At a time when the United States has still to ratify the Kyoto Protocol and China is reported to be opening one new coal-fired power station every five days, it is perhaps not appropriate for Financial Services Briefing to seek to apportion blame for the so-called global warming phenomenon, a feature which some scientists now report as existing on other planets in the solar system. However, Kyoto has given rise to the creation of the first new investment exchange in the UK since LIFFE and the International Petroleum Exchange in the 1980s, and is arguably the first exchange on which trading could be directly beneficial to our planet. This article therefore focuses on the European Climate Exchange, established in early 2005 to enable EU companies to trade in emission permits under the Kyoto arrangements and in financial instruments related thereto and the relevant regulatory aspects.
Background
The Kyoto Protocol established quotas for the greenhouse gases which each of its ratifying countries could produce. These countries then set quotas on the emissions of installations of businesses and other organisations, which are generically labelled as “Operators”. Each Operator is given a number of credits per year, whereby each credit allows the Operator concerned to emit one metric tonne of carbon dioxide or equivalent greenhouse gases. Operators which have not used all of their credits can sell these surplus credits either over-the-counter (OTC) or on exchanges established for the purpose to other Operators which need to emit more than their allocated quota of greenhouse gases.
The EU ETS and the ECX
The EU Emissions Trading Scheme (or EU ETS) provided for the OTC trading of carbon credits. In addition, carbon credit exchanges have already been established in Australia, Chicago, Montreal and, more recently, in London. The European Climate Exchange (ECX) was established in London in early 2005. The ECX is the first quoted and cleared market for EU emission rights and, as such, currently handles 90 per cent of the EU’s emissions trading. The ECX trades two types of carbon credit a Certified Emission Reduction Future and a Certified Emission Reduction Options - both on the ICE Futures electronic platform - and is a recognised investment exchange for the purpose of the Financial Services and Markets Act 2000 (FSMA).
Thus the ECX has, since 2005, in effect allowed trading in the "permits to pollute" issued under the Kyoto arrangements. The ECX aims to provide a liquid market in these permits and is currently trading around 5 million tonnes a day of CO2 allowances.
How the Kyoto arrangements and the ECX work in practice
The Kyoto arrangements work roughly as follows: a medium-sized power generator, for example, might wish to generate on average say 100,000 tonnes of CO2 in a year. Permits issued equate to that level. If the demand for power is lower then usual, or if efficiencies are introduced in the form of carbon capture technology, and it becomes obvious to the generator over the course of the year that it will fall short by, say 20,000 tonnes, then it can then sell permits equivalent to that amount of CO2. If sold on the ECX the power generator’s excess permits would, in this example, currently be worth €440,000. Meanwhile if another polluter looks like it could overshoot on its CO2 emissions in the year, it will need to buy the necessary additional permits. The ECX facilitates this exchange, in the form of traded futures contracts in permits.
There are over 80 members of ECX. A few are power generators or large energy companies but most are the banks and other trading institutions, which carry out business on behalf of the corporate CO2 producers. The permits traded cover the five main polluting industries: power generation, cement, oil and refineries, steel and metals and pulp and paper. However, over time the number of permits will reduce year on year in order that the EU achieves its objective of reducing pollution. Indeed, the first round of permits, covering 2005 to 2007, was not a particular success. The total of 2.1 billion tonnes a year for this period was too generous. The extra permits were not needed and in May 2006 the market collapsed as the CO2 price fell dramatically. Trading is now underway for Phase II 2008 to 2012, the annual total having been reduced to 1.9 billion tonnes and widened to include other greenhouse gases such as nitrogen oxide and sulphur dioxide.
The ECX operates in Bishopsgate in the City of London, with 4,500 to 5,000 dedicated screens around the world. The trading platform used is that of the ICE, and trades are cleared and settled through LCH Clearnet (which also serves the London Stock Exchange).
The ICE also expects to introduce a second product, dealing in certified emissions reductions. These will allow companies in the developing world introducing clean technology that reduces potential CO2 emissions to sell this reduction to polluters in the developed world. These instruments are discussed in more detail below.
ECX is owned by the AIM-listed Climate Exchange. There is a sister market, the Chicago Climate Exchange. Whilst there are 180 countries which have signed the Kyoto agreement they do not include the two biggest producers of CO2 - the USA and the PRC.
The ECX’s products
ECX’s products offer for the first time a European platform for greenhouse gas emissions trading, with standard contracts and clearing guarantees. ECX products include both futures and cash contracts in ECX Carbon Financial Instruments (ECX CFI). Each ECX CFI is based on emission allowances issued under the EU’s Emission Trading Scheme mentioned above. For the first phase of ETS, emission allowances came into effect from 1st January 2005 for around 12,000 energy and industrial installations that accounted for 46 per cent of the EU’s CO2 emissions.
The Chicago Climate Exchange
In contrast the Chicago Climate Exchange, ® Inc. (CCX) is a self-regulatory exchange that administers the world’s first multi-national and multi-sector marketplace for reducing and trading greenhouse gas emissions. CCX represents the first legally binding commitment by a cross-section of North American corporations, municipalities and other institutions to establish a rules-based market for reducing greenhouse gas emissions. CCX enables members to receive credit for reductions, and to buy and sell credits to determine the most cost-effective means of achieving emission reductions.
Trading based on the EU’s Emissions Trading Scheme
Trading of ECX contracts is based on the European Union Emissions Trading Scheme (EU ETS). The EU ETS, established under Directive 2003/87/EC, has now created the world’s largest market in emission allowances, and regulates the emission of carbon dioxide from installations across the 25 Member States of the EU, including power generation, mineral oil refineries, offshore installations and other heavy industrial sectors in its first phase (2005-2007). The second phase of the ETS (2008-2012) will coincide with the first Commitment Period under the Kyoto Protocol.
ECX Contracts
On 11th June 2007, the ECX announced the launch of its CER (Certified Emissions Reduction) futures and options contracts, subject to the regulatory approval. The contracts, formally known as the ICE ECX CFI CER Futures Contract (ECX CER Options), with secondary CERs as the underlying unit of trading, are listed and admitted to trading on the ICE Futures electronic platform and serve the market as cleared and standardised contracts.
Thus the ECX CER Futures and Options allow users to lock-in prices for project-based contracts delivered at set dates in the future and are a useful alternative to over-the-counter (OTC) CER contracts. All trades are cleared by LCH Clearnet. Subject to the ICE Futures Regulations, market participants will also be able to use the Exchange for Physical (EFP) and Exchange for Swap (EFS) mechanisms, and to register OTC CER contracts for clearing by LCH Clearnet. The ECX/ICE futures emissions volumes for EUA futures and options contracts have experienced increasing growth recently.
About the CDM and CER Credits
The Clean Development Mechanism (CDM) is an arrangement under the Kyoto Agreement which allows industrialised countries with a greenhouse gas reduction commitment (so-called Annex 1 countries) to invest in emission reducing projects in developing countries as an alternative to what is generally considered more costly emission reductions in their own countries. The CDM is supervised by the CDM Executive Board and is under the guidance of the Conference of the Parties of the United Nations Framework Convention on Climate Change.
CDM projects generate Certified Emission Reduction (CER) credits to qualifying greenhouse gas reduction projects that also provide development benefits to their non-Annex 1 host country. The CERs will be transferable to industrial countries, where they can be applied toward emissions reduction targets. Once a CER has been issued, it carries the same compliance value as an EUA. EU ETS market participants are thus able to import CER credits for domestic compliance to cover for some of their shortfall. Other parties interested in trading and investment strategies are also able to benefit from the addition of a standardised exchange-traded CER futures contract.
Legal and Regulatory Aspects
Carbon credits, as a generic investment, are not classified as such under FSMA. However, Section C (10) of Annex I MiFID classifies carbon credits as derivatives, and thus such contracts are likely to be specified investments under Articles 83-85 of the Regulated Activities Order, as amended (the RAO), Certified Emission Reduction futures being “futures” for the purpose of Article 84 of the RAO, and Certified Emission Reduction options being “options” for the purpose of Article 83 of the RAO.
MiFID was implemented in EU member states on 1st November 2007 and replaced the Investment Services Directive (“ISD”) and extended the range of investment activities and services subject to regulation. MiFID distinguishes between “investment services and activities” – which correspond to “core” services under the ISD - and “ancillary services” which correspond to “non core” services under the ISD. Firms which provide “investment services and activities” are subject to MiFID in terms of both the “investment services and activities” which they provide and the “ancillary services” which they provide. Under Article 4(2), a firm will be providing “investment services and activities” if the firm provides an investment activity with regard to carbon credits, since under MiFID Annex 1 Section C (10), “Financial Instruments” include “emission allowances”.
Further reading
For some further reading on this subject, see also:
The Making of the EU Emissions Trading Scheme : Status, Prospects and Implications for Business by Christian Egenhofer, CEPS, Belgium in European Management Journal Vol 25, No. 6, 2007 pp 453-463;
Emissions trading and competitiveness: pros and cons of relative and absolute schemes by Onno Kuik and Machiel Mulder, in Energy Policy 32 (2004) pp 737-745.
Internal emissions trading under the Kyoto Protocol: credit trading by Jan-Tjeerd Boom in Energy Policy 29 (2001) pp 605-613;
Systems for Carbon trading: an overview by Henrik Hasselknippe in Climate Policy 352 (2003) pp. 543-557; and
Emissions trading beyond Europe: Liability schemes in a post-Kyoto world by Niels Anger in Energy Economics (2007).
Martin Day
Financial Services Team
Farrer & Co
|