Liquidity and Risk Mitigation Issues Remain in Carbon Markets

While the future for carbon trading and cap-and-trade emission reduction schemes is certainly bright, there still remain issues relating to liquidity and risk-mitigation.

While questions concerning the credibility of cap-and-trade schemes as a mechanism for reducing harmful emissions have diminished, there is still some way to go before all the infrastructure and processes are in place to ensure that the market for carbon credits operates as smoothly and efficiently as those in more standard asset classes. Certainly, the second half of 2008 saw some important steps taken to resolve outstanding issues surrounding emissions trading - namely the establishment of a linkage between the European Union (EU) and United Nations-backed schemes.

However, market participants still face some challenges regarding counterparty risk and finality of settlement, and these will continue to be exacerbated by the ongoing global economic turmoil.

At a macro level, the future for emissions trading appears bright. The recent change of administration in the US is likely to signal a shift in attitudes towards these schemes and progress has already been made at the state level, most notably in California. And other initiatives - such as the new Emissions Trading Scheme (ETS) in New Zealand - have begun to spring up around the globe. These developments all point to a viable future for emissions trading and, if all outstanding issues are adequately addressed, a genuinely global market in carbon credits may not be too far away.

Risk Mitigation

Throughout 2008, many commentators predicted that the overdue establishment of the linkage between the EU ETS and the UN-backed Clean Development Mechanism (CDM) would herald a rapid surge in trading volumes. While volumes are steadily increasing, the current economic turmoil and - in many countries - recession have certainly contributed to a slowing of the development of this new asset class. Indeed, speculative trading in carbon credits has been greatly reduced with some participants leaving the market altogether - for now - and trading based on fundamentals such as hedging exposure has once again become dominant.

However, economic developments over the past 12 months or so have cast the spotlight onto issues of counterparty, credit and settlement risk as confidence and trust have begun to evaporate in many quarters. And these are issues that will only become more pertinent as the numbers of market participants, and their geographic diversity, increases. The bulk of the participants involved in this market are currently large institutions - such as extraction and energy firms - that are able to dictate terms to smaller counterparties (and, realistically, are unlikely to present much of a credit risk). But as trading increases, both proprietary and for compliance purposes, market participants will need greater guarantees as to the integrity of their counterparties, as well as mechanisms to reduce the risks involved in settlement. And while trading across an established exchange may mitigate some of these risks, a great deal of emissions trading still takes place on an over-the-counter (OTC) basis.

The risk that one side of a deal may renege on its obligations is, of course, present in virtually all financial markets. However, the mechanisms for reducing such risks are far more developed for more mature asset classes such as conventional equities. Indeed, one of the best ways to mitigate this type of risk is through establishing safe and efficient payment systems based on internationally recognised standards and practices. Some transaction banks have begun to develop tools to deal with settlement risk in the carbon trading market - tools that are based on proven infrastructure that has been tailored to meet the specific demands of this unique market.

For example, Deutsche Bank's service brings the settlement of trades in carbon credits into line with the recommendations of the Group of Thirty (G30) body of leading financiers and economists. It relieves investors and traders of the responsibility for the settlement process and provides a single platform for holdings across multiple currencies and national markets within the context of the EU ETS and UN CDM schemes. By allowing traders to allocate their carbon holdings across different national carbon registries, it can also help mitigate potential liquidity restraints in any one particular market.

Future Outlook

While a truly global carbon market may be impossible in a world of nearly 200 countries, linking up schemes to establish something close to this is certainly feasible. Indeed, as the emissions trading market gets larger, liquidity will increase, prices should become more stable and the marginal costs of trading and compliance will continue to drop steadily.

However, linking up geographically diverse and disparate schemes will not be straightforward. For example, establishing the type of linkage - unilateral or bilateral - may be a sticking point, and issues such as price capping in one scheme but not another will have to be taken into account. Indeed, price caps are a contentious issue in themselves as many feel that they undermine the integrity and original purpose of emissions trading schemes.

While there will certainly be stumbling blocks, with the establishment of the linkage between the EU and UN schemes and the change in administration in the US heralding a change in attitude towards climate change, the future for cap-and-trade emissions reduction schemes has never been better. However, as trading volumes increase, the issue of reducing the risk associated with the settlement of trades will become more pronounced and there will be an increased role for trusted intermediaries to handle issues of clearing and custody.

While there can be no two opinions on whether carbon emissions should be reduced, there appears however to be a continuing debate among companies on how to appropriately account for carbon credits. "At present there is no authoritative literature under the generally accepted accounting principles (GAAP) in India or the US, or the International Financial Reporting Standards (IFRS) on CER (certified emission reduction) accounting," says Mr Rahul Chattopadhyay, Associate Director, PricewaterhouseCoopers, IFRS practice. "Most Indian companies show earnings out of carbon credit trading as other income as they are not recognised by tax laws."

For starters, CERs represent a unit of greenhouse gas that has been avoided and certified by the United Nations Framework for Climate Change (UNFCCC) under the CDM (Clean Development Mechanism) provisions of the Kyoto Protocol.

The CDM is a trading arrangement between industrialised countries that are committed to reducing their greenhouse gas emissions under the Kyoto protocol (so-called `Annex 1 countries') and fast-growing economies such as China, India and Brazil (so-called `host countries'). Annex 1 countries can invest in those entities based in the host countries that are eligible to receive CER certificates.

The number of entities in the fast-growing Kyoto-ratified economies that own and sell CERs issued according to the Kyoto Protocol's CDM has been increasing.

According to industry reports, the average size of Indian CDM project has grown to 80,000 CERs a year between January and August, as against about 55,000 CERs last year. (The global project average is 1,20,000 CER.) It may help to know that currently the price of one CER is 19 euros or Rs 1,200.

"The lack of accounting guidance in this area has created diverse financial reporting practices, posing clear challenges for the users of financial statements," frets Mr Chattopadhyay, in the course of a recent email interaction with Business Line. He is hopeful though that the robust IFRS framework may provide some solution in the interim period until the standard setters release the accounting pronouncement on emission rights.