The truth about carbon trading

We talk to London-based Chris Leeds, head of environmental markets sales at Barclays Capital, about carbon trading.

How hopeful are you about the world reaching a climate agreement in Copenhagen?
The chances are evenly balanced at the moment. There appears to be a lot of goodwill and a desire to reach an agreement, but the global economy and national politics are going to have a significant impact on the negotiations. The main issues seem to be pressure from developing nations on the developed world to recognise their contribution to historic levels of greenhouse gas (GHG) and to do more to cut their emissions, in particular the US. And there is inverse pressure from the developed world, who want larger emitters (namely China and India) to accept binding caps.

A further complication is how fast the new US administration will get up to speed and be ready to enter negotiations fully in December. It looks positive but there is much to do. Yvo de Boer, executive secretary of the international treaty referred to as the United Nations Framework Convention on Climate Change, or UNFCCC, in a recent conference in Copenhagen seemed to lower his expectations of reaching an agreement in December, saying that his hopes were for positive progress towards an agreement. But there is not much time between now and then and there is a very strong likelihood that the conclusion of the agreement will need to occur in 2010.

What impact is the global financial crisis having on the carbon trading market?
In many ways the financial crisis has had a limited effect on trading. In fact volumes have increased consistently in the European Union emission trading scheme (EU ETS), with record volumes traded in February. This has happened as many more companies enter the market and as industrial emitters sold excess allowances (that they had been given for free) knowing that they would not need them due to the reduction in their output.

Consequently, the market has reacted in a similar way to all the other commodities markets. Prices have fallen to reflect a lower demand for EU allowances. As demand for Certified Emissions Reductions (CERs) -- the credits created under the Clean Development Mechanism (CDM) -- is linked to demand for European Union allowances, prices for CERs have fallen too. In fact we believe that demand for CERs will be much lower than originally forecast and will be easily met with the overall supply up to 2012. It is as yet unclear what will happen to CERs post 2012. There has been some talk that the fall in carbon dioxide (CO2) prices is somehow discrediting emissions trading but we believe the market is doing exactly what it is designed to do; reduce emissions below a predefined cap at the lowest cost. It is not designed to act as a subsidy to carbon reduction projects at any cost. Price floors or caps will distort the market and increase costs of meeting the targets.

Some of my colleagues here at FinanceAsia are sceptical of the carbon trading market -- they argue it is down not only because of the economy but because it was a bubble that has now burst and won't rebound. How do you respond to that?
As we said above, the market is working effectively and properly reflects market fundamentals. The high prices that we saw last year did incentivise the investment in carbon reduction projects worldwide, probably more than there was demand for. With the fall off in demand, as we outlined above, prices for those credits have fallen dramatically and it is likely that some people who bought them are facing losses.

However, it is worth noting that the projects themselves are still viable as the cost of the emissions reductions is typically very low. Investors will continue to put money into these projects even at current price levels, which are far from experiencing the type of collapse seen in 2007. As we move forward into a world where more and more countries are operating cap and trade schemes (US, Australia, Japan, New Zealand, Mexico and South Korea) demand for excess carbon credits may pick up again.

We should avoid mixing up carbon trading related to cap and trade and carbon credits created under offset schemes such as the CDM. These are good transitory mechanisms for creating an environment in which countries can start to adjust to the prospect of making emissions reductions. In the long run it makes sense for all countries to have caps. In Europe, while demand for carbon credits has fallen and could even be negative in the period 2008-2012, prices will not collapse as the EU has already fixed a 20% reduction target from 1990 levels by 2020. This means that companies will hoard their free EU Allowances as they know they will need them post 2012. In a nutshell, the market is reflecting supply and demand. Prices will recover when the demand side does.

These same sceptics are naturally in the camp that believe either that CO2 isn't a problem or that carbon reduction efforts aren't really making an impact. Do you hear that often? 
We hear this said less and less, but our view is that you should look at the evidence. The EU saw a marked switch from coal to gas in 2008 as the price of EU allowances made gas fired generation more competitive than coal. We have also seen many companies, such as Drax power station in the UK, start to burn more biomass in response to the emissions price. In the developing world billions of euros have been invested in carbon reduction projects, such as wind farms, biomass production facilities, industrial GHG reductions and energy efficiency projects. Whether or not you believe that CO2 is a problem, these projects help increase sustainable development, increase energy efficiency and reduce the globe's reliance on scarce fossil fuels. The issue of whether CO2 is a problem is one for the scientists and it is a fact that the scientific consensus is that it is [a problem], and it is due to man-made causes.

Asia is home to companies that create projects that are then certified to produce credits sold on the exchanges in Europe and even the voluntary market in the US. Are you seeing an increase in Asian traders who are buying these credits? Or is the market still largely European- and US-dominated?
The market is largely dominated by European and US buyers but we are starting to see demand from Japan, New Zealand and Australia. Singapore has been talking about setting up a carbon trading exchange and there have been similar comments from China. However, the majority of Asian investors have been looking at developing projects and selling the credits to European buyers.

Can you tell me about any new Barclays environmental markets products -- and what makes them special?
We are developing new products for the Australian and New Zealand markets that will allow buyers there to purchase and take delivery of CERs in those regions. Ultimately we would like to trade the Australian carbon pollution reduction scheme once the legislation is in place and the market has started to develop. We recently launched a standardised over-the-counter contract for trading allowances in the US for the regional greenhouse gas initiative, better known as RGGI, and are actively engaged in helping to design the market. In Europe we are the largest trader of carbon credits, having traded over one billion to date. We are now very active in the options markets and provide innovative risk solutions for clients across the carbon trading space.