One doesn’t have to look too far to be reminded how much risk there is in the world’s emerging greenhouse gas (GHG) emissions markets. Last year, it was most apparent in the EU Emissions
Trading Scheme (ETS), when allowance prices crashed in the first half of the year, as the market realised the system was massively oversupplied. This year, the risk has been felt by investors in the handful of listed project developers, whose share prices have been hammered by a slowdown in the issuance of the carbon credits on which their future profitability depends.

The past 12 months have also been characterised by greater scrutiny of the system – with questions raised over standards in the voluntary carbon market, the environmental quality of many of the projects registered under the Kyoto Protocol’s Clean Development Mechanism (CDM) and the high returns made by some investors and companies from destroying industrial GHGs.

But, despite this growing scrutiny, emissions trading is becoming more entrenched as a key tool to tackle the problem of climate change. EU member states placed trading squarely at the centre of the integrated energy and climate package, signed in March this year, which commits the EU to a reduction of at least 20% in GHG emissions by 2020, compared to 1990 levels. Commission proposals to bring aviation into the EU ETS are proceeding apace, marking the first extension of
the scheme to a new sector.

The European Commission also took a tough line this year with member states’ proposed targets for Phase II of the EU ETS ensuring, most analysts believe, that the scheme will escape the oversupply problems seen in Phase I. Indeed, while prices of Phase I allowances have declined from €6.70/tonne of carbon dioxide (CO2) on 2 January to €0.01 by the end of November, Phase II allowance prices have remained firm – trading in the second half of the year between €18/t and €23/t.

And, of course, 2008 marks the first year of the five-year Kyoto Protocol compliance period. For the first time, industrialised countries will have an obligation, under an international treaty, to control their emissions of GHGs.While, in most cases, the policy frameworks to achieve this have been in place for a few years, the start of the Kyoto ‘commitment period’ will likely bring efforts to reduce emissions into sharper focus.

In the US, cap-and-trade schemes are rising up the political agenda – particularly among the Democrat presidential candidates – and bills to cap US carbon emissions are advancing in Congress. Outside Washington, more states or groupings of states have pledged action on emissions, with three regional trading schemes now planned. And, in Australia, the Labor Party victory in the November election will speed the creation of a trading system there, as well as bring the country back into the Kyoto fold.

But, while interest in emissions trading picks up in the US and further afield, Europe remains the engine-room of the global carbon market. As trading in the first phase of the EU ETS (2005–07) draws to a close, traders and brokers expect activity to grow further.

“We’ve seen a rapid increase in volumes across the vintages, due in part to the ‘trueing up’ of positions for Phase I, the impending approach of Phase II, and the start-up of the Kyoto commitment period,” says John Molloy, head of European environmental products at broker TFS Energy, which was voted Best Broker, EU ETS – alongside a clutch of other placings in GHG markets.

“As we step into Phase II, things will really take off,” he adds, citing increasing involvement by financial players.“The airplay that the market has been given, from both a European and a global perspective, has dragged in even the slower groups. I’m seeing strong signals for a huge uptake in activity through Phase II.”

As might be expected, carbon risk management is becoming more sophisticated, and is spreading beyond the utility sector, which was the first to embrace emissions trading, says Louis Redshaw, head of environmental markets at Barclays Capital which, once again, was voted Best Trading Company, EU ETS:“A year ahead of the start of Phase II, we were already seeing companies outside of the utility sector actively hedging – that didn’t happen before Phase I, or hardly even during it.

“Generally, it’s via forward sales and purchases, but we’re starting to seeing more appetite for options,” he says.

More sophisticated risk management expertise could prove to be vital as we head into Phase II.
Guy Turner, director at UKbased analysis company New Carbon Finance, voted Best Advisory, EU ETS, predicts EU allowance prices will peak in 2008.Although he declines to be more precise than suggesting the price will be “north of €30”, he believes buying by utilities to cover their forward positions will combine with an unwillingness by industrials to sell any surplus allowances they might have so early in Phase II.

This price spike is likely to be exacerbated by the difficulty of importing certified emission reduction (CER) credits from CDM projects in developing countries, adds Turner.

The EU ETS has been the main driver of demand for CERs. A secondary market in CERs – ie, a market in credits whose delivery is guaranteed, backed by penalties for default, as opposed to credits bought directly from the project developer before they are issued – has built over the year.

“This is despite the Commission’s best efforts,” says Redshaw, who is scathing about the EU’s failure to link on time the Community Independent Transaction Log (CITL) – the piece of IT infrastructure that tracks EU emissions trades – with its UN equivalent. This linkage will allow companies to deliver CERs into the EU ETS, and use them for compliance – but may not happen until April 2009.

Although this will allow companies to take delivery of CERs in time to use them to meet their year one targets (sufficient allowances must be delivered by the end of April to cover the previous year’s emissions), Redshaw is not impressed. “The Commission does not seem to be cognisant of how markets actually function,” he continues. “You can’t expect people to continue to take risk in the face of complete uncertainty. And, on the face of it, it seems such a simple task.”

The problem could have been much worse. Most contracts now contain language to take account of ITL risk, says Peter Zaman, a senior associate with Clifford Chance, voted Best Law Firm, EU ETS.“We’ve been trying to lead the market in managing risks associated with the ITL and, over the last year, we’ve been helping to protect industry-level documents.”

Other aspects of the scheme, such as reporting and verification, are working more smoothly says Robert Dornau, Geneva-based global manager of the climate change programme at SGS which, as last year, was voted Best Verification Company, EU ETS. But, as always, there is room for improvement.“Local authorities should promote the benefits of a split verification approach,” he says, whereby a first assessment is undertaken some months before a follow-up visit. “This means clients would have more time to implement corrective actions,” he says.

Verification is not going quite so smoothly within the CDM, however. Although 2007 has seen solid growth in projects entering the pipeline, the rate of issuance of CERs has slowed – leading to EcoSecurities, one of the largest project developers, and winner of the Project Developer and Advisory categories for Kyoto Project Credits, to revise downwards its CER portfolio, sending its share price in the same direction.

Belinda Kinkead, head of implementation at the London-listed firm, says at least part of the blame lies with the inefficiency of the UN project approval process, and a lack of capacity among the ‘Designated Operational Entities’ (DOEs), the private sector verifiers charged with assessing each CDM project.

“There’s lots of layers of double-checking, instead of the [CDM] Executive Board trusting the DOEs. There’s a fundamental breakdown of trust,” she says, suggesting that, if DOEs aren’t providing sufficiently high-quality oversight, the UN should consider withdrawing their accreditation.

A particular problem, developers agree, is the number of projects which are subjected to a “request for review” – where developers are required to resubmit their projects because of some inconsistency in the documentation, even for small infractions, Kinkead says.“At the moment, everything is material – the Board needs to set thresholds” below which such reviews are unnecessary, she argues.

Werner Betzenbichler, head of carbon management services at TÜV SÜD in Munich – voted Best Verification Company for Kyoto Project Credits – agrees that requests for review risk clogging up the system. He says that relatively inexperienced staff at the UN climate change secretariat – who are screening projects before they reach the Executive Board, and recommending reviews – are partly responsible for the problem. However, as they gain experience with the system, such requests are likely to decrease, he says.

An additional problem is that, as the CDM market grows, new project developers are entering the market, “and they have to learn their lessons, and build experience. In many cases, their first project design documents are not optimal,” he says.

He also points to “problems with human resources capacity” at some DOEs, in the face of an “explosion in the workload”. Here, requests for review can create a vicious circle, by placing further burdens on staff.

Zaman at Clifford Chance predicts that problems with CER issuance will lead to consolidation
in the sector.“I think we’ll see a lot of mergers and acquisitions emerging out of carbon, when people expecting certain rewards for their CERs find themselves in difficulty. They’ll need financing or M&A to survive.”

Despite problems getting issued CERs physically into the hands of buyers, the market for guaranteed CERs has picked up dramatically in the past 12 months, says Jerome Malka, managing director of Orbeo, the Parisbased emissions trading company voted Best Trader, Kyoto Project Credits. Guaranteed CERs, backed by the credit rating of a wellcapitalised financial institution, allow buyers who could not transact with small developers or unrated carbon funds to access the CER
market. “The market is well established – we’ve more or less got transparency in the broker market, and we’re hoping for developments on the exchange front,” he says.

Thus far, only Nord Pool and the Chicago Climate Exchange have listed CER futures, with the
European Climate Exchange – which remains the dominant exchange for EUA trading, a fact reinforced by our survey – suffering delays to its plans for CER contracts. And, in the existing contracts, liquidity is limited, Malka says, which is holding back options trading.“Options are not really getting off the ground – you need a fairly liquid futures contract to allow delta hedging,” he adds.

But, while CER options trading remains difficult, complex structured products are emerging in the primary market, says Anthony Hobley, a partner at law firm Norton Rose, which scooped the Best Law Firm prize in the Kyoto Project Credits category.

“As a lot of the big projects have now been sewn up, people are looking at how to aggregate smaller ones into more commercially viable vehicles,” he says. Given the relatively poor credit rating of developers or carbon aggregators, “they are looking at ways of mitigating some of the delivery risk” by bringing together portfolios of CERs. “By aggregating projects, they can distribute
carbon without the balance sheets and credit status of the big investment banks,” he says.

The increasing involvement of these banks in the primary CDM market – contracting directly with
project developers – is forcing the ‘specialists’ to continue to innovate, he says. “The investment banks are increasingly competing with the carbon funds and aggregators – they are about six to 12 months behind the funds.The specialists will have to keep pushing the envelope to stay ahead of
the banks.” He expects to see these funds have to provide more financing to projects – putting more of their capital at risk – to stay ahead.

The ghost at the feast, of course, is Joint Implementation (JI), which has yet to deliver its potential, hamstrung by slow progress in key JI countries, notably Russia and Ukraine, in putting the necessary regulatory framework in place. Hobley says that “2008 is make or break for JI”.

Betzenbichler at TUV SUD says that 2008 could be the high-water mark for JI – at a relatively low level, compared with the CDM. “After 2008, it becomes too risky to develop a [JI] project that may not be profitable after 2012,” he says. While many expect the CDM to persist in some form after 2012, there are more questions over the future of JI.

In the US, meanwhile, a growing inevitability is building towards some kind of control on carbon emissions. In April, the Supreme Court ruled that the Environmental Protection Agency (EPA) has the authority to regulate GHG emissions – something the EPA had disputed – and should begin drawing up regulations.

Pressure has been building in Congress, as well. A spate of climate change bills have been
introduced in both the House of Representatives and the Senate. Indeed, on 1 November, a subcommittee vote to advance America’s Climate Security Act, introduced by Senators Joe Lieberman and John Warner, was hailed by the Pew Center on Climate Change as the first time that members of Congress had cast a formal vote in favour of an economy-wide cap-and-trade scheme.

It is unlikely that that climate bill – or any other – will become law while the Bush administration is in the White House. Indeed, as the presidential race begins in earnest in 2008, policy-making in Washington will grind to a halt. But corporate America is increasingly engaging with the climate change issue.

“We’ve got clients from across every economic sector asking about climate change,” says Craig Ebert, a managing director at ICF International, which was voted Best Advisory or North America in this year’s market survey. “There are the very heavy emitters, but also those who are extremely unlikely to be ever scooped up in any compliance programme.”

“You can’t find a heavy emitter that doesn’t believe that carbon regulations in the US will happen in the not-too-distant future,” he adds. “Strategically, they are trying to find out what it means for their company.”

“My best guess is that legislation will be passed at the start of the next administration, with any scheme starting in 2013,” he says, tying in with the start of the next phase of the international climate regime – whatever shape that takes. However, the extent to which any US cap-and-trade system is linked to international markets is an open question. While emissions trading advocates tend to argue for schemes to be as open as possible – on the assumption that the wider the
scheme, the more opportunities there are to find low-cost reduction opportunities – there is likely to be resistance in the US to relying too heavily on overseas credits.

“It’s too early to say which perspective will win out,” says Ebert. “Anyone who follows US policy will
see a strong domestic focus and an emphasis on US solutions.”

The timing will depend on which party wins the next election, notes William Thomas, Washington, DCbased counsel at Clifford Chance, which was voted Best Law Firm, North American GHGs this year. “If there’s a Democratic administration, it could be pretty quick,” he suggests, with front-runner presidential candidate Hillary Clinton particularly well advanced in terms of climate policy.

He adds that lots of detailed work is being carried out around the Lieberman-Warner legislation to fleshout some of the issues concerning the design of any emissions trading scheme.

But he adds that “there’s not a similar appetite for legislation in the Republican camp”. While a subsequent Republican administration would likely not be as opposed to action as the incumbent president, it would probably allow the EPA to legislate via the Clean Air Act, he says.

However, while federal legislation is likely to be at least 12 months away, the states are providing a laboratory of policy when it comes to GHG constraints. The regulations are coalescing for the Regional Greenhouse Gas Initiative (RGGI), which will see power plant CO2 emissions capped in 10 northeastern states from 2009.

In October, Evolution Markets – voted Best Broker, GHGs for North America – announced what is believed to have been the first offset trade under RGGI. Its president and CEO, Andy Ertel, expects
to see the first forward trade of a RGGI allowance take place within the next couple of months.

Few analysts expect the RGGI market to be particularly active – it only caps power plant emissions, and the targets are none too challenging. “We don’t think that there’s a very high hurdle for the first couple of years,” says Ertel.“To be frank, RGGI is just a warmup for full trading” at the federal level.

But, he points out, “the pool is flat – everyone is 100% short as no-one has any tonnes in their accounts.” And, with most states planning to auction all of the allowances (rather than granting some or all of them to power plants based on historical emissions), “none of us knows how auctioning will play out, or how speculative demand could drive the market. There are lots of questions to be answered,” Ertel adds. The first auctions are planned for June 2008.

But potential participants in North America’s fledgling carbon markets be warned: they are likely to be choppy and tempestuous over the next few years, says David Lee, chief operating officer at RNK Capital, the US-based environmental trading firm voted Best Trading Company in this year’s survey, for the second year running.

“The market is pretty much in its infancy, and there are still many competing systems – it will take several years before it reaches any level of conformity,” he says. “It won’t be an easy environment in the short term – we expect to see severe volatility.”

The development of California’s climate change policy is less well advanced than RGGI. AB32 – the Global Warming Solutions Act, which mandates reductions of GHG emissions to 1990 levels by 2020 – was passed in April 2006. However, proposals on market-based mechanisms to meet its emissions targets are not required until 2009.

Nonetheless, “California casts a very broad shadow, more so than RGGI,” over US climate policy, says Thomas at Clifford Chance. “The state is one of the greenest in the US, and has shown a willingness to push the envelope. Its [climate policy] starts to bump into the broader US economy – with the automakers, and the energy market in the western US, for example.

“The more aggressive California is on climate, the more it will inform and impact decisions made in Washington,” he says.

In Australia, too, regional government has proved more progressive in terms of climate
policy – but recent developments illustrate the difficulties caused when federal legislation supersedes local initiatives.

One state, New South Wales (NSW), introduced its GHG Abatement Scheme, aimed at the power sector, in 2003, intending it to run until 2020. However, in June, then prime minister John Howard announced that a national, federal scheme would be established by 2012. This date has been brought forward by the incoming Labor government – which won a general election in November – to 2010.

However, uncertainty about how NSW’s emission reduction certificates – NGACs – will be
treated in the new system has led to prices plummeting in the NSW market, says Michael Stone, head of environmental products at TFS Energy in Sydney, which won the Best Broker category in the scheme. Prices are down from around A$12–13 (US$10.60–11.50)/tonne of CO2e in June and July to around A$5.50 in late November.

“There is complete uncertainty and a lack of detail about how the scheme will transition into a national emissions trading scheme,” he says. “Some NGACs won’t be eligible, and people are talking about compensation, because they’ve priced in NGAC revenue [when making investments] to 2020.”

The New South Wales scheme has also been roiled by an oversupply of credits – partly as a result of its success in promoting energy efficiency measures. A number of companies were formed to create credits by distributing energy efficient lightbulbs – but some of those are struggling to survive. Australia’s drought has compounded the current oversupply, says Stone, as coal-fired power stations have lacked sufficient cooling water to operate, encouraging a shift to lesspolluting
natural gas capacity.

But the future looks rosy for Stone and environmental market advocates down under. As well as a Labor administration accelerating the development of a national ETS, it is also reviving the Mandatory Renewable Energy Trading scheme. “Australia will have two big, liquid schemes by 2010-11 … and the New Zealand emissions trading scheme kicks off in 2008, with forestry as the first sector covered.

“It’s a very exciting time,” he adds.