Where should the carbon markets be headed for?

A carbon expert shares his views on the future of carbon markets post Kyoto phase and what the carbon market requires to keep functioning smoothly.

Unlike global commodity markets that have been in existence for a long time, carbon markets are new and relatively speaking untested. They do not enjoy traction despite being around for more than a decade. Carbon markets are not easy to de-cipher either. They are complex entities that are characterized by multiplicity of trading platforms that trade in carbon instruments emanating from different production/generating systems. What is more, these instruments are subject to equally different regulatory requirements. This adds to the complexity of regulating them.

The role envisaged for carbon trading in the future regime that succeeds the Kyoto Protocol, will guide the destiny of carbon markets in the world. The good news is that the Cancun Summit of December 2010, has provided some degree of reassurance about the continuing role of clean development mechanism in the post- Kyoto protocol phase. This positive stance coupled with demand for carbon certificates on the part of  BASIC countries like India in the days to come, could contribute to a  boom in world carbon markets, provided the mandatory allowance markets in the developed  world also work well enough.  The latter will depend upon emission reduction commitments taken up by developed countries in the future climate agreement. This, in turn, will depend upon how the burden sharing issue is resolved in the post Kyoto agreement. 

Whatever be the shape of future climate accords, it is obvious that the days of independent carbon markets are over. The decline of voluntary markets in the developed world (including the Chicago Climate Exchange) is a clear indication of the difficulty of running carbon markets based on voluntary commitments. Philanthropy has its limits when it comes to generating trading volumes in carbon markets. Trading volumes provide the required liquidity for transactions to take place both in the physical and futures markets.

Given the anxiety about the uncertain pace of economic recovery in the developed world, the importance of well functioning futures contracts for carbon allowances and certified emission reduction certificates cannot be denied. Both buyers and sellers of carbon instruments are keen to discover prices in advance, in order to plan their buying/ selling operations ahead of time. True, futures contracts do exist for European Union Allowances (EUAs), Certified Emission Reduction (CERs) and Emission Reduction Units (ERUs). However in the absence of tough caps and tight regulations in developed country carbon markets, ‘investment funds’ do not have the right incentives to undertake futures trading in carbon instruments.

A well functioning futures market is also desirable for another reason. This has to do with the volatility of prices for carbon certificates in the spot (physical) markets.  During 2009-2010, though one witnessed rapid fluctuations in the daily prices of EUA, CERs , ERU , the swing in prices were bi-directional, creating greater uncertainty for players (buyers and sellers) in the carbon markets. Well functioning futures markets are required to reduce the uncertainty.

Apart from well functioning futures markets, the CDM segment of the international carbon market also requires reforms in the post 2012 phase. CDM is perhaps the only mitigation device acceptable to developing countries. However the play of existing markets does not seem to be doing much for CDM. The ‘fluctuating’ spread between CERs and EUAs is a matter of concern for CDM entrepreneurs from developing countries. In general, CERs go for a discount vis-a-viz EUAs. This is understandable given the fact that CERs enter the EU-ETS market as fillers. However there is a real problem at hand when the EUA-CER spreads fluctuate. 

One of the other intriguing facts noticed about the EU-ETS markets is that the spread between CERs and EUA prices is large when trading activity is high. For instance in  the heavy trading month  of March 2011, CER prices averaged Euro 12.5/ktCO2 as compared to the average EUA price of Euro 15.66/ktCO2.This situation calls for a re-look at the CER aggregation process in CDM countries. Small projects that generate small volumes of CERs need low cost ‘aggregation’ or ‘CER pooling’ processes that help them to reduce layers of intermediation between the seller and the ultimate buyer.The Government of India- GIZ sponsored ‘Carbon Bazaar’, is a welcome initiative in ensuring a ‘low or zero intermediation system’ for CER Trading. However this forum needs to operate with greater frequency than at present.

I would conclude by stating that carbon markets of the world need greater integration for improved efficiency in operations. More importantly, such integration will also help by eliciting greater buyer interest. Buyers will directly transact in carbon instruments with sellers, provided carbon trading platforms are well knit. All the same, such interactions should be enabled by price discovery tools.  The advantage of futures markets is that they enable carbon prices to be discovered in advance. This can promote efficient and satisfactory business transactions between the sellers and buyers of carbon instruments.

The author A Damodaran is a Professor with Indian Institute of Management, Bangalore. 

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Author: Damodaran A