Survey - Positive feedback

Energy Risk's second annual emissions survey charts the development of emissions trading in Europe since the start of the European Union Emissions Trading Scheme a year ago

The European carbon market is booming.Although forward trades had been made before 2005, last year saw an explosion in traded volumes from 6.3 million tonnes in January 2005 to 37 million tonnes in November - over 250 million tonnes for the whole year, according to Point Carbon. Many new players entered the market, and the use of more sophisticated products, including swaps and options, increased - as did investment in Clean Development Mechanism (CDM) projects in non-EU countries. This year's survey provides the most in-depth snapshot to date of this rapidly growing market.

Seventy firms took part in this year's emissions survey. Almost half the responses came from utilities or oil and gas companies; a third from banks and other intermediaries, with the remainder from industrials in the chemicals, manufacturing, cement and paper sectors.

Of the respondents, 55% are actively trading in the market (excluding brokers were not counted as traders) with 67% of those trading more than once a week. At least one respondent complained that "several times a day" was not an option on the survey. Only 21% of active traders restrict themselves to trading forwards - 75% trade in both the forward and spot markets.

To create and sustain the momentum of the ETS has required considerable political will from the European Commission. Perhaps as a result of this demonstrable commitment to the ETS, belief in the durability of the scheme has persisted, with 90% of respondents agreeing that the ETS would persist into phase 2 regardless of how much emissions reduction it actually creates.

The majority of respondents expect between 250 million and 500 million tonnes to be traded for the 2006/7 compliance period - and over 1 billion for the whole of phase two (see Fig 1).

There is also positive news on the structured products front (see Fig 2). At present, just 29% of respondents trade swaps or options. However, 38% say that they intend to trade options in the future, and 25% will eventually trade swaps. Banks looking to offer new structured products are likely to find a receptive audience.

Where will the price go?

The average predicted spot EUA price for 2006/7 was EUR22.53, while the average for 2008/2012 was EUR20.06. But there is some debate as to where EUA prices will head in the second phase. The majority felt the price is likely to fall, given the influx of supply as investments in CDM start to yield dividends.

"With all the CERs and similar products coming into the market in phase 2, firms will have more and more ways to meet their compliance targets," says Dan Butler, emissions broker at Atlantik, a Czech brokerage firm. "This could bring prices down."

But others argue that it is in the nature of the scheme to increase the pressure to reduce emissions as time goes on, and that more restrictive National Allocation Plans in phase 2 will create upwards pricing pressure.

"There will be more supply from CDM, but the overall outcome will still be a ratcheting down," says Gilles Corre, emissions broker at Evolution Markets.

Some take a more pessimistic view, arguing that carbon allowances will become more expensive in phase 2 because emissions in Europe are actually growing. "The reduction measures that need to be done by industry are not taking place," says a manager of emissions and weather at a major European utility. "Overall, gas is not replacing coal in the fuel mix."

CDM/JI

The survey results suggest that the Clean Development Mechanism/Joint Implementation (CDM/JI) market - which allows polluters in the EU to meet part of their reduction targets by purchasing certified emissions reductions (CERs) from projects in developing countries - is set to be an integral part of the ETS market. The CDM Executive Board issued the first CERs in October.

Of those actively trading in the ETS market, 65% are already involved in CERs. Only 20% of active traders and 22% of those respondents yet to start trading say that they are unlikely to become involved in CDM/JI (see Fig 3).

The nascent secondary market for CERs also looks set for growth: 17% of respondents are already trading CERs in the secondary market, and a further 29% intend to do so in the future.

CERs cannot yet be used interchangeably with EUAs. In theory, CERs derived from CDMs could begin entering the ETS market after the first quarter of 2007, when the UN's International Transaction Log (which facilitates the transfer of CERs into national registries) is scheduled to come online. But respondents disagreed on whether the CDM market will inject a significant amount of CERs into the ETS during phase 1. Some 42% said no, while 27% said yes (see Fig 4). And there is no consensus at all on how much CERs will cost in phase 2 - responses ranged evenly between 6 and more than 20.

Infrastructure

The survey results support the notion - arguably the received wisdom in the market - that the European Climate Exchange is the dominant exchange for carbon futures: 50% of respondents who use exchanges picked ECX. The spot market had no clear winner, although volumes may of course tell a different story.

There was some disagreement over whether the market would be better off if there was some consolidation among the exchanges: 41% felt it would be, while 27% disagreed. The typical complaint is that having too many exchanges divides liquidity unnecessarily - but not everyone takes this line.

"Having many carbon exchanges will not harm liquidity to a significant degree," says the emissions manager, "it's just the same as the equities markets."

The European Commission recently announced its intention to bring the aviation sector into the ETS framework - a move that the respondents backed almost unanimously. "The entire economy, one way or another, should be included," said one.

The survey asked what additional products or indices market participants wanted to see. Improved market information was on the top of many respondents' wish lists.

"It's difficult even to get an idea of volumes," says Butler. "It's like an OTC bond market - no-one knows who's holding what."

Most respondents felt that the standard clip size in the OTC market should be less than 25,000 tonnes (see Fig 5).

Finally, there was also a call for monthly, quarterly, seasonal and annual EUA swap markets, based on an average of the index price for the specified period, which would allow compliance traders to hedge more efficiently against seasonal exposures to the gas, coal and power prices.

A clearer picture of the emission market's future direction is starting to emerge, but it is worth stating that so far there is a scarcity of hard data. On March 31, the market will find out how much emission reduction has been achieved in the first year: any surprises could change market sentiment dramatically.