By wise-owl.com Equities Analyst Tim Morris
Tuesday 6th May 2008
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Carbon is a new emerging asset class that is presently little understood by local investors. However the market’s surrounding carbon trading and offset programs are set to rise in prominence following Australia’s recent ratification of the Kyoto Protocol. With the global carbon market bearing an estimated value of $30bn and rising, investors may be forgiven for questioning whether the old adage that ‘money doesn’t grow on trees’ is still holds true. To bring you up to speed on such matters, we have put together this ‘essential guide’.
• The global market for carbon credits has grown 24 fold since the Kyoto protocol came into effect in 2005.
• Europe is the heart of the global carbon market, where futures and options contracts over carbon credits are traded on dedicated ‘climate exchanges’.
• Carbon credit prices are driven by changes in the level of the legal emissions cap, the weather, fuel prices, and increasing market penetration as emission regulations are extended to more companies.
• Australia hosts the world’s second largest carbon credit market in NSW, but a national trading system has yet to be established.
• Investment in environmentally friendly carbon offset projects, which generate carbon credits, has also grown strongly.
• The market will create opportunities for the renewable energy and forestry sectors, although use of forestry projects is restricted.
• The technical outlook for European carbon credit prices is bullish.
Unlocked following the 19th century industrial revolution, the power of carbon has fuelled the wave of economic development which has delivered modern society’s greatest accomplishments, such as electric lighting, the automobile, and flight. However, in the later half of the last century we learned that these advances were not without cost, as the first clues began to surface about the toll which modern society’s habits were having on our planet.
Unlocking the power of carbon based fuel sources releases carbon gases into the air, trapping heat within the Earth’s atmosphere, creating what we all know as the global warming effect. For evidence of the effect we need only consider the increasing concentrations of carbon dioxide within the atmosphere. Before 1850 the Earth’s atmosphere contained about 280 parts per million (ppm) of carbon dioxide, however the figure is now 380ppm, and is forecast to reach 550ppm by 2050 according to the Intergovernmental Panel on Climate Change.
The potential impacts of global warming on sea levels, the weather, and the food chain are well documented, and the message is clear. Society needs to curb its addiction to carbon based energy to ameliorate global warming.
For many years global warming remained largely ignored as purely an environmental and academic issue. Only during the last few decades have world leaders begun to acknowledge the issue, as its potential economic, social and financial risks became more translucent.
As world governments unite to counteract the effects of global warming, a combination of regulatory and market based remedies are being adopted to essentially put a price on clean air. While this poses a threat to some old industries with unflattering environmental records, it has spawned an entirely new industry focused on the emerging carbon market, creating opportunities for investors.
A market for carbon evolved as a direct consequence of the Kyoto Protocol, an international agreement signed in 1997 that became effective from 2005. The treaty requires developed countries, referred to as ‘Annex I’ nations, to reduce their greenhouse gas emissions by 5.2% over 1990 levels by 2012. Developing countries that have ratified the agreement are not required to do so.
Discussions about greenhouse gas emissions often focus on carbon dioxide (CO2), which is the most common, but not the only gaseous villain in the battle against global warming. In addition to CO2, the Kyoto Protocol also targets reductions of five other dangerous gases, which have even greater ‘global warming potential’. However to avoid confusion and provide an ‘industry standard’, all greenhouse gas emissions are referred to in terms of CO2 equivalents. With CO2 being the industry’s reference point and four of the six greenhouse gases targeted by Kyoto containing carbon, it is no surprise to see this evolving field coined the ‘carbon market’.
Rather than simply placing a blanket ban on greenhouse gas emissions beyond a certain threshold, the Kyoto agreement recognises the need for a flexible approach for achieving emission reductions, offering 3 ways for governments and corporates to achieve compliance.
1. Direct emission reductions
This involves a company or government altering their existing activities to directly reduce their emissions. A simple example would be switching off the office lights overnight.
2. Invest in Emission Offset Projects
In circumstances when it is not feasible to directly reduce one’s own emissions enough to meet legal requirements, companies and governments are able to invest in separate projects that remove carbon from the atmosphere, to essentially offset their own activities.
3. Financial Compliance
By either paying a penalty for emissions beyond the legal limit, or through buying carbon credits, which are emerging financial instruments that permit the holder to emit beyond their legal limit.
By introducing a legal incentive for companies and governments to spend money on reducing their emissions, Kyoto has ascribed a monetary value to clean air, causing environmental issues to enter the realm of corporate financial strategy. Economic logic suggests that companies and governments will pursue the lowest cost means of achieving compliance. For the largest polluters, such as power plants and industrial companies, meaningful direct emission reductions are often unfeasible and very costly. Therefore we have witnessed strong growth around the later two compliance mechanisms involving carbon credits, and offset projects, which benefits those whose emissions fall below their legal limit, and those whose activities actually reduce
atmospheric CO2 levels.
Carbon credits are essentially licenses that enable the holder to emit one tonne of CO2 equivalent into the atmosphere within a certain period. Carbon credits are generated by parties that emit below their legal cap, and by those whose activities remove carbon from the atmosphere. These credits can then be sold to parties who need to offset their own emissions in order to achieve regulatory compliance. The cost of purchasing a carbon credit provides a price signal on the value of clean air.
Carbon trading was initially conducted through direct over the counter (OTC) transactions between governments and companies. The entry of commercial banks into the market in early 2005, as Kyoto came into effect, sparked the evolution of dedicated carbon exchanges whose sole purpose was to facilitate trade in carbon credits. The overall growth in trading volumes for carbon credits since this time has been nothing short of phenomenal. Trading volumes have increased 24-fold, from around 100 million tonnes of CO2 equivalent in 2004 to nearly 2.4 billion tonnes in 2007, 2/3rds of which was traded in the later half of the year. In 2006 the World Bank estimated the size of the market to be around $30bn.
The most advanced carbon market is hosted by the European Union, which established an Emissions Trading Scheme (EU ETS) built on the Kyoto mechanisms in 2005. The scheme covers around half of the regions emissions – regulating 11,000 installations and 6,500 entities across the energy, metal processing, mining, pulp, and paper industries. The scheme sets an emissions cap for each member entity over a specified time period, requiring those which have exceeded their emission limits to purchase spare ‘carbon credits’ or ‘allowances’ from those who beat their reduction target. In the case that no member of the scheme has any spare credits, polluters can pay a financial penalty for each tonne of CO2 equivalent emitted beyond their cap.
This financial penalty effectively sets an upper limit on the price of carbon in the European market, because if the cost of buying credits were to exceed the penalty rate, members would simply pay the penalty. During phase I of the scheme from 2005-07, the penalty rate was €40 per tonne of CO2 equivalent. However we have now entered phase II of the scheme, which sets a penalty rate of €100 per excess tonne from 2008-2012.
Most trading of European carbon credits or ‘allowances’ as they are known, takes place by way of futures contracts on the European Carbon Exchange (ECX), which has a market share of around 80%. Contracts are specified according to the year in which the underlying carbon credit is valid, and are traded for up to 2 years before the underlying credit expires. For example, the 2008 contract shown below shows the cost of offsetting emissions made during 2008, and provides the best indication as to the current value of a European carbon credit, which is currently just below €25.
Factors influencing the price of carbon are much more complicated than traditional commodity markets, which are typically governed by supply and demand. These market forces certainly play an important role in carbon pricing, however forecasting future supply and demand for carbon is very difficult because of the market’s emerging nature and the intangible nature of emissions and clean air.
As the market for carbon emerged as the product of a new legal framework, the regulatory environment will remain one of the most important drivers of price. In our view, the level of regulatory emissions cap will be one of the key long term drivers of carbon credit prices.
By altering the legal limits on emissions, governments and international regulators have the ultimate influence on demand for carbon credits. By lowering emission caps, regulators can increase demand and tighten supply by reducing the number of parties with credits available to trade. On the other hand providing caps that are too generous can dampen demand and result in an oversupply of credits that can depress prices. Regulators of the European Trading System learnt this lesson last year when carbon prices crashed.
The Carbon Crash
In order to set the caps for the first phase of the EU ETS, member entities were asked to estimate their annual greenhouse gas emissions. These estimates forged the basis of the caps imposed from 2005-07. However following the release of officially verified emissions data midway through 2006, it was evident that members had over estimated their emission profiles, causing the imposed caps to be too generous. The result was an over supply of carbon credits for the remainder of phase I of the EU ETS, which saw the prices of the 2006, 2007 and 2008 ECX carbon contracts crash. Prices for 2007 carbon credits suffered the most damage, falling from €31.50 per tonne in April to below €10 by May. Prices for the 2007 contract staged an initial recovery, trading around €15 for the next few months, but as the reality of the oversupply kicked in, their value began to fade again, becoming almost worthless during 2007.
Penalty Rates/Carbon Tax
The value of carbon credits will also be influenced by the financial penalty imposed on parties that fail to comply with the cap. Fixed rate penalties for each tonne of emissions beyond the cap, such as the case in the EU ETS, effectively put a price ceiling on the price of carbon credits. Throughout 2005-07, when the EU ETS penalty was €40/t, carbon credit prices never surpassed this level, as expected. However now that the EU penalty rate has been lifted to €100/t, European carbon credit prices have much more room to appreciate.
It has been suggested that favourable weather conditions for clean energy generators could influence carbon prices by increasing supply and reducing demand for credits. As clean energy providers have a positive impact on greenhouse gas emissions by reducing demand for electricity from ‘dirtier’ power sources, their activities generate carbon credits. So when excessively windy or sunny weather conditions allow them to generate more power, supply of carbon credits on the market could increase. At the same time increased output from clean energy providers could reduce demand from ‘dirtier’ forms of electricity, which could result in lower emissions and less demand for carbon credits.
Therefore, although it may seem obscure, favourable conditions for clean energy providers such as sunnier and windier weather could have a negative impact on carbon credit prices.
Demand for traditional forms of energy such as coal, oil and gas are expected to have an impact on demand for emission offset mechanisms such as carbon credits. Using price as a proxy for demand for these energy sources, we expect a positive relationship between their price and that for carbon credits. Therefore when coal use is strong, as indicated by higher prices, emissions would increase, increasing demand for carbon credits.
The EU’s regional trading system only covers a select few industries – the largest greenhouse gas emitters. Over the long term we may see the supply and demand fundamentals change as more industries are included under emission regulations. The landscape could also change as more countries introduce or join emission cap and trade systems. The US is the only developed nation which has not ratified the Kyoto protocol; however there is speculation that this could change following Presidential elections later in the year, which could increase volatility within existing carbon markets.
The US has been left on its lonesome following Australia’s decision to sign the Kyoto Protocol late last year as the Rudd government came into power. Despite being late in recognising Kyoto, the emergence of a local carbon market is well under way. A national carbon trading system is currently being developed with a target for commencement in 2010. However trading is already under way at the state level, with NSW hosting the world’s second largest trading scheme in terms of volumes and value of carbon credits transacted.
Local carbon markets have been evolving for several years because Australia’s reluctance to ratify Kyoto reflected an unwillingness to be legally bound to emission targets rather than reluctance to curb emissions. The NSW state government’s ‘cap and trade’ scheme has been in operation since 2003. Known as the ‘NSW Benchmark Scheme’, it regulates annual emissions of participants in the electricity market. The ACT government joined the scheme in 2005.
Carbon credits generated under the NSW system are known as New South Wales Greenhouse Gas Abatement Certificates (NGAC). Spot prices have recently traded around $6.80 to $7.20 according locally listed provider, CO2 Group (ASX code: COZ). Being the equivalent to less than €5, local carbon credit prices are much lower than their European counterparts because of differences in the type of activities permitted to generate excess credits, and the level of the penalty rate for non compliance.
The local penalty rate is only $12/t of CO2 equivalent, compared to €100/t under the EU ETS. So as long as this level is maintained, NSW carbon credits should not trade above $12. The EU ETS is also more restrictive in the types of activities that can generate credits, which serves to keep supplies tight. Unlike the NSW scheme, the EU ETS does not allow excess credits to be generated through forestry activities. The rationale behind this ruling is a source of contention within the industry, especially as the market for offset projects has ballooned in recent years.
‘Offset projects’ are a way of generating carbon credits in addition to directly curbing emissions below the legal cap. They are recognised by Kyoto because they remove greenhouse gases from the atmosphere, which is a process known as carbon sequestering. Carbon can be sequestered from the atmosphere through natural activities such as planting new trees which absorb it, or by artificial processes which ‘capture’ carbon and store it underground. Activities that replace others which would have otherwise resulted in greenhouse gas emissions, such as renewable energy, also generate carbon credits.
Investment in projects whose sole purpose is to generate carbon credits by offsetting emissions has ballooned. The Kyoto protocol differentiates between projects undertaken in developing and developed nations. Projects undertaken in developing nations are known as ‘Clean Development Mechanism’ (CDM) projects, while those undertaken in developed nations are known as ‘Joint Implementation’ (JI) projects. Developing nations have attracted the bulk of investment in carbon offset projects, with the total value of CDM project investment being over US$5.25bn during 2006, which is 37 times greater than the $US141m invested in JI projects over the same period.
China has attracted the bulk of carbon offset project investment, hosting 70% of all CDM projects in 2006, with the next largest player, India, hosting 12%. The fact that developing nations are being used by industrialised corporate to offset emissions has stirred much debate. This trend makes sense from a financial point of view because administering projects in developing nation carries a lower cost. However the critics argue that this system ignores the actual source of emissions taking place, which is typically on the other side of the world.
Carbon Credits and Forestry Projects
The emergence of the carbon offset industry has the potential to create an illusion that, contrary to what our mothers always told us, money does in fact grow on trees. However after taking a closer look at the fine print governing the EU ETS and Kyoto, we do not suggest that members start counting on that large Eucalyptus tree in the back yard for their retirement income.
The Kyoto protocol imposes several restrictions on how forestry projects can be used to generate carbon credits and offset emissions. Only plantings on areas that did not previously host a forest are eligible to qualify for credit generation. These areas must not have hosted a forest on 31st December 1989, and only new plantings made after the year 2000 are eligible. Therefore in layman’s terms, only new trees on previously unplanted areas can qualify for carbon credit creation.
As there remain issues over how to measure the amount of carbon ‘sequestered’ from the atmosphere by new plantings, these kinds of projects are excluded altogether from the EU ETS. This exclusion also helps to mitigate the problem of companies ignoring their own emissions by pursuing the low cost option of planting a new forest in a developing country. This strict ruling on forestry activities is an area of contention, as critics argue that it does not incentivise developing countries to preserve existing forests.
Implications for the Local Forestry Sector
The NSW Benchmark system is more flexible than the EU ETS, as it permits the use of forestry projects, as long as they comply with the Kyoto rulings. This has the potential to generate new opportunities for locally listed forestry companies, which in a general sense have struggled in recent years following changes to tax laws. In light of the growth in carbon trading it can be easy to envisage the sector receiving a fresh wave of investor sentiment. Although we see opportunities for these companies to use their forestry plantations to generate carbon credits and extra revenues, the upside would be limited.
The NSW system’s current restrictions mean that areas where forestry companies cut down and replant areas of forest would not be able to generate credits. However what the current rules do suggest is that when forestry companies plant a new area of land for harvest sometime in the future, that area is able to generate carbon credits, but only once. When these new areas are ultimately harvested and replanted, more carbon credits would not be awarded, as the replanting is thought to simply maintain the sequestering role of the previous trees.
With the growth drivers behind the global carbon market set to remain strong over the years ahead we anticipate that some interesting opportunities will arise for investors. However with the market still in its emerging stages in most areas of the world, investors should adopt the same cautious approach as they would to any other opportunity. Domestic and international regulatory frameworks will play a vital role, but as the Europeans learned from last year’s carbon crash, there are likely to be ‘kinks’ that will need ‘ironing out’.
There are opportunities to directly invest in carbon credits via a number of global climate exchanges, but given uncertainties over factors driving carbon prices, successfully operating a carbon futures account could be out of reach for most investors. However for those who may be interested, we have provided a simple technical outlook on the price of the ‘2008 ECX CFI futures’ contract, which is essentially the futures price on European carbon credits valid to offset emissions during 2008.
Based solely on historical price patterns, the outlook has turned bullish after prices recovered following the 2007 crash. Strong support has been established near €18.50 after prices ‘triple bottomed’ around this level. Prices are currently trading just below €25, which is a significant resistance level. A break above this level would be bullish. The emergence of an ascending triangle, a typically bullish pattern, supports the case for a break above €25.
In terms of other opportunities, the choice of listed companies that participate directly in the carbon market is currently very limited. However we would not be surprised to see more IPO’s emerge along this theme during the next few years. Therefore while the market remains in its emerging stages we see the best opportunities in companies that are positioned to benefit from the rise of carbon trading, but whose business models are strong enough to survive, with or without carbon trading. With this in mind, we view the renewable energy and forestry sectors as ones to watch, but reiterate our stock specific focus.
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