Published: September 02, 2011
In 2010 the global carbon market was valued at approximately $142bn. This represents a slight decrease in value on the previous year ($143.7bn, 2009) and a reverse in the trend after five years of consecutive, robust growth. The global carbon market comprises both compliance markets and voluntary markets but the large majority of transactions occur within the compliance markets with the voluntary markets accounting for only 0.3% of total global carbon market volumes.
The CDM market represents an opportunity for the developing continent to engage in the carbon market by implementing project activities which reduce carbon emissions.
Within the compliance markets the European Union Emissions Trading Scheme (EU ETS) accounts for 84% of the global carbon market and therefore the major trends within the global market are dominated by the rules and regulations promulgated by the European Commission (EC) with respect to the EU ETS. Certified Emission Reductions (CERs) generated by CDM projects in developing countries, more commonly referred to as ‘carbon credits’, can be used for compliance purposes within the EU ETS and together with the EU ETS allowances, secondary CDM transactions comprise 97% of the current global carbon market. This article examines the state and trends of both the EU ETS and CDM market in detail before taking a brief look at other international compliance schemes and the voluntary market.
Of most interest, from an African perspective, is the CDM market as this represents an opportunity for the developing continent to engage in the carbon market by implementing project activities which reduce carbon emissions from the ‘business as usual’ or baseline scenario. These projects, upon registration with the UNFCCC, are compensated for their efforts (and adoption of higher cost technology) by developed countries in the form of carbon credit revenue and technology transfer.
Over the past year there have been a number of significant market developments within the EU ETS compliance framework. The first of these is the decision by the EC that CERs derived from the abatement of HFC and adipic acid (N2O) emissions will no longer be eligible for offsetting purposes within the EU ETS after 2012. Given the fact that HFC and adipic acid CERs account for approximately 407 million of the 607 million total emission reductions to date, it is no surprise that this is having a substantial impact on trading within the EU ETS market. The trend is now to surrender these credits early and rather take a long position on EUAs (emission allowances issued to EU facilities regulated by the scheme), saving them for use in phase III when the HFC and adipic acid N2O credits are no longer eligible. This can be seen by the increase to an estimated 89 million of credits surrendered in 2010 versus 81 million credits in 2009 (2008:81 million). It has also created an eligibility price spread which ranges between EUR 1 and EUR 10.
The second notable decision was that CERs from any project registered after 2012 in non-LDCs (Least Developed Countries) would not be eligible for compliance purposes within the EU ETS. Looking at the state of LDC participation within the CDM market, this is a move that will have major impacts for the CDM mechanism. There are currently only 20 CDM projects registered in LDCs and these have generated a mere 16,000 CERs which is only 0.003% of the 605 million credits issued to date. Compare this to, for example, China which alone contributes 42% of the overall number of registered CDM projects and generates 62% of the CERs from CDM and one can see that LDC participation in the CDM is insignificant.
The price of carbon theoretically affects long-term emission trends by influencing investment decisions.
The decision to exclude non-LDC credits has had two primary consequences. Firstly there has been a marked rush to register projects in non-LDCs before the end of 2012, with a record 720 projects registered in 2010 and a further increase expected for 2011. And secondly, the focus for post-2012 CDM project developers has now shifted to Africa where 33 countries are classified as LDCs compared to Asia’s nine LDCs and the Americas one LDC. There is no doubt that LDCs in Africa will attract the next wave of investment in CDM project development, but given the lack of institutional capacity within many of these states, as well as their infrastructure and governance issues, the question remains whether they will fully be able to translate these investment opportunities into sustainable CDM projects that can reliably issue credits year on year.
Given the current situation with regards to CDM investment in LDCs and the difficulty associated with realising projects within these states, one has to wonder if this decision will present a supply and demand discontinuity within the CDM market? Not necessarily. The demand for CERs will be somewhat dampened with the third restriction that has been imposed on the EU ETS – that no more than 50% of emissions may be offset with CERs in phase III – but more importantly, both the primary and secondary CDM market remain a buyers’ market. This can be seen in the current Emission Reduction Purchase Agreement (ERPA) trends where purchases are conditional upon EU ETS eligibility and the agreement for CER sales persist at variable prices. This variable pricing is a buyers’ preference, with observed market prices between 60% - 80% of market value, while sellers would rather secure a fixed price and thus be protected from any further price decreases. This outlook is an exact reversal of the previous trend where sellers were inclined to favour variable pricing on the expectation that prices would increase. As such, this reversal represents that the downside risk is now viewed as much greater than in previous years. [[[PAGE]]]
Downside risk is, however, not the only factor influencing the above trend. The uncertainty surrounding the post-2012 regulatory framework is the biggest deterrent to investment in the carbon markets and has actually instigated noticeable shifts in investment decisions. A good example of this is the propensity for sovereign buyers with residual emissions obligations to shift their focus from procurement activities and promotion of the project-based primary CDM market and to concentrate their resources in the more stable AAU market (allowances for carbon emissions allocated to developed countries) or in the secondary CDM market where they can contract for guaranteed delivery of CERs. It can also be seen in the refusal of banks to consider potential carbon credit revenue when debt sizing for project finance. This is a significant hurdle which project developers have to face especially in light of the fact that under CDM rules, the project must demonstrate that the financial return of the project is insufficient to go ahead without the carbon revenue stream.
In contrast, from a securing project financing perspective it must be able to hold its own without CER revenue. This is an awkward challenge which stems directly from the uncertainty surrounding the future of the global carbon market and has the consequence of impeding the effectiveness of the CDM in supporting clean technology uptake in developing countries.
The price of carbon theoretically affects long-term emission trends by influencing investment decisions. If in the long term it is going to be cheaper to invest in more expensive low-carbon capital expenditure now than to pay the carbon price for a cheaper carbon-intensive alternative investment, then investment decisions will favour the low-carbon solution. This is the ultimate goal of pricing carbon but in reality we do not always see this result achieved. Two factors contribute to this: the first is that of leakage, whereby carbon intensive operations simply shift production outside of emission regulated zones to areas where no carbon price is applicable (or the price is much lower). This has always been a major concern within the EU ETS but does not seem to be the trend as this has not occurred in any significant volume and 80% of regulated facilities purport to have actually not even considered moving.
With the scrapping of a US federal cap and trade scheme, the recently enacted Californian cap and trade market is the predominant US carbon market.
The second factor is price instability. General market consensus indicates that internal abatement will occur at a carbon price of greater than EUR 30 per ton CO2 but with no binding international agreement likely to be in place before the end of the Kyoto period and regional emission regulation efforts still in the process of being developed, it is unlikely that a stable carbon price will emerge in the near future. There are, however, some causes for optimism. The EU ETS is expected to extend beyond 2020, which means that the biggest sector of the global carbon market will be in operation in the long term. Despite the new restrictions introduced by the EC and the uncertainty surrounding the introduction of further new restrictions, the EU remains committed to using market mechanisms as part of its emission reduction plan with a focus on sectoral crediting. The reform of the CDM under the UNFCCC process is also expected to streamline its implementation with the introduction of standardised baselines. REDD (Reduced Emissions from Deforestation and Degradation) and REDD+ are also touted to be included under the CDM mechanism and will form the most likely new offset type while HFC projects are expected to be excluded in the future.
The next conference of the parties (COP17), which is the negotiating process under the UNFCCC trying to establish a multinational climate change agreement, is to be held in Durban at the end of this year. Expectations that a second commitment period to the Kyoto agreement will be garnered are mixed and this line of negotiation is predominantly being pushed for by developing countries. It is largely agreed though, that this is an unlikely outcome and rather a bottom-up approach is emerging whereby countries are deciding on their own emission reduction targets and the measures that they will take to meet those targets. Included in some of these mitigation measures is the use of carbon market mechanisms and the last year has seen the establishment of new or emerging regional carbon markets. [[[PAGE]]]
With the scrapping of a US federal cap and trade scheme, the recently enacted Californian cap and trade market is the predominant US carbon market. Most trading of allowances and offsets are expected to take place on exchanges rather than over the counter (OTC) which is in line with EU ETS current practice but bucks the initial trend of the EU ETS to transact OTC at the outset. Most Californian companies expect to use offsets and it is foreseen that these will come from US-based projects from the forestry sector, livestock methane emission reductions and ozone depleting substance projects. The Californian market is expected to link into the Western Climate Initiative (WCI) with credits eventually being tradable between states. The WCI consists of California, Washington, Oregon and four Canadian provinces.
South Africa is also considering the implementation of a carbon tax.
Australia is the latest country to announce a carbon tax that will be applicable as an interim measure starting in 2012 and eventually graduating into a full cap and trade system and associated emissions trading scheme in 2015. The initial carbon tax represents the highest current carbon price in the world at AUS$23 per ton CO2. It is applicable to the top 500 emitting companies which account for 60% of the country’s emissions. The tax is not yet finalised, though, and may yet be sidelined, but nevertheless, it is an ambitious move which sends a strong signal to the Australian market that they can expect to face a carbon price in the near future. The NZ ETS, which has been in operation since 2008, will continue to function but will most likely look to link up with any Australian ETS in the future.
Japan and South Korea have also initiated independent emissions trading schemes but political holdups in both countries have left the outcome uncertain as to whether the schemes will actually be implemented. China is also considering emissions trading scheme options at regional levels with possible federal linkages over time, but as yet no significant carbon market exists.
South Africa is also considering the implementation of a carbon tax. An initial discussion paper was released for comment and indicated that the tax would apply to primary fossil-fuels rather than actual emissions and would start at R80 per ton CO2. There has been a significant industry response to the proposed tax and many issues still need to be properly thought through before any final decisions are made. The actual implementation of the carbon tax is therefore more than likely a few years away still. Importantly, South Africa will be affected by the new EU legislation that excludes CERs from projects registered post-2012 in non LDCs. South Africa is not an LDC and as such the window for CDM project developers to register their projects before the end of 2012 is rapidly closing. There are currently 19 CDM projects registered in South Africa and 21 projects in the registration process, which is a very small share of the global CDM market. Many project developers are now looking to the voluntary market as an alternative, but whether this is a viable option or not will largely depend on the type of offsets that the new and emerging compliance markets allow to be used within their emissions trading schemes.
2010 was a record year for the voluntary market with the transaction volume increasing 34% on 2009 levels to 131Mt CO2e (2009: 98Mt CO2e). Demand within the voluntary market is a mixture between pure voluntary offsetting (70%) and pre-compliance buying. Prices within the voluntary market range so extensively that it is impossible to settle on a meaningful average. Rather the price is a function of the standard that is applied and the type of project. REDD forestry projects have been the darling of the voluntary market in the last year with an increase in market share on 2009 of over 500% and supplying 29% of the year’s voluntary credit volume. This is largely due to the renewed appetite for forestry credits after the Cancun climate meeting and the robust methodologies which have been established under the Verified Carbon Standard (VCS). [[[PAGE]]]
Pre-compliance buyers have tended to focus predominantly on landfill gas credits in anticipation of a US federal scheme under which they would be eligible, but have now turned their attention to the Californian emissions trading scheme and the offset types that are eligible thereunder. Voluntary carbon finance is active in 45 countries with the US being the predominant supplier originating 35% of transacted OTC volume. Despite this, over half of the credits transacted OTC originated from developing countries with forestry being the focus project type. Although the voluntary market is tiny in comparison with the compliance market, there is much scope for it to be linked to various compliance markets which would stimulate growth and investment and certainly makes it an interesting carbon market that should not be discounted.
The African carbon market presents an exciting opportunity for expansion and future investment. Unfortunately, given the uncertainty surrounding future international climate agreements and the institutional barriers present on the continent, the constraints are currently too high to effectively spur this investment to any significant degree. It remains to be seen whether the outcome of the climate negotiations in Durban will have an impact on stimulating the growth of the still immature and underdeveloped African carbon market.
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