January 17, 2007 — From California to Australia, emissions trading has been rocketing up the political agenda in 2006 - despite a little local difficulty with Europe's flagship scheme. Mark Nicholls talks to the winners of the greenhouse gas categories in Carbon Finance's annual market survey

The last 12 months have seen both triumph and tribulation for carbon trading. Greenhouse gas (GHG) emissions trading schemes are under development on both coasts of the US, and in Australia. And money is pouring into emission reduction projects in developing countries, facilitated by the Clean Development Mechanism (CDM).

But the story is more mixed in the EU, where the bloc's Emissions Trading Scheme (ETS) has had a torrid year.Traded volumes in the scheme are, according to World Bank figures, likely to double this year compared to last, reaching some $18 billion. However evidence that emerged in late April of an unexpected surfeit of allowances (EUAs) caused the market to collapse, with prices dropping to below €9 ($12)/tonne of carbon dioxide (CO2), from a high above €30/t.

Most analysts now believe that the market is structurally oversupplied with allowances for Phase I (2005-07), meaning that prices will trend towards zero. Market participants were understandably anxious that the European Commission should insist on tough targets for the second phase of the scheme, which runs concurrently with the 2008-12 Kyoto Protocol target period.

Louis Redshaw, head of environmental markets at Barclays Capital - which displaced Shell as Best Trading Company, EU ETS, in this year's Carbon Finance Market Survey - is sanguine about the scheme's teething problems. "It's important to make a distinction between emissions trading being the answer [to helping to cut GHGs] and the design of an individual scheme. "Any first mover will be susceptible to criticism, and the Commission has always said this is a learning-by-doing phase. And there are lots of lessons that have been learnt," he adds, such as how information about company emissions should be released to the market, for example.

Successful Market

"The market worked," says Andy Ertel, president of New York-based environmental and energy broker Evolution Markets - which, as last year, scooped a slew of places in the survey, including Best Broker, EU ETS."Every speculator in the market until May was playing it on the long side," buoyed by most analysts believing that the scheme was short of allowances. "Once we got the signals, the market did what it was supposed to do, and corrected."

This is a view shared by Peter Koster, CEO of the European Climate Exchange, which was once more voted Best Exchange in this market. His exchange saw a dramatic boost in volumes as volatility spiked, and he expresses himself satisfied with how the market - and the exchange - operated. "The way the market behaved, the volumes traded, and the fact that bids and offers were always on the screen - it acted as a mature product," he says.

Redshaw at Barclays concedes that the extreme volatility in April and May did take some participants out of the market: "It has had an effect on participation, but the market hasn't suffered, as the companies that have pulled out have been replaced by others.The rate of development has slowed, but there are more people in the market than ever before."

There is also some evidence that the scheme is delivering on its environmental objectives. "The scheme has led to a more vigilant analysis of the way in which data relating to fuel consumption are managed, which in turn can ultimately lead to better emissions management," says Nadine McAuley, UK-based EU ETS product manager at SGS, which was voted Best Verificaton Company in the scheme, pushing last year's winner, DNV, into second place.

However, she adds that "the EU ETS has not significantly altered corporate behaviour in terms of acting as a driver towards more efficient energy use ... financial gains still tend to be the predominant driver for energy efficiency."

But all eyes are on the next phase of the scheme. The Commission's first verdicts on member states' national allocation plans (NAPs), which were announced at the end of November, were encouraging (see Carbon Finance, November 2005, e-mail update).

However, regardless of how effectively the Commission is able to tighten up the NAPs, prices are unlikely to rise as high as in the early part of Phase I, says Abyd Karmali, the London-based European manager at consulting firm ICF International. His firm won the Best Advisory firm in the EU ETS, as well as winning places in the Kyoto Project Credits and North American categories.

"Many of the original drivers of the carbon price that we have been highlighting seem to be lining up," he says. Gas prices are falling compared to coal, making the use of the lower-emitting fuel more attractive for power generators, and the supply of carbon credits from the CDM and Joint Implementation (JI) is building. "Companies are becoming aware that, while the Linking Directive [which governs the extent to which CDM and JI credits can be imported into the EU ETS] may be binding at installation level, it won't be at the EU level," he says. Member states, via the directive, are proposing installation-level limits on CDM and JI credit usage, but with many companies unlikely to need to import any credits whatsoever, intermediaries will encourage them to 'rent' their limits to those likely to breach theirs.

It is the links between the EU ETS and the Kyoto markets that have been providing Claude Brown, partner at Clifford Chance in London, with a growing amount of business for the firm's environmental and climate markets practice. The company was voted Best Law Firm in the EU ETS and North American categories, and runner-up in Kyoto Project Credits.

"A lot of people are looking at structured products, especially to introduce CERs [certified emission reductions] - and latterly ERUs [emission reduction units] - into the EU ETS," he says.

Essentially, the contracts used to source credits from projects - emissions reduction purchase agreements (ERPAs) - are not suitable for then selling credits into the EU ETS, Brown explains. "We're of the view that you don't want to use back-to-back ERPAs. People are looking to buy under an ERPA, and then sell on through a bespoke instrument."

The EU ETS certainly provided a spur to the Kyoto credit market, alongside the Protocol's entry into force in early 2005."There's a lot more projects coming around," notes Einar Telnes, whose company, DNV, was once more voted Best Verification Company in the Kyoto Project categories. But, according to World Bank figures released in October, the CDM market is unlikely to show much, if any, growth between 2005 and 2006, with around $3 billion in CDM transactions taking place.

"This could be a sign of saturation unless we get clear signals for post-2012," he says."We will have significantly less investment in the CDM from 2008 onwards" unless investors can be assured that a carbon market - and a value for CDM credits - will continue after the first Kyoto commitment period.

Nevertheless, there is no shortage of capital available for CDM projects, says Martijn Wilder, a Sydney-based partner at Baker & McKenzie, which won the Best Law Firm title in this category. "Part of the problem is that there's so much money around, people don't know what to do with it." But, explaining the reported slow-down in transactions, he adds that "the reality is that money only goes into credible projects." While there may be hundreds of developers looking for capital, investors are becoming increasingly choosy. Steve Drummond, managing director of CO2e, which took Best Broker honours in Kyoto Project Credits, says that, while the next wave of projects may be tougher to undertake, the CDM is only beginning to show its potential.

"There's huge promise in energy efficiency - it's been really overlooked. There's a lot of industrial infrastructure in some significant CDM countries that is incredibly inefficient. The [CO2] gains can be dramatic, but they're more complicated - it can be like executing 20 mini-projects," he says.

Pedro Moura Costa, chief operating officer and president of UKbased project developer EcoSecurities, disagrees with the World Bank figures. "In our experience, the number of transactions has increased dramatically. The difference is, far fewer are publicly announced than before. Credits are being bought for compliance or strategic reasons, and the buyers have less interest in PR."

His company, which was voted Best Project Developer, floated on the London Stock Exchange at the end of 2005, raising €80 million. The float helped accelerate its evolution from a consultancy (its also won Best Advisory in Kyoto Project Credits) into a developer.

Another company that has shifted focus is Natsource, which has transformed itself from an emissions brokerage into a carbon asset manager. In October 2005, it raised €510 million into its Greenhouse Gas Credit Aggregation Pool - a 'compliance' vehicle, supplying credits to energy and other industrial companies - and now also runs a number of managed accounts and the Aeolus funds, which essentially trade as environmental markets hedge funds.

The company - which still offers transaction and advisory services - was voted Best Trading Company in the Kyoto markets. "These markets don't trade as such," says president Jack Cogen."It's more of an investment in projects or off-takes from projects; it's more like private equity - trading on a geological scale," he adds.

In the US, policy-makers, pundits and potential market participants have been watching the EU ETS with interest. While the White House remains dead set against mandatory caps on carbon emissions, preferring voluntary efforts, this year has seen plans advance for mandatory regional trading schemes in California and the north-east.

"It looks like the CDM market five years ago - it's still a tiny market," says Ertel at Evolution Markets, which was voted Best Broker North America. "There are early speculators in the market looking for very high-quality projects" that they expect to generate credits that will be eligible in future trading schemes.

He estimates that around 50 million tonnes (Mt) of CO2 have changed hands in 2006 in the US market, in addition to around 40Mt on the Chicago Climate Exchange (CCX).

"The CCX remains a critical piece of what's going on in North America," says Robert Koltun, managing member of investment fund RNK Capital, which was voted Best Trading Company in the North American carbon markets. "But it's not the only game in town - increasingly, voluntary and pre-compliance buyers are managing risk through the offset market."

No Rapid Developments

Despite the recent Congressional elections, his colleague Kedin Kilgore remains sceptical about any rapid developments in a federal emissions trading system. "I think that by 2008-10 we will know what a regime might look like - but I'm not expecting legislation under this administration."

In Australia, however, developments have moved faster than expected. Last year saw the publication by the state governments - all of which are run by the Labor Party - of a proposal for a national emissions trading scheme, with targets from 2010. This was in the face of opposition from the Liberal-led federal government, which pulled out of the Kyoto Protocol, and which had set its face against a domestic trading scheme.

"It's always been recognised that the state leaders would much rather the federal government would take the initiative, and they're still saying that," says Michael Stone, manager of environmental products in Australasia for broker TFS. His company was voted Best Broker in the region's only mandatory emissions trading scheme, put in place in 2003 in New South Wales.

He adds that liquidity in the scheme has risen over the previous 12 months. A year ago, an average of one trade (typically of 30,000-40,000 tonnes of CO2e) would go through the brokered market each day; that figure has doubled, with up to 10 trades taking place on active days. "It means that traders are actually acting like traders - taking profits when the price rises, and picking up volumes when the price is low." He adds that reasonable price volatility in the scheme has helped attract traders, with the price running up from around A$10 (US$7.90)/tonne in January to A$14/t, and then dropping to A$10.75, before recovering to A$12.50 in mid- November.

How the Survey was Conducted

Some 2,000 companies were approached in October and November and asked to nominate the leading brokers, dealers, and advisors in emissions allowances, weather derivatives and renewable energy certificates, via an online survey. Voters were asked to vote only in those categories in which they had direct experience and to make their judgments on the basis of: efficiency and speed of transaction; reliability; innovation; quality of information and service provided and influence on the market, not just the volume of transactions handled. More than 900 completed responses were received. Only one vote per company was allowed and those firms that nominated themselves had their votes disregarded.