Market change – slow but certain

With the current uncertainty about the EU’s Phase III Carbon Market Initiative, how do you see future developments and trends?
Anette Nordskog (AN), VP Corporate Communication and Project Development, Navita Systems: There is definitely much uncertainty about Phase III. Before the Conference of the Parties (COP) in Copenhagen last year, expectations from the market ran high, and disappointment in the outcome was massive. This year, things are different – expectations are low – and it seems we should be quite pleased if we don’t find ourselves taking a step backwards now.

Where we might make some progress is in decisions on Clean Development Mechanism (CDM) projects, mostly on such issues as transparency in decisions from the executive board, streamlining of application and qualifying processes, unbundling of projects, and regulation of the area of forestry – the Reducing Emissions from Deforestation and Forest Degradation.

The carbon market resembles other commodities, but the purpose behind it – reducing global carbon emissions in a cost-efficient way – and the fact this is a compliance market sets it apart from other trading commodities. This means it is harder to analyse the carbon markets and difficult to anticipate future developments.

Still, there are things to watch for that will make a difference for carbon trading in Phase III. Specifically, we are looking at regulatory changes, including target-setting, national allocation and level of auctioning, qualifying and approving of CDM projects, and how all of this affects the forward price curve.

What we know is that Europe – largely due to decreased production after the credit crunch – will likely reach its 20% target by 2020. Now production is picking up and there is more growth in the European economy, which means emissions will start to increase again. There is talk of increasing the target to 30%, but no decision has yet been made. I believe it is necessary to increase the target, not only to achieve the push on industry to make carbon reducing changes in production methods, but also to increase liquidity in the current market.

National allocations to the energy sector are likely to drop close to zero in the next phase. With increased targets, lower allocations and increased level of auctioning, we will probably see better liquidity in the market and more stable price developments.

There has been a great deal of uncertainty about new CDM projects after 2012. In late November 2010, the European Commission decided to exclude HFC-23 from CDM and joint implementation (JI) projects from January 1, 2013. These projects on industry processes currently supply almost two-thirds of the Certified Emission Reduction (CER) market, so this will lead to a significant lowering of the amount of CERs issued. These projects, however few in number, are usually large in scope and generate a great amount of CERs.

In 2010, issuance of CERs from HFC-23 destruction projects that are currently registered and requesting credits has been suspended, awaiting approval by the UN. Depending on its decision, which is expected some time in the next few weeks, we might see a change in the CER market even pre-2013.

Now, although dependent on supply and demand, the carbon price is still largely reactive to changes in regulatory affairs and news from the industry. Although moving in the same pattern as oil and gas prices, correlations over time tend to be quite low. I believe this is due to the compliance component and, although setting the regulations around Phase III will make the market easier to predict, correlation to other energy-related commodities will continue to be significantly lower.

Fraud has been a recurrent problem for the carbon markets. What can be done about it?
AN: I think much has been done already.  Phase I was clearly a learning phase, where a lot of things went wrong. There were possibilities for fraud and these were taken advantage of in a big way. After some arrests were made earlier this year in several countries, VAT fraud has hopefully been put behind us.

Windfall profits have been a recurrent issue, and companies with quota allocations that have become too lenient have been able to cash in on quota sales due to significant lowering of or halting production. This has been noted in several instances, but how it will be dealt with in Phase III, other than stricter allowances, is not yet known. What seem to pose the biggest threat to the market in terms of fraud right now are the CDM and JI projects. Clearly risks run higher here, but it seems the executive boards are making the neccessary changes in the pre-qualifying assessments and approving of projects. This might take some time, but it is on the agendas of the boards, and is being actively handled.

What has been the role of technology in the growth of the environmental markets? How can technological changes benefit the carbon market and help it develop?
AN: Regulatory changes, rather than technology, have primarily triggered the growth – even though it has been the enabler of the growth to some extent. However, we are getting closer to a critical mass of environmental trading in which an additional step change in technology will be needed to allow for further growth. This will require technological upgrades for both the central market places (in particular the certificate registries) and trading system vendors like Navita.

The technology mostly lives up to the requirements, given the current level of trading. However, as trading volumes grow, the need for improvements in direct integration with trading platforms and certificate repositories will be greater.

The biggest challenge for the carbon market from a technology point of view is to standardise the way the communication between participant trading systems, market platforms and registries is handled, in order to enable automated processing on a larger scale.

So far, the changes in the technological landscape of the environmental markets have been very moderate. Many market participants still manage the environmental markets outside their core commodity trading platforms. Others only have the environmental products in their trading system to enable profit-and-loss and risk calculations, but manage the end-to-end process manually. The key developments happened shortly after the introduction of environmental products by the traditional trading systems that were being adapted to handle the new products. But, since this first wave of development, very little has actually happened, primarily due to uncertainty about where the market was going.

Is the technology currently available for green markets up to the job it is designed for, and what do you consider to be the biggest challenges in the current green market?
AN: From a technology perspective I think we are able to handle the EU Emissions Trading Scheme (ETS) in a good way today. Since the first EU Allowance was traded on NordPool in 2005 using Navita’s Pomax software, the regulatory changes in the market have only called for smaller adjustments to the software. It is the trading volumes and integration of green trading into the traditional trading portfolio that is now calling for a new generation of green trading solutions.
There has been a notable change in how the ETS has been handled in the industry from 2005 up to today. Trading of carbon quotas has moved from being strictly a compliance issue in the regulatory affairs unit or even the corporate social responsibility unit of a company, to creeping closer and closer to the trading floor.

However, green trading – or environmental value trading – is, in my opinion, mostly about optimisation. Looking at the ETS alone, production companies, utilities or trading companies will not get the optimal value from the market.

I think that is the main challenge for the software providers today – finding a way to combine the compliance markets in ETS, the various national certificate schemes for renewable energy and the voluntary schemes to optimise the value of the trading portfolios.

One particular challenge is the combination of fragmentation and limited volumes. The fragmentation has led to significant lack of standardisation. This means technology providers need to deal with a significant number of communication channels and, as long as volumes are moderate, it is hard to justify the economical cost for investing in the development needed.

However, we do seem to have reached a critical mass now. At Navita we are following the development in ETS and certificate schemes in energy markets, specifically to customise a software package that can accommodate all of these markets and help our customers obtain optimal value when manoeuvering in environmental markets.