Structural work underpins carbon market optimism

If 2017 was the year of carbon market maintenance, with legislation extending the life of schemes in the US and Europe, 2018 could be defined by greater linking between initiatives, says Michael Hurley

The past 12 months in the carbon markets have been high in drama – from litigation in the US to regulatory changes and fallout from contentious elections on both sides of the Atlantic, as well as enduring uncertainty as to when China's long-awaited national market will be launched.

However, the winners of this year's Annual Market Rankings broadly agree that, following a period of turbulence for the markets that has its origins in the 2008 financial crisis, there are signs that recent structural changes could create the basis for a period of relative stability.

Martijn Wilder, partner at Baker McKenzie, which picked up the title of Best Law Firm across four categories, agrees this "rebuilding period" is defined by a lot more talk about how carbon markets can become effective and stable, which is partly inspired by Article 6 of the Paris Agreement on climate change, he says.

In the EU Emissions Trading System (ETS), the price of allowances (EUAs) has been climbing, reaching €7.68 per tonne of carbon dioxide (CO2) at the time of going to press – up from a low in May of less than €4.50 – which is a sign of confidence brought about by the EU agreeing to long-term reforms, according to Jeff Swartz, director of climate policy and carbon markets at South Pole Group. The Switzerland-based company was voted Best Trading Company on the secondary market and Best Project Developer for Kyoto project credits (JI and CDM).

EU Member States backed the ETS Phase IV (2021-2030) reform package in a November vote. The reforms include a commitment to reduce the overall cap on the total volume of emissions, annually, by 2.2%, to reduce oversupply – which has been a key weakness of the system in past years.

Louis Redshaw, founder and chief executive of Redshaw Advisors, says the proposed Market Stability Reserve (MSR), into which surplus emission allowances removed from the market will be placed, starting in January 2019, is "the main driver for the return of some speculative interest in the market."

Redshaw retained the title of Best Advisory/ Consultancy – EU ETS and was also voted Best Trading Company, Spot & Futures – EU ETS, in this year's poll.

"Investors and speculators who are not necessarily involved in the carbon market each day are now taking part due to the forecast impact on prices," he says. "The market looks healthier than it has done for years."

"The next 12 months is pretty much business as usual: the market will likely be slightly long but from January 2019 the 'MSR effect' will flip this situation on its head and the market will be short," says Redshaw.

The reforms must be approved by the EU's environment committee, with final approval not expected until February 2018.

Prices rose as much as 3.3% to €7.98 following announcement of the deal.

This increasing market confidence is likely to be important for the future development of carbon markets, Wilder says.

"This year, for the first time in a long time at the COP climate negotiations in Bonn we saw a lot more focus on how carbon markets should be linked. In that way, a strong EU ETS market is very important," he says.

However, the discussions are "only just starting to play out", he says, and the subject of linking is fraught with difficulties that require further work on regulation. Wilder doesn't expect a significant amount of additional linkage to happen any time soon.

"The problem will be, come 2020, how does that linking stand up when countries have imposed obligations to reduce emissions," Wilder asks, referring to the Nationally Determined Contributions, made by countries under Article 4 of the Paris Agreement.

"There are a whole lot of interesting issues about how you account for linking under the Paris Agreement, which considers Internationally Transferred Mitigation Outcomes (ITMOs)," Wilder says. "If you transfer your carbon abatement from one country to another, one benefits while the other loses out."

Redshaw agrees this issue of 'overlapping policies' needs to be addressed.

"We see it all across Europe with national policies negatively impacting the EU ETS. The Phase 4 regulations have partially solved this problem by allowing EU Member States to cancel an amount of EUAs that corresponds to the emissions reductions caused by another complementary policy.

"But the question remains – will they do this? When it comes to the crunch will a Member State cancel 20Mt of EUAs that it could have auctioned at €20 each? €400 million is a lot of money to deny yourself and the Member States have not done well in the past – consider the massive over-allocation in Phases 1 and 2," Redshaw says.

Nicolas Girod, head of trading and research at ClearBlue Markets, which was voted Best Advisory/Consultancy for North American markets, said the UK's Brexit vote may affect pricing over the next year.

A Brexit clause in the EU's proposed Phase 4 reforms says that, to avoid UK EUAs being invalidated from 1 January 2018, UK law must ensure the compliance deadline for 2018 emissions is no later than 15 March 2019.

UK issued allowances from 1 January 2018 will no longer be marked with a country identifier and therefore will be valid for compliance, although the European Commission will be permitted to "regularly assess whether prohibiting the use of allowances is still necessary". The regulation will also allow EUAs to be marked with a country code and become invalid for compliance.

"It's just before the compliance for 2018 - will the free allowances in 2018 be worthless? That will be a lot of risk to manage for UK compliance entities," Girod says, adding that he is not bullish about EU ETS prices in 2018, which he predicts will remain between €8 and €9.

"What could happen with the UK is what happens with Switzerland – it's outside the EU but links with the EU ETS.

"I don't see why the UK would not start its own market and try to link to the EU's - or maybe link to the [North American] RGGI market."

Shaun Bainbridge, director of assurance at Lucideon, which was voted Best Verification Company for the EU ETS, agrees the implications of Brexit for the ETS are huge: "The one word associated with the ETS at the moment is Brexit. That's regardless of whether you are a UK operator or verifier or from one of the other EU countries."

There are three different pathways that could be taken post-Brexit for the UK, he says: full involvement in the ETS; a proprietary UK trading scheme that's linked to the EU ETS; or a "simple" carbon tax.

"The UK is such a large part of the EU – it will have implications on reporting, the carbon price, the fluidity of the market and, in the short term particularly, the timing of reporting and verification.

"You can see it even pre-Brexit, because of when people use their allowances to settle their accounts. The other Member States are asking the UK to bring forward verification and reporting [ahead of 2018 compliance] - there are very serious implications for UK companies," Bainbridge says.

If the UK were to implement its own carbon market, he says, it could link exclusively with the EU, with other schemes like RGGI, or even those in the Far East such as Taiwan, China or Korea.

"To link several would be challenging but doable. The timeframes would be long," Bainbridge says. "The key thing is fungibility of allowances: that all the allowances are equivalent and the reporting and verification is robust enough to prove they are equivalent."

Redshaw agrees: "Brexit has served up a dose of the political realities of this market. But by being close to developments it is possible for companies to implement coping strategies," he says.

South Pole's Swartz echoes Wilder's call for more structural work around the ETS, and says that although the reforms have been successful in that they have increased investor confidence and pushed up allowance prices, EU law-makers have shown a lack of ambition that could undermine progress.

"The EU has a target to reduce emissions by 40% by 2030, and 20% by 2020, from a 1990 baseline – the 2020 target has already been met: it was achieved in 2014. We've now had six years where we're not working towards the 2020 target.

"The EU should increase its target, and one way to do it cost-effectively is by meeting it with international credits, by showing the rest of the world that the EU is interested in supporting other countries to reduce their emissions. This would allow European firms to purchase credits that are low cost, and also support action in developing countries, which are those hardest hit by climate change.

"It's a political decision Europe has declined to make and, taking that as an example, other governments have also decided not to take increased action on reducing emissions between now and 2020," Swartz says.

Meanwhile, in North America, regulatory changes similarly helped shore up the price of allowances when they were floundering.

Zach Eyler, vice president of greenhouse gas programmes at Ruby Canyon Engineering, which retained the title of Best Verification Company for North American markets, said: "The most important factor over the past year was the passage of the AB 398 bill, securing California's cap-and-trade programme to 2030. This certainty was welcome to all, even if the offsets component of the bill was disappointing."

AB 398 extended the California programme past its 2020 expiry date in the face of legal challenges which alleged that the pricing mechanism constituted a tax. Under local law, new taxes require a two-thirds vote to pass into legislation, which AB 398 achieved in July.

Lenny Hochschild, a managing director and head of US carbon markets at Evolution Markets, which was voted winner of six categories, said: "This event provided the political certainty that the linked California-Quebec market needed in order to grow, and meet the requirement of 40% lower greenhouse gas emissions by 2030, compared with the 1990 level."

Randy Lack, chief marketing officer at Element Markets, winner of three categories in the North American markets, agrees AB398 instilled confidence in the California carbon market, which fed through to prices.

"Heading into the period when the bill was passed, we saw a strengthening of the market. We were around the $14 to $14.25 level. Going into and following the passing we saw the market touch as high as $15.75.

"Since then the auctions have been fully subscribed, the market's been much stronger and the volume has picked up," says Lack.

"Companies are looking out beyond 2030, and hedging exposure along the curve, which has increased volume and allowed some of the speculators to come back in and invest with confidence.

"As we reach that 2020 period, once we sop up the excess supply in the market - which some people believe will come in the mid-2020s - the projection is that we'll see higher prices."

For offsets, there is a different outlook, says Lack: part of the AB398 extension was a reduction in the potential use of offsets from the current limit of 8%, to 4% between 2021 and 2025, then after 2025 up to 6%. At least half of the offset credits must be sourced from projects that provide direct environmental benefits inside California, which "will create a bit of difficulty" for offset suppliers outside California post-2021, Lack says.

ClearBlue Markets' Girod, says the outlook for the market "is looking much more positive than it was at the beginning of the year."

California's November auction saw, for the first time, some of the unsold allowances from past auctions coming back to the market. Allowances were sold at $15.06 - $1.49 above the $13.57 floor price, and $0.31 higher than the August clearing price - the highest ever clear above the floor price since the market started.

Girod says an agreement that will see Ontario's carbon market link with California is a positive sign for 2018: "The Ontario market is short overall, so will add more demand in the Quebec-California-Ontario market," he says.

"The floor price next year will be around $14.50. I expect there will be a bit less demand in the auction at the beginning of next year, but by the end of the year I expect [a price of] $16."

Nonetheless, November 2018 will see the end of the second compliance period in the California-Quebec market, which will add more demand, he says. "In addition, a lot of unsold allowances will come back to the market, which will need to be absorbed."

Eyler, at Ruby Canyon, says that the California market seems in good health.

"The next 12 months could be interesting, with an election upcoming in Ontario as well as potential for new markets in Oregon and Washington.

"We are also very interested in developments in Mexico. We participated in the first ever mandatory facility greenhouse gas verifications this year and are excited about the steps Mexico is taking in developing their programme," Eyler says.

Girod says he has heard that Ontario has been pushing hard with California to link with Mexico.

He warns that elections happening in Ontario in June "will add a bit of stress - according to polls the Conservatives are leading the Liberals by between 10 and 20 points, and the Conservatives said they would scrap the Ontario cap-and-trade system."

For the Regional Greenhouse Gas Initiative (RGGI) market of nine US states, Lack says a reduction in the amount of allowances, which will come into place in 2020, "has really bolstered prices", while expected new entrants to the programme are likely to provide an extra boost.

"Following recent governor elections, it's expected Virginia will join RGGI, and New Jersey is very likely to join. This is giving additional support to the programme, and has really caused an uptick in prices as well as a lot of long-term pricing support - and we expect that to continue.

"I expect 2018 to be a pretty strong year for RGGI," says Lack.

Evolution Markets' Hochschild said a commitment by RGGI states to cut power plant emissions by an additional 30% by 2030, "signals further long term growth for the market".

Meanwhile in Asia, while most market observers await the launch of China's national carbon market, there are also eyes on the Korean ETS, which has been beset by supply issues.

Nandagopal Paramesh, a director at Kanaka Management Services, again voted Best Advisory/Consultancy for Kyoto project credits, says: "We had more than five million credits lined up to trade in the South Korean market by this year, ...but the market is not ready to trade. I guess by the end of next year it should be."

Swartz says that across the water in China, when its national market launches, it will be implemented in phases. "As I understand, the market will start with just one sector – the power sector – and the government will gradually phase in other sectors over time," he says. "The market will be a test period for the first few years – consistent with how markets have started in other jurisdictions, including Europe.

He warns that, "in order for markets to work effectively, they need to send a long-term policy signal, and they need to be very liquid.

"Different entities need to engage in carbon markets, and we don't know yet if the market will be open in the sense that it involves many different actors - companies that provide offsets, those that can trade and provide liquidity.

"An open and liquid market is essential for China to have a long-term carbon price curve and for Chinese companies to effectively manage their exposure and reduce costs and risk," Swartz says.

Casting an eye into the future, the winners of this year's Annual Market Rankings are optimistic, but think change is essential.

Wilder says he is disappointed at the pace at which the International Civil Aviation Organisation's scheme for offsets, CORSIA, is progressing: "I had hoped it would go a bit faster - but it hasn't and it isn't, so that's a bit of an issue", and he sees the availability of quality carbon data from companies as a big challenge in the battle to reduce emissions, as it leaves them struggling to understand the carbon profile of their business.

Swartz says the potential for the CORSIA scheme is exciting, and is "a beautiful marriage between the aviation sector and the carbon markets", but would like to see airlines become more pro-active.

"The best thing they can do is get familiar with markets and explore what type of emissions reductions they would like to invest in – not only for the airlines but also for the markets to understand what airlines are interested in purchasing."

Redshaw says that, for the next 12 months, "It won't be plain sailing and volatility is the only certainty, but it is hard not to see prices rising through 2018. The MSR already is already starting to alter hedging behaviour across Europe."

Kevin Townsend, chief commercial officer at Bluesource, which retained the title of Best Offset Originator for California and Best Project Developer for North American Markets, believes additional sub-national markets will take shape in the US and Canada next year.

"There will be states and provinces designing their own programmes or looking to link with existing Western Climate Initiative jurisdictions [California, Quebec and Ontario]," he says. "There will be new actors that begin to shape their markets beyond the jurisdictions everyone's talking about today."

K. Sudheendra, a director and head of operations at Epic Sustainability Services, voted Best Verification Company for Kyoto project credits, says markets require enhanced government and business support, as well as increased ambitions.

Wilder nonetheless says the general health of the market is good – "You can see that from the increase in prices.

"Certainly all the structure behind carbon trading – the monitoring and reporting seems to be becoming more efficient – and becoming scandal free. Earlier on we had things like carousel trading [a tax avoidance scam], but those issues seem to have been ironed out, and we have a strong registry that seems to be working well.

"And in the US the states are more determined than ever to move ahead in the context of Trump," Wilder says. "All around it's relatively quite positive.

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