The business of carbon trading

Feature article

60 renewable energy focus September/October 2007

The business of carbon tradingJUST AS CORPORATIONS BUY AND SELL CARBON EMISSIONS TO WIPE OUT

THE FOOTPRINT OF THEIR LESS ENVIRONMENTALLYFRIENDLY MANU

FACTURING PRACTICES, ‘CARBON OFFSETTING’ IS ALL THE RAGE IN THE

CONSUMER WORLD. IN A SPECIAL FEATURE FOR RENEWABLE ENERGY

FOCUS, MILES AUSTIN INTRODUCES US TO THE MECHANISMS OF

CARBON TRADING, AND PAULA MINTS EXAMINES WHETHER CARBON

OFFSETTING CAN VIABLY PROVIDE OFFGRID SYSTEMS TO THE

DEVELOPING WORLD. Miles Austin, EcoSecurities

While the concept of carbon trading has been on the radar screen since

the signing of the Kyoto Protocol in 1997, it has only really started to

gain momentum over the last two years through the European Emis-

sions Trading Scheme (EU ETS). There is now a live, traded price for CO2

– similar to any other commodity. In addition to EUAs (EU Allowances,

which are the permits allocated to participants in the EU ETS), the fl ex-

ibility mechanisms of Kyoto have created a class of carbon credits (CERs

and ERUs) that provide another source of global CO2 assets. Through the

growing number of schemes and products, there now exists a real plat-

form for the development of an increasingly sophisticated, liquid – and at

some stage global – market for carbon emissions.

Background and markets

Although the term “carbon trading” is used, what are actually being traded

in all cases are emissions rights measured in tonnes of CO2. The warming

potential of other greenhouse gases covered by the Kyoto Protocol are

measured in terms of the equivalent amount of CO2 that would have the

same warming eff ect, or CO2e. The 6 gases covered by the Kyoto Protocol

are: Carbon dioxide (CO2); Methane (CH4); Nitrous oxide (N2O); Hydrofl uor-

ocarbons (HFCs); Perfl uorocarbons (PFCs); Sulphur hexafl uoride (SF6).

The three fl exible mechanisms of the Kyoto Protocol are primarily

designed to allow emissions savings to be made on a least-cost basis.

They achieve this by making the fact of the actual emissions abatement

of greater importance than the location. The three fl exible mechanisms of

the Kyoto Protocol are the Clean Development Mechanism (CDM); Joint

implementation (JI); and Emissions Trading.

The CDM takes place in countries that are signatories to the Kyoto Protocol

but do not have binding emissions targets. The CDM allows projects that

reduce Greenhouse gas (GHG) emissions to generate credits for those

emissions reductions. Known as Certifi ed Emissions Reductions (CERs),

these can be used by countries with Kyoto targets and EU ETS installations,

towards complying with their emissions reduction obligations.

JI allows for parties from countries with targets under Kyoto to set up GHG

emission reduction projects. The credits generated this way are known as

Emissions Reduction Units (ERUs). ERUs can be used in the same way as

CERs for Kyoto Protocol and EU ETS compliance.Taking advantage of the CDM: Irani is a pulp and paper biomass project in Brazil (source: EcoSecurities)

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renewable energy focus September/October 2007 61

The key feature of emissions trading that makes it more attractive than

conventional command and control emissions caps, is that the fl exibility

provided by emissions trading systems can signifi cantly reduce the costs

incurred whilst achieving the same environmental goal.

The European Emissions Trading Scheme (EU ETS)

The EU ETS was designed with exactly this in mind, and is now the cornerstone

of EU climate policy. Reports commissioned by the EU estimate that the emis-

sions savings made under the EU ETS will cost €2.9-€3.7 billion. An estimate of

what the cost would have been using alternative non-market policies set the

fi gure at €6.8bn, suggesting a saving of €3.1bn-€3.9bn.

The EU ETS covers all of the EU Member States (MSs), with a total of over 11,000

installations, receiving approximately 2.1 billion EUAs per year in the Phase I

2005-2007. Use of CERs and ERUs is capped, with the caps amounting to an

average of circa 10% per country. Designed as a 3 year test (in order to high-

light any fl aws in time to fi x them for Phase II) Phase I of the EU ETS runs until

the end of 2007.

Phase II of the EU ETS runs in parallel with the Kyoto Protocol’s First Commit-

ment period 2008-12. In keeping with its status as a test phase, Phase I Euro-

pean Allowances (EUAs) cannot be banked into Phase II. Part of the impetus

for having a short initial test phase was the experience of the US SOx trading

scheme. This was initially hampered by too many permits being issued, coupled

with having no test phase and thus banking being allowed.

Initially Phase I seemed to be running well, though it was widely believed to

have too few EUAs to cover the emissions of European industry. As a result

of the anticipated under allocation, EUA prices rose from initial levels of €8

to circa €30 in April 2006. It is essential that if cap and trade schemes are

to function eff ectively, the number of emissions permits issued must be

lower than the emissions of the facilities covered. In the absence of this, the

emissions permits will be oversupplied. This oversupply has two immediate

eff ects: fi rstly, the scheme will not reduce emissions and fail environmentally,

and secondly – as a result – the permits will become valueless.

All cap and trade schemes undergo a periodic process known as ‘truing

up’. Truing up essentially boils down to installations handing in emissions

records and the equivalent allowances to cover the emissions. To true up

under the EU ETS, installations give the regulator an independently veri-

fied report of their emissions and the equivalent volume of EUAs. The

first Phase I true up took place in April of 2006 and covered 2005 emis-

sions. At this point it rapidly became clear that – contrary to what the

majority of the market was anticipating – the EU ETS had a surplus of

EUAs. As a result, the Phase I EUA price fell from circa €30, to €11 in a

week. Subsequently it has declined further, and – at the time of writing

– is trading at around €0.15.

The reasons for the size of the surplus are open to debate. At a price of €30 per

tonne it is likely that some zero and low cost abatement took place. However

the prime culprit was – and remains to this day – the historical emissions

data that the Phase I allocation was based upon, coupled with projections for

growth in industrial output. Both of these were provided to Government by

industry, with no independent checks.

Under Phases I and II of the EU ETS, countries present a National Allocation

Plan (NAP) to the European Commission (EC) for approval. The 2005 verifi ed

emissions data, coupled with the surplus of EUAs, has provided the EC with

two useful tools to ensure that Phase II does not have a surplus of emissions.

Firstly, unlike the historical emissions data that Phase I was based upon, the

2005 emissions data is independently verifi ed. Secondly, it is inevitable that,

given the speed and degree of the EUA price crash, some market participants

lost money. As stated earlier, EUAs that were valued at €30 in April 2006, are

currently valued at €0.15. This created pressure from the fi nancial sector to

ensure that Phase II was not over allocated.

As a result of having both independently-verifi ed emissions data and the

political capital to maintain a fi rm stance, the EC has cut 20 of the 23 proposed

NAPs which it has ruled on to date. At the time of writing, the EU ETS alloca-

tions suggest a shortage of approximately 6.4%-6.8% in comparison to the

2005 emissions data. This shortage is similar to that anticipated for Phase

I when it was trading at €30. At the time of writing futures for Phase II are

trading at circa €20.

The Clean Development Mechanism (CDM)

Today, the CDM is by far the more dominant Kyoto mechanism. As of May

2007, the CDM is projected to create circa 2bn tonnes of reductions to 2012,

compared to the JI’s 153 million. A large degree of the CDM’s success is down

to host country Governments putting in place the required institutions and

regulations in a timely and effi cient manner. The linking directive aided this

already positive environment by opening up the EU ETS to the CDM market.

This helped to buoy up investor confi dence, as it provides a more liquid and

easily quantifi able market than would be provided by simply selling in bulk

to national Governments.

The eff ect of the EU ETS has to a large extent helped to drive the scale of invest-

ment that has taken place. The World Bank, in its State and Trends of the Carbon

Market 2007 report, estimated that in 2006 the CDM market accounted for US$

Ecosecurities’ Miles Austin: “the EU ETS is the cornerstone of EU climate policy.” Taking advantage of the CDM: San Jacinto Tizate is a geothermal project in Nicaragua (source: EcoSecurities)

Carbon markets


Carbon markets


5.2bn of transactions compared to US$2.6bn in 2005. The same report esti-

mated that the EU ETS accounted for US$24bn in 2006 compared to US$7.9bn

in 2005.

How does trading happen?

For installations under the EU ETS, trading of EUAs, CERs and ERUs takes place

in a number of diff erent ways. The most simple deal is bilateral trade where

Company A sells X volume of emissions to Company B. This is normally done

under an Emissions Reductions Purchase Agreement (ERPA), for which

various formats exist.

EUAs are also spot-traded on some exchanges, however the primary form

of EUA exchange trading is in futures. The European Climate Exchange

captures some 70% of exchange based EUA trades. It trades EUA futures for

the years 2007-2012, to be delivered in December of the contract’s vintage.

So, for instance, the December 2008 contract delivers in December 2008.

CER futures are currently being traded on the Nordpool exchange. These are

delivered in December of the contract’s vintage. Another form of trading CERs

is through ‘swaps’. Swaps are attractive to holders of EUAs, as CERs currently

trade at a discount to the Phase II EUA price. Phase II EUAs are swapped

either for a larger number of CERs; or an alternative option which has proved

popular is to carry out a one-to-one swap with the EUA vendor being paid a

premium.

The CER to Phase II EUA price diff erential presents a number of obvious advan-

tages. Firstly, it achieves the same compliance result as purchasing EUAs, but

at less cost. In the event that a company over purchases CERs, they have the

advantage over EUAs of being a global carbon currency which can be used for

compliance in any country with an emissions target under Kyoto.

Currently, spot trading of CERs is not possible as the international registry

International Transaction Log (ITL) that will facilitate this is not yet

connected to any country registries. For the EC, this is predicted to happen

in December 2007. It is a fair assumption that spot trading will commence

almost instantly.

Paula Mints, Navigant Consulting

Buying back your sins – one credit at a time

Just as Corporations buy and sell carbon emissions to wipe out the footprint

of their less environmentally friendly manufacturing practices (see above),

the unregulated practice of buying back our environmental sins has hit the

consumer world. Choose to drive an SUV, take a long plane fl ight, or decide not

to purchase a PV system because it is too expensive, and you can off set all of

these choices by spending with an unregulated carbon off set company. You

can make up for your sins by planting trees, investing in methane reduction,

or in windfarms. Why, if you spend enough money, you can erase your carbon

footprint all the way back to the cradle.

Carbon emission trading became a business after Kyoto, and a profi table one

for some. CO2 has become a commodity, and selling global warming is big busi-

ness. In 2005, the international market was on the order of US$10bn – tripling

in 2006 to US$30bn. If pollution on the grand scale is profi table, why not open

the practice to consumers of polluting goods – the question, it appears, is

rhetorical.

On the consumer level, buying carbon off setting allows a person to reduce

or eliminate their CO2 footprint at a reasonable price. By sending US$40.00

to DriveNeutral.org, I can buy a Tier Two Drive Neutral Certifi cate and erase

my car’s carbon footprint. With US$40 invested in methane reduction projects,

reforestation projects, or renewable energy projects my gas guzzling ways

can be eradicated. I can spend US$149.95 with Terrapass.com and eliminate

100,000 miles of business air travel (or 40,000 pounds of CO2), and receive a

free luggage tag along with my investment in wind or biomass projects. Carbon

off set companies are both for profi t and nonprofi t, and are at this time unreg-

ulated. So, though my environmental conscience is clear, how do I know that a

tree was planted, a wind farm erected, or methane reduced?

Carbon off sets are quite popular with movie stars and US politicians. Limo rides,

private jets and the energy required to electrify mansions are erased while the

behaviour goes on in perpetuity. But enough complaining, if the company

providing the off set makes good on its promise to invest in a renewable

project, this is not such a bad way to ease one’s conscience, along with being

(as many websites promise) a unique gift for weddings, holidays, birthdays or to

commemorate another special occasion.

Still, with three billion people in the world living without electricity, perhaps

the improvement in just one person’s standard of living provides a reward far

beyond the US$40.00 I would spend to erase my car’s carbon footprint. If we

can be certain that the dollars donated to a nonprofi t, or spent with a for-profi t

company actually improves lives, then these off set dollars are a worthwhile

investment in the erasure of our environmental sins.

With individuals investing money to erase their carbon footprints, it is impor-

tant to consider exactly where the money is going, as, and this is even true

for nonprofi ts, a certain amount of the money collected must go for business

administration. The website must be updated, paperwork fi lled out and people

paid for watching over donated or spent funds. Also, renewable energy projects

are themselves expensive to administrate and implement, and in the case of

PV electric, the hardware is expensive. Consider this; IF a manufacturer can be

induced to donate the modules (a reasonable unlikelihood); we are still looking

at a bottom price of (on the order of) US$150 for a 50-watt solar home system

– a vast diff erence from the approximately US$13-watt these systems now cost,

but still presenting an aff ordability problem for people in the developing world

who often live on US$1 a day. Providing a village in the developing world with

20 solar home systems, along with a combination community centre and clinic

would, in the best case, cost from US$15,000-US$20,000 – that is approximately

500 small car carbon off sets – and this is with free modules.

In the case of PV (and likely other renewables) in 2006, 4%-5% of modules

produced went to the developing world. So, in practical terms it is

unlikely that the carbon offset businesses will be able to turn the tide.

And PV remains the best hope that most in the developing world have

for electrification. Figure 1 breaks down 2006 demand for PV modules

by region. The developing world population is primarily found in Latin

America, Southeast Asia, Africa and the Middle East.

Taking advantage of the CDM: Wahei hydro-electric power station in China (source: EcoSecurities)


http://DriveNeutral.org

http://Terrapass.com

Carbon markets


In 2006, off-grid was 14% of total PV demand – in a perfect world, a well

run carbon offset program might increase supply to a population in

desperate need of electricity. Unfortunately, an admittedly cursory over-

view of the non- and for-profit companies involved in this sector did not

find that a majority of these projects were solar – a solar electric system

is still expensive and a large scale project more so. The trend to grid-

connected demand (where the money and incentives are) is unlikely to

change – continuing to leave less module products available for remote

projects in the developing world. Figure 2 highlights the demand trend

to grid-connected sales, from 1999 to 2011.

Even renewable technologies have a carbon footprint. Considering

the installation of a silicon-based PV system; who is buying the carbon

offsets for the energy used during silicon feedstock manufacturing,

along with the energy used for module manufacturing, manufacturing

of balance of systems, the installation and the decommissioning of the

system? Though, considering the environmental good done by PV (and

other renewables) this point is moot.

For the industrialised world, the investment, or in the US the power purchase

agreement model holds promise for these carbon off set companies – if, they

can convince their investors/customers to take on the risk that accompanies

the potential of high reward. Globally, the development of diff erent invest-

ment models for fi nancing solar projects has lead to strong growth in the

grid-connected commercial market segment. These investment models change

the paradigm of owning the means of production (a solar system), back to one

the electricity customer understands, that of renting electricity. To be successful,

and reduce risk to the investors, all investment models, whether the model is in

Asia, Europe or the US require an extremely low system cost, that is, modules

<US$3-Wp, and low cost BOS and labour. To be successful this model needs

incentives in place to further lower the system cost to the investor, and there-

fore allow the investment team to off er low-priced electricity. Typically, the price

of the system is set by market forces with profi t taken all along the chain. With

the investment model there is no further mark up from the cost of installing

the system. This model could provide revenue to the carbon off set companies,

though, again, the risk is as high as the reward.

But back to the personal level; poor populations in the developing world are

not investing in carbon off sets. This population of poor people is just trying to

survive. The middle class around the world, and, of course, the rich, are the ones

investing in carbon off sets. If these off sets go towards worthwhile projects, and

a real result can be tracked, then this new trend in personal giving has long-

term validity. However, if this currently unregulated industry should prove inad-

equate to the enormous and expensive job it has undertaken, then it will off er

more evidence to current doubters about the long-term viability and aff orda-

bility of solar and other renewables.

And fi nally, if the ability to spend a few hundred dollars (or, several thousands

in the case of the rich) in carbon off sets becomes the choice – ahead of buying

a solar system – this will indeed be a shame along with money misspent. The

power of solar as a distributed generation source – and one that allows a person

to own the means of electricity production – should remain a primary buying

motivation, well ahead of the purchase of carbon off sets. Therefore, to really

make a dent in a person’s environmental footprint, owning the renewable

means of electricity production is a mighty powerful (albeit expensive) choice.

But consider, the approximately US$20,000 paid for a solar system on a residen-

tial house provides on the order of 25 years of clean electricity, while reducing

the carbon footprint of the system owner and likely his or her neighbours.

We can, of course, make the easy choice – if it makes us feel better – and

send money to AlmosClear Climate Club, Carbonfund.org, e-BlueHori-

zons, DriveNeutral.org, DrivingGreen Ireland, Terrapass, Native Energy,

The Carbon Neutral Company and a host of others, to erase our last plane

flight, inefficient refrigerators and SUVs. As long as the money we spend

goes towards a functioning renewable project, it is money well spent. Or,

we could invest in a PV system of our own and know for certain where

our money really went.

Figure 1: 2006 worldwide PV demand Figure 2: Grid-connected and remote PV demand (1999 to 2011)

Navigant’s Paula Mints: “Carbon off sets are quite popular with movie stars and US politicians. Limo rides, private jets and the energy required to electrify mansions are erased while the behaviour goes on in perpetuity.”


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The business of carbon trading