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Despite its faults, the drive towards a green market is travelling the right road – by pedal power, of course

by Agustin Hochschild

Recently the Financial Times published an article entitled, ‘Rapid growth of carbon trading threatens other markets, warns the FSA’.

This was alarmist, but the performance of the quoted carbon trading sector (Camco, EcoSecurities and Trading Emissions) has been disappointing.

Two climate change scientists, Professors Prins and Rayner, described the Kyoto Protocol as ‘a litmus test of political correctness’. And it has become dangerously unacceptable to question prevailing theories of global warming.

I happen to accept the Intergovernmental Panel on Climate Change (IPCC) evidence that global warming is occurring. To opponents of this view, surely the argument remains that it cannot be bad to reduce emissions of greenhouse gases.

Spurious products

However, a fervent public is being led into buying spurious products such as mortgages linked to offsetting. Some schemes also price offsetting at a significant multiple of the present benchmark EU Allowance (EUA) price of ?24.75/tCO2. But these products tend to characterise the voluntary market, not to be confused with the much larger ‘compliance’ market, established by Kyoto. Most London-listed companies are dedicated to the compliance market. Principally they develop carbon credits (Certificates of Emission Reductions – CER) from clean development mechanisms (CDM).

CDM projects take place in developing countries and either cut emissions of existing installations or provide new clean energy. To gain CERs, a project must pass rigorous vetting. At present the CDM pipeline could account for the cutting of 2.5 billion tonnes of CO2 over the Kyoto period.

Emissions trading is also seen as a false market created by politicians – so doomed to fail. The most frequently cited evidence is the over-allocation of emission allowance in the first phase of trading (2005-07) in the EU’s Emission Trading Scheme (EU-ETS), which led to the market collapsing.

The failure hinged on industry’s and many EU governments’ reluctance to give accurate emissions data, and problems inevitably occurring in such an experiment. But the EU quickly announced tighter cuts for the second phase (2008-12). Confidence restored, the 2008 EUA rallied from €13.01/t CO2 to the present €24.75/tCO2, showing the market works according to the laws of demand and supply. To ensure a market-based system, Kyoto adopted a capping-and-trading mechanism. A carbon tax would have been far less appealing.

Problems remain. The EU has yet to link its trade clearing system, the CITL, with the UN’s ITL. This could place credits in limbo, and the EU has only committed to linking the systems by April 2009. Similarly, the UN’s bogged-down CDM vetting is holding up issuing credits. So some companies have put off selling credits, delaying profitability.

Holding out for profits

EcoSecurities noted how many credits it expected to generate over the Kyoto period, and in November 2007 announced a 20% downward revision of its credit portfolio. Its share price fell 53% from 257.5p to 137.5p.

Companies can withstand these disruptions without raising further equity as they all have healthy net cash balances. Share performances have been disappointing mainly because of concerns that their small cap status exposes them to credit risk.

This should be reversed once these companies turn profitable, which should begin to happen by Q1 2009 with the linking of the CITL with the ITL. To boot, the delay in issuing credits argues that the CER price could be significantly higher than those used in the original placing memoranda.

Higher end forecasts suggest an EUA price

by 2012 of €48/tCO2. Extrapolating the average CER/EUA discount of 25% in 2007 suggests a doubling of the CER price from present levels to €33.60/tCO2. Even without such estimates, the future looks positive. Yet the main uncertainty remains about what happens once Kyoto expires in 2012. Without a replacement by the Copenhagen summit in 2009 the market could disappear. However, a successor regime looks increasingly likely – and it could include the US federal government.

If this happens, in time the emissions markets could begin to rival in value the trading of any other commodity.

Agustin Hochschild is a director of research at Dawnay, Day Corporate Broking, with a particular focus on alternative energy