17 December 2018

Carbon markets reap rewards of regulation

Carbon markets in North America and Europe have been buoyed by legislative changes introduced last year, and the momentum looks set to continue into 2019, the winners of Environmental Finance's Market Rankings tell Michael Hurley

Increased trading activity and rising prices over the past 12 months in European and North American carbon markets have been sparked by regulatory intervention, according to the winners of Environmental Finance’s Annual Market Rankings.

However, areas of uncertainty remain – chief among which is Brexit – the UK’s expected exit from the European Union in March.

Steffen Koehler, chief operating officer at EEX, which was voted Best Exchange for the EU’s Emissions Trading Scheme (ETS), says the past two years have seen a significant increase in the volume of emission allowances traded.

“This shows two things – first, it’s good news for achieving our emission reduction targets. A liquid and diverse market allows efficient trading, strengthening the EU ETS. Second, it shows market participants’ trust in the system – the market sentiment has been good over the last months. One factor contributing to this is the comprehensive policy reform of the EU ETS,” he believes.

These reforms, which the EU signed off in April to increase stability in the ETS between 2021 and 2030, include the introduction of the Market Stability Reserve (MSR) in January, into which surplus emission allowances removed from the market will be placed.

The reforms introduced the following elements:

  • The progressive reduction of the total quantity of carbon permits - known as the Linear Reduction Factor - will be changed, to 2.2% each year from 2021 to 2030, up from the current 1.74% a year.
  • The number of allowances to be placed in the MSR – or feeding rate – will be doubled temporarily until the end of 2023.
  • From 2023 onwards, the number of allowances held in the MSR will be limited to the auction volume of the previous year. Holdings above that amount will lose their validity.

“It’s positive that the reform takes steps to increase not only scarcity [of allowances] in the ETS but also predictability,” Koehler said. “The increase of the linear reduction factor addresses the long-term, while the higher feed-in rate to the Market Stability Reserve and planned cancellation in 2023 address the short term. This adds to the credibility of the EU ETS, as it establishes clear expectations for the market.”

Bernadett Papp, a senior market analyst at Vertis, says a big increase in the volume of EU Allowances (EUAs) - which each represent one tonne of carbon dioxide (CO2) - that were traded in response to the reforms contributed to the company’s good performance. Vertis traded almost double the amount of allowances this year compared to 2017.

Vertis won four titles in the EU ETS and Kyoto Project Credits (JI and CDM) categories.

Bernadett Papp, VertisPapp adds that many companies were spooked by the potential for further steep price rises, and chose to purchase sooner, rather than be hit by higher prices later.

Prices for EUAs have soared in recent months to about €25 in September – up from less than €4.5 in May 2017. At the time of going to press, prices remain around €21.

“Whenever an organisation had spare money and saw the prices dropping they purchased a couple of allowances they would need in future, which has created a difficult situation for many compliance entities [which], in the last five years, were used to seeing prices between €5 and €7.

“The first shock came when prices passed €10 this year... Then in a matter of weeks they increased to €20. This was a shock for those installations that did not consider purchasing allowances a big task,” Papp claims.

Price volatility has also caused more companies to hedge their investments: “Where they previously preferred to purchase allowances in the spot market, this year they have showed more interest in forwards, futures and options. It’s a new development in this market.”

Another significant development this year is that EUAs have become financial instruments regulated by the EU’s Markets in Financial Instruments Directive, says Papp. “It’s an invitation for many new market participants who do not have compliance obligations but find the carbon market an intriguing investment opportunity.

"This year [companies] have showed more interest in forwards, futures and options. It's a new development in this market"
- Bernadett Papp, Vertis

“This has pros and cons: one positive is that it provides liquidity in the market. The negatives are that many compliance entities are afraid of ‘speculators’ – those entities that don’t have a compliance obligation. Supposing they purchase millions of allowances in 2018, there’s a risk that they will sell allowances [only] when they think they have made enough profit,” which could distort prices, warns Papp.

Shaun Bainbridge, director of assurance at Lucideon, which was again voted Best Verification Company for the EU ETS, sees Brexit as the risk that “overshadows everything else” in the scheme.

“There’s been so much turmoil, with nobody knowing where the UK will go. The market needs clarity,” he explains.

Bainbridge says there are four possible options for the UK after March: it could remain part of the EU ETS; create its own ETS; create its own ETS and link it to the EU’s; or introduce a ‘simple’ carbon tax.

In October, the country’s government said it would introduce such a tax in the event that the UK leaves without agreeing a deal, but added that monitoring, reporting and verification would continue to underpin this. However, its current preference is to remain a full member of the ETS until at least 2021 – the duration of the so-called transition period before a permanent relationship is agreed.

“That would be the best option of the four,” Bainbridge agrees. “If the system ain’t broke, don’t fix it!”

ETS Markets director Tim Atkinson believes that, so far, Brexit uncertainty has had a limited impact on the price of EUAs, which are finding support between €17 and €20 – a trend that will be cemented by the introduction of the MSR in January.

However, he urges UK operators to prepare for the possibility of a ‘hard Brexit’ by ensuring they have a way of selling or holding any surplus allowances.

ETS Markets was voted Best Advisory/ Consultancy for the EU ETS, after it came runner-up last year.

Atkinson urges policymakers to step back from a market in which prices are on the up, and the scheme is at its most effective since its inception.

“With the exception of the UK, we have some certainty across the EU ETS. Companies can start to make decisions based on the back of that,” he says. “The ETS could benefit from a period of policy stability.”

In North America, the linked California and Québec cap-and-trade programmes, which form part of the Western Climate Initiative (WCI), were jolted in July by Ontario cancelling its participation in the programme.

Ontario formally joined the WCI in September 2017, but in June the province’s populist premier Doug Ford announced his intention to withdraw from the programme. This caused disruption to plans by the country’s federal government to implement a nationwide carbon pricing system, slated to begin on 1 January, 2019.

Under this plan, provinces and territories are asked to implement a ‘system that makes sense for their circumstances’ - either an explicit price-based system, such as a carbon tax, or cap-and-trade. The government also committed to implement a federal carbon pricing backstop that will apply in any province or territory that requests it, or that does not have a carbon pricing system in place in 2018 that meets federal requirements.

Entities that were expecting to be covered by Ontario’s now defunct capand- trade programme have been rushing to understand how the federal system will work, which has sustained client demand at ClearBlue Markets, according to Michael Berends, the company’s managing director of origination.

ClearBlue Markets was voted Best Advisory/Consultancy for the North American Markets.

Nicolas Girod, ClearBlue’s managing director of markets, claims that although the decision initially hit market sentiment in California, because Ontario was short on supply of emissions permits, “it had almost no impact” on demand.

In its most recent quarterly auction, the first since Ontario’s exit, California sold all its permits and raised $813 million, while Québec – a smaller market – raised $167 million.

“It was done in a pretty clean way, and it shows on a longer-term basis that linkage and de-linkage is possible and those markets are flexible,” says Girod. “A lot of lessons will be learned because of this de-linkage.”

He believes that, in the long-term, it will make the market stronger.

Berends and Girod suggest that there is scope for further linkage between schemes in both the WCI and the Regional Greenhouse Gas Initiative (RGGI) market of nine states in the north-eastern US.

A number of southern states are also considering joining RGGI, as is coalintensive Virginia. Meanwhile, there is potential for Mexico and Oregon to join the WCI.

“There have even been whispers of WCI linking with RGGI, which may be something of a dream but could happen one day”, suggests Berends.

In September, WCI and Europe signed an agreement, but this was more a signal of collaboration on how to harmonise the structures of the WCI and the EU ETS, rather than a statement of intent to link the two, says Girod.

Randy Lack, chief marketing officer at Element Markets, winner of three titles in the North American GHG markets, says the California scheme has been characterised by a ‘wait and see’ approach among traders, and has been pricing tight, following the passage in July 2017 of regulation to extend the scheme.

Market participants are increasingly casting an eye towards the future, he claims. “We have seen greater speculation, and more hedging. The market is expected to go negative in supply-versus-demand between 2022 and 2024, and companies with renewed confidence are now doing longer-range planning. We didn’t see this in the early stages,” Lack suggests.

Meanwhile, 2018 has been a fantastic year for RGGI, he says.

Prices have been boosted by the anticipated reduction in the number of allowances due to be auctioned next year, as well as the expected addition of New Jersey and Virginia, which will add a lot of demand, Lack says.

“There doesn’t seem to be any downward pressure [on prices] in RGGI. Instead, there seems to be a push towards the upside,” he says. On 1 January, futures contracts for December 2018 were $4.22, while at the time of publication they stood at about $5.35, Lack observes.

“New Jersey and Virginia potentially stepping into the market early, and adding into demand, will create a stronger 2019 than would normally have been expected,” he predicts.

Kevin Townsend, chief commercial officer at Bluesource, which won two titles in the North American markets, says: “In the WCI market, the withdrawal of Ontario was a blow, but the California government reacted quickly, and market participants are dealing.

“[However,] the regulatory landscape continues to see battles over issues related to programme design beyond 2020, and there’s uncertainty over various key aspects, including offsets, that have caused some uneasiness.”

Ontario’s continued push-back against the Canadian federal programme will be something to watch in 2019, he says.

Zach Eyler, vice president of greenhouse gas programmes at Ruby Canyon Engineering, which retained the title of Best Verification Company for North American markets, predicts a steady year ahead for both these regional markets.

“In the next 12 months we don’t see much official linkage happening within North America. Mexico’s pilot programme should hopefully begin early next year and we have hope for Oregon this coming legislative season.

“While programmes are communicating about potential links, we’ll continue to see mostly siloed programmes across North America for now. We see potential linkage opportunities over the coming years, but not in the short term,” Eyler adds.

There is also positive sentiment in the international offset markets, says K. Sudheendra, a director and head of operations at Epic Sustainability Services, voted Best Verification Company for Kyoto project credits, and he expects them to grow over the coming year.

Elsewhere, activity in China’s emissions trading system has been muted, according to South Pole’s director of climate policy and carbon markets, Jeff Swartz. South Pole picked up awards in three categories for Kyoto Project Credits (JI and CDM).

A pilot phase of China’s national scheme was launched late last year. Starting with the power sector, it is expected the country will gradually phase in other sectors over time. However, the market has seen very little activity, says Swartz: “China is slow. We had hoped to see more.”

“The other country that is really interesting is Colombia. It is well into implementing its carbon tax – this was the first year that you could use only credits [created] in Colombia, which led to a shortage of supply.

“We’re developing a lot of projects there, mostly in the land use sector,” Swartz reveals. “Colombia is planning to transition to an emissions trading scheme in the next three years. How much that morphs into a kind of EU ETS will be interesting.”

Australia is another market that South Pole is watching with intent. “Australia always presents an interesting story, and recently there have been signs of growing support from the people of Australia for carbon pricing, which bodes well for some kind of new government policy,” says Swartz.

Martijn Wilder, partner at Baker McKenzie, which built on the success of previous years and picked up the title of Best Law Firm in five GHG categories, agrees that demand is high in Australia.

The national government's Emissions Reduction Fund (ERF) under which it purchases Australian Carbon Credit Units, is currently about AUD8 billion ($6 billion) in size and is a very large demand driver, Wilder says.

In addition, the country's Safeguard Mechanism imposes limits on large greenhouse gas emitting facilities to ensure that net emissions are kept below a baseline. Although this has so far been implemented with a light touch, Wilder says, "it has the ability to be increased such that it imposes far more rigorous obligation."

He is hoping the Katowice climate change conference (COP 24) can drive additional demand for offsets. At the time of this article’s publication, national governments were gathered in Poland to flesh out the rulebook required to implement the Paris Agreement.

"We have a lot of transactions pending the outcome of Article 6,” he says, referencing the section of the Agreement dedicated to market-based climate change mitigation mechanisms such as emissions trading.

“Where countries have set targets for emission reductions, there is still a lot of uncertainty about how trades will be accounted for," Wilder says.

"What restrictions will be placed on my ability to purchase credits and have them transferred internationally? If I'm in the UK, and I wish to buy carbon credits from an activity in Brazil, whose target does that count towards? For developing countries that have targets [to reduce their emissions] but want financial assistance in return, will an international transfer under Article 6 always result in an addition to their target if the reduction occurred in a covered sector? And what happens if it was not in a covered sector?”

"We don’t think the rulebook will be completed [at COP] but we are hoping for sufficient clarity to allow companies to do international emissions trading," says Wilder.South Pole’s Swartz echoes Wilder’s plea: “We need clarity out of COP. Among the key issues that needs to be resolved is so-called double counting. Nobody wants a system with loopholes, which unfortunately you had under the Kyoto Protocol. “We don’t expect a lot of detail, but a list of high-level provisions - a sort of Ten Commandments for the Paris Agreement.”

South Pole is currently studying what projects it can develop under Article 6. “We’re on the cusp of developing some of the very first activities that you could consider international transfers of credits,” Swartz adds.

The company is particularly interested in how Article 6 might link with the International Civil Aviation Organisation’s scheme for offsets, CORSIA. The scheme is a potential source of high demand for what will be compliance credits post-2020, Swartz believes.

CORSIA, which will look to offset aviation emissions through the process of an airline purchasing emission offsets, is expected to be introduced in phases. It will start as a voluntary scheme from 2021 until 2026, and from 2027 almost all international flights will be subject to offsetting requirements.