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6 Carbon markets.

As discussed, the flexibility mechanisms of the Kyoto Protocol are designed to bring about the same type of market efficiencies that are generally associated with trade. Moreover, they are expected to mobilize private capital on a scale that public transfers cannot. Through price discovery, private markets associated with the flexibility mechanisms are expected to reveal whether current regulations place a value on greenhouse gases emissions that is consistent with what modeling efforts suggest are need to curb global warming.

In this section, we discuss what can be broadly termed carbon financial markets. These are the markets that are motivated directly by greenhouse gas policies. As the discussion of national policies in the preceding section suggests, the markets operate across a heterogeneous set of public and private institutions. Regulatory uncertainty associated with some markets is high and basic information can be scarce. Even so, the scale, sophistication and pace of growth in these markets and derived risk markets are remarkable. Project investment levels supported by these markets are likely to be larger than anticipated by model studies.

Model studies of potential size of the market for the flexibility mechanisms

Several estimates of the potential demand for emissions reductions as well as the size of the CDM market are listed in Table 1. The estimates of the potential demand for GHG offsets ranges from 600 to 1713 Mt[CO.sub.2]e (million tons of CO2 equivalent) per year over the first commitment period, 200812. The estimates differ substantially mainly due to uncertainties involved with the projection of emissions growth in Annex I countries and alternative macroeconomic model specifications (Springer, 2003). The estimates of the size of the CDM market ranges from 0 to 520 MtCO2e per year.

The wide range is due primarily to alternative assumptions about the supply of Kyoto allowances (AAUs) from Russia and Ukraine, which can serve as an alternative for project credits. In many of the modeling exercises, the combination of US withdrawal from Kyoto markets and the unconstrained sales of allowances from Russia and former Soviet countries drive CER prices to zero and supplies of project credits to zero. Nevertheless, as discussed, market incentives may encourage Russia and the Ukraine to withhold some of their allowances, and this creates opportunities for project credits in several model scenarios. By way of example, Haites (2004) suggests that if Russia and Ukraine restrict the supply of their surplus Kyoto units to about 40 percent, the market demand for CERs would be about 1250 Mt[CO.sub.2]e CDM units over the first commitment period. However, most modeling exercise suggest that emission trading and project credits are likely to meet only a small portion of the demand for the emission reduction units (Zhang 2000).

Nevertheless, early indications from project registrations suggest greater levels of investment than anticipated by the modeling exercises. As is discussed in greater detail below, the number of CDM projects submitted for validation has grown exponentially from 5 in 2003 to 58 in 2004, 499 in 2005, 885 in 2006, and 1,480 in 2007. Projects already in the CDM pipeline by February 2008 could potentially produce about 499 Mt[CO.sub.2]e annually, which is close to the top-end of the model projections reported in Table 1.

The evolution of carbon project financing

In a broad sense, carbon markets began in the late 1990s, when corporations, non-government organizations and governments began experimental programs in market-based regulations--including pilots under the already discussed AIJ program. (64) Moreover, because of a provision allowing for early action, the CDM market emerged before the rules governing the CDM were finalized. In fact, when Russia agreed to ratify the Protocol in October 2004, thereby making it certain that the Kyoto Protocol would enter into force, more than 120 CDM transactions had already been recorded.

The participants in the Prototype Carbon Fund (PCF), six governments and fifteen private companies, were the first investors in the CDM. The PCF is a closed $180 million mutual fund managed by the World Bank to purchase emission reduction credits under JI and the CDM. The PCF was established in 1999, became operational in April 2000, and signed its first emission reduction purchase agreement for a CDM project in Chile in 2002.

Another key player in the early market was the Government of the Netherlands, which decided early on to purchase emission reductions through flexibility mechanisms as part of a comprehensive strategy to meet its Kyoto target. In addition to participating in the PCF, the Government of the Netherlands also developed the first carbon tenders for CDM and JI in 2001. In 2004, the two original players in the CDM market--the Government of the Netherlands and the World Bank (whose carbon finance activity had by then grown to include new funds besides the PCF)--still represented about a third of the total volume of project-based transactions. The adoption of the Marrakesh Accords in December 2001 led more players to move in. Private firms from Japan started to enter the market in 2002 and 2003, despite the absence of a domestic climate policy in Japan; the Japanese climate policy was approved only at the end of 2005. European firms followed about a year later, when it became clear that the EU Emissions Trading Scheme would become operational and that CERs would become eligible at least in part, under the EU-ETS. Around 2005, other Annex B governments came into the market as the Kyoto Protocol entered into force. By 2007, a number of secondary market participants had entered the market, including banks and investor funds that do not need CERs or ERUs for compliance.

The first CDM transaction was struck in early 2002 followed by more than one hundred transactions during the next two years. Still, three years elapsed between the adoption of the Marrakesh Accords and the registration of the first CDM project by the Executive Board in 2004.65 Moreover, by the close of 2005, only 63 projects were registered by the Board, despite a growing number of projects entering the pipeline. Still, as the number of CDM projects entering the pipeline grew steadily, the average number of days between the start of the public comment period and submission for registration began to decline; from January 2006 to July 2007, start-up delays at the validation stage decreased from about 250 days to less than 30 days.

The slow start and high initial transaction costs for early projects are consistent with experience in other tradable schemes. (66) This generally comes about because of the time and costs associated with building public and private institutions. In the particular case of CDM, a project enters the CDM pipeline at the start of the 30-day public comment period, which is the first step of the validation phase of the project cycle. During this phase a third-party designated operational entity (DOE) reviews and validates the project's baseline and monitoring plans. As discussed, new baseline technologies must be approved by the CDM Board. Early on, capacity constraints among the small number of designated third-party validators (DOEs), drawn-out rule making by the CDM Board, and a low stock of approved methodologies all worked against speedy registration. Conversely, start-up costs declined as the stock of approved baseline and monitoring methodologies accumulated and as project managers, third-party entities and regulators gained experience.

In 2006, developing countries supplied nearly 450 MtCO2e of primary CDM credits for a total market value of US$4.8 billion. The carbon market and associated emerging markets for clean technology and commodities have attracted a significant response from the capital markets and from experienced investors, including those in the United States. Analysts estimated that US$11.8 billion had been invested in 58 carbon funds as of March 2007 compared to US$4.6 billion in 40 funds as of May 2006, half of which is managed in the UK (Bulleid, 2006; New Carbon Finance, 2007). By August 2007, the CDM Board had registered 760 projects expected to deliver about 1 billion CERs by 2012. In addition, 1,500 projects were at the validation stage or ready for registration. Together, these 2,260 projects could deliver close to 2.2 billions CERs by 2012.

Joint Implementation shares the same origins as CDM, since early treaty negotiations concerning project credits made no distinction between projects located in transitional or developing countries. Consequently, some exploratory project investments hosted in Annex I countries were made in 2001--before the first CDM transaction--by public buyers. Nevertheless, as separate mechanisms evolved, JI project development stalled--due in large part to a decision to allow early crediting only under CDM. Delays among Annex I countries to meet JI eligibility requirements along with uncertainty together with delays associated with establishing track-two project-cycle rules further dampened investment. Nevertheless, as UNFCCC and host country domestic rules evolved, projects began to enter the JI pipeline, beginning in late 2006 and by February 20008, pipeline projects represented a potential of 188 Mt[CO.sub.2]e by 2012 (UNEP RISOE, 2008).

Evaluations of mitigation potential and project investment

As discussed earlier, bottom-up and top-down methods have been employed to provide an understanding of how emission trading might affect abatement activities. To start, the viability of a given offset project has to do with basic physical and economic characteristics. Bottom-up studies in particular take stock of the potential for different types (asset classes) of investment over a range of potential market prices for carbon. For example, reducing emissions by switching fuels might be economically viable at lower prices for carbon, while investing in alternative sources of energy may be viable at higher prices. In the aggregate, the distribution of viable technologies also has implications for the geographic distribution of investments. Both the geographic and asset class distribution of potential projects are important for policy makers. For one, different types of abatement activities are associated with different costs and the relative potential supply of low or high cost mitigation opportunities will affect the costs of meeting the policy emission goals. Different types of abatement activities also have different implications for additional spillover benefits such as health or biodiversity co-benefits and technology transfer. Where projects locate is important as well, since it determines who benefits from any economic, developmental or spillover effects associated with the project.

A number of studies have looked at the composition of project location under alternative policy settings; Haites (2004) provides a review as do recent IPCC evaluations.67 These studies roughly indicate country or regional potential for Kyoto-project offsets since they are driven by abatement costs. In general, most models suggest that Asia has the largest potential for CERs. For example, Jakeman et al. (2000) place about 62 percent of the predicted CDM market in Asia, Sijm et al. (2000) suggest 71 to 78 percent and Jotzo and Michaelowa (2002) estimate 72 percent. For studies that provide country detail, China is usually the largest source of potential offsets. (68) Asia's dominance is partly due to the large population but also because of the composition of the region's industrial base and its reliance on coal and oil.

There is less agreement as to differences in sectoral potential. In their synthesis of sector studies, Barker et al. (2007) suggest large potential savings in all regions based on improving energy efficiencies in residential and commercial buildings, accomplished through, for example, improved lighting and insulation, gains in small appliance efficiency, and the use of alternative coolants. Sijm et al. (2000) suggest that potential gains in energy efficiency account for most potential emission reductions. In developing countries, agriculture and forestry projects are significant when carbon prices remain under $20 per t[CO.sub.2]e This includes the use of better soil management techniques to improve soil sequestration and adding to sinks through afforestation and reforestation projects. At higher prices, the composition of potential projects expands to include more industry-based (the use of more efficient equipment, the control of non-carbon-dioxide emissions, etc.) and energy-supply projects (renewables, fuel-switching, etc.)

The geographic distribution of Kyoto-project credits

To date, the supply of issued and potential CERs remains firmly centered in Asia. Nearly 75 percent of the pipeline projects accounting for about 79 percent of potential first-period CERs are hosted in Asia. (69) This is largely due to population and also the relatively high consumption levels of oil and coal in Asia. Latin America accounts for 21 percent of the projects and 15 percent of pipeline CERs and, on a per capita basis, hosts a larger share of the first-period pipeline than Asia. Sub-Saharan Africa accounts for about 2.6 percent of the pipeline potential. Across all regions, the least-deve countries host few projects and account for about 1 percent of potential first-period CERs. A relatively small set of countries account for most of the CDM pipleline; most of the potential CER supply comes from China (53.2 %); India ranks second (15%) Brazil third (6%) and South Korea (4.1%). Similarly, the JI first-period pipeline is dominated by Russia (61%) and the Ukraine (26%).

Capoor and Ambrosi (2006) provide estimates of market activity based on interviews with a range of market participants and voluntary reporting of emission reduction purchase agreements. They estimate that, in 2006, developing countries supplied nearly 450 MtCO2e of primary project credits for a total market value of US$4.8 billion, up from $2.4 billion in 2005. China accounted for 61 percent of transacted volumes, down slightly from 73% in 2005. Next was India at 12%, increasing from 3% in 2005. Asia as a whole led with an 80% market share. Latin America--an early pioneer of the market--accounted for 10% of CDM transactions overall with Brazil alone at 4%. The share for Africa remained constant, at about 3%; however African volumes transacted increased proportionally to the increase of overall volumes transacted. The smaller market for credits from JI projects also grew in 2006, with 16.3 MtCO2e transacted, up 45 percent over 2005 levels. Russia, Ukraine and Bulgaria provided more than 60 percent of transacted volumes- for a value of US$ 141 million.

Ukraine, Russia and Bulgaria accounted for 20% each of the ERUs supply traded through 2003-2006 (44 M tCO2e transacted, or about 10% of the primary CDM market in 2006). Other countries--and not only in Eastern and Central Europe, but also New Zealand for instance--have also taken part in the market, although to a lesser extent. Transactions in the second half of 2006 and the first quarter of 2007 already exhibit a trend with fewer emission reduction purchase agreements (ERPAs) signed in Europe (as was historically the case) and more in Russia and Ukraine. This is no surprise as the biggest potential is expected to lie in these two countries associated with large projects in the oil and gas as well as the power sector (refurbishment and energy efficiency improvements as well as methane capture). In addition, the EU decision on double counting discussed earlier means that the JI potential can only be realized from projects outside the sectors covered by the EU ETS, particularly restricting opportunities in the newer members of the EU. (70) It remains to be seen what portion of the JI potential in Russia and Ukraine may however materialize, given remaining uncertainties with regard to issuance procedures and a limited five-year crediting period that may not be sufficient to get many projects up and running.

Balance across asset classes

By project count, most projects involve renewable energy sources. For example, as of February 2008, hydro 26%), biomass (16%) and wind projects (12%) accounted for 54 percent of the CDM pipeline. However the largest source of CERs (31%) are derived from a small number of industrial gas projects, considered the low-hanging fruit of greenhouse gas projects. These projects involve reducing the emissions of very concentrated greenhouse gases, or converting them to less harmful gases. The projects are straightforward from an engineering and baseline point of view and can deliver CERs at low risk for a limited upfront investment with a short lead-time. In 2005, HFC23 destruction projects account for two-thirds of CERs entering the CDM pipeline and in 2006 projects for the destruction of N2O captured a 13% market share of volumes transacted. This type of project has been heavily criticized as delivering few additional development benefits and may work to slow the phase-out of ozone-reducing gases (Pearson 2007).71 In the case of China, concerns prompted interventions, and most proceeds from related CER sales into a clean development fund to finance mitigation projects in priority sectors (World Bank 2006). Moreover, proposals have been advanced under the UNFCCC to limit credits from new facilities.

Separately, there is some indication that new opportunities for these types of projects may be tapering off. For example, by February 2008, the supply of pipeline CERs for renewables had grown considerably, representing about 30 percent of first-period CERs. Moreover, Capoor and Ambrosi (2006) conclude that CDM projects have been successful in jump-starting clean energy projects in developing countries. They estimate that financial flows to developing and transition countries through Kyoto projects grew to about US$7.8 billion in 2006 (signed contract value). By some estimates, carbon finance - in 2006 alone - leveraged approximately US$10 billion in clean technology investments in developing countries, about 48 percent of their total investments in clean technologies.

The share of transactions from energy efficiency projects and fuel switching projects increased dramatically from 1% in 2005 to 9% in 2006. Together, these types of projects now comprise over 19 percent of the CDM pipeline and are mostly energy efficiency projects at industrial facilities. Despite their overall potential demand-side management energy-efficiency projects are held back by methodological challenges (additionality requirements for activities that are considered economically rational or because of issues with monitoring) and as of February 2008 make about 1 percent of the pipeline.

(71) In the case of projects involving the destruction of HFC-23, a bi-product of producing HCFC-22, used in coolants and the production of Teflon, there are also concerns that income generated from the projects create incentives to delay the phase-out of HCFC-22 coolants under the Montreal Protocol (Schwank, 2004)

Similarly, carbon assets from land use (LULCF) projects are rare in the CDM market; their cumulative market share, in terms of volumes transacted, hardly reaches 0.2%.72 This is largely due to their exclusion from Europe's ETS.73 Even so, this is striking and viewed by many as a failure of current policies since emissions from deforestation and land degradation account for an estimated 18 to 25 percent of all global greenhouse gas emissions. (74)

To a degree, obstacles for including forestry projects under the Kyoto mechanisms have given rise to projects in the voluntary markets that emphasize additional biodiversity benefits and other positive spillovers. Examples include the World Bank's Forest Carbon Partnership Facility, the Australia Global Forest Fund and Carbon Neutral Norway among others.

Carbon credits from clean energy projects comprise the greatest share of the JI market, with slightly less than two thirds of volumes transacted over 2003-2006. ERUs from energy efficiency improvement and fuel switching projects came first at 28%, followed by biomass, wind and hydro with respectively 13%, 12% and 10% of the market. N2O projects from industrial installations account for 8%. This picture could change notably in the coming years as Russia and Ukraine bring opportunities from the oil, gas and power sectors. The pipeline for JI indicates expected credits by 2012 from reducing fugitive emissions will come from pipelines (44%), emission reductions from energy efficiency improvement and fuel switching (32%) and coal mine methane (12%). (75) Unlike in developing countries, where green-field projects have long lead times, many such opportunities in JI countries are associated with existing facilities and sites and have relatively shorter lead times. Many such projects are likely to be implemented within the 2012 time-frame provided financing is available before the window of opportunity starts to close.

Who is buying project credits?

European buyers dominated the primary CDM and JI market with 86% market share (versus 50% in 2005) with Japanese purchases sharply down at only 7% of the primary market in 2006 (versus 46% in 2005). Within Europe, the United Kingdom had a 50% market share of volumes transacted (up from 15% in 2005) consolidating its leadership position as the carbon finance hub for the world. Many companies, including project developers and players with an eye on the secondary market, have opened accounts on the U.K. national registry. Private sector players were the main buyers of CDM assets in 2006, with about 90% of purchases coming from the European private sector in 2006. In contrast, the JI market has long been dominated by public buyers (mainly the Netherlands, Denmark and Austria), representing 92% of those transactions in 2006 (up from 80% in 2004 and 2005).

By the end of first quarter 2007, EU governments had purchased 143 Mt[CO.sub.2]e, about 30% of the assets identified for purchase from the flexible mechanisms (CDM, JI and AAUs).76 506 Mt[CO.sub.2e], about 45% of the expected demand for CDM and JI credits from EU ETS installations in Phase II, have already been contracted by European entities, either directly, by natural compliance buyers and the funds in which they are participants, or indirectly, by entities planning to sell back these credits on the secondary market. (77) As far as Japan is concerned, 266 Mt[CO.sub.2]e credits purchased by Japanese entities so far account for around half of the expected shortfall for Japan (use of Kyoto Mechanisms by the Government and share of the burden borne by the private sector). (78) Together, these sources of demand could add up to at least one billion t[CO.sub.2]e in the next year or so. Even without factoring in any potential demand from Australia, Canada and the United States, there is still significant potential demand for CDM and JI from Japan and the EU before 2012.

The carbon market and associated emerging markets for clean technology and commodities have attracted a significant response from the capital markets and from experienced investors, including those in the United States. Analysts estimated that US$11.8 billion had been invested in 58 carbon funds as of March 2007 compared to US$4.6 billion in 40 funds as of May 2006, half of which is managed in the UK (Bulleid 2006; New Carbon Finance 2007).

Markets and the pricing of project credits

Though nascent, formal market for pricing emission reduction units are quickly forming for Kyoto project-based offsets, CERs and ERUs. Exchange-traded futures and options contracts for CERs were launched in late 2007 on the Chicago Climate Futures Exchange and the Norwegian exchange Nord Pool and in March 2008 on the European Climate Exchange (ECX) and the European Energy Exchange (EEX). Similar contracts are in place for allowance under the EU ETS. When traded volumes are sufficiently large, exchange-based contracts offer the most transparent form of pricing. The contracts are of standard quality and the exchange stands behind delivery. For example, the exchange guarantees the delivery of any CERs purchased for future delivery. Behind the exchange markets are a range of related markets, differentiated by quality or by risks associated impediments to their delivery.

Prices for project-based offsets have increased regularly in recent years and the pricing process has become more transparent and market-driven, largely because the rules governing how they can be used in Annex B countries has become more clear and because of the development of formal markets for European allowances. The largest class of CDM transactions involves the direct purchase of CERs from registered projects. According to Capoor and Ambrosi (2007), weighted average prices for these primary CERs reached about US$10.90 in 2006, representing a 52% increase over 2005 levels. (79) Still, these average prices mask a range (US$6.80-US$24.75) related to the heterogeneity of the underlying projects and contracts.

Transactions on the primary market involve forward streams of credits and therefore the buyer faces a number of risks, linked to project performance and to the eligibility of the generated credits for its compliance purposes. Some risks are project specific--for example, risks related to the variability of rainfall feeding a small scale hydro-power project--while others may be country specific--for example, risks related to the performance of the national Designated National Authority. And, since most projects are related to an underlying business--for example, the production of electricity --vagaries associated with that side of project can affect emission performance as well. In addition, uncertainties about policy can affect how useful the credit is for meeting regulatory or even contractual obligations. By way of example, credits from land-use CDM projects are ineligible for delivery against CER future contracts sold on the EEX and the ECX.

CERs that have already been issued sell at a significant premium, since they are without project performance risk. To date, nearly xxx CERs have been issued by the CDM board, but many of these were sold under existing contracts so pricing information is scarce. Still, Capoor and Ambrosi note that issued CERs can trade at nearly double the prevailing price for primary CERs. Still, even issued CERs are not without risk, in part because the International Transaction Log--a system for tracking and affecting the transfer of tradable Kyoto units--including CERs--is not yet fully implemented. Consequently, since title of the CER cannot be transferred, some element of counter-party risk remains. Additionally, there may be an eventual requirement to become a project participant to enter a primary transaction, a time-consuming process that does not come without risks of legal or public exposure.

Another strategy for managing performance risk relates to a secondary market, which grew to 25 Mt[CO.sub.2]e in 2006. The market draws on portfolios of guaranteed-delivery CERs,, with most if not all delivery risk assigned to the seller. Players on this market are primarily financial institutions, large energy players and investors' funds. Buying on the secondary market certainly has some advantages: the buyer is purchasing a near compliance-grade asset with firm volumes deliveries and guarantees and the buyer also does not have to create an infrastructure or team to source and structure carbon transactions. There is increased standardization of contracts in the secondary market and this standardization considerably facilitates the trade of CERs for compliance purposes, for hedging purposes and for arbitrage purposes.

As discussed above, exchange-based instruments for managing risk are developing to round out the range of markets developing around the Kyoto flexibility mechanisms. In addition to futures and options contracts, which open the door to a range of traditional hedging techniques, some insurance products have emerged as well. An example is a recent MIGA guarantee against certain sovereign and non-commercial risks related to a CDM project involving Luxembourg and El Salvador.

To date, many of the developments in the CDM market are motivated in part the EU ETS and a clarification of rules concerning the use of CERs and ERUs within the significantly large European system (1,100 Mt[CO.sub.2]e in 2006 transacted volume.) Still, the same set of supporting markets is not yet as developed for JI markets. The prices at which ERUs transacted in 2006 increased to an average of US$8.70, representing a 45% year-on-year rise, but ERUs remained cheaper than CERs on average. JI assets traded in a range from US$6.60 up to US$12.40, which is lower than the range at which primary CERs (US$6.80-US$24.75) were transacted. In many cases, host country rules and laws are unclear, and this sovereign risk may translate into a discount compared to the CDM price. Market players report that the key to closing JI deals is the ability to bring upfront financing (up to 50% of ERPA value). The price of ERUs is often discounted in transactions to reflect the cost of providing upfront finance.
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Title Annotation:Carbon Markets, Institutions, Policies, and Research
Publication:Carbon Markets, Institutions, Policies, and Research
Date:Oct 1, 2008
Previous Article:5 Domestic policies in the European Union, the United States and Australia.
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