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Home > Blogs > Anthony Harrington > Carbon trading, a lesson in putting the right people in to bat

Carbon trading, a lesson in putting the right people in to bat

Finance Blogger: Anthony Harrington Anthony Harrington

Europe is leading the world in developing a market for carbon trading, using a market formula based on the cap-and-trade technique first developed in the US for air pollution control. According to a report by the World Bank, “State and Trends of the Carbon Market 2009,” the carbon market more than doubled from 2007 to 2008, up from $63 billion in 2007, to $126.3 billion in 2008.

It is, of course, a totally contrived market generated by regulatory manipulation of what high carbon emitters are allowed to do. No one actually wants to buy carbon. But all this demonstrates is that contrived markets are just as real as any other kind of market if the regulatory pressure cooker keeps working.

For those who haven’t yet got their heads around carbon trading the basic idea is simple. You give high carbon emitters like big manufacturers a free certificate at the start of the year for each ton of carbon they expect to produce—less, say, 10%. At the end of the year they hand the certificates back and then buy any shortfall in certificates on the open market. The theory is that the certificates end up being about the same price on the open market as the cost to manufacturers of implementing carbon reduction technologies.

In other words, as a manufacturer you can either invest to emit less, or invest in additional certificates. Eventually you will get the point that investing in new technologies to emit less carbon produces benefits that roll on from year to year, whereas if you just rely on certificates, you have to go back to the market each year.

Plus, of course, if you emit less, instead of having to buy certificates, you have surplus certificates, so you can recoup some of your investment in new technology by selling your certificates to the market.

Fine so far? Good. My point for the day, however, is not the carbon market per se, but the attitude companies adopt to it. I had a conversation recently with a carbon broker (a buyer and seller of carbon certificates) who was tearing his hair out over the failure of some corporates to see that the carbon market is a market—i.e. something you can exploit for profit.

If you treat carbon trading as a regulatory issue instead of as a market, then you give responsibility for it to your compliance team. Compliance teams are not incentivized to make profits. Why does this matter? If Company A, a high emitter, is given 10 million free certificates in February 2009, it does not have to hand those certificates back to the regulator till April 2010, that’s just how it works.

Now the spot market for carbon certificates had a record high of €28.73 in July 2008, and a record low of €7.96 in February 2009. High or low, the certificates clearly have a value. If you give those certificates to a compliance team, they will, in all probability, put them in a drawer and forget about them till April 2010. If you put a trading desk in charge of the certificates, they will instantly put them on the spot market, bank the cash (say €15 × 10 million, or a cool €150 million) and buy a futures option on the number of certificates they will need in April 2010.

In our example, one company has a drawer full of paper, the other has a well papered bank account. The lesson, in other words, that the carbon market has for company management teams is that it is important to understand the nature of the task before you decide where to assign responsibility for the task. Getting it wrong can cost you serious money.

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Tags: carbon trading , EU , regulation , spot market
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