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Your ask the expert: Carbon trading

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  • Abyd Karmali answers your questions on carbon emissions trading
  • What is a simple explanation of cap-and-trade given?
  • How does the financial crisis affects carbon trading market?
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You wanted to know more about carbon trading, and Abyd Karmali, Managing Director and Global Head of Carbon Emissions at Merrill Lynch answered.

How will the current financial crisis affect the carbon market?

"For starters, kindly give the uninformed a simple definition of the term 'carbon trading'."
Ako Amdi, Nigeria

Karmali: "Carbon trading" has become jargon for "cap-and-trade system for reducing greenhouse gas emissions."

There are several concepts included here that need further explanation.

First, "greenhouse gases" refers to several gases recognized by scientists as enhancing the greenhouse effect. The most important of these in terms of their global contribution to climate change are carbon dioxide and methane.

"Cap" means the quantitative limit of emissions that is imposed by a regulator on a region, a country, a set of sectors, or a group of installations. The cap is usually expressed in terms of a certain amount of greenhouse gas emissions permitted to be emitted in one year.

The cap is then broken down into allowances (also sometimes called permits) and then those allowances distributed to each of the entities that has the legal obligation to comply with the cap. Each allowance corresponds to one unit of emissions (e.g. one tonne of carbon dioxide equivalent).

The regulator's objective is to set the cap so that there is a shortage of allowances relative to what the companies' business-as-usual emissions will be.

It is this scarcity of allowances that sets the price of emissions in the marketplace and can allow a derivatives market (futures and options) to emerge. The economic benefit from carbon trading comes in the "trade" part.

At the end of the emission accounting period (usually year-end) each entity with a compliance obligation will need to hold allowances that are at least the same in number as its actual emissions for the period.

Entities now face a critical choice with every unit of emissions they produce. Should they purchase emissions allowances from other participants in the market or should they find ways to reduce emissions by implementing changes in their operations?

The virtues of the carbon trading approach are many. The principal one is that, when considering all of the participants' overall costs of reducing emissions, economic theory and now business practice teaches us that a carbon trading approach is the least cost way of meeting the environmental objective.

Another key benefit of trading is each of the participants under a cap has complete flexibility in how they reduce emissions.

The price of carbon thus acts as both a motivator for action and a catalyst for technological innovation. Furthermore, it rewards companies who over-reduce their emissions since they can earn revenue from selling their allowances to those who find it less easy to reduce emissions.

I know you asked for a simple definition Ako but one other important point I should mention is that "carbon trading" is sometimes used synonymously with "carbon markets."

The latter usually refers to "cap-and-trade" and "baseline-and-credit" approaches, the latter which refers to generating carbon credits for implementing eligible emission reducing projects measured against an approved baseline scenario.

At present roughly 80 percent of the value transacted in the global carbon markets is via carbon trading and around 20 percent through carbon credit deals.

One of the keys to ensuring an efficient carbon market is for the financial instruments traded under cap-and-trade programs to be fungible (exchangeable) with those created under baseline-and-credit programs. This is precisely what the drafters of the Kyoto Protocol had in mind by including both emissions trading and carbon credit mechanisms in the architecture of the international agreement.

The European Union is an example of a region that has implemented these principles by creating the world's largest emissions trading program known as the EU Emissions Trading Scheme which allows entities with compliance obligations to meet part of the reductions in emissions by purchasing carbon credits generated from eligible projects in developing countries.

"How has the recent investment banking crisis affected capital flows into carbon trading schemes? Is carbon trading as a concept threatened by the current instability in the world's financial system?"
Theresa Moore, UK

Karmali: This is a very timely question Theresa.

My view is that the carbon crunch is a longer-term crisis that is multi-generation in nature and will significantly outlast the ongoing credit crunch. This is certainly not to diminish the nature of the current financial crisis but rather to put it into perspective against the scale of the challenge posed by climate change.

In the short-term there will be some impacts. For example, there is already a slowdown in the carbon credit segment of the market.

This is for several reasons:

1) Finance for carbon credit projects is more difficult to secure - this is particularly the case for projects that would have been seeking debt finance.

2) Financial institutions are looking in much more detail at counter-party risks and many of the carbon project developers operating in the carbon markets tend to be undercapitalized.

3) The underlying trend was for primary CER project development activity to slow down already given the post-2012 policy uncertainty which may only be resolved by December 2009 at the earliest.

Merrill Lynch's forecast, however, is that the global carbon markets are still on course to record significant year on year growth which should easily top $100 billion as compared with $ 64 billion last year.

Some of the other activities in the frontier areas of the carbon markets, e.g. financing avoided deforestation projects, will likely slow down because the carbon instruments being created are less liquid than existing Kyoto-compliant carbon instruments trading in the market.

On the flip side, there should be more emphasis on companies covered by carbon caps to seek cost-effective emission reductions since companies face more pressures to reduce operating costs.

Also, proactive companies can take advantage of the opportunities presented in the carbon markets to secure cheaper financing than that available in the financial markets.

For example, companies should be more inclined to put on "repo" trades where they can exploit the fact that the true cost of carry is not fully reflected in the forward curve and so they can make returns from selling short-term allowances to a financial intermediary, investing the funds in risk-less financial instruments, and purchasing back their longer-term allowances.

Say I want to set up a small green business, composting and earthworm farming locally, would I get access to carbon trading?
Pat Sommer, Beijing, China

Karmali: The activity you describe sounds like a promising and sustainable business venture but unfortunately may not be generating carbon credits in sufficient scale to merit carbon financing.

Carbon finance deals typically have transaction costs that can add up to around $50,000 to $100,000 to the overall costs. Whether your business venture could exploit the financing available via the carbon markets is also subject to the ever evolving rule book of what constitutes an eligible carbon credit.

In the absence of specific numbers or details, however, a useful exercise to undertake would be to consider the carbon footprint of the business as usual scenario which will serve as a comparison case for your green business activities.

For composting, this might be more traditional waste management which typically releases methane emissions.

Lets say that you conclude that your business venture is reducing X tonnes of greenhouse gas emissions per year compared to the reference case. In this case you are on the way to passing what is known as the "additionality" test, i.e., demonstrating that your business is less carbon intensive than the reference case and resulting in real, measurable, and independently verifiable carbon emission reductions.

You will undoubtedly have a good sense of the costs involved in setting up and running the business and so can come up with a levelized cost estimate that tells you the $/tonne of emissions reduced.

This is a good number to flag for potential investors who can then compare that price against the prevailing price of carbon in today's market. You should also be prepared to answer tough questions about the variety of "carbon credit delivery risks."

For example, if an entity is buying carbon credits from you, they will want to know factors like: 1) how well will you likely execute your business venture over the time, 2) how financial stable is your venture, and 3) is there any technology performance risk?

Pat, I wish you the best of luck in your venture, regardless of whether you succeed in attracting carbon finance.

Click here to read more of your questions and Abyd Karmali's answers on cap-and-trade and carbon emissions.

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