16 December 2020

Carbon markets resist 2020's headwinds

Cap and trade schemes were not immune to the pandemic, but growing support for climate policies helped them recover, the winners of the 2020 Market Rankings told Annabelle Palmer

The effects of the Covid-19 pandemic have reverberated across financial and commodity markets this year, and carbon markets were no exception.

While the impacts have been uneven in different regions, the overall trajectory is one of recovery.

Environmental Finance spoke with the winners of the 2020 Market Rankings to see how the events of the past year have impacted their regional compliance markets, and what they predict for the year ahead.


"There never seems to have been a dull moment for carbon in 2020", says Louis Redshaw, CEO and founder of Redshaw Advisors, which won two awards in the European Union's Emissions Trading System (EU ETS) market category – Best Trading Company, Spot & Futures and Best Advisory/Consultancy. Louis Redshaw

As widespread lockdown measures were implemented earlier this year to halt the spread of Covid-19, production levels decreased across multiple sectors and, as a result, demand for EU allowances (EUAs) plummeted.

In March, the price of the EUA Dec '20 Futures contract fell as low as €14 ($17) per tonne of carbon dioxide (CO2) as financial players liquidated their positions.

"[Speculators] panicked and some even went short," says Redshaw. Since then, the initial price crash in March has given way to an impressive rally, with prices passing €30 three times over the course of the summer.
As of 27 November 2020, prices were hovering around €27, which is approximately 12% higher than at the end of 2019. 

One reason for the impressive bounce back was due to the European Commission's (EC) plans for an EU Green Deal. "This stopped Covid's negative impact on the market in its tracks," says Redshaw. 

"The EU's green deal will have to entail materially higher EUA prices "sooner-rather- than-later", Louis RedShaw, Redshaw Advisers.

Since it was announced in December 2019, it has renewed speculator interest in the carbon market, and the medium- and long-term outlook remains bullish.

In addition to a 2050 climate neutrality target, there was a strengthened 2030 emissions reduction target of 55%, up from the previous 40% target. Proposals to achieve this include a lower supply of allowances, additional sectors to be covered by the EU ETS – such as shipping and buildings – and a carbon border adjustment mechanism (CBAM) from 2023 to better address the risk of 'carbon leakage' – that higher compliance costs would drive companies or operations to other regions of the world.

Bernadett Papp"There seems to be a strong support of the CBAM among politicians and corporates as well," says Bernadett Papp, senior market analyst at Vertis Environmental Finance, which topped the polls for Best Trading Company, Options in the EU ETS market – a position it has held for four years in a row. “The EU could also be a pioneer and motivate other countries and regions to implement carbon pricing.

The details of how the carbon content of products from different countries will be calculated is unknown.The EC is currently drafting a law to align the ETS with the Green Deal’s objectives and opened a public consultation on various measures on 13 November.

Further details on the proposals are expected in June 2021.

Until then, “we wait with bated breath,” says Redshaw, but he adds that such measures will have to entail materially higher EUA prices “sooner-rather-than- later.”

According to Gordon Bennett, managing director, utility markets at Intercontinental Exchange (ICE), which won Best Exchange/Clearing House in the EU ETS and Best Exchange in the Kyoto Project Credits (JI and CDM) category, policy support from Brussels for a long- term price signal for carbon has perhaps never been stronger.Gordon Bennett

"If the world is to meet its net-zero ambitions then we need a higher price of carbon. Most governments and multilateral development banks have shadow carbon pricing well in excess of $100 per tonne," he says.
2021 also marks the first year of a new trading period (Phase IV) for the EU ETS, which includes tighter rules on free allocations. Redshaw points out that most big emitters, such as steel companies, continue to be protected with generous free allocations in Phase IV.

“However, the prospect of a much higher emissions reduction target for 2030 is likely to dramatically alter the Phase IV landscape, at some point,” he cautions. 

Another important issue for the EU ETS is Brexit, which continues to create uncertainty. The Brexit transition period finishes at the end of 2020, at which point the UK will leave the EU ETS.

In mid-December 2020, the UK announced that it will set up a domestic ETS that could then link back to the EU system. However, given that Brexit negotiations are still ongoing at the time of writing, it is not certain how quickly a linkage to the EU ETS could be achieved.

Peter Zaman, partner at Reed Smith – and winner of Best Law Firm in the EU ETS for the second year in a row, says: "[Assuming there is a deal that allows continuity] I think we are going to have a period where the UK ETS operates in isolation, but in a consistent manner to the way that the EU ETS is operating, to facilitate easier linkage under the terms of a Brexit deal – perhaps, as indicated, by the passing of secondary legislation during the first half of 2021," he says.

Before the announcement of plans for a domestic system, the UK had been weighing up a carbon tax instead of a UK ETS.

At this time, Bennett at ICE was not in favour of the UK adopting a carbon tax, saying that it would have been "a deeply regrettable step backwards from the enormous progress the UK has made – and the leadership it has shown – supporting cap and trade schemes which are so fundamental in allowing the market to put a price on pollution and, in doing so, enable energy transition."

The UK government has stated that its domestic ETS will be more ambitious than the EU-run scheme it will replace - with the overall emissions cap 5% lower than for the EU ETS and an expansion of sectors.

In the meantime, the market is in wait- and-see mode as the market awaits further details on this and Brexit negotiations continue.

Francesca Cerchia, global product manager of environment, health and safety at SGS, winner of Best Verification Company in the EU ETS category, says verifications of UK installations for the 2020 reporting year are being carried out under a 'business as usual' scenario under SGS's United Kingdom Accreditation Service (UKAS).

"However, as a result of the limited geographical coverage of UKAS accreditation, SGS had to re-allocate a series of pan-European verification contracts to SGS affiliates in EU member states," she adds.

North America

North American markets have endured a similarly volatile year.

Randy Lack"We expected this to be a year of solidification and growth," says Randy Lack, founder and co-president of Element Markets, which topped the rankings for Best Trading Company, Spot & Futures, Best Trading Company, Options in North American markets (California) and Best Trading Company in North American markets (RGGI) and Best Advisory/ Consultancy in North American markets (all).

Instead, optimism was replaced with tremendous volatility and downward pressure on prices when Covid-19 hit the US in March.

For the Western Climate Initiative (WCI) – the linked California and Quebec cap-and-trade programme – there was an expectation that the California allowances would hold the auction floor price of $16.68.

However, as funds in Europe and California liquidated, and WCI's clearing agents increased margin requirements to manage volatility, California Carbon Allowance (CCA) prices were driven to lows of $11.50.

While CCA prices have since recovered and are now trading at around the $17.20 level, California Carbon Offset (CCO) prices have not recovered, with the allowance/offset spread now at an all-time high.

This is partly because of a rule change starting in 2021 that reduces the usability of offsets in California from 8% down to 4%. As a result, the market has an oversupply of offsets. It remains to be seen how long this will persist.

Michael Coté, president at Ruby Canyon Environmental, winner of Best Verification Company, North American markets (all), says: "It's made some projects pause and reflect on the scale they were expecting to roll out future projects," he adds.Michael Coté

He sees interest growing in projects centred around natural climate solutions, such as land use change and agricultural practices, however.

"Even though they aren't necessarily the biggest in terms of delivering tonnes, I am seeing a genuine interest in those kinds of projects.We're also seeing interest from US oil and gas companies as to how they could get some credit for methane reduction projects within their portfolios – in areas that are not regulated right now," he says.

Meanwhile, in the north-eastern US, the worst effects of the market volatility were tempered by the re-entry of New Jersey into the Regional Greenhouse Gas Initiative (RGGI) cap and trade system, and the fact that lawmakers have initiated processes for Pennsylvania, the US's third biggest coal producing state, and Virginia to join as well.

However, Coté says he had also hoped that more states, such as Washington and Oregon, would have joined the compliance market by now.

"They've repeatedly failed to get it across the line, so that's been disappointing," he says.

More recently, the market received a boost from the recent US Presidential election results.

While the 'blue wave' – whereby Democrats won both the House and Senate – didn't happen, David McCullough, partner at Eversheds Sutherland, and winner of Best Law Firm, North American markets (California), says "the prevailing view is that Biden will be very favourable to the carbon markets".

For now, the US awaits the results of the Georgia Senate run-off race, which will decide whether the Biden administration will pass future legislation through a Democratic or Republican-controlled Senate.

David McCulloughIf the Senate remains in the hands of Republicans, Lack at Element Markets says he will be watching where the Biden administration can affect clean energy and sustainability policy without needing Congressional approval.

Another political boost came to the US market earlier in the year when a federal judge rejected a Trump administration lawsuit that was designed to put a halt to California's cap and trade programme.

The filing argued that the WCI's linkage with Quebec represented an international treaty which cannot be enacted independently by a state. The rejection of that lawsuit in July was significant in terms of providing confidence to carbon markets.

"It had the markets spooked a bit," says McCullough at Eversheds Sutherland. "Some investors were concerned that it could overturn the framework in place, negate credits that have been traded in California and imported from Canada, and the value of their investment would either disappear or be significantly negatively impacted.

"It demonstrated that the courts would defend against the aggressive changes in the political swings that can happen in the United States," he says.

Kyoto Project Credits

The 1997 Kyoto Protocol and the 2015 Paris Agreement are separate and independent instruments of the United Nations Framework Convention on Climate Change (UNFCCC).

As part of the Kyoto Protocol, UNFCCC's Clean Development Mechanism (CDM) allows emission- reduction projects in developing countries to earn certified emission reduction (CER) credits, each equivalent to one tonne of CO2.

More recently, the focus and attention has shifted to the Paris Agreement, which will see countries implement their Nationally Determined Contributions (NDCs), leaving the fate of the CDM and CERs unknown.

"The future market for CERs remains somewhat uncertain, but we continue to see a role for these units – particularly in those emissions trading schemes that recognise CERs for offset purposes. However, the CDM transition in the context of Article 6 of the Paris Agreement remains highly contentious in the negotiations," says Ilona Millar, head of Baker McKenzie's Global Climate Change practice, which continued its multi-year winning streak for Best Law Firm in the Kyoto market and topped the poll for Chinese markets as well.

G Vishnu, quality manager of EPIC Sustainability, winner of Best Verification Company in the Kyoto markets, is positive about the role the market will continue to play in 2021: "We strongly believe that the Kyoto mechanism is the most matured mechanism, with an excellent technical and working foundation, which is a knowledge reservoir for future actions by the governments and society," he says.

Dr Madhukar, director of Kanaka Management Services, which won Best Advisory/Consultancy and Best Project Developer in the Kyoto markets, says the UNFCCC structure is "indispensable in a multilateral setup" but he cautions that time is fast running out for "cheap credits like renewables where there is not much real additionality".

Instead, he is seeing a shift to nature- based credits.

Chinese market

The Chinese national cap and trade market, originally expected in 2017, is still yet to be fully implemented.

It had been hoped that it would finally be up and running this year.While that has not happened, China has released an updated draft proposal on how the ETS would operate. Compliance has been also backdated to 2019.Nicolas Girod

The updates have been optimistically received by the carbon market, says Nicolas Girod, founding partner and managing director of ClearBlue Markets, and winner of Best Advisory/Consultancy in the North American markets (California) and Chinese markets.

"China is adopting policies that have worked for others, such as allowing China's nine ETS pilot markets to operate until 2025. Additionally, the Chinese government is reducing oversupply without hurting companies, by reducing benchmarks but also allowing for generous correction factors," he says.

Free allocations will be the primary means of distributing credits, while China Certified Emission Reduction (CCER) offsets will also be allowed – up to 5% for compliance markets.

Millar at Baker McKenzie says the potential for ETS participants to use a small portion of offsets for compliance is encouraging.

She adds that another key feature which the market is tracking closely is whether foreign investors will be able to trade in the scheme.

"We have been encouraged by the recent release of the updated allocation plan for the national ETS, along with the draft ETS rules and registry regulations, and are waiting with anticipation for trading activity to commence, likely in early 2021," she adds.

Looking ahead

There are plenty of significant market developments on the horizon. One key aspect will be clarification of rules surrounding Article 6 of the Paris Agreement, the outcome of which will determine how countries can reduce their emissions using international carbon markets.

Discussions on the matter were expected to take place at COP 26, which has been delayed by a year to November 2021.

In addition, the collapse in aviation fuel demand was a disappointing turn of events for those market participants expecting airlines to be big buyers of carbon offsets as part of voluntary preparations for Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), ahead of a mandatory phase due in 2027.

"Article 6 and CORSIA were both expected to be catalysts for an international carbon market to replace the CER market, of which over 3 billion tonnes is traded on ICE. Covid-19 has impacted both; one through the delay of COP26 and the other through the destruction of demand for airline fuel and the decision to utilise 2019 as the baseline," says Bennett at ICE.

The International Civil Aviation Organization (ICAO) Council's decision to use 2019 emissions as the baseline for CORSIA's implementation during the pilot phase of 2021 to 2023 has been controversial. If air traffic fails to recover to 2019 levels during this time, airlines will not be required to purchase carbon credits.

Despite these headwinds, Lack at Element Markets, says "it's still an incredible market" and he is hopeful that post Covid-19, there will be resurgence in air travel and that will lead to an increased demand for offsets: "We expect at least 550 million tonnes of demand coming from the airlines by 2035," he says.

He says that substantial investment is required to meet the requirements of both compliance regimes and CORSIA.

"We're very bullish about offset development opportunities: there are still a lot of credits out there that appear to be inexpensive relative to the demand we see on the horizon," he adds. Such a picture means carbon markets are likely to attract further interest from investors seeking to diversify portfolios or use carbon to hedge against energy transition risks.