28 Jul 2008 | Author: Rajesh Chhabara – ClimateChangeCorp.com
The Asian economies want a piece of the world’s carbon trading action. The move adds further threat to carbon brokers dealing in over the counter carbon credits
Exponentially growing global carbon trading has caught the fancy of the top financial centres in Asia. Hong Kong, Tokyo, Singapore, Mumbai, Shanghai and Beijing are reported to be considering opening exchanges for trading carbon credits. But analysts warn that it may be too early for Asia to join the party unless the key economies in the region create local demand for credits.
There is a growing recognition of carbon as a soft commodity that can be traded as carbon credits and in the form of other complex financial products, such as derivatives and exchange traded funds.
According to Oslo-based research firm Point Carbon, the global carbon trade crossed €40 billion in 2007, a growth of 80% over the previous year. In terms of volume, 2.1 billion tonnes of carbon dioxide equivalent credits were traded, a hefty 64% increase over 2006. Carbon trading is estimated to hit €100 billion in 2008.
The global carbon market could be worth €2 trillion by 2020, says Point Carbon, if a greenhouse gas cap and trade scheme takes off in the US.
However, Asia’s role in global carbon trading has remained limited as a supplier of carbon reduction emission (CER) or carbon credits under the Clean Development Mechanism (CDM) of the United Nations Framework on Climate Change Convention (UNFCCC), which was born out of the Kyoto protocol.
CDM allows reduction in greenhouse gases achieved in developing countries to be sold as carbon credits to developed countries, which have ratified Kyoto protocol, to help them meet their emission reduction targets.
China alone accounts for 61% of global supply of CERs followed by India with a 12% share. China, India, Malaysia, Thailand and South Korea together generate a staggering 80% of all the CERs. Almost all the CERs are currently purchased by European companies and governments to meet their own emission reduction targets under the Kyoto protocol.
The bulk of the CER trading takes place through brokers, bi-lateral agreements and personal negotiations. Asia does not have any real trading platforms or exchanges for banking or transacting carbon credits.
Asian ambitions
Asian financial centres now want a piece of the action. The Hong Kong Stock Exchange is going over a feasibility study it commissioned toward the end of last year to determine how to position itself in the carbon trading market. Chinese authorities are working on their own plans for a carbon trading platform.
The Multi Commodity Exchange of India – the country’s largest commodities exchange, which has a strategic alliance with the Chicago Climate Exchange – launched futures trading in carbon credits in January this year. Carbon credit futures are exchange-traded derivatives or standard contracts, allowing the buyer and seller enter into a legally binding agreement to buy or sell carbon credits at a certain price to be delivered at a certain date in the future. Futures protect the contracting parties against a price risk.
The South Korea Stock Exchange plans to launch carbon trading sometime this year. Singapore is aiming to become Asia’s carbon trading hub and is offering tax incentives to carbon trading firms. It is banking on its robust financial institutions and proximity to CDM projects in South-east Asia.
Though most players are tight-lipped about their plans and the scope of trading, market sources say the exchanges may be looking at a variety of options. “Trading in CERs, Voluntary Emission Reductions (VERs) and derivatives are the obvious possibilities,” says Rahul Kar, KPMG’s sustainability services manager in Singapore. Derivatives are complex financial instruments based on the value of underlying assets, which in this case are carbon credits. Types of derivatives include futures, forwards, options and swaps.
The VER market is small, but has the potential to grow. Hong Kong-headquartered Cathay Pacific airlines recently introduced carbon offset options for its passengers using VERs. The airline is buying VERs from greenhouse gas emission reduction projects, mainly in China, which are verified using Voluntary Carbon Standard, developed by The Climate Group, the International Emissions Trading Association and the World Business Council for Sustainable Development. Other companies may follow suit to cater to green demands of their customers, or simply to put forward a socially responsible image.
“Hong Kong can possibly aggregate CER volumes from South Asia and South-east Asia and trade them on the exchange for international buyers,” says Marco Monroy, president and chief executive of MGM International, a leading carbon credit project developer.
China trades up
Last year, the governments of Hong Kong and Guangdong province in China agreed to work on a pilot emission trading programme to reduce sulphur dioxide emissions from industries that want to address pollution over the Pearl River Delta.
In another development, the Chinese government announced in June this year that local companies in Hong Kong can now participate in the CDM projects and sell CERs resulting from projects undertaken within Hong Kong. However, Hong Kong companies are still not permitted to generate CERs from CDM projects by their subsidiaries in the mainland China. China has barred companies in Hong Kong, Macau and Taiwan from participating in the CDM projects in the mainland and treats them as foreign entities.
In spite of sitting next to the world’s largest supplier of CERs, a carbon trading exchange in Hong Kong cannot bank on carbon credits from China. China requires all CDM developers to pre-sell all CERs to foreign buyers, who are almost always European entities, above a floor price set by the government, before approving a project. This means primary CERs will not be available for trading on a Hong Kong exchange.
In China, Beijing and Shanghai are competing to take the lead. Another province, Tianjin, even entered into negotiations early this year with the Chicago Climate Exchange to set up a carbon trading bourse in partnership with China National Petroleum Assets Management and the Tianjin Property Rights Exchange (TPRE). However, the deal fell through in June on account of disagreements on the foreign ownership of the exchange.
Last year in February, China announced two carbon trading initiatives. The first aimed at setting up a carbon trading exchange in Beijing in joint venture with the United Nations Development Fund (UNDP); the second involved $1.7 million carbon finance for 12 western Chinese provinces to educate them in carbon trading. However, sources say there has been no progress on the UNDP-partnered plan.
Peng Zhiyuan, managing director of China Beijing Equity Exchange, who was in Singapore in June for a carbon markets conference, said: “We are working on the model and will be introducing carbon trading in the near future”.
China Beijing Equity Exchange is different from Shanghai Stock Exchange. It deals only in state-owned equity transactions: investors willing to buy government-owned companies’ equities go through here. Shanghai Stock Exchange is the national exchange and operates as any other stock exchange in the world.
Both of them plan to have carbon trading. But at this time, it’s not clear how they will position themselves and what will be traded on them. Both are under different regulatory bodies.
For a local exchange to be successful, China will need to change its CDM policy and allow project developers to sell the credits through a local exchange. If this happens, European buyers will have to buy Chinese CERs on a local exchange rather than through bi-lateral agreements with project developers. A China-based exchange will also make brokers who currently play a crucial role in match-making between buyers and sellers redundant. Most of them are European, such as Eco Securities and TFS Green.
Observers say carbon trading in China will benefit local CDM project developers and increase their access to carbon markets. “A local exchange will reduce the transaction cost and bring more transparency to CER pricing,” says Chen Dongmei, the climate change and energy program director of WWF China. Since the bulk of CER trade takes place through bi-lateral agreements, a central database of price movements is not available. Sellers often complain that the brokers only protect the interests of buyers. But if credits are traded on an exchange, daily prices and volumes are available in real time. Exchanges can also develop indices reflecting the price movement. Industry sources say that, currently, prices of primary CERs (yet to be issued) are in the range of $9-$23 a tonne, though no official figures are available.
There are sceptics of China’s trading plans. A market analyst in Hong Kong said on condition of anonymity that China, unlike Hong Kong, does not have an open and efficient financial market infrastructure. The analyst said China would find it hard to convince international buyers to shop on Chinese carbon trading exchanges.
“It will be best if China encourages Hong Kong to explore emissions trading as Hong Kong is the one market on Chinese soil that is not a closed market, while Shanghai still is,” says Christine Loh, a former legislator and the chief executive of Civic Exchange, a Hong Kong based environmental advocacy group.
Chinese financial markets are heavily regulated, protected from foreign competition and underdeveloped, while Hong Kong is a mature and robust international financial centre with hardly any barriers for foreign businesses and no restrictions on capital flow. Hong Kong has been ranked first in terms of economic freedom for 14 years in a row by the Heritage Foundation, a Washington think tank, which publishes an annual index of economic freedom and rates 157 nations.
Hong Kong Stock Exchange is said to be considering emission related-structured products that may include contracts, options and futures. It also plans a listing of green Initial Public Offerings (IPOs). According to a press release by the Hong Kong exchange, green IPOs will involve “listing companies that provide products and services which help to reduce emissions”.
Hong Kong Exchange has also said it is exploring the potential for establishing an auction platform for CERs.
Japan’s cap and trade
Japan is planning an EU-style cap and trade mechanism, announced by the prime minister in June, which can set the stage for a promising carbon market in the country. The city of Tokyo is also considering a cap-and-trade scheme to reduce emissions.
Japan has until now encouraged industries to voluntarily reduce emissions rather than imposing binding targets.
Tokyo Stock Exchange, the world’s second largest bourse, has said it is planning a carbon trading platform. Currently, Japanese companies buy CERs directly from project developers in developing countries or through brokers. A local exchange can reduce transaction costs.
However, Japanese industry associations have opposed the cap-and-trade plans, saying that tougher emission targets will prompt businesses to shift production to developing countries.
Monroy of MGM International says: “It will be cheaper for Japan to import CERs rather than use cap-and-trade to meet compliance obligation. Efficiencies are already high in Japanese industries and achieving further emission efficiency, which will be needed if cap and trade is imposed, will be very expensive for the industry.”
Creating local markets
Some CER project developers are wary of an emissions exchange. Monroy says: “It is too early to have an emission trading exchange in China. An exchange requires liquidity. Both supply and demand are needed for liquidity and China currently does not have demand for carbon credits.”
Market analysts are similarly sceptical about Asia’s carbon trading dream. Though Asia has a large supply for CERs, there is no local demand in the region except from Japan, which remains the sole buyer of CERs in Asia to meet its Kyoto obligations. Other Asian countries still do not have regulations requiring companies to reduce emission or buy credits.
An exchange requires liquidity which comes from a healthy match of demand and supply. The European Climate Exchange (ECX) and Chicago Climate Exchange (CCX) thrive because they have local demand and supply due to the cap-and-trade mechanism. CER is only a small part of their total trade and accounts for only about 20% of global emissions trading.
Roger Raufer, an emission trading expert who worked on the feasibility report for the Hong Kong Stock Exchange, says: “Asia needs to develop its own carbon trading markets rather than simply copying the European or the US markets. It needs to create its own demand based on local emission issues and solutions.”
The story is different in Europe. The European Union’s Emission Trading Scheme (ETS) was launched in January 2005 as a result of Kyoto protocol, before the UNFCCC’s CDM took shape. A cap-and-trade mechanism was introduced covering energy intensive industries. Companies in these industries are issued an allowance for carbon dioxide emissions. If they emit more, they must buy carbon credits, known as European Union Allowance (EUA), from those who have polluted under their allowance, or face a heavy fine.
The ETS created a huge compliance market for carbon credits. The EU later allowed companies to import CERs to meet compliance when the CDM was introduced.
In the process, the ECX and Oslo-based Nord Pool emerged as the largest carbon trading exchanges in the world. According to carbon research and rating firm Idea Carbon, ECX accounted for 87% of global carbon trading in 2007.
The total value of EUAs traded last year was $43.8 billion, most of it transacted over the ECX, while Nord Pool accounted for $1.6 billion worth of EUAs and CERs. In the US, which did not ratify the Kyoto protocol, a voluntary carbon offset market came into operation. The CCX, which was launched in 2003, has become a significant player for trading in VERs and emission reduction related structured products.
Liam Salter, head of climate for WWF Hong Kong, points out that the CDM market is too uncertain to base a trading exchange upon. “The number of CDM projects can fall if the post-Kyoto scenario remains unclear,” he says. Kyoto protocol expires in 2012 and international negotiations are dragging on to decide the post-2012 mechanism.