11 December 2014

The only way is up

This year's winners in the carbon markets section of our annual rankings believe the tide has finally turned after the economic downturn in 2008 sent prices and volumes tumbling. Graham Cooper and Sophie Robinson-Tillett report

Optimism has returned to the carbon markets after several years of rock-bottom prices, depressed trading activity and policy uncertainty.

From the long-established EU Emissions Trading System (ETS), to the new markets in California and China, the winners of this year's Environmental Finance Market Rankings say the omens are good for the coming years.

This is not to say they expect volumes or prices to rise dramatically, or that policy is crystal clear. And, against the general trend, Australia has, for now at least, turned its back on greenhouse gas (GHG) trading.

But the widespread feeling is that the worst is past. "Most of the pain has occurred," says Andy Ertel, president and chief executive of US brokerage Evolution Markets, an ever-present winner in these annual polls. (see box 1)

Despite subdued overall activity in the EU ETS in 2014, the market "has been good to us," says Ertel. While other brokers have come and gone, he says Evolution stayed "focused and committed" and has been rewarded with a bigger market share.

Tradition, the other leading broker in the carbon markets this year, and winner in the EU ETS options category, is also bullish. "We expect an uptick in options activity in the year ahead," says John Molloy, head of environmental products.

The decision of many financial firms to turn their back on the EU ETS has also created an opportunity for new entrants. Notable among them is Redshaw Advisors, a start-up launched by Louis Redshaw, the former head of environmental markets at Barclays, which won three titles in this year's poll. (see box 2)

Box 1: Evolution Markets

"Investment banks' withdrawal from the carbon market has left a gap," Redshaw says. "Research has gone and price forecasts have gone". Yet there is a growing need for such information, he believes. By 2020, two-thirds of installations will be short of EU allowances, and many industrial end users face a double whammy of rising prices and declining allocations, he says.

Tschach Solutions, which shared the crown for Best Advisory/Consultancy, EU ETS, with Redshaw Advisors, agrees that EU allowance (EUA) prices are set to continue their recent recovery.

The German company bases its price forecasts on rigorous modelling of compliance buyers' behaviour. "That's the basis of our success", says Ingo Tschach, head of market analysis. Speculators have little influence on the market, except in the short-term, he adds.

Another multiple award winner in this year's Rankings – and a dominant presence in previous polls, is law firm Baker & McKenzie (see box 3).

Graham Stuart, head of the London office's environmental markets practice, says the EU ETS is "still in pretty poor shape". But, he adds, "I think that the situation in Europe is moving forward" thanks to proposals to restrict the number of EUAs in the system.

The estimated excess of more than 2 billion EUAs which has built up in recent years, has caused the price to plummet to below €5 ($6) earlier this year from a high of around 30 in 2008.

The first key decision, approved by the European Parliament in December 2013, was to withhold 900 million EUAs from the auctions scheduled for 2014-16.

This 'backloading' initiative was a temporary fix, says Stuart. But it showed there was still political will to try and make the EU ETS work. However, "the really important thing is the Market Stability Reserve (MSR)," he says. This longer-term approach to curb EUA supply, would automatically withhold 12% of allowances each year, if the number of EUAs in circulation exceeds 833 million.

The key questions are when the 'backloading' allowances will be returned to the market – currently scheduled for 2020 – and when the MSR will be introduced. The Commission has proposed 2021, but many market players want it to be 2017.

Another new winner in this year's rankings is Spanish firm Aenor, voted Best Verification Company in the EU ETS. Like Evolution, it has been gaining market share during the market downturn. "We've seen growth in the number of companies requiring our service," says Jose Magro, environmental services manager. In 2015, "we expect not only a strengthening of the scheme but more stability in its requirements," he says.

The same expectation is common in the newer markets of North America. Both the Regional Greenhouse Gas Initiative (RGGI) which covers nine states in the northeastern US, and California's two-year old carbon market, have made progress this year and participants are bullish about the future.

As in the EU ETS, Evolution Markets is the dominant broker in these markets and Baker & McKenzie is the leading law firm.

Volumes in the US markets have been higher than last year, says Evolution's Ertel. California trades in fits and starts, he notes, but "it looks more like a market than last year".

2014 has been a growth year for the US carbon market, agrees Rick Saines, head of Baker & McKenzie's North American climate change and environmental markets practice. "California seems to be surviving the various challenges that have been thrown at it and … people are recognising it's here to stay," he says.

Integrating a carbon price has now become "part of overall business planning," agrees Randy Lack, chief marketing officer at Element Markets, voted Best Trading Company, Options, in the California market.

Companies are mainly focused on achieving compliance, rather than long-term planning, he says, but Element has been helping some firms put hedges in place.

Allowance prices have not moved far from the floor price of $11.34 in the past year, but the planned extension of the programme to bring in fuel distributors from January, should boost demand. This is likely to mean higher prices, even though these companies will have three years in which to demonstrate compliance with their initial target, traders say.

"I think you'll see a bump in pricing next year, if fuels are included, but it will be blunted by the [three-year] averaging period," Saines says. "There will also be more offsetting protocols and projects admitted to the California market," he adds.

California has been particularly important for EOS Climate, voted Best Project Developer in North American GHG markets. "Most of the offset credits we've generated have been sold in the California compliance market," says Jeff Cohen, senior vice-president of science and policy.

Michael Coté, president of Ruby Canyon Engineering, which held on to its crown as Best Verification Company in the North American markets, agrees. "The biggest growth we've seen is in the California compliance market. That's been a big market for us. … We expect it to continue growing."

Cohen is also bullish on the market's future. "California recently had its first joint auction of allowances with Quebec – that is adding to the momentum to expand the scope of market-based mechanisms in North America."

Further expansion of the RGGI market is also possible, following the Environmental Protection Agency's June call for power plants to cut their emissions by 30% from 2005 levels by 2030.

The proposal gives states the choice of using emissions trading to comply with the GHG regulations and "joining RGGI could be the path of least resistance," says Lack of Element Markets.

"The EPA is encouraging states to look at regional approaches, and encouraging emissions trading. So I think there's some room for optimism," agrees Saines of Baker & McKenzie.

Like the EU ETS, RGGI suffered from an excess of allowances which left prices languishing around the auction reserve price of $1.86 until late 2012. But the bold decision to cut the annual emissions cap by 45% from January this year has seen prices rise above $5, with the 5 December auction posting a clearing price of $5.21.

"The environmental markets are finally maturing," says Izzet Bensusan, CEO of Karbone, voted Best Advisory firm in the California market and North American markets overall. "We've seen significant growth in traded volumes, notional value and number of clients in the past 12 months," he adds.

Many market players are also optimistic about the Chinese carbon market. This currently comprises seven pilot programmes, with a nationwide trading system planned by 2020 and possibly as early as 2016.

But the country faces some "structural limitations," which will need to be resolved before an efficient national market could be introduced, says Karl Upston-Hooper, general counsel with GreenStream Network. The Helsinki-based firm is licensed to trade in three of the Chinese pilot markets and retained the title of Best Advisory/Consultancy (China) in this year's poll.

He points out that China doesn't have a liberalised power market, so power companies can't pass through the price of carbon. "But power makes up about 42% of [China's] emissions". Also, Chinese exchanges "are prohibited by law from offering futures or forward contracts".

"If you were to be realistic, you could say that China has so far not developed a carbon trading scheme, but an emissions monitoring scheme," he says. He expects to see signs emerge next year about how the national market will be structured.

China's resolve to curb its GHG emissions was made clear in an announcement in November that the country is aiming for its emissions to peak by 2030 and decline thereafter.

The announcement coincided with President Barack Obama committing the US to reduce its GHG emissions to 26%-28% below 2005 levels by 2025. This compares with a current US target of a 17% reduction by 2020.

These commitments bode well for next year's UN climate change negotiations in Paris, market insiders say.

"The development of China's domestic market and the outcomes of the [UN climate change talks] in Paris will be two decisive factors in determining how the market for international offsets and project-based credits will develop," says Michael Curran, manager of European utilities trading at Vitol, voted Best Trading Company in RGGI and the Best Trading Company for spot and futures contracts in the California market.

Sindicatum Group, voted Best Project Developer and Best Primary Originator in the Kyoto Project Credits market, is also taking a great interest in China, says CEO Assaad Razzouk.

Following the collapse in prices for Kyoto offset credits, Sindicatum has "refocused on clean energy assets" in four countries – India, Thailand, Indonesia, and the Philippines. It still holds a portfolio of carbon credits from Clean Development Mechanism (CDM) projects in China, but is unable to sell them at present, Razzouk notes.

Demand for CDM credits has dried up as few emitters in the EU have any need to buy project-based credits to supplement their EU allowances.

Box 2: Redshaw Advisors

Many hope this mechanism for financing emission reduction projects in developing countries can be resurrected in some form in a new international agreement on climate change that they hope will emerge from the UN negotiations in Paris.

Although it has many critics, the CDM is estimated to have channelled some $400 billion to developing countries, and prevented around 1.5 billion tonnes of carbon dioxide emissions.

As the price of CDM credits has collapsed to below 0.4 from about 20 in 2008, activity has dried up - as this barely covers the cost of verifying the emission reductions.

The fees for validation and verification have gone down drastically, says K Sudheendra, director and head of operations at EPIC Sustainability Services of Bangalore, voted Best Verification Company for Kyoto Project Credits in this year's poll. And "it feels sometimes the [verifier] may not recover the cost of service delivery," he adds.

But the future looks brighter. "The market is expected to become more and more active" depending on the outcomes of the Lima and Paris meetings, he adds. These "will decide the future of the climate regime and associated businesses," he says.

Fellow Indian company Kanaka Management Services, voted Best Advisory/Consultancy in this category, agrees. If the outcome of this month's Lima meeting is positive "then the market will start climbing," says director Nandagopal Paramesh.

Kanaka is currently focused on Asian markets but, if the Lima meeting triggers renewed interest in the CDM, expansion into new territories is planned.

So, across the world, the carbon markets seem poised for growth. The glaring exception, however, is Australia, where the government recently repealed the Carbon Pricing Mechanism, a tax which was evolving into a trading market.

"It's been a bumpy year in Australia, with the government trying to rescind a lot of the regulatory frameworks that drive the green markets," says Chris Halliwell, senior broker at TFS Australia, named Best Broker in the Australasian markets.

Some carbon market insiders say a new A$2.55 billion ($2.12 billion) government fund, which will pay industrial emitters for their emission reductions, could evolve into a baseline-and-credit market. But others say the issue has become so political, the future is highly uncertain.

Box 3: Baker & McKenzie

"It is unclear how effective the emissions reduction fund will be" says Martijn Wilder, Sydney based head of Baker & McKenzie's global environmental markets practice.

Freddy Sharpe, CEO of Climate Friendly, says his firm – voted Best Project Developer in the Australasian markets – has seen a growing number of forestry and land-use projects being developed this year. But, as these offsets were mostly intended for use under the Carbon Pricing Mechanism, demand will dry up once the final 'true-up' period ends in February 2015.

After that date, such projects will have to sell their offset credits either into the government's Emissions Reduction Fund or the voluntary market. In either case, it is likely that prices will be lower than has been the case in the compliance market, he warns.