Carbon Emissions Trading: The Next CFO Worry...or Just a Lot of Methane?

From the Nov. 2006 edition of AFP Exchange magazine

With the Kyoto Protocol limiting carbon emissions, an international market has developed for trading emissions permits. Some companies include carbon trading in their risk management strategies. Although the U.S. hasn't signed the Kyoto accord, experts here and abroad think the market is one to watch.

Some people call it the right to pollute. Others call it the 'new kid on the block in commodities trading.' Whatever you call it, carbon emissions trading is beginning to catch the eye of financial professionals.

By international agreement under the Kyoto Protocol, which went into effect last year, signing countries agree to certain emissions caps and then issue permits to emit a certain volume of carbon dioxide over a certain period of time. The thinking is that companies able to reduce emissions easily can sell their credits to ones that can't.

Companies now can purchase permits for carbon emissions, and these trade on a developing market. Although signing countries are keen to limit greenhouse gasses, it is also the case that a certain amount of emissions do take place in businesses, especially in manufacturing industries. Particularly in Europe, building carbon trading into an overall risk management plan is an idea that has begun to take hold, though not without considerations, especially on the accounting side.

According to an October World Bank report, the carbon market, which encompasses project-based trades as well as emissions allowances, reached $22 billion in the first nine months of 2006, more than double what it had been last year. Much of this volume came from China.

In October, Exchange spoke to Odin Knudsen, joint CEO of IDEAcarbon in Washington, D.C., which helps companies find profitable opportunities and manage risks in the fast-growing but uncertain carbon markets. He described the scope of the emissions trading market and what CFOs can expect in the future.

How did the trading of permits to emit carbon dioxide come about?

The trading of carbon permits originates from the Kyoto Protocol, an international agreement to fight climate change through reducing greenhouse gases in the atmosphere. The Protocol allows developed, mainly OECD, countries with compliance obligations (requirements to cut their emissions of greenhouse gases--mainly carbon dioxide--below 1991 levels by 5% or more) to purchase carbon emission permits from projects in developing countries. These permits are generated by projects to improve energy efficiency, grow forests sequestering carbon, reduce industrial carbon emissions etc. in developing countries such as China, India, Nigeria and Brazil.

To meet the obligations of the European Union under the Kyoto Protocol, a European Trading System has also been developed which promotes industries to exchange permits or allowances for carbon emissions. Australia has a similar system for New South Wales and the U.K. has an internal system of emissions trading. Japan is now developing its internal system.

Although the U.S. hasn't signed the Kyoto Protocol, California, the world's 12th largest emitter, has recently announced that it will develop its own system in coordination with northeastern states. And the Chicago Climate Exchange trades voluntary permits for U.S. companies. These voluntary permits allow U.S. industries to hedge their possible future compliance obligations and meet voluntarily their environmental responsibilities.

Interestingly, even though the United States did not ratify the Kyoto Protocol, it was our government that advocated global trading of permits based on a very successful national trading system to trade sulfur dioxide (acid rain) permits among power utilities.

What is the intended effect of carbon emissions trading?

Because greenhouse gases disburse freely in the global atmosphere, it does not matter which country reduces its greenhouse gas emissions. This global nature of greenhouse gases creates the conditions for world trade in permits. Since the cost of reducing these emissions in OECD countries is much higher (up to $250 per ton of carbon) compared to in developing countries (less than $10 per ton of carbon, the natural conditions for trade are created), just like for any commodity. Allowing trade of carbon permits helps minimize the costs of meeting global targets on reducing greenhouse gases in the atmosphere.

How big is the market now and what are your views on its continued development?

The carbon market grew in the first three quarters of this year to over $21 billion and will likely reach $30 billion by the end of 2006. This trade exceeds most world commodities and is double the global trade in wheat. And this is just the beginning. Carbon permit trading is projected to exceed $120 billion as compliance obligations grow. If the United States enters the market, these values of trade will be far exceeded. Not to push it too far, but the sky isn't even the limit. Seriously, the bottom line is that carbon trading of permits is the fastest growing market in the world, one that every business manager and entrepreneur should be aware of and be taking advantage of. Europe and the rest of the world are far ahead of us here in the United States.

The issue of climate change is not going away nor is the challenge to mitigate it. Carbon markets are the best way to signal to companies to develop new technologies and seek greater energy efficiency. It is part and parcel of globalization and is here to stay and grow.

And where does most of the trading take place?

Most of the trading takes place in Europe and is over the counter. But the official exchanges are growing rapidly as is the derivatives market. London is quickly becoming the financial hub of the carbon market. Many hedge funds and investment banks are already active in the market or are entering.

Why should corporate CFOs have this on their radar screens? Is it part of a risk management strategy?

Every corporate CFO should have on their radar screen the implications of carbon emissions. Many companies are unaware of the "hidden" liabilities and even assets that carbon obligations and trading could have on their balance sheets. Already market analysts are starting to take into account in their valuations these potential liabilities. Corporations should be hedging their obligations, finding financial instruments to use to manage the risk of future obligations and surveying their overseas entities and holding to account for carbon assets and liabilities. An active debate is taking place in Europe to adjust accounting rules to take into account carbon. It is only a matter of time before this will take root in the United States.

How is China involved in carbon emissions trading?

China is the largest source of relatively cheap emission reduction permits. Buyers of permits are flocking to China and are actively engaged with companies to buy carbon emission permits. In October, one of the largest "trade" shows took place in Beijing attended by over 1,500 buyers, sellers and analysts.

Can you give examples ofsome of the larger deals you have seen?

Carbon deals range in size from under $1 million to the hundreds of millions. For example, I negotiated for a set of European, Japanese and U.S. buyers the two largest deals in the history of this young market. It was for permits to reduce a very highly toxic greenhouse gas in China known as HFC23. The value of the transaction was nearly $1 billion. Currently the permits from this deal have doubled in market value.

How can financial professionals obtain further information?

There is an abundance of information available but some of the best Web sites are http://www.IETA.org and http://www.pointcarbon.com. The United Nations has a useful Web site http://unfccc.int/2860.php. Also I highly recommend the Stern Report that was recently issued by Tony Blair in the U.K. It can be obtained at http://www.hm-treasury.gov.uk

Odin K. Knudsen is the joint CEO of IDEAcarbon with offices in London, Washington D.C., Singapore, New York and Mumbai. He was formerly the senior manager of the Carbon Finance Business of the World Bank. He can be reached at oknudsen@ideacarbon.com. IDEAcarbon provides independent carbon ratings, research and strategic advice on carbon finance and markets, specializing in risk management strategies, intelligence and advice for financial institutions, corporations, traders and developers.