Carbon Credit and Emissions Trading - Dissertation Example

? The carbon credit and emissions trading market: Price drivers and market structure for emissions trading August 24 INTRODUCTION The spectre of green house gas emissions, pollution and deteriorating quality of air have forced governments to bring in the practice of carbon credits and emissions trading. Governments acknowledge that it is not feasible or possible to reduce or stop activities that lead to carbon emissions (Hbsp, 2007). The system of emission trading allows a central authority such as a government commission or the stock exchange commission to set a limit on the amount of emissions that a nation can release and this limit is called the cap. Regulatory agencies of governments sell smaller units of this limit to individual organisations in the form of emission permit or carbon credit (Bayon, 2007). The emission permit gives an organisation the right to emit a specified volume of green house gas. The carbon credits can be traded in the market and on specified stock exchanges. Organisations must buy the required number of permits equivalent to the amount of emissions. There is a limit on the total number of permits that are offered by the government. If an organisation needs more permits, it can buy these from the market and thus offset their emissions. The whole system of carbon credit trading is rigidly controlled by the stock exchanges. While erring firms now have the option of getting away with pollution and excess emissions, the government is at least making these firms to pay for the emissions. Since the number of carbon credits available is limited, the price of the credits can fluctuate. Eventually, erring firms would be expected to improve their process so that fewer emissions take place. The carbon credit trading market is worth more than 64 billion USD in 2007 and the market is expected to grow rapidly as accountability increases (Tietenberg, 2009). This dissertation will research the structure of carbon credit market and emissions trading. The dissertation will also examine price fluctuations, drivers for price variations and make recommendations to improve the market structure. 1.1. Rationale for the paper The term carbon credit is used to identify a permit or tradable certificate. It gives the owner the permission to emit one tonne of greenhouse gases or carbon dioxide or any other equivalent gas such as sulphur or carbon monoxide. One carbon credit represents one metric tonne of green house gases and is designated by the term tCO2e. The Kyoto Protocol brought in some accountability for nations and signatories to this protocol agreed for some legal targets that limited the amount of emissions by each nation (Stone, 20110. The European Union Emissions Trading Scheme - EUETS and other bodies have agreed to reduce the CO2 emission by 8% in 2012 as compared to the 1990 levels. As per the protocol and agreements, emission quotas were assigned to each nation and these are called as assigned amount units AAAs. Each nation was allowed to sell these units to industries and even individuals. Based on the nature of industry and processes, each industry was expected to buy a certain amount of units. Failure to comply would result in social stigma besides having to pay extra taxes. In some nations, these units were in shortage and in France, Germany and UK; the price for a unit quickly rose from 50 Euros to 90 Euros per unit. Croci (2011) says that nations such as Russia, Ukraine and many other former USSR satellite nations had huge surpluses and they dumped their AAAs in the market, bringing the market down. It was also seen that during recession, the amount of emissions in many nations reduced and this was mainly due to fewer industries operations. Overall, the market for carbon credit sees a lot of volatility, fluctuations and even price manipulation (Stone, 2010). Existing literature does not examine these aspects or understand the correlation between various drivers. In addition, since the subject of emissions trading is relatively recent, many studies have not been conducted in this field. This dissertation will strive to fill this gap by researching the market, studying various trading organisations and analysing the market drivers. 1.2. Literature Review According to Chevallier (2009), energy credit trading is done in the same manner as stock trading or commodity futures and derivative trading is done. To trade directly on the floor of the exchange, one has to be a member of the bourse; else trading can be done through brokers or by electronic trading. Just as crude futures are traded in the commodity markets such as NYMEX, brokers are allowed to trade in carbon credit futures. Greising (2008) suggests that in such a trade, a contract of a certain volume of credits can be offered for sale and these would be a forward futures contract that would be called at a fixed future date. According to Madaleno (2011), the rate as of today called the spot rate may be lesser than the rate per contract at a future date. Therefore, traders agree to buy the contract that would mature for example on December 25, 2008. On the specified date, the broker has to call the future and pay the specified contract value and take delivery. If the rate at the future date is more than what he has paid today he makes a profit, else he makes a loss. Traders are allowed to offload their contracts at any point of time if they feel the price is right, by paying the spot rate (Matsumoto, 2010). Given below is a live example of future contracts along with the historic rates, taken from the ECX futures contract database. Detailed movements of the price and volume are given in the graph (ECX, 2008). Figure 1.1. Carbon Credit Futures Contracts to 26 Dec, 2008 (ECX, 2008) As seen in the above graph, the actual futures contract rates as on date 11 October 2008 for settlement date of 26 December 2008 is about 23 Euros/ tonnes. The contract rate on 2 June 2006 was about 27 Euros/ tonne and the highest rate achieved in the period was about 33 Euros per tonne. The market is falling for carbon credits and this is in line with the general fall in the stock market in the world. Though there is a huge fall in stock prices across the world and there are threats of recession coming in, the prices of carbon credits have not fallen to the extent that stock indices have plunged (Stevens, 2011). Therefore, this is a relatively stable market (ECX, 2008). Following graph shows the trading prices as on 12 October 2008. Figure 1.2. Carbon Credit Spot Rates as on 12 October, 2008 (ECX, 2008) The above table gives the spot rates for EUA and CERs for different contracts that would be called from December 10 to December 14 and for December 2009. Rates are given in Euros per tonne for bid, ask, first, last, high and low. Bid rates refer to the rate that a buyer is ready to pay; ask is the rate that the seller wants; first is the first rate that was quoted, last is the last rate that was quoted before the bourse closed; high is the highest rate that was quoted while low is the lowest rate that was quoted and ‘Sett’ is the rate at which the contract was settled. Total volume refers to the total number of contracts that were traded. On contract is for 1000 tonnes of Carbon dioxide in EUAs or CERs units and fifty contracts is about 50,000 tonnes. The settlement prices in taken as the average if volume and weighted average of the total trade that has been conducted. A fixed time between 16.00 and 16.15 GMT local time is set aside and the results are notified after the bourse closes (ECX, 2008). According to reports by Point Carbon (Point Carbon, 13 March 2008), the world carbon and emission trading market in 2007 was 64 billion USD and this represented an increase of 80 percent over 2006. While 1.6 billion tonnes of carbon was traded in 2006, the figure rose to 2.7 billion tonnes in 2007. There are different types of trading markets that function like stock markets and the important ones are European Union Emissions Trading Scheme - EU ETS, Clean Development Mechanism - CDM; Joint Implementation - JI and the independent voluntary markets. Each market has its own trading patterns, volumes, and issue instruments such as the EUAs - European Union Allowances and the CERs - Certified Emission Reductions (Stone, 2010). Carbon Offset is a type of financial derivatives instruments that represent a specific amount of reduction in greenhouse gas emissions. The units of carbon offset give the reduction of one MT (metric ton) of CO2e, or its equivalent in other greenhouse gases. Companies and nations that cannot control their pollution and emission can buy the carbon offset to compensate the extra pollution they have caused and in 2006, about 5.5 billion USD worth of carbon credits were purchased and this represents reductions of carbon dioxide of 1.6 billion metric tons (Tietenberg, 2009). Individuals who feel that they are causing pollution by frequent air travel or who commute by car can also buy these offsets to compensate for the pollution that they have caused. In 2006, individuals purchased about 91 million USD worth of carbon offsets. This means that they have contributed to 1.6 billion MT of reductions in CO2. Funds that are generated from carbon offsets are used for the development of renewable energy generation projects (Gillenwater, 2007). As seen in the above paragraphs, the market for emission trading is very well organised. Ehrhart (2008) has alleged that the current market structure allows big firms to pool their resources and manipulate the market so that they manage to buy the credits at lower prices. The author asserts that shrewd traders misuse project based or pooling norms to create output restrictions that suppress the prices when the call rates at delivery time is issued. This results in artificial suppression of price and the traders are able to offset their losses. Wang (2008) says that such practice are not illegal since EU trading norms do not forbid such activities but they are unethical, considering that emission trading has been brought in for noble causes of global warming reduction and organisations should not make profit out of misery. However, obviously for some people, profits are crucial and they would not regard anything as sacrosanct. A number of issues regarding the price volatility and price movement with reference to the standard indices will also be examined in the research. 1.3. Research Question and Objectives The research question framed is “The carbon credit and emissions trading market: Understanding the Price drivers and market structure for emissions trading”. Some objectives have been framed and these are as given below. Understanding the market structure and exchange where carbon credits are traded Analysing the price movements over the years on different exchanges Evaluating the link if any, between the price of carbon credits and indices such as Nymex crude price, Dow Jones, GDP of selected nations and the industrial development 1.4. Methodology The paper dissertation will use the quantitative method of research supported by case studies and secondary research. Resources used will include databases of emission stock markets, peer-reviewed databases as ProQuest, reliable government websites and company annual reports. The method of analysis will be based on a contextual analysis. References Bayon, R., March 2007. Voluntary Carbon Markets: An International Business Guide to What They Are and How They Work. Earthscan Publications Ltd. Chevallier, J., 2009. Emissions trading: what makes it work? International Journal of Climate Change Strategies and Management, 1(4), pp. 400-406 Croci, E., 2011. Determinants of cities’ GHG emissions: a comparison of seven global cities. International Journal of Climate Change Strategies and Management, 3(3), pp. 275-301 ECX. 2008. European Climate Exchange. [Online] ECX. Available at http://www.europeanclimateexchange.com/default_flash.asp [Accessed 22 August 2011] Ehrhart, K., 2008. Abuse of EU Emissions Trading for Tacit Collusion. Journal of Environment Resource Economy, 41, pp: 347–361 Gillenwater, M., 2007. Policing the voluntary carbon market. Journal of Nature Reports Climate Change, 6. pp: 85–87 Greising, D., 2008. The carbon frontier. Bulletin of the Atomic Scientists, 64(3), pp. 32-37 Hbsp, 2007. Harvard Business Review on Green Business Strategy. Harvard Business School Press, USA Madaleno, M., 2011. Risk premia in CO2 allowances: spot and futures prices in the EEX market. Management of Environmental Quality: An International Journal, 22(5), pp. 550-565 Matsumoto, K., 2010. Analyzing long-term impacts of carbon tax based on the imputed price, applying the AIM/CGE model. Management of Environmental Quality: An International Journal, 22(1), pp. 33-47 Point Carbon, 13 March 2008. Carbon Market Insights 2008. [Online] Point Carbon. Available at www.pointcarbon.com [Accessed 23 August 2011] Stevens, K., 2011. Comparative study of selected greenhouse gas offset protocols. International Journal of Climate Change Strategies and Management, 3(2), pp. 118-139 Stone, M., 2010. Carbon Management in Emerging Economies: New mechanisms for managing carbon dioxide emissions. Business Insights, London, UK Stone, M., March 2011. Corporate Carbon Strategies: Threats and opportunities arising from the new energy imperative. Business Insights, London, UK Tietenberg, T. H., 2009. Emissions Trading: Principles and Practice, 2nd edition. RFF Press, USA Wang, Q., 2008. From command and control regulations to a business proposition: creating a Chinese market for emissions trading. International Journal of Energy Sector Management, 3(1), pp. 62-82 Read More