Published: June 01, 2008
The following article is the Executive Summary of the full ‘State and Trends of the Carbon Market 2008’ Report by Mr Karan Capoor and Dr Philippe Ambrosi of the World Bank. The full Report, which we would encourage readers to consult, can be accessed from the World Bank’s Carbon Finance Unit at http://www.carbonfinance.org. We are grateful to Mr Capoor and Dr Ambrosi and the World Bank for their permission to publish part of this Report in TMI.
Climate change captured the public’s imagination in 2007, as a major report prepared by the Intergovernmental Panel on Climate Change (IPCC), a Nobel Peace Prize and the launch in Bali of the negotiation process for a post-2012 climate change regime, contributed to making climate change a key part of the global economic and environmental debate. January 1, 2008 also marked the formal start of the compliance period of the Kyoto Protocol and of Phase II of the European Union Emission Trading Scheme (EU ETS).
Regulation constraining carbon emissions has spawned an emerging carbon market that was valued at US$64 billion (€47 billion) in 2007.
The growth of the carbon market
The carbon market is the most visible result of early regulatory efforts to mitigate climate change. Regulation constraining carbon emissions has spawned an emerging carbon market that was valued at US$64 billion (€47 billion) in 2007 (see Table 1). Its biggest success so far has been to send market signals for the price of mitigating carbon emissions. This, in turn, has stimulated innovation and carbon abatement worldwide, as motivated individuals, communities, companies and governments have cooperated to reduce emissions.
Allowance markets
The EU ETS market has been successful in its mission of reducing emissions through internal abatement at home, and of stimulating emission reductions abroad. The European Commission, learning from the experience of Phase I, has strengthened several important design elements for EU ETS Phase II. Along with recent EU proposals for Phase III (‘Climate Action and Renewable Energy Package’, EU Commission, Jan 23, 2008) these improvements include tighter emission targets, stronger flexibility provisions for compliance (at least for EU Allowances, or EUA, although not for project-based credits, see below), more attention to internal EU harmonization and, most importantly, longer-term visibility for action to reduce emissions until 2020. These proposed reforms create confidence in emissions trading as a credible and cost-effective tool of carbon mitigation. Australia, Japan and authors announced that they too would develop their own emissions trading schemes (ETS).
In 2007, US$50 billion (€37 billion), almost entirely in Phase II allowances and derivative contracts were traded over-the counter, bilaterally, and, increasingly on exchange platforms that publish transparent data about price formation in the markets. (The major European carbon marketplaces are the European Climate Exchange (ECX) and the London Energy Brokers Association (LEBA). Markets and exchanges also emerged around the world, including New York, New Delhi & Mumbai, India and elsewhere.) Energy utilities and industrial companies hedged their carbon exposure by buying the EUA and financial companies bought and sold the EUA for their clients (“flow trading”) and for their own account (“proprietary trading”).
Project-based markets
In 2007, buyers also continued to show a strong appetite for primary project-based emission reductions, reflected by continued growth in the project pipeline showing that 68 countries had identified and offered to reduce 2,500 million tonnes of carbon dioxide equivalent (MtCO2e) through over 3,000 projects. This potential supply received strong interest, mainly from private sector buyers and investors, who in 2007 transacted 634 MtCO2e from primary project-based transactions (up 8% from 2006) for a corresponding value of US$8.2 billion (6.0 billion), up 34% from 2006.
Compliance-driven market
CDM accounted for the vast majority of project-based transactions (at 87% of volumes and 91% of values) and JI saw transacted volumes doubling and values tripling in 2007 over the previous year. The CDM alone saw primary transactions worth US$7.4 billion (€5.4 billion), with demand coming mainly from private sector entities in the EU, but also from EU governments and Japan. The voluntary markets, supporting activities to reduce emissions not mandated by policymakers, also saw transacted volumes doubling to 42 MtCO2e and value tripling to US$265 million in 2007. There were reports of growing demand for voluntary “pre-compliance” credits for U.S.-based forestry projects under the California Climate Action Registry (CCAR). [[[PAGE]]]
China dominates, Africa emerges
China was again the biggest seller, and expanded its market share of CDM transactions to 73%. Countries in Africa (5%) and Eastern Europe and Central Asia (1%) emerged in the carbon market and offered buyers an opportunity to diversify their China-overweight portfolios. The share of India and Brazil (6%) reflected a preference from some sellers favoring the sale of already issued Certified Emission Reductions (CERs), of which there are a total of only 130 MtCO2e in the market so far.
The voluntary markets saw transacted volumes doubling to 42 MtC02e and value tripling to US$265 million in 2007.
CDM delivers on clean energy
Carbon contracts from clean energy projects (energy efficiency and renewable energy) accounted for nearly two-thirds of the transacted volume in the project-based market, appropriately reflecting the CDM’s mission of supporting emission reductions and sustainable development. These project types typically use sound, road-tested technology, are operated by utilities or experienced operators, and have predictable performance, resulting in CER issuances that are expected to yield between 70-90% of expected Project Design Document (PDD) volumes, based on current expectations. This explains why they are being targeted by buyers, now that the known industrial gas project types have been more or less contracted.
Prices and price differentiation
The growth in transacted values reflected higher prices for primary forward contracts, which had an average price of €10 in 2007. Prices for primary market forward transactions were in the range of €8-13 in 2007 and early 2008. The generally higher prices reflected the intense competition and activity in the global market to encourage projects that reduce global emissions. Prices in the higher end of that range typically rewarded projects that were further along in the CDM process (such as registered projects), projects that were being developed by experienced and established sponsors (low credit risk and performance risk), and/or for projects with high expected issuance yields. Spot contracts of issued Certified Emission Reductions were transacted at €16-17, a nice premium to the primary CER, but still at a discount to the EUA, reflecting a combination of the impact of the European Commission’s 2020 proposal (see below), the time value of money, and some remaining procedures related to the delay in connectivity of the International Transaction Log (ITL) to the EU.
Climate-friendly investment
Analysts estimated that US$9.5 billion (€7 billion) were invested in 2007 in 58 public and private funds that either purchase carbon directly or invest in projects and companies that can generate carbon assets. The total capitalization of carbon vehicles could reach US$13.8 billion (€9.4 billion) in 2008, with 67 such carbon funds and facilities. This capital inflow was characterized by a substantial increase in the number of funds seeking to provide cash returns to investors and by more funds getting involved earlier in the project development process, taking larger risks through equity investment in expectation of larger returns. In I. Cochran and B. Leguet’s report, published 2007, “Carbon Investment Funds: The Influx of Private Capital”, Mission Climat Caisse des Dépôts (Paris:France), the authors estimate that in 2007 alone, CDM leveraged US$33 billion (€24 billion) in additional investment for clean energy, which exceeded what had been leveraged cumulatively for the previous five years since 2002. [[[PAGE]]]
Secondary markets
The biggest overall market development in 2007 and early 2008 was the emergence of the secondary markets. A segment of the secondary markets that the authors had discussed in the 2007 report had largely involved primary project developers providing project-specific guarantees, often along with credit enhancement.
The biggest overall market development in 2007 and early 2008 was the emergence of the secondary markets.
In 2007, as a wide range of procedural delays and risks of CER registration and issuances grew (see below), the carbon market innovated by providing portfolio-based guarantees. In these transactions, a secondary seller, typically a market aggregator, sold guaranteed CER (gCER) contracts that were secured through a slice of its carbon portfolios. These guarantees were also usually credit-enhanced through the balance sheet of a highly-rated bank engaged by the secondary seller for this purpose. Some aggregators and banks also provided services warehousing, selling or swapping other tranches of the risk with partial guarantees. Some banks also structured equity- or debt-like notes to institutional investors looking for some exposure and diversification to carbon. Some banks originated CER through spot contracts and sold gCER contracts forward, making small margins on a large number of transactions. This segment had greater price transparency and gCER contracts were listed on major exchanges.
Procedural delays in the CDM
In spite of its success, or perhaps even because of it, (as one market participant told the authors in an interview: “If there had been only five or 10 CDM projects in the market, we would not have any problem”) the carbon market came under close public scrutiny in 2007. The success of the CDM is threatened by a creaking infrastructure that, despite some efforts to streamline, is struggling to process the overwhelming response from project developers worldwide in a timely manner.
Procedural inefficiencies and regulatory bottlenecks have strained the capacity of the CDM infrastructure to deliver CERs on schedule, as too many projects await registration and issuance:
Complex rules and the capacity constraint
DOEs, who are accredited to validate and verify CDM projects, are unable to keep up with a large backlog of projects awaiting registration, and are finding it difficult to recruit, train and retain qualified, technical staff to apply the complex rules consistently. As a result, some projects have been registered incorrectly, resulting in a call for more reviews being requested by the CDM Executive Board, which, in turn, causes even more delays.
Important concerns have been voiced about CDM on issues of its additionality, its procedural efficiency and ultimately, its sustainability. Some critics of the CDM maintain that its rules are too complex, that they change too often and that the process results in excessively high transaction cost; they ask for relief from the rules. Other critics question whether certain project activities are truly additional, or whether CDM can create perverse incentives; they ask for even more rules. [[[PAGE]]]
Delays can and do impact carbon payments
CDM project registration and CER issuances are generally lower and slower than expected and regulatory efforts to reform and streamline the process are urgently needed. The authors are sympathetic with those primary project developers that are facing delays in financing and implementing projects because of the delay in project registration and CER issuances. Delays for any reason in a project’s schedule can jeopardize elements of its financing package, and ultimately its construction and implementation.
Those delays, in turn, affect expected CER delivery schedule, as well as dampen enthusiasm for further innovation, which is urgently needed to mitigate climate change. Delays in payments also increase a systematic bias in favor of those projects that can be self-financed by large, wealthy project developers. Projects that really need the carbon payments to overcome barriers are more likely to fail as a result of these delays. Conversely, projects that are not as reliant on carbon payments for their construction and implementation, are more likely to be able to take the financial hit from the delays. Clearly, the delays are untenable and are a major risk to CDM momentum and market sentiment.
Private companies and commercial risks
There is a troubling tendency of some companies in the market to point a finger at the CDM and to hold its procedural delays to be solely responsible for the poor performance of their companies. In a market where the “production” of the asset or commodity is not in the control of market players, but rather in the hand of a regulator, the risk of regulatory delay must be treated as a core element of commercial risk. Some companies clearly made incorrect and imprudent commercial decisions, for example, by taking on excessive risk or burning too much cash, or guaranteeing too many CERs for delivery by a certain date against penalties without adequate risk management. Their commercial contracts should balance the risks and rewards of various parties. While the carbon regulatory infrastructure clearly needs urgent reform, it is simply wrong to blame the regulator for all problems. Companies also have to examine at the appropriateness of their commercial and business decisions.
Carbon market momentum is strong for now
After some growing pains in its first phase, the EU ETS has created a robust structure to cost-effectively reduce greenhouse gas emissions. Created by regulation, the carbon market’s biggest risk is caused, perversely, by the absence of market continuity beyond 2012 and this can only be provided by policymakers and regulators. This will require increased efforts well beyond what is envisaged by the current policies of major world emitters.
While the carbon regulatory infrastructure clearly needs urgent reform, it is simply wrong to blame the regulator for all problems.
The CDM is at a crossroads
The European Commission’s post-2012 proposal, which strengthened several design elements of the EU ETS, however, did not provide much comfort for the project-based market, which, after its strongest year yet, finds itself at a significant crossroad. By linking additional EU ETS demand for CDM and JI credits to the success of post-2012 global climate change negotiations, the European Commission proposal has the risk, surely unintended, of slowing the momentum for the project-based mechanisms. Under the proposal, the issued CERs and the Emission Reductions Units (ERUs) would be less flexible and less fungible, limiting their risk management and compliance utility vis-à-vis the EUA. The EUA spread over the secondary CER widened to nearly €10 at the time of this writing, and even higher for most primary CER contracts. The key challenge, in our view, is not how to reduce the success of the CDM, but rather how to raise the ambition of the world, including the EU, to set science-based emission reduction targets and meet them cost-effectively.
Time to re-think the CDM
The CDM’s biggest strength has been its ability to bring developing and developed countries and the public and private sectors together to reduce emissions cost-effectively. In the years ahead, all countries will want to scale up their efforts to reduce emissions while growing their economies in a sustainable manner. As the world considers scaling up serious action to combat climate change, it would be desirable to re-think the CDM as a helpful tool for the challenges ahead.
The forest for the trees
In its next phase, the CDM needs to move up the learning curve and evolve toward approaches and methodologies that conservatively estimate emission reduction trends on the aggregate level, and away from the current focus on trying to account for every last ton reduced or removed from the atmosphere. The next generation CDM should focus on catalyzing step changes in emission trends, and on creating incentives for large-scale, transformative investment programs. [[[PAGE]]]
Built to last
Several jurisdictions, including various states, regions, and countries are considering whether and how to link up with international opportunities for reducing emissions. It would be helpful to find ways for them to learn together from and build on the CDM experience so far, with the goal of encouraging efficiency, reducing transaction costs, avoiding unnecessary duplication and creating, from the start, compatible infrastructure with strong linkages and inter-operability.
Global cooperation on climate change
Given enough incentive and a long lead time, developing countries can deliver large volumes of cost-effective emission reductions which can help meet science-based emission reduction targets. This puts a special responsibility on countries to cooperate under the Bali Action Plan to reach an ambitious international agreement to reduce emissions. It also makes it important for the EU, the U.S. and other major emitters to find ways, even before 2009, to encourage the continued engagement of developing countries in mitigation activities. International negotiators (and regulators of domestic programs) should consider providing incentives for early action with sufficient lead time to develop emission reduction programs and projects.
It would be desirable to re-think the CDM as a helpful tool for the challenges ahead.
Solving the problem of climate change will need ingenuity to encourage a scaling up of action to reduce or avoid emissions as early and efficiently and in as many sectors and countries as possible. Long-term policy signals about intended carbon constraint policies and well-designed regulatory systems and infrastructure will send the appropriate signals to investors. The experience of the carbon market so far shows that the private sector is capable and willing to cooperate in solving the problem, provided that policies are predictable, consistent and transparent and regulations are efficient.
Mr. Karan Capoor has seventeen years of experience in carbon finance, energy and climate change. At the World Bank, he originates, structures and negotiates carbon transactions. He helped design and market the World Bank’s new carbon funds and has co-authored the ‘State and Trends of the Carbon Market’ Report for the past six years. Earlier in his career, Karan led PricewaterhouseCoopers’ Climate Change Services team. He also developed clean energy projects in Asia and Latin America for EnergyWorks LLC. Karan also worked for several years at the Environmental Defense Fund, where he was closely involved in negotiations of the UNFCCC and the Kyoto Protocol.
Karan has an MBA from the University of Virginia’s Darden School of Business and a BA from Middlebury College.
Dr. Philippe Ambrosi, Environmental Economist with the Climate Change Team (Environment Department) at the World Bank, is working on mitigation issues, notably in the field of carbon finance. Together with Karan Capoor, he is a co-author of the ‘State and Trends of the Carbon Market’ Report. He is also contributing to the assessment of the carbon footprint of World Bank projects as well as to the working group on the development of financing instruments to address climate change. He holds a PhD in Environmental Economics at the École des Hautes Études en Sciences Sociales (Paris) and graduated from École Normale Superieure (Paris).
The World Bank is a vital source of financial and technical assistance to developing countries around the world. We are not a bank in the common sense. We are made up of two unique development institutions owned by 185 member countries-the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA).
Each institution plays a different but supportive role in our mission of global poverty reduction and the improvement of living standards. The IBRD focuses on middle income and creditworthy poor countries, while IDA focuses on the poorest countries in the world. Together we provide low-interest loans, interest-free credit and grants to developing countries for education, health, infrastructure, communications and many other purposes.
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