CARBON CREDITS – A MARKET OF THE 21st CENTURY
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With growing concerns among nations to curb pollution
levels while maintaining the growth in their economic activities, the
emission trading (ET) industry has come to life. And, with the increasing
ratification of Kyoto Protocol (KP) by countries and rising social
accountability of polluting industries in the developed nations, the carbon
emissions trading is likely to emerge as a multibillion-dollar market in
global emissions trading. The recent surge in carbon credits trading
activities in Europe is an indication of how the emissions trading industry
is going to pan out in the years to come.
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What is a carbon credit? Simply put,
one carbon credit is equivalent to one tonne of carbon dioxide or its
equivalent greenhouse gas (GHG). Carbon credits are “Entitlement
Certificates” issued by the United Nations Framework Convention on Climate
Change (UNFCCC) to the implementers of the approved Clean Development
Mechanism (CDM) projects. The potential buyers of carbon credits shall be
corporates in various Annexure I countries that need to meet the compliance
prevailing in their countries as per the Kyoto Protocol or those investors who
would like buy the credits and with the expectation of selling them at a
higher price during the KP phase (2008-12). The extension of KP shall be
ratified by the current signatories of KP in their future meetings
essentially to curb GHG emissions into the environment.
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Sources of demand & supply
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Emerging carbon credit markets offer enormous
opportunities for the upcoming manufacturing/public utility projects to
employ a range of energy saving devices or any other mechanisms or
technology to reduce GHG emissions and earn carbon credits to be sold at a
price. The carbon credits can be either generated by project participants
who acquire carbon credits through implementation of CDM in Non Annexure I
countries or through Joint Implementation (JI) in Annexure I countries or
supplied into the market by those who got surplus allowances with them. The
buyers of carbon credits are principally from Annexure I countries. They
are:
- Especially European
nations, as currently European Union Emission Trading Scheme (EU ETS)
is the most active market;
- Other markets
include Japan, Canada, New Zealand, etc.
The major sources of supply are Non-Annexure I countries
such as India, China, and Brazil.
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Trading In Carbon Credits
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Emissions trading (ET) is a mechanism that enables
countries with legally binding emissions targets to buy and sell emissions
allowances among themselves. Currently, futures contracts in carbon credits
are actively traded in the European exchanges. In fact, many companies
actively participate in the futures market to manage the price risks
associated with trading in carbon credits and other related risks such as
project risk, policy risk, etc. Keeping in view the various risks
associated with carbon credits, trading in futures contracts in carbon
allowances has now become a reality in Europe with burgeoning volumes.
Currently, project participants, public utilities, manufacturing entities,
brokers, banks, and others actively participate in futures trading in
environment-related instruments.
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Price influencing factors
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In Non-Annexure B countries (the developing countries)
across the world, CER prices are influenced by various factors including
EUA prices, crude oil prices, electricity, coal, natural gas, the level of
economic activities across Annexure I countries, among others
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Some of the major price influencing factors:
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- Supply-demand
mismatch
- Policy issues
- Crude oil prices
- Coal prices
- CO2 emissions
- Weather/Fuel prices
- European Union
Allowances (EUAs) prices
- Foreign exchange
fluctuations
- Global economic
growth
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Risks associated with carbon credits
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There are market- and policy-related risks for CER
producers, including the supply-side risks starting from the DNA approval
risk to the CER issuance risk in a complete CDM approval cycle. Apart from
these risks there are a host of other risks from both the supply and demand
sides that the real market players confront with.
Most CDM projects by their very nature take a long time to generate the
CERs and hence, face the aforesaid risks in large proportion, which if not
hedged would lead to reduced realization. Under such a situation, the
realization of CER generators at times may not even cover the investment
put in to generate the CERs and thus, has the potential of even making a
CDM project unviable in the long term. Given the long gestation period of
CDM projects and the risks involved, it is rather inevitable that they
pre-sell their potential credits in the futures market (preferably a
domestic futures market, to avoid forex risk attached to participation in a
foreign exchange) and thereby, cover their probable downside in the
physical market.
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Potential participants in carbon credits trading
are as below
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Hedgers
- Producers
- Intermediaries in
spot markets
- Ultimate buyers
Investors
- Arbitragers
- Portfolio managers
Diverse participants with wide participation
objectives
- Commodity financers
- Funding agencies
- Corporates having
risk exposure in energy products
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India as a potential supplier
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India, being one of the leading generators of CERs
through CDM, has a large scope in emissions trading. Analysts forecast that
its trading in carbon credits would touch US$ 100 billion by 2010.
Currently, the total registered CDM projects are more than 300, almost
1/3rd of the total CDM projects registered with the UNFCCC. The total
issued CERs with India as a host country till now stand at 34,101,315 (around
34 million), again around 1/3rd of the total CERs issued by the UNFCCC. In
value terms (INR), it could be running into thousands of crores.
Further, there has been a surge in number of registered projects in India.
In 2007, a total of 160 new projects were registered with the UNFCCC
indicating that more than half of all registered projects in India happened
last year. It is expected that with increasing awareness this would go
further up in the future. The number of expected annual CERs in India is
hovering around 28 million and considering that each of these CERs is sold
for around 15 euros, on an average, the expected value is going to be
around Rs 2,500 crore.
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Various industries that have scope of generation
of CERs:
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- Agriculture
- Energy ( renewable
& non-renewable sources)
- Manufacturing
- Fugitive emissions
from fuels (solid, oil and gas)
- Metal production
- Mining and mineral
production
- Chemicals
- Afforestation &
reforestation
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The role of MCX
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With MCX keen to play a major role on the emission front
by extending its platform to add carbon credits to its existing basket of
commodities with regard to commodities futures trading, the existing and
potential suppliers of carbon credits in India have geared up to generate
more carbon credits from their existing and ongoing projects to be sold in
the international markets. With India supposed to be a major supplier of
carbon credits, the tie-up between the two exchanges is expected to ensure
better price discovery of carbon credits, besides covering risks associated
with buying and selling.
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Advantages of an MCX carbon contract
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In India, currently only bilateral deals and trading
through intermediaries are widely prevalent leading to sellers being denied
fair prices for their carbon credits. Advantages that the MCX platform
offers are:
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- Sellers and
intermediaries can hedge against price risk;
- Advance selling
could help projects generate liquidity and thereby, reduce costs of
implementation;
- There is no
counterparty risk as the Exchange guarantees the trade;
- The price discovery
on the Exchange platform ensures a fair price for both the buyer and
the seller;
- Players are brought
to a single platform, thus, eliminating the laborious process of
identifying either buyers or sellers with enough credibility; and
- The MCX futures
floor gives an immediate reference price. At present, there is no
transparency related to prices in the Indian carbon credit market,
which has kept sellers at the receiving end with no bargaining power.
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