1

An Introduction to Carbon Markets

Financial Markets GroupLondon School of Economics

15 May 2008

Sam Fankhauser

IDEAcarbon

2

Overview

• Why markets?

• The efficiency of markets

• Permits vs. taxes

• Carbon markets

• EU Emissions Trading System

• The Kyoto mechanisms

• Voluntary markets

• The future of carbon markets

• Creating a market

• Policy environment: the global deal

3

The need for emission cuts

From the Stern Review

4

United States

Can-Aus-NZ

Russia

Japan

W. Europe

EITs

Middle East

China

Latin America

Other Asia OtherAfricaIndia

-

1.00

2.00

3.00

4.00

5.00

6.00

0 1000 2000 3000 4000 5000 6000

Population (Million)

Em

issio

ns (

Ton

nes o

f C

arb

on

Per

Cap

ita)

South Africa

Developing country (non-Annex I) countries

Sharing the abatement burden

5

0

10

20

30

40

50

60

70

80

90

No trading Annex 1 trading Full trading

The benefits of emissions trading

Source: Manne and Richels (1998)

US$ billion

Cost of meeting Kyoto targets for the USA, 2010• Effectiveness

• Track record in reducing emissions

• Efficiency

• emission reduction at lower costs

• Integration

• Finance and technology flow to emerging markets

6

Taxes vs permits

• Economic efficiency argument

• Taxes: certain cost, uncertain quantity

• Permits: uncertain cost, certain quantity

• Optimal choice depends on the slope of marginal abatement, damage cost curves (Weitzman)

7

Taxes vs permits

Mar

g. A

bate

men

t C

ost

Flat MB curve

Mar

g. A

bate

men

t C

ost

Steep MB curve

target target

MAC

MAC

MB

MB

8

Taxes vs permits

Mar

g. A

bate

men

t C

ost

Choose tax

Mar

g. A

bate

men

t C

ost

Choose permits

target target

MAC

MAC

MB

MB

9

Taxes vs permits

• Political economy arguments are more conclusive

• International carbon tax agreement difficult to achieve

• Domestically, industry prefers (grandfathered) permits

10

Grandfathering – a source of profit

Meuro (2006)

CEZ: Revenues EBITDA Value of EUAs Net sales

5,6252,268738245

Drax: Revenues EBITDA Value of EUAs Compliance purchases

94658332640

RWE: Revenues EBITDA Value of EUAs Compliance purchases

44,2567,8612,436141

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Overview

• Why markets?

• The efficiency of markets

• Permits vs. taxes

• Carbon markets

• EU Emissions Trading System

• The Kyoto mechanisms

• Voluntary markets

• The future of carbon markets

• Creating a market

• Policy environment: the global deal

12

More than one carbon market

• Allowance market (cap-and-trade)

• EUA EU Emissions Trading System

• AAU Kyoto International Emissions Trading

• Kyoto mechanisms (baseline-and-trade)

• CER Clean Development Mechanism

• ERU Joint Implementation

• Voluntary market

• CFI Chicago Climate Exchange

• VER Voluntary carbon offsets

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…dominated by the EU ETS

Source: World Bank

14

Heterogeneous prices

Source: Reuters Interactive

15

• Clean Development Mechanism

• Annex I firm/country financing emission reductions in a non-Annex I country

• Joint Implementation

• Same as CDM but between entities in Annex I countries

• International emissions trading

• Trade of AAUs between Annex I parties

• Green Investment Schemes

The Kyoto Mechanisms

16

Technologies Sellers

Source: World Bank

A closer look at the CDM

17

A growing pipeline

Source: IDEAcarbon / ECON Global Carbon Report

0

400

800

1,200

1,600

2,000

2,400

Dec

-03

Mar

-04

Jun-

04

Sep

-04

Dec

-04

Mar

-05

Jun-

05

Sep

-05

Dec

-05

Mar

-06

Jun-

06

Sep

-06

Dec

-06

Mar

-07

Jun-

07

Milli

on C

ER

s

HFC & N2O reduction RenewablesCH4 reduction & Cement & Coal mine/bed Energy Efficiency Fuel switch

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PIN rating per risk category

Kyoto and Emissionreduction framework risks

Project context andenvironment risks

Project developer riskProject definition and

execution

Project risk (Technology,Size, Complexity)

Accounting for project risks

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Kyoto supply

Number of

Projects

PDD volume pre-2012

(mt)

Predicted delivery

(mt)

CDM - issuing 213 506 363

CDM –registered 525 490 362

CDM - under validation

1,548 1,039 715

CDM - before validation

3,600 841 505

JI - all stages 350 174 107

Total pre-2012 6,236 3,050 2,052

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CER Supply

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Compliance Demand

Category Purchaser Amount per year Total 2008-2012

Non-EU ETS EU Governments 108-120 540-600

  Canada 14 70

  Switzerland 2 10

  Norway 7 35

  New Zealand 7 35

Australia 0-18 0-90

  Japan (public) 40-60 200-300

  Japan (private) 30-40 150-200

Sub-total 208 - 266 1040 - 1470

EU ETS* 15 – 90* 45 – 450*

Total   223 - 356 1,085 - 1,920

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• Serve public sector demand first• Less price elastic

• Price differentiation allows to charge more

• Serve private sector demand• Price elastic, demand determined by in-house

abatement options

• Downward pressure on prices

• Bank supplies into post-2012 period• Regulatory uncertainty means sale at a discount

Clearing the marketInventory is larger than potential demand

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The 2008-12 market

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Question mark: AAUs

Source: World Bank

EU 6.4%

US 19.3%

Japan 8.5%

Canada 23.5% Australia

15.4% OOECD 12.7%

EU-A -46.4%

OEIT -78.9%

Ukraine -83.6%

Russia -43.6%

-300

-200

-100

0

100

200

300

400

Reductions required (MtC)

Reductions required

Increases allowed

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• 11,000 installations in 27 EU countries• Energy, refining, minerals, metals, pulp&paper

• Annual compliance requirement • Targets set in National Allocation Plans

• Mostly grandfathering, some auctioning

• Possibility to import Kyoto carbon

• At least three trading phases

• Phase I 2005-07

• Phase II 2008-12• Phase III 2013-20

EU Emissions Trading Scheme

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Price volatility

Source: IDEAcarbon / ECON Global Carbon Report

0

5

10

15

20

25

30

35

€ pe

r tC

O2

EUA Spot price

EUA Forward price 2008

… a sign of insufficient market information

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Collapse of phase I price

Source: IDEAcarbon / ECON Global Carbon Report

-20

-10

0

10

20

30

40

50

Mineral industry Metal industry Others Pow er & Heat Pulp & paper Refineries

mtC

O2

Surplus of allow ances in 2005

Surplus of allow ances in 2006

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• National Allocation Plan• Both phase II and phase III through banking

• Ratio of coal to gas price• Determines fuel switching

• Marginal abatement cost elsewhere

• Weather

• Cooling / heating demand

• Hydro availability

• Output / GDP

• Process emissions in industry

• Electricity demand

Price drivers in the EU ETS

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Prospects for Phase II

0

10

20

30

40

50

60

70

80

90

100

1,700 1,950 2,200

Emissions (mtCO2/year)

Quo

ta p

rice

(€ p

er tC

O2)

Base case

Higher growth (+1%)

5% decline in industry

Cap = 2,105 mtCO2

Cap with creditimports

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Chicago Climate Exchange

• Self-described as “world’s first and North America’s only voluntary, legally binding, rules-based GHG reduction and trading system”

• Established in 2000 with currently 312 (voluntary) members• power, automotive, chemical industry; banks, universities,

municipalities; project developers, offset aggregators, NGOs

• Six gases, both allowance-based and offset credits

• In 2006 about 10.3 MtCO2e were transacted,

worth US$91m; as of July 2007 26.3 MtCO2e had

been traded on the exchange

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Overview

• Why markets?

• The efficiency of markets

• Permits vs. taxes

• Carbon markets

• EU Emissions Trading System

• The Kyoto mechanisms

• Voluntary markets

• The future of carbon markets

• Creating a market

• Policy environment: the global deal

32

Growing European market

Source: IDEAcarbon, ECX

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

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• US state-level

• Regional Greenhouse Gas Initiative (RGGI)

• Western US Initiative

• California AB 32

• US federal level

• Lieberman-Warner Climate Security Act• Before the Senate in H1 2008

• Other bills in both House and Senate

• Canada

• Intensity targets for large emitters

North America

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• New Zealand (NZ ETS)

• Starts trading in summer 2008 with forestry

• Covering all emissions by 2013 (industrial processes by 2010)

• Australia (AETS)

• Starts trading in 2011

• Covering >70% of emissions (ex. Agriculture, forestry, fugitive emissions)

• Japan

• Focus on voluntary schemes (JVETS)

Asia - Pacific

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• Permit allocation

• Auctioning, grandfathering, benchmarking

• Scope

• Difficult sectors like agriculture, transport

• Upstream vs. downstream

• Safety valves against price spikes

• Carbon leakage and competitiveness

• Linking with other schemes

• CDM imports

• Linking with other schemes (e.g. NZ – Aus)

Open issues

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• Carbon markets in practically all OECD countries

• Regional schemes linked by an extended, enhanced CDM

• Underlying assets: 7.5 billion allowances, worth 200 billion?• Of which > 4 billion in a US federal scheme?

• Trading volume: 8 – 13 billion tCO2

• What is the global deal?

Long-term: Markets in 2020

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The “global deal”

• Long-term target: a 50% cut by 2050

• For a 450 - 500 ppm stabilisation target

• Consistent with G8, EU rhetoric

• Equitable burden-sharing

• Up to 80% cut in developed countries

• Developing countries get help on technology, carbon finance

• The next 6 months are crucial

• Target: agreement by 2009, ratified in 2012

• Next step: G8 Japan (summer); COP (Poznan)

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Contact Detailssfankhauser@ideacarbon.com

Tel +44 20 7664 0205

www.ideacarbon.com