As we shall see in greater detail later, despite the fact that it has only recently been established, trading on various climate exchanges around the world has reached a stage where it can be confidently classified as a truly great commodity market. Like all other great commodity exchanges, the actual traded commodity (carbon dioxide emissions equivalent permits/offsets) does not physically enter the market place.
What are actually traded are ownership rights to the commodities. That is, ownership of the Certified Emissions Reduction Credits (CERs), Emissions Reduction Units (ERUs) or European Union Allowances (EUAs), as I have described these in previous columns. Major commodity markets no longer rely on auctions from warehouses where samples are provided for inspection beforehand by prospective buyers. Modern communications have drastically reduced reliance on such outdated mechanisms and have as a consequence brought huge savings in warehousing and auction charges.
Under the UNFCCC and the Kyoto Protocol, the negative impact of greenhouse gases is technically measured in terms of equivalents to the global warming impact (GWI) of carbon dioxide.
There are, as readers already know, far more potent greenhouse gases than carbon dioxide. Thus one metric ton of emitted methane is measured as 23 metric tons of emitted carbon dioxide. If readers think about it carefully this is an intangible abstraction.
However, climate exchanges deals not only with intangible commodities (emissions allowances and offset credits) but these are to be generated in the future, which always entails some degree of uncertainty. In this way commodities traded on the carbon market are more complex than those traded on traditional exchanges for tangible physical commodities like sugar, bauxite or gold.
Three dimensions
All great commodity markets have three key dimensions to them. There is the ‘spot’ market, where spot prices are formed for commodities with delivery fixed for a particular place (spot) at a specified time. Then there is the ‘futures’ market. This deals in forward contracts for forward delivery at an agreed future price. This is not affected by price changes in the intervening period. There is also the “options” market. This permits buying and selling of emissions allowances and carbon credits/offsets at a given price within a stated period, typically three months.
Most transactions on climate exchanges take place through forward contracts for future delivery of emissions allowances or carbon credits/offsets. Such future transactions entail what is termed as a ‘cost of carry.’ This is another technical term with which readers need to be familiar. The cost of carry is the opportunity cost or time value of money (read interest rate) the seller foregoes by having to wait for payment on delivery at the end of the forward contract period. Usually a premium is added to the spot price to compensate for the cost of carry.
Markets
There are two broad types of carbon-trading markets, reflecting the legal imperative behind each. One is the compliance market. This is the market that fulfils legal mandatory emissions limits. Good examples are markets designed to meet the EU and other rich countries’ pledges under the Kyoto Protocol. The other is the voluntary market. As the term suggests, this refers to markets serving the needs of individuals, organisations and businesses that, without regard to legal limits on emissions, voluntarily agree to reduce their carbon footprints. A common example is the purchase of offsets to compensate for carbon emitted through airline travel. In the non-mandatory voluntary market carbon offsets/credit are specifically verified to a voluntary carbon standard established by independent standards-setting bodies.
I would argue that on the whole the United States is a voluntarily market, because there are no binding commitments to limit carbon dioxide emissions under the Kyoto Protocol. Thus I would class the ten-state North-East regional voluntary cap-and-trade scheme for power plants established in 2009 and scheduled to expire in 2018 unless a Federal programme replaces it, as a voluntary market. Current members are Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont. California is also on track to be a voluntary market with its proposed cap-and-trade scheme, hopefully to be established before 2011. The North-East climate exchange appears to be dominated by investors who are hedging that there will be in the future widespread regulations fixing emissions limits at both the federal and state level. At this point in time, however, climate regulation has not made much progress under the present Obama administration and Congress.
Price signals
At this stage readers should be able to address the question: What does the carbon price on these exchanges signify? Firstly, the carbon price signals to consumers (demand) the carbon footprint generated by the goods and services they consume. Consequently, a rise in the carbon price would indicate a worsening impact of human activities on atmospheric pollution, global warming and climate change. Secondly, the carbon price signals to producers the cost to be incurred and the benefits to be derived from de-carbonizing their inputs and production processes. Thirdly, the carbon price would give incentives to investors seeking to generate new knowledge and technology in this field, while facilitating their transfer, application and dissemination. Finally, the carbon price encapsulates in a single number all of this information, thereby making it essential to efficient decision-making.
As a consequence we can conclude that, under ideal conditions (there is no biased speculation in the market, discriminatory market rigging does not occur, and neither does the deliberate concealment of information) the carbon price helps to reduce waste, inefficiency, and perhaps also minimize the divergences between what economists term as private and social costs. It could also help to capture the value of any externalities in these markets. If all this occurs then the observed carbon price becomes the proxy for environmental cost. When this happens economic entities would treat environmental cost as they would other cost items such as wages, raw materials, or debt.
Finally, there is an issue of permanence in regard to forest-based reduction in carbon dioxide emissions. If trees are cut down after a credit is issued or otherwise die, then carbon is returned to the atmosphere. The market caters for such temporary credits or offsets based on the limited lifespan of the project. Temporary CERs are issued and traded in; the typical period is five years.
Next week I shall continue to treat with carbon markets.
