Carbon markets grow despite lingering complications

13 December 2019

Carbon markets in Europe and North America have shown resilience in the face of a changing political and regulatory landscape. The winners of Environmental Finance's Market Rankings commented on the year that was and what promises to be a dynamic twelve months ahead. Christopher Marchant reports

The politics of carbon was again a key talking point for the year, with Britain's impending departure from the European Union, the Western Climate Initiative (WCI) and the state of California facing legal action by the Trump administration, and wrangling over Article 6 of the Paris Agreement at COP25 in Madrid. 


Nevertheless, the market concluded the year in a bullish style, as it entered the final part of Phase III of the EU's Emissions Trading System (ETS). Throughout the year the prices of EU allowances hovered at around €25 ($28), although peaking at €29.81 in July. This is a marked comparison to previous years, with the EU ETS closing in 2016 at €6.57 and still at less than €10 a tonne at the beginning of 2018.

According to Peter Zaman, partner at Reed Smith, winners of Best Law Firm for the EU's ETS: "Carbon is a product that has gone up dramatically within a relatively short period of time, primarily due to the market stability reserve mechanism that the European Commission has put in place to address the surplus in the market. It could be argued that EU allowances were the best performing commodity in 2018, with no reason to believe that that isn't going to continue into 2020 given the state of play."

The Commission launched the revision process for Phase IV of the EU ETS in 2015, when the carbon price generated by the system was at a relative low. This phase will begin in 2021 and is expected to run to 2030, and signals a significant escalation in the project, coupled with the European Commission's intention of cutting greenhouse gas emissions by at least 40% compared to 1990 levels.

"2020 will still be bullish. Brexit will hopefully be solved and then as we go past 2020 it will be a new phase in the EU ETS and a new phase in the WCI. Things are going to get tighter and tighter", says Nicolas Girod, founding partner and managing director of ClearBlue Markets, winners of Best Advisory/Consultancy in the EU ETS, California and overall North American Markets.

Article 6 of the Paris Climate Agreement is intended to assist governments in implementing nationally determined contributions (NDCs), and resolve issues such as two nations claiming to the same emissions reduction or 'double counting'. At COP 24 in Katowice countries failed to agree on a defined rulebook on Article 6.4, in part due to Brazil's desire to exempt developing countries from this double counting legislation, leaving much to do at COP 25 in Madrid.

According to the International Emissions Trading Association (IETA), Article 6 has the potential to reduce the total cost of implementing nationally determined contributions by more than half (equating to savings of $250 billion a year in 2030), and facilitate the removal of 50% more emissions, at no additional cost.

"We want to see the rules, we want to understand how Article 6 will be implemented so that we have the certainty to then develop our own activities under Article 6. Without this rulebook it will be very hard for us to make these investments because we will have uncertainty", says Jeff Swartz, formerly of IETA and now director of climate policy at South Pole, which was winner of Best Broker, Secondary Market and Best Advisory/Consultancy for the Kyoto Project Credits and was highly involved in the initial drafting of Article 6.

One early success from COP 25 was the Partnership for Market Implementation, unveiled on the side-lines of the event by the World Bank and country partners including Canada, Chile, Germany, Japan, Norway, Spain and the UK. The partnership will provide technical assistance to countries to design, pilot and implement carbon pricing and market instruments. It will support the direct implementation of carbon pricing in at least 10 developing countries and help a further 20 countries to do so.

Meanwhile as the UK prepares to host COP 26 in Glasgow in November 2020, well over three years following the referendum on the issue, three prime ministers and two general elections later, the UK remains for now in the European Union and its position within the EU ETS remains uncertain.

The UK currently represents about 10% of the EU ETS compliance market, so if UK compliance entities are not included in the EU ETS, in theory, you would need a 10% reduction on the EU ETS supply itself in order to maintain balance with demand. On this logic, Zaman says: "While there is some grounding to this I suspect that it is slightly underestimating the significance of UK based market participants, who along with the UK compliance entities, are historically more active in the market compared to many of their European brethren."

On the subject of Brexit and its effect on pricing in the EU ETS, Girod says: "If you look at the investor side of things, the financial participation has reduced quite a bit, that is what has driven prices to come back down to around €25. A lot of those are financials that have had a very good year in 2018, probably waiting on more certainty on what will happen in the EU ETS, and that means waiting to see what happens with Brexit."

Gordon Bennett, managing director for utility markets at ICE (winners of Best Exchange/Clearing House in the EU ETS), notes the UK's energy position in comparison to Germany: "Historically the politics of European primary fuels and carbon produced very diverse outcomes, especially at times when the price of carbon in Europe was low. The Carbon Price Floor, introduced during 2013 by the UK Government, helped natural gas replace coal in the generation stack, whilst at the same time in Germany, natural gas was seen to be marginalised by renewables and coal."

Marc Falguera, managing director of Vertis, winner of Best Trading Company, Spot and Futures and Best Trading Company, Options in the EU ETS, and Best Trading Company, Secondary Market in the Kyoto Project Credits, said: "High carbon prices have incentivised the decarbonisation in many sectors already. Higher available renewable capacities also contributed to the decrease of emissions in the power sector. 2019 might be the first year when the share of renewables in the German power mix was higher than that of coal."

North America

In North America, the linked California and Quebec cap-and-trade programmes, which form the WCI, have been adapting to the first full year without Ontario in the programme, as the Canadian province departed in July 2018.

Susan Lafferty, partner at Eversheds Sutherland, winners of Best Law Firm in the North American Markets, says: "Ontario's departure certainly created some uncertainty because this linkage is all still new and relatively novel. Market participants who held credits or offsets in various programmes were a little bit nervous about what would happen to any investments they had made. This market has mostly made its way out of that issue."

On 2 and 6 December, the Air Resources Board (ARB) released its annual reports on the disposition of 2020 Carbon Credit Allowances, of which 222.5 million Vintage 2020 allowances will be auctioned at a minimum price of $16.68.

On pricing in the WCI, Randy Lack, founder and chief marketing officer at Element Markets, winner of Best Trading Company, Spot and Futures and Best Trading Company, Options in the California market and Best Trading Company in the Regional Greenhouse Gas Initiative (RGGI), says: "The markets in the US were characterised by new money. We've seen several entities enter the market, searching for yield. We saw in the middle of the year a big run-up in pricing, we've seen it pull back towards the end of the year, but we think that that has a volatility as normal, and we are certainly expecting a strong year in 2020."

In October the WCI was rocked by legal action issued against it and the state of California by the US federal government. The case relates to the WCI's linkage with Quebec, which the filing argues is an international treaty which cannot be enacted independently by a state, namely because: "This intrusion complexifies and burdens the United States' task, as a collective of the states and territories, of negotiating competitive international agreements."

David McCullough, partner at Eversheds Sutherland, assesses the case: "We've done very detailed analysis on this, and at this time we don't see the lawsuit having a significant chance of success. There's a lot of time for it to play out, at least three years if not more when you factor in appeals to the district court and the 9th Circuit, and possibly ending up in the Supreme Court. There's a lot of stories left to tell on this lawsuit but at this time we don't think it has much likelihood of success."

Lafferty expects the case may be dropped entirely if there is a change of presidency in 2020. Donald Trump has already announced the United States withdrawal from the Paris Agreement, and the attitude shown by the Department of Justice towards the WCI may be seen as simply another part of this resistance towards international agreements aimed at combating climate change.

The position of the Trump White House is notably at odds with both previous Democratic and Republican-led administrations. Andrew Ertel, president and CEO of Evolution Markets, winner of two awards in the EU ETS categories and three in the North American markets, says: "This administration has tried to sabotage previous bipartisan efforts across the board. I don't think it is going to work in the long run because the cat is out of the bag; people today see the real world effects of climate change.

"The US is coming closer to the European mindset where corporates and consumers are pushing us rapidly in a new direction."

Meanwhile in the North-eastern US, the RGGI has been buoyed by the planned re-entry of New Jersey into the scheme from 2020, and perhaps even more notably Pennsylvania, the US's third biggest coal producing state, agreeing to join in October 2019. From January to November 2019 the prices per tonne of carbon dioxide emissions in the RGGI was always in the region of $5-6.

Jay Wintergreen, market area director for greenhouse gas services at First Environment, voted Best Verification Company for the North American markets, says: "Historically, the scope of RGGI has been too small and allowance prices too low to generate many offset projects which would require verification services. While we remain hopeful that the programme may eventually generate market activity beyond allowance trading, at this point, other voluntary and regulatory programmes offer better opportunities to most offset project developers.

"We see some potential opportunity in the RGGI market as more states are joining, and clearing prices appear to be rising."

A notable development in 2019 was the beginning of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), a scheme aimed at offsetting and reducing the carbon dioxide emissions from the worldwide aviation industry.

McCullough says: "That's something that's very much on the horizon. You'll see real meaningful growth in the coming decade because of jet fuel and emissions from vessels are the real two areas that are difficult to reduce the carbon footprint, because electric engines can't currently be used for those types of transport.

"It is one of those things that is just hitting the horizon now. In the next three years you'll probably see a lot more interest, a lot more activity around those markets."

It is forecast that CORSIA will mitigate around 2.5 billion tonnes of carbon dioxide and generate over $40 billion in climate finance between 2021 and 2035. According to G.Vishnu, manager at EPIC Sustainability, voted Best Verification Company in the Kyoto Project credits: "We believe CORSIA is going to help the carbon markets revival and sustenance on a long term basis."

Kyoto Project Credits

While there is little ongoing trading with the Kyoto Project Credits, its impact as a trendsetter for the international carbon market is undeniable. Ilona Millar, head of global climate change practice at Baker McKenzie, winner of Best Law Firm for Kyoto Project Credits, said: "I think the Kyoto Protocol has been incredibly important in setting the market standards for the development of offset projects and whilst there's been a number of ups and downs with the market, the fundamental design of the Kyoto mechanism has underpinned the design and implementation of almost every other offset scheme both for compliance and voluntary markets.

It's still a very robust design for the project cycle, which will be very useful to inform the development of the new market mechanism under Article 6.4 of the Paris Agreement."

R.Madhukara, director for projects and client engagement at Kanaka Management Services, winner of Best Project Developer for the Kyoto Project Credits, is also positive: "The system will continue its significance because of the market reputation and excellent work done by UN Framework Convention on Climate Change in the last two decades. We also believe there will be more programmatic approach to project development going forward."

Meanwhile, the Chinese national cap and trade market, originally expected in 2017, is yet to be fully implemented but is now tantalisingly close to launch. According to a report from Latham & Watkins, winner of Best Law Firm for California, in China the biggest challenges will be transitioning from more limited, provincial programs to a national ETS, in part because the pilot programmes were implemented with key variations based on the economy and size of each province.

On China and the Asian market more broadly, Millar says: "Assuming the Chinese national scheme comes online next year, that's going to result in significant market activity, which as a global law firm Baker McKenzie is very closely tracking."

On carbon supply and pricing worldwide, Millar says: "In Australia prices have been increasing particularly for the secondary market transactions. I think the question is going to be whether we start to see convergence towards a more global carbon price but I can't see that in the near term just because of the disparate nature of all of the different emissions trading schemes and other carbon markets schemes and carbon taxes at the moment."

Overall, the cap and trade markets seem healthy, especially as a result fixes made in the EU ETS and the continued strength of international carbon markets such as the WCI. However, there are still great hurdles to face, and uncertainties such as the blocking actions of the Trump administration and the UK's future in the EU ETS.