Carbon Trading Markets

Origins of carbon economy and carbon finance

Some atmospheric gases, mainly carbon dioxide (CO2), but also methane (CH4), halocarbons (HFCs and PFCs), nitrous oxide (N2O) and sulphur hexafluoride (SF6), are called greenhouse gases (GHG): they act as a natural blanket retaining the earth's heat.

Human activity increases the blanket's thickness causing significant potential global warming with multiple consequences. Some countries have developed greenhouse gas emissions (GHGs) control systems with the aim of limiting climate change through reduction of greenhouse gases. These policies are based on the principle “polluter pays”

“Carbon finance” is the name given to the mechanisms and markets used to exchange and trade GHG (greenhouse gas) emission quotas.

Mandatory trade and management of CO2 emissions systems go back to the 70's. The first implementation of a similar system was developed in the United States from the 90's. Its aim was to regulate emissions of a gas which causes acid rain, sulphur dioxide (SO2).

Nowadays, the carbon economy and finance are in constant evolution, with differences depending on geographical zones . The carbon economy is considered as being one of the major challenges for the XXIst century's economy.

Regulatory frameworks and markets

There exist several carbon regulatory frameworks in the financial markets, based either on international treaties or on private law contracts. Each of them defines an emission allowance trade and exchange system: the organised carbon markets.

There are also alternative mutual agreement transactions systems –organised outside carbon markets: OTC - Over The Counter.

Regulatory frameworks

Kyoto Protocol

The Kyoto Protocol establishes an emissions trading system. It included a target to reduce greenhouse gases by an average of 5% over the period 2008-2012 compared to 1990 levels.

The participants (industries and countries) are the following:

• 5 industrial sectors located in 25 EU countries (listed in appendix 1 of the Kyoto protocol ): power and heat generation, mineral oil refineries, iron and steel, pulp and paper, building materials (cement, ceramics, and glass)
• 5 industrial sectors located in countries outside EU: Japan, Australia, NZ, Russia, Ukraine, Canada, etc. (listed in appendix 1 of the Kyoto protocol)
• India, Brazil, China, etc. (listed in annex 2 of the Kyoto protocol)

Regional regulatory frameworks (outside Kyoto)

These regulations are based on quotas and regional objectives.

Energy sector of 10 states of the USA

10 states from the USA and Canada

Electricity sector of New South Wales (AUS)

7 states from the USA and Canada

Regulations in project phase / ratification phase

Canada

Voluntary markets

These regulated trade and exchange systems not committed to Kyoto nor to other regional agreements. Quotas and reduction targets are defined on a voluntary basis.

Trading outside regulated frameworks

The emergence and development of the new carbon markets is heavily dependent on the evolution of regulatory frameworks (some are still in their design/experimental phase).

Calendar of Kyoto

See below for the main stages of the implementation of the Kyoto protocol which governs regulated markets as ECX, EEX, the North Pool, Bluenext

Carbon Registry Systems and operations

Registry systems (allowance accounting)   record emission allowances:

• by geographical zone,  
• by country,
• by industrial actor (ultimate emitter).

They also record operations concerning allocation and exchange of carbon allowances: initial allocation, purchase, sale, obtaining of new rights, etc.

Kyoto protocol carbon accounting units and operations

Registry systems keep track of the emission allowance allocations defined by the Kyoto protocol regulatory framework.
Registry systems are also necessary for monitoring the activity of Kyoto participants (industrial or country) from one of the 3 Kyoto mechanisms (known as Kyoto flexibility mechanisms):

• Emissions Trading : trading system allowing the sale/purchase of “unused” carbon allowance units.
• The Clean Development Mechanism (CDM) : Acquisition of carbon emission credits, later convertible into quotas, by investing in a Kyoto certified projects (that follow the criteria requirements for CDM project, see below)
• Joint Implementation (JI) : Acquisition of carbon emission credits, which are later convertible into quotas, by investing in a Kyoto certified projects (that follow the criteria requirements for JI project, see below)

The operations issued from these mechanisms are recorded through the following units of account:

Kyoto protocol and “clean” projects (CDM,JI )

Kyoto protocol and registry systems

Registry systems used for Kyoto protocol implementation are listed below:

Organised Markets

Organised carbon trading markets are enforced by both GHG international and regional regulatory frameworks.

The most important market legally submitted to Kyoto protocol framework is the ECX-European Climate Exchange (London) market, representing by itself, 87 % of the global market. There exist other markets committed to Kyoto protocol framework: North Pool (Norway), Bluenext (France) and European Energy Exchange / Eurex (Germany). These organised markets are regulated - FSA, AMF, etc. - and have their clearing houses - LCH.Clearnet, the North Pool, etc…

Voluntary Markets

Carbon voluntary markets present more facilities than organised markets:

• Regulatory framework: is defined by the market operator (ex: Chicago Climate Exchange) or by following a standard (ex: Voluntary Carbon Standard)
• Emission reduction targets : Industrials have access to the market on voluntary basis
•  Participants : no constraints on industrial sector nor localisation
• Tradable Products:
  • carbon products traded in organised markets are also available in voluntary markets
  • Standardised carbon products issued from projects that do not require Kyoto standards certification

Investors participate in voluntary markets for different reasons:

• To benefit from arbitrage opportunities created by finance carbon evolution
• To foresight/survey on regulatory frameworks evolutions (financial impacts)
• Improve society's marketing image through sustainable development (Corporate Social Responsibility).

The leading Voluntary Carbon market is CCX-Chicago Climate Exchange. The CCX trades different carbon allowances issued from a large range of standardized projects: energy efficiency, the renewable energy, the capture of fleeting gases (methane), reforestation, among others. The Voluntary carbon markets are more developed in countries where there is no regulation or where it is under approval. The evolution is prominent across Atlantic (NYMEX-green Exchanges (NY) and CCFE-Chicago Climate Futures Exchange).

Tradable units are defined by each voluntary market. For example, markets following VCS standards (Voluntary Carbon Standard) adopt the following account units and products:

The carbon markets typology