Carbon Markets and Kyoto
It's difficult to believe, but despite years of debating the pros and cons and details of the Kyoto Protocol, which was negotiated in 1997, the period it covers only just started on January 1, 2008. To recap, the protocol creates an obligation from 2008 to 2012 for developed countries to reduce greenhouse gas emissions to 5% below 1990 levels. Some estimate this to be the equivalent of a 29% cut from "business as usual" emissions expected in 2010.
The protocol came into effect following the ratification by Russia in 2004, and today it covers 172 countries representing some 61.6% of the developed world's (so called Annex 1) CO2 emissions. Many foresaw that the cost of carbon abatement would vary widely from country to country, with the biggest costs hitting those countries with the highest CO2 emissions per capita - that is, Australia, Canada, Japan and the United States.
To lower the cost of reducing emissions, a number of "flexibility mechanisms" were designed into the protocol. These included Government-to-Government carbon trading, the Clean Development Mechanism (CDM) for projects outside Annex 1, the Joint Implementation (JI) for projects inside Annex 1, and regional emissions trading schemes, such as the European Union's Emissions Trading System (EU ETS). Despite this built-in flexibility, a number of countries still decided not to ratify Kyoto and some have since revealed they will not meet their targets.
Europe is a different story. It has become the centre of the new carbon market and a whole industry has developed around it as a result. It should be pointed out that Japan is also active on a voluntary basis. The demand for carbon allowances and credits within Europe is split between government and industry, the latter representing about 45% of all CO2 emissions in the European Union. The EU emissions trading system, the first phase of which came into effect on January 1, 2005, covers industrial CO2 output exclusively, obliging roughly 14,000 industrial facilities to meet reduction targets. Each year, these large emitters must give back an amount of emission allowances to the government that is equivalent to their CO2 emissions in that year.
Annual targets are met by surrendering a combination of allowances and imported credits from CDM and JI projects. Allowances and credits are traded bilaterally and through exchanges. There are 10 such exchanges either in operation or close to operation. In 2007, some €40.4 billion greenhouse gas emissions permits and credits were traded and the average European price for allowances in 2007 was 17.5 €/tonne.
The supply of CDM and JI credits has created an industry of consultants, project development companies, carbon infrastructure funds and traders. At the leading carbon conference in 2007 some 1,600 delegates participated from all over the world. According to data from the United Nations, about 2,600 CDM projects are in development and so far about USD $12 billion in project equity has been committed, mostly from London-based fund managers. Getting national and international CDM project designs validated can be a tortuous process, which is repeated again during verification of actual carbon emission reductions. But this process is now well understood in leading markets, such as China, India and Brazil.
Continuity is the key to investor confidence. Judging by project development trends and carbon trading beyond 2012, the market appears to be betting on a renewal of carbon targets beyond the end of Kyoto's 2012 expiry. It could be a safe bet, considering the EU's announcement of a revised emissions trading system proposal that is considered necessary for achieving a new reduction target of 20% below 1990 levels. But the impact of including other developed and developing countries in the carbon market is still unknown. The outcome will depend on coming negotiations between North America and major developing countries.
Charles Vaslet is an Investment Director with Emerald.