The global financial crisis and inevitable fall in industrial output are bad news for the carbon and CDM markets. But just how bad will it get for the traders in these complex – some would say arcane – disciplines, asks Chris Webb?

Chris Webb

The very concept of a market to trade carbon seemed ludicrous to some only a decade ago. All that changed, however, after the Kyoto Protocol claimed its place in history and assumed a cherished position in the lexicon of environmental science. Ten years down the line, and just a few months ago, carbon looked to have matured as a commodity in the same way as grain or coffee. Then came the credit crunch.

Since then, the integrity of the carbon markets and that of the Clean Development Mechanism (CDM), have been thrust into the spotlight, the price of a tonne of carbon has dipped below €18 ($23) and carbon traders have battled to bring an understandable nervousness under control. “Prices are going up from here,” said Lionel Fretz earlier this month. Fretz, who founded Carbon Capital Markets, the carbon trading and fund management company in 2004 and is its chief executive officer, is upbeat about the outlook. Other commentators are more cautious about a bottoming-out of the carbon price.

And with good reason too. The volatility in financial markets worldwide has shown that even the most mature commodities are susceptible to economic fluctuations of roller coaster proportions. Carbon is a lesser-known quantity than, say, cereals or metals. Yet as recent events have shown, even these staples are not immune to wild swings in prices.

The Kyoto Protocol on Climate Change, which entered into force in February 2005, resulted in the launch of the European Union’s Emissions Trading Scheme (EU ETS). The world’s first international emissions trading scheme, the EU ETS works on a cap-and-trade basis, forcing companies to emit less carbon dioxide than their Kyoto target allows or buy carbon permits from elsewhere (CERs and ERUs). The second phase of the scheme runs from 2008-12 and coincides with the Kyoto Protocol commitment period. No timetable has yet been established for the post-2012 regime.

The three major mechanisms relating to emissions trading under the current Kyoto Protocol are the Clean Development Mechanism (CDM), Joint Implementation (JI) and cap-and-trade. Of these the first two could be set for radical change following the recent talks organised by the United Nations Framework Convention on Climate Change (UN FCCCC) in Ghana. Already under fire from critics citing the credibility of major projects in China, CDM is also at the centre of the ‘additionality’ row over the award of carbon credits for emissions reduction projects.

As pointed out by the consultancy Arthur D Little in a recent ‘Carbon Insights’ analysis, further stimulus for change is provided by the recognition that the CDM and JI in their original form failed to address some important areas related to emissions reduction, including funding for carbon capture and storage, crediting avoided deforestation, and whether to issue carbon credits to nuclear power plants. Other options for dramatic change relate to the possible introduction of sectoral targets into CDM and JI, on either a voluntary or a mandatory basis.

Recession looming

But now that everyone is using the ‘R’ word, particularly in Europe, where the ETS pioneered dealing in carbon certificates, the future of these complex instruments has been cast more firmly into close scrutiny. More importantly, market observers are trying to predict the extent of the fallout. And it does not make for pretty reading. Deutsche Bank’s analysts Mark Lewis and Isabelle Curien said, in a paper issued last month looking at the effects of recession in Europe, that the EU’s renewable energy targets now look even more ambitious. This came as one of its members, the UK, raised the bar from 60 per cent to achieving an 80 per cent cut in emissions by 2050.

The impact of a recession on carbon markets will be multi-dimensional, arising from a sea change, so far as the energy sector is concerned, in the utilization of resources. A credit crunch induced recession implies lower emissions over the 2008-2010 period, said the Deutsche Bank paper, but also higher coal fired electricity output over the entire 2008-2020 period as planned investments in new capacity are put on hold.

“The recession we are now factoring into our model stems from a vicious credit crunch, and we think this will make it much more difficult to obtain financing for large infrastructure projects such as new wind farms over the next two to three years,” say the researchers.

Similar concerns are voiced by Point Carbon. Lower industrial output will have the inevitable effect of cutting emissions, making it easier for industry to meet its targets. Demand for carbon credits will fall, and prices will soften as a consequence. After earlier record highs in oil and gas prices, the more recent downward adjustments will also weaken carbon positions. Moreover, in the US, a weaker appetite for any cap-and-trade policy that could raise energy costs at a crucial time in the economic cycle looks set to stifle any growth.

On the supply side, the CDM market is seen as particularly vulnerable, as more expensive project finance begins to bite and there are reduced investment incentives due to potentially lower European carbon allowances (EUA) prices. Overall, said Point Carbon, carbon transaction volumes will suffer with potentially fewer compliance buyers. A reduction in emissions of just 1 per cent would, it says, translate to a massive 17 per cent reduction in carbon credit demand.


But long-term regulatory certainty on the carbon market is likely to be its saving grace. In September, Point Carbon predicted the European carbon price would rise to €37/tonne on average over the 2009-12 period, an increase of €3 over previous forecasts. It said a reduction in available Certified Emissions Reductions (CERs) and Emission Reduction Units (ERUs) would also force the price of European carbon allowances up, despite a possible decrease in industry emissions as a result of the global economic downturn.

Certainly, confidence in the carbon markets remains strong. The latest analysis by New Carbon Finance (NCF) indicates that the world’s carbon markets grew by 81 per cent over the first nine months of 2008 to reach $87 billion by the end of the third quarter. As recently as October, NCF was predicting that the market would smash through the $100 billion barrier for the first time, reaching $116 billion by the end of the year.

And as PEi went to press, elsewhere in the market the greatest political event of the year was unfolding in the US, with the presidential election. With both the Republican and Democrat candidates expressing support for cap-and-trade at the national level, the election is set to usher in a new era of US engagement in international climate negotiations, irrespective of who wins.

With the introduction of a such a move on greenhouse gas emissions in the world’s biggest polluter, Point Carbon was predicting earlier this year that global carbon markets could be worth almost €2 trillion, with total transaction volume forecast at 38 billion tonnes of carbon dioxide equivalent per year by 2020. According to estimates, some 67 per cent of this €2 trillion would be traded within a US emissions trading scheme, dwarfing that (23 per cent) traded through the EU ETS.

Regulatory certainty will not in itself insulate carbon markets from the chill of recession, however. Alessandro Vitelli is director of strategy and intelligence at Idea Carbon. He believes that an immediate consequence of the slowdown will be a fall in EUA and CER demand. “As European industry reduces its output, its carbon emissions will fall,” he said.

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“The economy will also consume less energy, so emissions in the power sector will fall too. The effect is dampened by the fact that buildings are still heated and the lights are still on, even if machines run at less than full capacity. Nevertheless, since energy emissions dominate those from industry, what happens in the power sector is probably the most noticeable effect.”

Idea Carbon research shows that the European carbon market is far less sensitive to a change in annual output than to changes in fuel prices. Moreover, fuel prices have historically been much more volatile than economic growth rates.

Vitelli says that his firm estimates that a persistent 10 per cent fall in annual GDP growth, say from 2 per cent to 1.8 per cent, would reduce the system-wide shortfall – emissions to cap – by no more than 2.5 per cent. This in turn would lead to a 4-4.5 per cent drop in EUA prices. CER prices, which tend to follow EUAs, would experience a similar correction. In comparison, a 10 per cent drop in the price of gas would trigger a fall in the EUA price of about 9 per cent.

The current slowdown, Vitelli says, could thus have a noticeable impact on the price of carbon. Two years of growth in the 0.8-1.2 per cent range, followed by a return to trend, translates into an average growth rate of 1.65 per cent per annum over the second EU ETS phase.

This is about a fifth below the long-term trend, and so would imply a drop in the Phase II price of between 8 and 9 per cent. However, the Idea Carbon argument goes, this ignores the fact that Phases II and III of the EU ETS are inextricably linked. If the Phase II price falls traders, will find it advantageous to stock up on cheap EUAs and resell them in Phase III.

The price effect of the current crisis would therefore be spread over the entire trading period up to 2020. “Over this longer period, the effect of a slowdown today is much smaller,” says Vitelli. The overall effect would be that average growth would be reduced only to 1.95 per cent per annum, or fairly close to the long-term trend. The downward correction in the average EUA price should therefore be expected to be no more than about 3.5 per cent, or just under €1/tonne.

In terms of what this means for the power sector, a downward price correction of less than €1/tonne would have the effect of increasing the competitiveness of coal versus gas, says Idea Carbon, though this in turn would lead to increased demand for EUAs and renewed upward pressure in prices. More importantly, it would lower the incentive to carry out abatement projects at industrial plants. The onus would therefore fall on compliance through trading.


Availability of credit – or the lack of it – is another factor affecting carbon markets. As the availability of credit to underpin futures trading gets squeezed, companies may face obstacles in accessing the market; industrial companies will find they do not in the main have sufficient credit lines to engage in large-scale forward trading.

As Vitelli and his colleague Friedel Sehlleier pointed out in a recent analysis, for them the more attractive option is to access the spot market, where delivery and payment take place within three working days. And with credit being squeezed hard, the spot market becomes even more attractive.

Historic daily prices of 2008 European Carbon Allowances September 2005 – April 2008 Source: Point Carbon
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Some industrials may well decide that involving their company in what is, for them, an unnecessary CER-EUA swap transaction is not wise, and may decide to stay away from the market. They may choose simply to keep their EUAs until compliance has been completed, and then sell any surplus EUAs outright. This strategy, the Idea Carbon analysis says, effectively ‘strands’ EUAs; by not swapping EUAs for CERs and using them for compliance, industrial companies are effectively removing EUAs from the market that would otherwise have been sold to power generators who have a significant shortfall in EUA allocation.

Such an event could lead to a spike in EUA prices as generators scour the market for any surplus EUAs. In addition, CER prices may well dip as interest in the swap declines. It all raises the question: how do generators persuade their industrial counterparts to part with their EUAs?

Clearly, a widening CER-EUA spread will eventually entice some industrials back into the market to carry out the swap on a spot basis. But generators will also need to do their part.

Many of the larger utilities have healthy CDM project portfolios of their own, and they could structure bilateral CER-EUA swaps to guarantee their flow of allowances. In short, utilities will have to do whatever it takes to persuade industrials to release EUAs. Lionel Fretz says what is certain is that carbon trading is here to stay. “It is basically a good, economically efficient instrument [for curbing emissions], better than a tax, and if implemented properly, a key tool for reducing emissions. All of the problems the carbon market has experienced are solvable, and are teething problems seen in the context the next forty years. The EU ETS is here to stay, and as a policy tool it is close to being irreversible. We have consistently argued for high standards of regulation in the market, as low ones undermine it, and destroy opportunities for the rest of us. That has paid dividends.”

What is less certain is the post-2012 situation for carbon trading. Debate and developments continue in the ongoing talks leading up to the last of the current programme of UN FCCC meetings, due to be held in Copenhagen, Denmark in December 2009.

The most fundamental areas of debate are likely to be on the issue of whether developing countries should have to cap their emissions post-2012 and how much developed nations should increase funding for developing countries to help them mitigate and adapt to climate change.

And with major industrialized nations still likely to be beleaguered by recession, they are set to be politically challenging discussions.