Climate change concerns draw attention from different industries and individuals. Whether they are based on well-justified information or driven largely by expectations, one thing is for sure: the fight against climate change brings more data. These data points and services include more reporting on emissions, climate projections, and emission allowances emerging as a product of cap-and-trade programs.

As the annual UN Climate Change Conference in Durban, South Africa, is approaching, we are watching developments in the carbon markets. With the Kyoto Protocol’s first commitment period (2008–2012) getting closer to expiration, the conference will focus on securing a global climate agreement extension of the Kyoto Protocol into Phase II. Besides this issue, there is an interesting proposal, submitted by Russia, which calls for a periodic review of the list of countries falling under “developed” versus “developing” status. Re-categorized to the “developed” status, countries will face greater financial contributions, which, under the current conditions, are loaded towards the developed parties. If this proposal is accepted, several large developing countries will be assigned to the “developed” camp, will have cap-and-trade programs implemented. This means more products for the primary compliance markets, but mostly secondary financial markets.

Europe is a leader in environmental products traded under the European Union Emissions Trading System (EU ETS), the first emissions trading scheme in the world launched in 2005. In the meantime, low liquidity and loss of confidence has been a matter of concern. Some of that resulted from the EU ETS’ market crisis following a wave of approximately 3.3 million carbon credit (costing about EUR 30 million) thefts in early 2011. Besides, the EU carbon market has been undermined by the excess supply as a result of lower than expected industrial output during the recession.

The graphs below demonstrate the drop in prices of European carbon products traded on different platforms:

ICE ECX CFI futures contracts for December 2011 and December 2012 expiration dropped in price in winter 2009. EEX spot contracts suffered a similar blow at the same time period. None of them succeeded in recovering and returning to the previous price level.

Different mechanisms that reduce the risk of repeated system break-ins have been considered. One of them is the possibility of carbon spot contracts to be reclassified as financial instruments thus becoming subject to the Market Abuse Directive. Liquidity of carbon markets is expected to be improved through introduction of an EU-wide cap replacing the current National Allocation Plan system and the shift toward 50% of the allowances to be auctioned compared with just 3% in EU ETS Phase II (2008-2012). A stricter cap was introduced for Phase II and even more actions are being asked for in Phase III that will run between 2012-2020. Deutsche Bank estimates that with the addition of the Phase III contracts, the system will be short 400 million allowances through to 2020, which is likely to boost volumes of carbon trading.  

While the EU is struggling with the fall of consumer confidence and trying to find ways to increase liquidity of the markets, the US carbon markets have built an even more interesting case. First of all, after many attempts to pass a federal bill, nothing has ever come to fruition. Currently there is no federal carbon reduction program in place and not much is expected to occur in the nearest future.

At the same time, there has been an active carbon derivatives market. Without any underlying component, they were somehow priced and have been traded. However, at the end of 2009 it became apparent that the most aggressive attempt to introduce a nation-wide carbon cap-and-trade system as a part of the American Clean Energy and Security Act of 2009 failed. The prices for futures dipped and have continued dropping since then. The graph below demonstrates results of trading three Carbon US Futures contracts on CCFE platform.

Doomed by the drop in the market participants’ interest and plagued by the Congress’ failure to pass any binding cap-and-trade bill, in 2010 the Chicago Climate Exchange ceased its trading of carbon emissions and ultimately collapsed to its demise.

The drive to act on expectation of something grander to come along and to be the first entrant played out badly for many. At the same time, this approach contributed to generation of more market data, even though sometimes misleading. We just have to wait and see what the new fashion trend, a.k.a. California cap-and-trade program, will bring to us. With the compliance period starting only in 2013, California carbon allowance products are already traded by ICE, GreenX, and various brokers; whilst Argus launches California CO2 Allowance Index…

To learn more about the subject read ZE DataWatch November 2011 issue at: Datawatch November