduce the excess that accumulated after the economic slowdown after 2008.

"The news from the power sector is almost as bad as it can be but carbon is still struggling to break higher," he says.

ETS Markets – voted Best Trading Company (EU ETS) – shares Redshaw's concern. "It's a frustrating time," says Tim Atkinson, the firm's founder. "We would like to be working more proactively with clients about developing future compliance strategy but Brexit concerns, unclear Phase 4 reforms and low prices make that difficult."

"All the signs are for lower [EUA] prices next year."
Louis Redshaw, Redshaw Advisors

Many companies see too much uncertainty to take a long-term view at present, he says. Although allowance purchasing requirements are going up, as targets tighten and surpluses are used up, at current prices EUAs are not a significant cost for many companies, he adds.

Few market insiders expect any dramatic recovery in prices next year. Redshaw says he expects 2017 will see the French nuclear plants resume generation, and lower gas prices as more LNG capacity becomes available, but no major increase in demand for allowances. Furthermore, the end of backloading will mean an increase in EUA supply.

"Some pretty serious headwinds are coming," he says. "All the signs are for lower prices next year."

Further bad news for the embattled EU market, is the threatened mandatory closure of coal-fired power stations in several European states. "Such intervention is undermining the carbon market," Redshaw says.

2017 will be an important year for companies to keep track of EU ETS Brexit negotiations and Phase 4 reforms, notes Atkinson at ETS Markets. They should remember "that policy decisions can cause sudden price movements so being able to react quickly will be important," he says.

Tim Atkinson, ETS MarketsIn response to the low prices, both Atkinson and Redshaw have been looking beyond their core activities based around the EU ETS.

ETS Markets has started to do more advisory work on renewable energy and energy efficiency, while Redshaw has advised South Korean companies about emissions trading and provided firms in the aviation sector with training on emissions trading. Most airlines will be covered by a new carbon market – the Carbon Offsetting and Reduction Scheme for International Aviation (Corsia) – from 2021.

Baker & McKenzie, which held on to its title of Best Law Firm in the EU ETS, for the eighth year in succession, is also seeing more interest from airlines. "We see an increasing of level of activity here," says Martijn Wilder, head of the firm's global environmental markets and climate change practice.

The company's work on the EU ETS has been "pretty limited" in the past year, he adds. The focus has been more on advising its European clients who operate internationally in other markets, while also working on the REDD+ forestry crediting mechanism and policy work, Wilder says.

But, despite the low prices, EUA trading volumes remain robust, with average daily volume on the Intercontinental Exchange (ICE) in London of about 20,000 lots, says Gordon Bennett, managing director, utility markets at the exchange. ICE was once again voted Best Exchange/Clearing House for the EU ETS.

And, with more than 100 companies trading on a typical day, the EUA futures contract is one of ICE's leading utility- focused contracts, he adds.

Volumes have also been strong in the bilateral over-the-counter (OTC) market. "We have seen an uptick in OTC volumes and expect that to continue into 2017," says Michael Karavias, a London-based managing director at Evolution Markets, which was once again voted Best Broker in the EU ETS.

The world's second largest carbon market – that of California – is also beset by uncertainty and low prices. But the reasons are specific to the state and unrelated to the election of a president who has dismissed climate change as a Chinese hoax.

"Many companies see too much uncertainty to take a long-term view at present."
Tim Atkinson, ETS Markets

The California market didn't move at all in reaction to Trump's election, says Lenny Hochschild, MD and head of the Carbon Americas group at Evolution Markets, which also retained its stranglehold on the title of Best Broker in both the California and RGGI market categories. "I don't see the federal election affecting California's policy," he adds.

Even if the incoming US administration cancels the Clean Power Plan, the Californian market is unlikely to be affected, agrees Kevin Townsend, chief commercial officer at Bluesource, which retained its title as Best Project Developer in the North American markets as well as Best Offset Originator in the California market. The California administration is "going to do what they need to do to achieve their goal," he says.

But 'spillover effects' from other polices of the incoming administration could affect the market, cautions Izzet Bensusan, CEO of Karbone, which won the Best Advisory/Consultancy title for California and all North American GHG markets. "If Trump finds ways to support the fossil fuel sector, actually implements his infrastructure improvement plan, or 'brings back manufacturing' in some meaningful way, each of these could theoretically increase emissions in California (and the rest of the country), thereby increasing allowance prices."

The state continues to set the pace in terms of emission reduction targets in the US and in August the state Assembly and Senate passed bills that set an aggressive new target for 2030 – to reduce California's GHG emissions to 40% below their 1990 level.

But the market, launched in 2012, is under attack from the local Chamber of Commerce and others who argue that auctions of emission allowances are effectively an illegal tax, while the state's 'Environmental Justice' lobby group remains opposed to the very principle of cap and trade.

Kevin Townsend, BluesourceRick Saines, head of Baker & McKenzie's North America climate change and environmental markets practice, notes that the 2030 target is now codified in law, so "the big question is how best to meet it".

He thinks it is likely that industry will rally to support the cap-and-trade market if the alternative is 'command and control'. "All the infrastructure is there for a very solid market," he notes.

Baker & McKenzie has been voted Best Law Firm in the North American carbon markets for six years now, mirroring its leading role in the EU market.

The story of the year in the US has been significant progress at state level, adds Saines. In addition to California's plans for 2030, Oregon and Washington are both considering trading markets while several other states have undertaken preparatory work in anticipation of the Clean Power Plan being enacted.

"Even before Trump's election, much of the activity was at the sub-national level across North America," agrees Zac Eyler, vice-president, greenhouse gas programmes, at Ruby Canyon Engineering, which was again voted Best Verification Company in the North American GHG markets.

And, notes Hochschild, Ontario is expected to link to the California market in 2018, following in the footsteps of Quebec. The RGGI market has also discussed the possibility of aligning its rules with those of California, market insiders say.

"We expect more certainty on legal and policy challenges in 2017"
Kevin Townsend, Bluesource

The likely demise of the CPP under the Trump administration would be more of a blow to the RGGI market than to California, they warn. This was reflected in allowance prices immediately after the election result was announced. Carbon prices in RGGI dropped 10.4% to about $4.2 within 24 hours of Trump's victory being announced. California prices, on the other hand, were virtually unchanged at about $12.8.

The final CPP rules – which aim to curb emissions from US power plants – "are supportive of regional and potentially national trading," notes Saines. Several states were believed to be considering joining RGGI to help them comply with the Plan.

But the CPP was already facing a legal challenge, before Trump's election victory. The US Supreme Court put the brakes on the plan in February, pending a judicial review. The US Court of Appeals for the DC Circuit heard the challenge against the CPP in late September, but it is unlikely to reach a verdict until next year.

Several states intervened in favour of the CPP, although 25 others opposed it, Saines notes. "Some of the plans developed in preparation for CPP may proceed even in the absence of the CPP."

"I think you're going to see some states taking aggressive action on climate change; while others will breathe a sigh of relief," if the CPP is cancelled, he says.

2016 has been "a pretty difficult year" for RGGI, says Hochschild at Evolution Markets. In addition to the unexpected decision by the US Supreme Court to 'stay' the CPP, also unexpected was the decision in August by NY governor Andrew Cuomo to provide billions of dollars to help four nuclear plants to remain operating. This exerted some further downward pressure on carbon allowances in the market.

Rick Saines, Baker & McKenzieBut most major players are optimistic for 2017.

"I think 2017 should be much better," says Townsend at Bluesource. "We expect more certainty on legal and policy challenges in 2017."

"We are still confident in the momentum and direction for 2017 and after," agrees Eyler at Ruby Canyon, "overall there is still good momentum for carbon markets even with the uncertainty that Trump's election has caused."

Hochschild at Evolution Markets says he expects the challenge to the California market to be resolved in the first half of the year.

There is also renewed optimism in the international market for 'Kyoto credits' thanks to the Paris Agreement. The 1997 Kyoto Protocol – the precursor to the Paris Agreement – created instruments such as the Clean Development Mechanism (CDM) which award tradable carbon credits to projects in developing countries that prevent, or avoid, GHG emissions.

Although prices for CDM credits have collapsed to levels that are insufficient to make many potential projects economically viable, there are widespread hopes that a mechanism similar to the CDM will form the basis of international offset trading under the Paris Agreement.

"I think you're going to see some states taking aggressive action on climate change; while others will breathe a sigh of relief [if the CPP is cancelled]"
Rick Saines, Baker & McKenzie

"We are in early discussions with several parties on transitioning projects from the existing infrastructure under the CDM to the future mechanism, and/or bilateral transactions under Article 6 of the Paris Agreement," says Caspar Chiquet, a key account manager for the public sector at South Pole Group, voted Best Project Developer and Best Trading Company in the Kyoto credit market. "It looks like existing CDM projects, especially [those] in least developed countries, will play an important role."

In addition, he adds: "Our public advisory team works on assisting governments and multilaterals in the transition from the Kyoto Protocol to the Paris Agreement."
The Zurich-based company is also engaged in the World Bank's effort to support the CDM via its innovative Pilot Auction Facility and was among nine winners in the second auction, for methane reduction projects, held in May 2016.

K.Sudheendra, head of operations at India's EPIC Sustainability, which retained the title of Best Verification Company in the Kyoto credit market, says methane projects are among the most popular in the market at present. Despite the low prices for most CDM credits, he reports reasonable supply and demand and is confident that there will "definitely be more activity" in 2017.

Another source of work for South Pole is the proposed new market in offset credits for the aviation sector. The company "is in talks with several airlines regarding early action and pre-compliance engagements," says Chiquet. "Many of those airlines are existing buyers of voluntary offsets from our portfolio of projects," he adds.

Baker & McKenzie also sees potential in the aviation sector. "We see an increasing level of business here," says Martijn Wilder. Another possible growth area is the Chinese national carbon market which is due to begin in 2017. "We are getting more and more queries," but the market is still developing and remains quite opaque, he adds.

And the Paris Agreement "has had a big impact," Wilder stresses. Among other projects, Baker & McKenzie is advising various governments on their national emission reduction plans submitted as part of the Agreement; working on the REDD+ mechanism to reward projects that prevent deforestation; and developing ideas around Article 6 of the Agreement, which provides a foundation for international cooperation through markets.

And, he adds, "many corporate clients are developing plans to develop carbon offsetting plans and climate strategies.

"For us it is like post-Kyoto all over again and the opportunities are significant," he concludes.

 WinnerRunner up
Best broker, spot & futures Evolution Markets  
Best trading company, spot & futures ETS Markets Redshaw Advisors
Best broker, options Evolution Markets  
Best trading company, options ETS Markets CF Partners
Best advisory/consultancy Redshaw Advisors ETS Markets
Best law firm Baker & McKenzie  
Best verification company DNV GL Lucideon CICS
Best exchange/clearing house ICE Futures Europe EEX
 WinnerRunner up
Best broker, spot & futures Evolution Markets Karbone
Best trading company, spot & futures Vitol BP
Best broker, options Evolution Markets Karbone
Best trading company, options Vitol Element Markets
Best offset originator Bluesource Element Markets
Best advisory/consultancy Karbone Element Markets
Best law firm Baker & McKenzie Stoel Rives
 WinnerRunner up
Best broker Evolution Markets Karbone
Best trading company Vitol Element Markets
 WinnerRunner up
Best advisory/consultancy Karbone Element Markets
Best law firm Baker & McKenzie Latham & Watkins
Best verification company Ruby Canyon Engineering ESI Carbon
Best project developer Bluesource EOS Climate
 WinnerRunner up
Best trading company, secondary market South Pole Group Statkraft
Best advisory/consultancy Kanaka Management Services South Pole Group
Best law firm Baker & McKenzie  
Best verification company EPIC Sustainability Services TUV Nord
Best project developer South Pole Group  
Best exchange ICE Futures Europe