Carbon (CER) - Commodity Trading Knowledge

Carbon (CER)   CARBON CREDITS – A MARKET OF THE 21st CENTURY

With growing concerns among nations to curb pollution levels while maintaining the growth in their economic activities, the emission trading (ET) industry has come to life. And, with the increasing ratification of Kyoto Protocol (KP) by countries and rising social accountability of polluting industries in the developed nations, the carbon emissions trading is likely to emerge as a multibillion-dollar market in global emissions trading. The recent surge in carbon credits trading activities in Europe is an indication of how the emissions trading industry is going to pan out in the years to come.

What is a carbon credit? Simply put, one carbon credit is equivalent to one tonne of carbon dioxide or its equivalent greenhouse gas (GHG). Carbon credits are “Entitlement Certificates” issued by the United Nations Framework Convention on Climate Change (UNFCCC) to the implementers of the approved Clean Development Mechanism (CDM) projects. The potential buyers of carbon credits shall be corporates in various Annexure I countries that need to meet the compliance prevailing in their countries as per the Kyoto Protocol or those investors who would like buy the credits and with the expectation of selling them at a higher price during the KP phase (2008-12). The extension of KP shall be ratified by the current signatories of KP in their future meetings essentially to curb GHG emissions into the environment.

Sources of demand & supply

Emerging carbon credit markets offer enormous opportunities for the upcoming manufacturing/public utility projects to employ a range of energy saving devices or any other mechanisms or technology to reduce GHG emissions and earn carbon credits to be sold at a price. The carbon credits can be either generated by project participants who acquire carbon credits through implementation of CDM in Non Annexure I countries or through Joint Implementation (JI) in Annexure I countries or supplied into the market by those who got surplus allowances with them. The buyers of carbon credits are principally from Annexure I countries. They are: Especially European nations, as currently European Union Emission Trading Scheme (EU ETS) is the most active market; Other markets include Japan, Canada, New Zealand, etc. The major sources of supply are Non-Annexure I countries such as India, China, and Brazil.

Trading In Carbon Credits

Emissions trading (ET) is a mechanism that enables countries with legally binding emissions targets to buy and sell emissions allowances among themselves. Currently, futures contracts in carbon credits are actively traded in the European exchanges. In fact, many companies actively participate in the futures market to manage the price risks associated with trading in carbon credits and other related risks such as project risk, policy risk, etc. Keeping in view the various risks associated with carbon credits, trading in futures contracts in carbon allowances has now become a reality in Europe with burgeoning volumes. Currently, project participants, public utilities, manufacturing entities, brokers, banks, and others actively participate in futures trading in environment-related instruments.

Price influencing factors

In Non-Annexure B countries (the developing countries) across the world, CER prices are influenced by various factors including EUA prices, crude oil prices, electricity, coal, natural gas, the level of economic activities across Annexure I countries, among others

Some of the major price influencing factors:

Supply-demand mismatch Policy issues Crude oil prices Coal prices CO2 emissions Weather/Fuel prices European Union Allowances (EUAs) prices Foreign exchange fluctuations Global economic growth

Risks associated with carbon credits

There are market- and policy-related risks for CER producers, including the supply-side risks starting from the DNA approval risk to the CER issuance risk in a complete CDM approval cycle. Apart from these risks there are a host of other risks from both the supply and demand sides that the real market players confront with. Most CDM projects by their very nature take a long time to generate the CERs and hence, face the aforesaid risks in large proportion, which if not hedged would lead to reduced realization. Under such a situation, the realization of CER generators at times may not even cover the investment put in to generate the CERs and thus, has the potential of even making a CDM project unviable in the long term. Given the long gestation period of CDM projects and the risks involved, it is rather inevitable that they pre-sell their potential credits in the futures market (preferably a domestic futures market, to avoid forex risk attached to participation in a foreign exchange) and thereby, cover their probable downside in the physical market.

Potential participants in carbon credits trading are as below

Hedgers Producers Intermediaries in spot markets Ultimate buyers Investors Arbitragers Portfolio managers Diverse participants with wide participation objectives Commodity financers Funding agencies Corporates having risk exposure in energy products

India as a potential supplier

India, being one of the leading generators of CERs through CDM, has a large scope in emissions trading. Analysts forecast that its trading in carbon credits would touch US$ 100 billion by 2010. Currently, the total registered CDM projects are more than 300, almost 1/3rd of the total CDM projects registered with the UNFCCC. The total issued CERs with India as a host country till now stand at 34,101,315 (around 34 million), again around 1/3rd of the total CERs issued by the UNFCCC. In value terms (INR), it could be running into thousands of crores. Further, there has been a surge in number of registered projects in India. In 2007, a total of 160 new projects were registered with the UNFCCC indicating that more than half of all registered projects in India happened last year. It is expected that with increasing awareness this would go further up in the future. The number of expected annual CERs in India is hovering around 28 million and considering that each of these CERs is sold for around 15 euros, on an average, the expected value is going to be around Rs 2,500 crore.

Various industries that have scope of generation of CERs:

Agriculture Energy ( renewable & non-renewable sources) Manufacturing Fugitive emissions from fuels (solid, oil and gas) Metal production Mining and mineral production Chemicals Afforestation & reforestation

The role of MCX

With MCX keen to play a major role on the emission front by extending its platform to add carbon credits to its existing basket of commodities with regard to commodities futures trading, the existing and potential suppliers of carbon credits in India have geared up to generate more carbon credits from their existing and ongoing projects to be sold in the international markets. With India supposed to be a major supplier of carbon credits, the tie-up between the two exchanges is expected to ensure better price discovery of carbon credits, besides covering risks associated with buying and selling.

Advantages of an MCX carbon contract

In India, currently only bilateral deals and trading through intermediaries are widely prevalent leading to sellers being denied fair prices for their carbon credits. Advantages that the MCX platform offers are:

Sellers and intermediaries can hedge against price risk; Advance selling could help projects generate liquidity and thereby, reduce costs of implementation; There is no counterparty risk as the Exchange guarantees the trade; The price discovery on the Exchange platform ensures a fair price for both the buyer and the seller; Players are brought to a single platform, thus, eliminating the laborious process of identifying either buyers or sellers with enough credibility; and The MCX futures floor gives an immediate reference price. At present, there is no transparency related to prices in the Indian carbon credit market, which has kept sellers at the receiving end with no bargaining power.