The World Bank's recent snapshot of the state of the carbon markets found rising volumes, underpinned by greater certainty. But, as the Ecosystem Marketplace finds, it also highlighted some concerns about the current shape of the Clean Development Mechanism. At the press conference launching the latest World Bank study of the global carbon market, Bank economist Frank Lecocq was able to confidently tell reporters that "the market is gearing up for a new phase". The report, State and Trends in the Carbon Market [to download the full report, click here], is the fifth annual assessment of the emerging carbon market — or carbon markets — that the World Bank has carried out, this time with the help of two leading emissions brokers, Evolution Markets and Natsource. Launched at the Carbon Expo conference in Cologne on May 11, 2005, the report looks at both 'allowance' markets (such as the EU Emissions Trading Scheme, or EU-ETS) where carbon allowances are granted to companies by a regulator — and project-based markets where carbon credits are awarded to projects that reduce emissions beneath a 'business-as-usual' baseline (primarily the Clean Development Mechanism, CDM, and Joint Implementation, or JI). The report analyses prices and volumes in both markets, and examines who is buying and selling and, in project markets, what types of greenhouse gas (GHG) reductions are taking place, and what contracting terms are being used. It also considers current barriers to the growth of the carbon market, and its future prospects. "This fifth report is about how the market has responded to two major developments – the launch of the EU Emissions Trading Scheme, and [the] Kyoto [Protocol's] entry into force," Lecocq told the press conference.
And, the answer, as the report stresses, is that "more than increases in volumes, the major change on the market over the previous twelve months is probably in the realisation that the carbon constraint is now serious." The volume story, however, is a compelling one. The report finds that transactions in the project market in 2004 were up 38% on 2003, at 107 million metric tonnes (Mt) of carbon dioxide equivalent (CO2e). In the first three months of 2005, 43 Mt were transacted — and the report finds large amounts of "incipient demand" and significant volumes of reductions promised by projects under development. Furthermore, the allowance market — which only accounted for 2.5% of volumes between the inception of the carbon market in 1998 and May 2004 — was almost as large as the project market in 2005. While the report includes the UK ETS, the Chicago Climate Exchange, and the New South Wales GHG Abatement Scheme, the bulk of these transactions were in the EU ETS, an ambitious undertaking covering around 45% of the EU's emissions of CO2. "We're coming to you with a story that the market is getting bigger and stronger, and that we're seeing increasing interest in the CDM," said Dirk Forrister, the managing director of Natsource's London office, at the press conference. Andy Ertel, the president of New York-based Evolution Markets, agreed: "We're at a tipping point — and we're seeing new companies coming into the [EU ETS] marketplace every day."
Beneath the Headlines: Future Supply Bottlenecks
But beneath the headline growth in volumes, the report also illustrated a number of potential problems with how the market is developing; problems that are acknowledged by the World Bank, which has invested heavily in helping these markets develop. According to the report, however, the predominant concern of the Bank is that the carbon market is developing too slowly to meet the likely demand for carbon credits that will develop once companies and governments begin to fully appreciate the magnitude of the emissions reductions that they need to deliver to meet their Kyoto Protocol targets. "[One of] the critical issues ahead [is] clearly the ability of the CDM and JI to supply large volumes of emission reductions," the report notes. The report further finds that – despite growing regulatory certainty around carbon caps – the pace of growth in the project-based markets had slowed. Volumes had doubled between 2001 and 2002, and between 2002 and 2003, but growth has slowed significantly in 2004. It gives a number of reasons for this:
- Slow supply response to increased demand While there are clear signs of high pent-up demand — as evidenced by the hundreds of millions of dollars now flowing into 'carbon funds' (which invest in portfolios of reduction projects, and typically repay their investors with carbon credits) — it takes time to source and develop projects, particularly given bottlenecks in the CDM's regulatory approval process.
- It remains unclear who in the private sector needs to buy credits The extent to which the burden of reductions under Kyoto will be passed to the private sector is unclear, with Japan and Canada yet to elaborate their policies in this area. While European companies within the EU ETS already face targets, their aggregate reduction commitments in the scheme's first phase (2005-07) are modest, and they will not know their 2008-12 targets until next year at the earliest.
- Many market players are adopting a wait-and-see attitude The Bank speculates that some market players may be delaying purchases in the face of continuing regulatory uncertainty. On the other side of the market, some project developers "appear not to be selling now in the hope of getting better prices in the future".
A Window is Closing
Despite these reasons, the outgoing head of the World Bank's carbon finance business, Ken Newcombe, warned at Carbon Expo that the window was closing to develop many CDM projects if they are to deliver carbon credits into the market before the end of the first Kyoto commitment period, which runs from 2008 to 2012. Not for the first time, Newcombe warned that for many projects "next year will be too late". Any project finance deal takes time to put together, and the complexities of steering an emissions reduction project through the CDM approval process does little to help. With project lead times of three to seven years, each year that passes from here on in closes down whole categories of emission reduction projects. The hope for putative project developers is that governments party to the Protocol will agree subsequent commitment periods, for which the 'certified emission reductions' (CERs) generated by CDM projects would be eligible. Indeed, Andrei Marcu, executive director of the International Emissions Trading Association (IETA) said that he was hopeful that government negotiators meeting in Montreal in November and December, to continue Kyoto negotiations, would send such a signal to investors. In the meantime, in some cases, the World Bank's carbon funds are contracting to buy post-2012 reductions from projects on a speculative basis.
Not Delivering on Sustainability Promise
This continuing uncertainty, and the closing window before 2012, is skewing the market towards certain types of projects, warns the Bank – exacerbating the concerns of many in the NGO community that the CDM is failing to deliver on its promise of driving sustainable development. The report finds that this year, as last, large-scale HFC23 destruction projects dominate in terms of the volumes of reductions contracted, at 25% (compared to 23% in 2003). Projects destroying HFC23 — a potent GHG, which is a byproduct of the manufacture of HCFC22, a refrigerant — deliver large volumes, relatively quickly, and relatively cheaply but, their critics argue, do little to enhance host country sustainable development. The CDM has been criticised for failing to do enough to promote renewable energy – partly because the revenue from carbon credits is typically too small to dramatically improve the economics of such projects. Wind farms, for example, account for just 7% of projects contracted between January 2004 and April 2005. Energy efficiency and fuel-switching projects do even worse, collectively making up just 4% of total volumes, despite their attractiveness for environmental reasons. "This is likely to continue in the foreseeable future, as projects with emission reductions that can be generated quickly are developed to meet first commitment period requirements," the report notes.
The report also makes disappointing reading for those hoping to see carbon finance applied broadly throughout the developing world. India, Brazil, and Chile account for fully 58% of the project market — a figure which understates their importance in terms of CDM projects (which only developing countries can host) given that some 20% of the overall volume is made up of JI and voluntary projects in industrialised countries. China and Mexico are also developing large numbers of projects, but these have yet to reach the market, the report says. Africa, by contrast, accounts for less than 1% of project volumes in 2004-05. Indeed, a recent report from NGO CDM Watch blasted the World Bank — and, by extension, much of the carbon market. The World Bank and the Carbon Market: Rhetoric and Reality stated that "the last few years have also demonstrated the limitations of a carbon market as a driver of anything other than cheap carbon credits…Investment is focused overwhelmingly on the richer developing countries, and within those countries is going not to projects that deliver sustainable development or alleviate poverty but to projects that involve reductions of gases from chemical facilities, coal mines and landfills." The World Bank's carbon finance unit clearly acknowledges these concerns: two of its funds, the Community Development Carbon Fund and the BioCarbon Fund, are explicitly orientated towards least-developed countries. And its State of The Carbon Market report says that, "in terms of trends, the market seems to be concentrating in large, middle-income countries…The concentration of CDM flows…is consistent with the current direction of Foreign Direct Investment." But it adds that "the under-representation of Africa raises deep concerns about the overall equity of the distribution of the CDM market."
The EUA-CER Spread
The Bank report raises — and addresses — another equity concern: That is the observation by CDM project developers and sponsors that the prices they can attract for their CERs bear little relation to prices of EU Allowances (EUAs) in the EU ETS. Despite the fact that CERs are eligible for use towards EU ETS targets, EUAs are currently trading around €18 ($22.5)/tonne of CO2, compared to prices for verified emission reductions (VERs) or CERs of between $3.60 and $7.15/tonne. "Given the price differential between EUAs and CERs, buyers under the EU ETS or arbitrageurs would be expected to purchase CERs on the CDM market and sell them back into the EU ETS for a handsome profit," the report says. "But we do not observe price convergence, at least so far. The price gap has in fact increased recently, mostly because the price of EUAs has doubled," it adds. The World Bank begins explaining this price differential by suggesting that the current price of EUAs is higher than the fundamentals of supply and demand suggest that it should be. One explanation for this is that buyers in the market — namely Western European utilities — have begun trading, and have been buying allowances to cover their positions, while sources of supply — companies in Eastern Europe — are still getting to grips with the scheme, and have yet to enter the market (see EU ETS: Is the bull out of steam? Click here). In theory, the Bank continues, CERs should enter the scheme to correct this imbalance, but it elaborates a number of reasons why this has not, thus far, taken place. First, as discussed, it takes time to generate credits and, for them to be of value to companies with targets under the first phase of the EU ETS, they must be delivered quickly. Relatively few projects are in a position to guarantee that their credits will be delivered for use against 2005, 2006 or 2007 EU ETS targets. This problem is exacerbated by the fact that the International Transaction Log (ITL) — the registry that will track the issuance and transfer of CERs – is not yet in place, and may not be for some months. Until the ITL is in place, project developers will not be able to physically deliver CERs, the Bank notes.
All About Risk
But the most important reason for the price differential is simply that — so far — CERs are higher risk instruments than EUAs. The latter are in the process of being transferred by governments (the UK, for example, is distributing its EUAs this month) and, once they are held by companies, they are guaranteed to be valid for compliance against emissions targets. Once CERs have been issued, and transferred via the ITL to the buyer, they will have the same value as EUAs (in fact, they will be worth slightly more, as they can be 'banked' and used in the EU ETS second phase, unlike first phase EUAs). Until that point, CERs carry varying degrees of delivery risk — ranging from the failure of the project to qualify under the CDM, up to the default of the company developing the project. These various risks, the Bank notes, are reflected in the prices at which VERs and CERs are changing hands. VERs intended for Kyoto compliance, but which have not yet been registered under the CDM, carry a weighted average price of $4.23 as the buyer takes the risk that the project will fail to be successfully registered. CERs, however, where the seller takes registration risk, trade at an average price of $5.63. The Bank concludes that, over time, price convergence will occur, as larger volumes of CERs reach the market and technical barriers to their delivery are overcome. But, "it is unclear whether it will be as early as 2006-07, or only in 2008 and beyond," the report says. And it is unclear as to whether projects with more sustainable development attributes are likely to flourish in such an environment: "We expect non-CO2 projects to increase, because they can deliver large volumes, at low risk, quickly," said Lecocq. In other words, although greater policy certainty is helping the carbon market find its feet as a viable mechanism for trading emissions, some of the Kyoto Protocol's architects will surely be asking whether it is delivering on some of its underlying environmental and social objectives. Mark Nicholls, a regular contributor to the Ecosystem Marketplace, is the London-based editor of Environmental Finance magazine, and consulting editor to its sister publication, Carbon Finance. He can be reached at email@example.com. First Posted: May 30, 2005